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Unformatted text preview: October 24, 2006 Theorem of the Second Best and Principle of Targeting The theoretical argument in favor of liberal trade is based on ideas con- cerning the e ciency of market outcomes, and on the Principle of Compara- tive Advantage. This Principle implies that under free trade and given that domestic markets are not distorted, a country exports commodities that it can produce relatively more cheaply than its partners. More cheaply is understood in terms of opportunity costs rather than in terms of dollars or labor hours. I review the meaning of opportunity cost using a two- commodity example. Then I discuss the Theory of the Second Best and the Principle of Targeting. Suppose that food and steel are the only two commodities. In this setting, the opportunity cost of steel is simply the number of units of food that the economy must sacri f ce in order to obtain one more unit of steel. The economy converts food into steel by reallocating factors of production from the food to the steel sector. Firms that use the factors of production, and workers and land-owners who supply these factors, maximize their pro f ts, utility, or rent. In an undistorted competitive equilibrium, it is not possible to increase output of one commodity without decreasing output of the other commodity: the allocation of factors is e cient. The opportunity cost of steel equals the equilibrium relative price of steel, p s p f where p s is the nominal price of steel and p f is the nominal price of food. If two economies have di f erent equilibrium relative prices in autarky, then one economy necessarily has a lower equilibrium relative price of steel. That economy has a lower opportunity cost of steel a comparative advantage in steel and it exports steel in a free trade equilibrium. When the equilibrium trade price di f ers from the autarkic prices, trade increases total income in both of the countries. The income of owners of any particular factor of production might fall as a consequence of trade. In general, some agents gain and some lose when relative prices change. However, the income loss of one group is less than the gain of other groups, so total national income increases with trade. In this case, it is possible for the winners to compensate the losers, so that all are better o f as a consequence of trade. (Of course, if the winners do not actually compensate the losers, the latter are worse o f .) 1 The conclusion that trade increases national income depends on the as- sumption that the economies are undistorted. Anything that causes the economy to be at an ine cient equilibrium can be viewed as a distortion, including imperfect competition, missing markets (e.g. absence of insurance markets) or government policies that restrict trade (e.g. tari f s)....
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This note was uploaded on 08/01/2008 for the course ECON 131 taught by Professor Karp during the Fall '07 term at University of California, Berkeley.
- Fall '07
- Comparative Advantage