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9.1 Chapter Overview

Learning Objectives

  1. Understand that the presence of market imperfections or distortions in a trade model changes the potential outcomes of trade policies.
  2. Learn the basic terminology used in discussing the theory of the second best.

Most of the models previously discussed incorporate a very standard economic assumption: namely, that markets are perfectly competitive. This was true in the Ricardian model, the Heckscher-Ohlin model, the specific factor model, and all the partial equilibrium analyses of trade and domestic policies using supply and demand curves in specific markets. The only deviation from perfect competition was in the discussion of economies-of-scale models and monopolistic competition. This is important because almost all the results concerning the effects of trade and trade policies presume that markets are perfectly competitive. But what if they’re not?

Many critics of the economic conclusions about trade argue that the assumptions of perfect competition are unrealistic and that as a result standard trade theory misses some of the important impacts of trade found in the real world. There is much truth to this. By default, perfect competition models include many assumptions that are unrealistic. However, in defense, that is the nature of model building. Simplification is necessary to make the models tractable and solvable. If we were to try to create a model that included many or most of the complexities that we can imagine are present in real-world markets, we would no doubt quickly be overwhelmed with the model’s intractability and might find it impossible to even identify an equilibrium solution. Indeed, in the real world, being in “equilibrium” might even be a rare occurrence.

Criticisms of economic theory along these lines, however, fail to recognize that economic analysis includes many attempts to incorporate market realities. Although it remains difficult to include many complexities simultaneously, it is possible to study them in a piecemeal way: one at a time.

The all-encompassing terms economists use to describe these complexities are market imperfections, or market failures, and market distortions. These cases are worthy of study because it is clear that markets rarely satisfy all the assumptions made under perfect competition. These cases offer compelling arguments for protection, including the infant industry argument, the optimal tariff argument, strategic trade policy arguments, and arguments concerning national security.

Market imperfections or market distortionsAny situation that deviates from the explicit or implicit assumptions of perfect competition., generally, are any deviations from the assumptions of perfect competition. These include monopoly and oligopoly markets, production with increasing returns to scale, markets that do not clear, negative and positive externalities in production and consumption, and the presence of public goods.

When imperfections or distortions are present in a trade model, it is usually possible to identify a trade policy that can raise aggregate economic efficiency. In this chapter many cases are demonstrated in which trade policies improve national welfare. These welfare-improving policies, although detrimental to national welfare when used in a perfectly competitive setting, act to correct the imperfections or distortions present in the market. As long as the welfare impact of the correction exceeds the standard welfare loss associated with the trade policy, the policy will raise welfare.

Trade policies with market imperfections and distortions represent applications of the theory of the second bestDescribes the class of models that consider policy implications in the presence of market imperfections and distortions., formalized by Richard G. Lipsey and Kelvin Lancaster.See R. G. Lipsey and K. Lancaster, “The General Theory of the Second Best,” Review of Economic Studies 24 (1956): 11–32. When imperfections or distortions are present in an international trade model, we describe the resulting equilibrium as second best. In this case, the standard policy prescriptions to maximize national welfare in a first-best or nondistorted economy will no longer hold true. Also, the implementation of what would be a detrimental policy in a first-best world can become a beneficial policy when implemented within a second-best world. For example, tariffs applied by a small country in the presence of domestic distortions can sometimes raise national welfare.

In 1971, Jagdish Bhagwati presented a general theory of distortions in trade situations.See J. N. Bhagwati, “The Generalized Theory of Distortions and Welfare,” in Trade, Balance of Payments and Growth, ed. J. N. Bhagwati, R. W. Jones, R. A. Mundell, and J. Vanek (Amsterdam: North-Holland Publishing Co., 1971). He characterized many of the distortions that can occur and considered which policies could be used to correct each distortion and raise national welfare. He considered not only trade policies but also domestic tax or subsidy policies. He showed that for most distortions, a trade policy is inferior (in terms of the extent to which it can raise national welfare) to other purely domestic policies. The most appropriate or first-best policyThe policy that raises welfare to the highest level possible; with market imperfections or distortions present, the policy that most directly corrects the distortion or imperfection., in general, would be the policy that most directly corrects the distortion or imperfection present in the market. This chapter provides numerous examples of policy rankings and applications of this general rule.

In one case, a trade policy does prove to be first best. This is the case of a large import or export country in international markets. In this case, the first-best policy is the optimal tariff or the optimal export tax.

Thus the results of this section are somewhat schizophrenic. On the one hand, these models offer some of the most compelling arguments supporting protection. For example, one can easily use these models to justify protection when national defense is a concern, when unemployment may arise in a market, when trade causes environmental degradation, or when there are infant industries in a country. On the other hand, in almost all of these cases, a trade policy is not the most effective policy tool available to correct the problems caused by the distortion or imperfection.

Finally, when more complex markets are considered, as when there are multiple distortions or imperfections present simultaneously, our ability to identify welfare-improving policies rapidly diminishes. The theory of the second best states that correcting one distortion in the presence of many may not improve welfare even if the policy makes perfect sense within the partial equilibrium framework containing the one distortion. The reason is that correcting one distortion may have unintentional (and probably immeasurable) impacts in other sectors due to the presence of other distortions. For example, suppose a trade policy is implemented to correct an environmental problem. One might be able to measure the welfare costs of the trade policy and the environmental benefits that would accrue to society and conclude that the benefits exceed the costs. However, the trade policy will have an impact on prices and resource allocation, potentially spreading across numerous sectors. Suppose one other sector, adversely affected, generates positive spillover effects that act to raise well-being for some groups. Then it is conceivable that the loss of the positive spillover effects would more than outweigh the net benefit accruing to society due to the environmental improvement. This means that the well-intentioned and reasonably measured environmental trade policy could result in an unintentional welfare loss for the nation. The more complex is the economy and the more distortions and imperfections that are present, the more likely it is that we simply cannot know what the national effects of trade policies will be.

Key Takeaways

  • In the presence of market imperfections or distortions, free trade may no longer be the best policy, even for a small open economy.
  • Although trade policies can sometimes generate national welfare improvements, trade policies are often second-best policies, meaning that there are other nontrade policies that are superior (called first-best policies).
  • The first-best policy is the policy that targets and corrects the market imperfection as directly as possible.


  1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”

    1. The term describing any assumption that represents a deviation from the standard assumptions of perfect competition.
    2. The term describing a policy that most directly corrects the market imperfection or distortion in a market.
    3. The name of the theory describing the class of models that consider policy implications in the presence of market imperfections and distortions.