Tuesday, February 22, 2011

Free Trade, Efficiency, and a Punch in the Nose

Mark Thoma brings us the good news that William Polley is blogging again (I know how you feel, William!), and directs us to "Should Losers from Free Trade be Compensated?"

Following this discussion, and particularly after reading Uwe Reinhardt's contribution from the other day ("How Convincing is the Economists' Case for Free Trade?") I am reminded of a parable that one of my graduate school professors would tell to his Econ 101 students. That professor, by the way, was named Uwe Reinhardt.

Anyway, here's my retelling of Uwe's parable:

Economic Efficiency and a Punch in the Nose

Suppose that there is a guy who used to be a competitive boxer. He was very good and very successful, but probably took one too many knock-out blows during his career. At any rate, after he retired from boxing he missed the thrill of the fight, and in particular he really missed punching people in the nose. (Don't ask me why, but for some reason, he really liked punching people in the nose. Which probably had something to do with why he was such a good boxer.)

One day his urge to punch someone in the nose becomes overwhelming to him. So he goes to his neighbor, who's a nice guy who has never boxed before - let's say he's an economist - with a proposition. He says: "Hey Bob, maybe we can help each other out. I really miss hitting people. Unfortunately, I can't just go around hitting people when I feel like it, at least not without getting arrested. But on the other hand, I do have lots of money. What would you say if I offered to give you $5,000 in exchange for you letting me punch you in the nose?"

Bob thinks about this for a minute, and figures that he would be quite happy to endure a bloody nose, and a couple of days of soreness and bruising, in exchange for $5,000. In fact, he really would have been willing to do it for $3,000, though of course he's not going to tell the boxer. So they shake hands and make the deal.

Now, an economist (Bob, for example) would say that this transaction is economically efficient, as is obvious once you realize that it will increase GDP by at least $5,000 as the boxer purchases this new "service" from Bob. Furthermore, the transaction will also make everyone better off, and thus be what economists call pareto optimal. The boxer will be better off than he was before, or he wouldn't have proposed the deal. The economist will be better off than he was before, because to him it will be well worth getting punched in the nose if he gets $5,000. Heck, he would have been willing to do it for $3,000.

Okay, fast forward to the moment of truth. The boxer winds up and gives Bob a good punch on the nose. Bob howls in pain, his nose starts streaming blood, and the boxer feels immensely better. A few minutes later, Bob is sitting down with an ice-pack on his nose, and asks the boxer for his $5,000. The boxer replies by saying that he's changed his mind, and he doesn't actually want to give the economist $5,000. And then the boxer (who was a good economics student in college) adds: "Hey, don't be glum. Yes, you got punched in the nose. Yes, you didn't get the money. But together we made the world a better place - we improved world welfare!"

The economist thinks about this for a moment and then agrees. "You're right," he says. "I only lost about $3,000 worth of happiness by getting punched in the nose. You gained more than $5,000 worth of happiness by punching me in the nose. Together we have increased welfare and made the world a happier place, even though you screwed me over."

Would anyone (with the exception of some economists) agree with the conclusion that the boxer punching Bob in the nose - and then not paying him what he had promised - makes the world a happier place? Yes, it's an economically efficient outcome. But is that really what matters here?

It's the same with trade, whether it's international trade or trade between two people in the same country. Trade is economically efficient. But there are always winners and losers, and if the losers aren't compensated for getting punched in the nose, then it's pretty tough to argue that trade has necessarily led to a good outcome.


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