Informationally Efficient Trade Barriers∗

Why are trade barriers often used to protect home producers, even at the cost of introducing deadweight losses from higher commodity prices? We add an informational friction to the standard textbook argument in favor of free trade, and show that trade restrictions may be a more efficient policy than a lump sum transfer to the displaced producers. Trade barriers, while generating deadweight losses, have the benefit that they do not generate a need for compensation. When the policy maker does not know the amount that should be transferred, the risk of over-compensating may make trade barrier more efficient. ∗Email: [email protected] and [email protected]. We thank V.V. Chari, Tom Holmes, Ray Riezman, and Narayana Kocherlakota for helpful comments. Why are trade barriers often used to protect home producers, even at the cost of introducing deadweight losses from higher commodity prices? According to a standard textbook argument in favor of free trade, in order to maintain the welfare of the home producers at the pre-trade level, a combination free trade and a lump sum transfer to displaced home producers is a more efficient policy than trade barriers. The reason is that trade barriers imply higher commodity prices, which cause deadweight losses for the consumers. This paper shows that this argument hinges on the assumption that the policy maker has complete information about the losses suffered by the displaced home producers. We relax this assumption and show that trade barriers can be the informationally efficient policy instead. We add the informational friction to focus on the informational problem associated with implementing the textbook “winners compensate losers” argument. Seemingly inefficient trade barriers arise only as the optimal response to the information constraints. The policy has an interesting form: the losers choose between a fixed transfer (which can be interpreted as a workers assistance program) and the trade barrier. Our explanation relies on the intuition that trade barriers, while inefficient, have the benefit that they do not generate a need for compensation. When the policy maker does not know the amount that should be transferred, there is a risk of over-compensating. Compensating with a transfer is expensive because it induces losers to over-report their losses in order to receive a higher transfer. There have been several attempts to explain the apparent contradiction between the textbook free trade argument and the empirical fact that trade is, for the large part, not free. We believe this paper provides a novel explanation to the puzzle (see Section 1). We introduce in Section 2 a very stark model. Consumers in a small open economy benefit from trade through lower world prices. Home producers may lose from being displaced; this loss is simply a parameter, meant to embody the various ways in which displacement may be costly. We do not model explicitly the nature of competition, since we are interested only in constructing a particular set of outcomes and comparing them to the complete information optimal policy, which, by textbook logic, corresponds to free trade. In an attempt to make the results as strong as possible we assume that the foreign good is always cheaper than the domestic good, and that the difference is larger than the loss suffered by the displaced home producers. Therefore, under complete information, the consumer would always choose to consume the foreign good and compensate the home producer with a transfer. By doing so, we are intending to make it as difficult as possible to get trade barriers to arise. We do not model the aggregation of consumer’s preferences and assume that a representative consumer dictates the trade policy. We also do not model the reasons