COVER STORY • Prospects & Solutions for a Volatile Global Economy • 5Theory & Practice inFree Trade

By Jota Ishikawa

Why is trade conducted between countries? The short answer tothat question is that “the exchange of goods and services between
countries is mutually beneficial.” The bottom line is “mutualbenefits”. However, some of the talking points on this issue revolvearound the notion that one side suffers nothing but losses frominternational trade, with the “mutually beneficial” perspective
nowhere to be seen. This essay will highlight the gains from freetrade and/or trade liberalization from the economic perspective, andthen discuss, mainly from the political economy perspective, why
free trade has a hard time making progress despite the benefits it
supposedly provides.

Why Free Trade Is Good— the Economic Perspective
The most fundamental benefit of trade is that of exchanging goods
and services that have low scarcity in your country for goods andservices that have high scarcity. The benefit is particularly large whengoods and services that are hard to produce, if at all, domesticallyare being imported. Natural resources such as oil and rare metals or
agricultural products such as coffee and bananas are such examples
for Japan. Very few people will deny the existence of benefits fromimporting these products.
The question is whether it is necessary to import goods andservices that can be produced domestically without any problems.
For example, beef can be produced in Japan. Therefore, some people
may think that importing beef is bad because it hurts Japanese cattle
farmers. “Go local!” is a phrase that we sometimes hear. Economists
counter these arguments with “comparative advantage”, thefundamental concept underpinning international trade. Specifically,
even when the goods and services can be produced either
domestically or in other countries, productivity differs acrosscountries. So an international division of labor based on the relative
productivity among countries becomes mutually desirable.
For example, when Japan and Australia are compared, bothcountries can produce beef and automobiles, but Australia canproduce beef relatively more efficiently than Japan, while the20 Japan SPOTLIGHT • January / February 2017

Author Jota Ishikawa

opposite is true for automobiles. This means that Australia canproduce beef relatively more cheaply, while Japan can do the samewith automobiles. So, if Japan exports automobiles to Australia andimports beef from the latter, the relative difference in prices
generates the “gains from exchange” between automobiles and beef.
Furthermore, the “gains from specialization” will enable Japan toshift the factors of production (resources) being used to produce
beef to producing automobiles by importing beef from Australia,
while Australia will be able to shift the factors of production(resources) being used to produce automobiles to producing beef byimporting automobiles from Japan. Behind the resulting increase in
the production of exported goods and the decrease in the productionof imported goods lies the more efficient reallocation of resources
between industrial sectors, which results in a rise in income.
According to traditional theories in international economics suchas the Ricardian and the Heckscher–Ohlin models, an environment inwhich governments do not intervene in the market, i.e. free trade
based on comparative advantages, is preferred from the perspectiveof resource allocation and maximizes the economic welfare of theworld as a whole. There are two points to keep in mind regarding
this conclusion. First, free trade may maximize gains to the world ora country as a whole, but it does produce “winners” and “losers”.
For example, when Japan liberalizes trade more and imports more
beef, domestic consumers gain but domestic producers lose. In
other words, engaging in free trade will not automatically benefit all
the people in that country. But if the groups that lose arecompensated by the groups that gain, then everyone will be able toenjoy the gains from free trade.
One matter requires attention here. According to the strict
theoretical analysis under the Heckscher–Ohlin model, the impact offree trade differs between the short term and long term. While
everyone engaged in an import competing industry loses in the shortrun, that will not be the case over the long run, as there is a shift of
the factors of production (i.e. resource reallocation) from the importcompeting industry that suffered losses to the export industry thatgained benefits. Furthermore, it is known that when multiple factorsof production such as labor, land, and physical capital are being used

in an import competing industry, there will be winners and losers inboth export industries and import competing industries in the longrun (the Stolper–Samuelson theorem). For example, liberalizing
agricultural imports results in immediate losses for everyone
engaged in agriculture including landowners and agriculturallaborers. But in the long run, the landowners may lose, whilelaborers may gain.
Second, traditional theoretical models assume that “there are nomarket failures”. More specifically, they assume that the market isomnipotent and functions perfectly in that there is perfectcompetition in the market, all economic activities are being traded in
the market, and so on. However, in reality, it is all but impossible forthis premise to be fulfilled. That said, it is important to note that thegains from trade will exist even when there are market failures.
Take a case where the market is not perfectly competitive, the caseof imperfect competition where a small number of firms control themarket. If the firms control the market because they are protectedfrom foreign competitors, free trade will promote competition in thedomestic market. In the opposite direction, there is the followingcase where domestic producers benefit. One reason why markets
become imperfect is “economies of scale”. Economies of scale meanthat the average cost of production declines as the quantity ofproduction increases. When free trade expands the market for exportindustries, export industries with economies of scale will be able toenjoy them even more.
Traditional models basically explain trade between industries,
which implies that there will be no trade between two countries ifthey are identical in every aspect. However, in international trade in
the real world, there is more intra-industry trade than inter-industry
trade, particularly with regard to intra-industry trade between similarcountries (especially with regard to manufactured products). The key
to explaining intra-industry trade is imperfect competition. For
example, benefits to the consumer (i.e., utility) increase as free trade
increases the variety of goods available according to a model thattakes product differentiation based on imperfect competition intoconsideration. There are two kinds of increase conceivable here. Firstis the notion that in consuming, say, two units of a product withsignificant product differentiation, the utility for the consumer isgreater when he/she consumes one unit each of two differentiatedproducts than two units of a single product. To put it in another way,
when purchasing two cars, the utility for the consumer will begreater with the purchase of a Lexus and a Mercedes Benz instead of
two Lexuses. Another is the notion that the utility to the consumer isenhanced when trade broadens the variety of goods in the same
category so that he/she is able to acquire goods that are moreclosely aligned with his/her preferences. For example, tradebroadens the variety of watches that are available for purchase, so it
becomes easier for a consumer to acquire a watch that is closer toher or his ideal watch even when only one watch is being purchased.
Marc Melitz at Harvard University focused on the heterogeneity inintra-industry productivity and used a product differentiation model
to show that economic welfare is increased as the productivity of anindustry as a whole is enhanced through trade liberalization thatforces low productivity firms to exit from the market.
Some technologies and knowledge spill over even without being
the subject of licensing agreements or other market transactions.
Free trade encourages the spillover of superior knowledge andtechnologies from abroad. New technology, for example, is often
embedded in imported products, and the new technology andknowledge are encountered and absorbed by importing them. This
benefit is particularly important for developing countries. Free trade
can also increase technology and knowledge spillovers across firms
domestically as clustering of export industries progresses, resulting
in productivity gains.
Finally, let me take note of how import liberalization encourages
exports. When the cost of acquiring intermediate inputs fromoverseas declines as trade barriers against intermediate inputs
disappear, final goods can be produced more cheaply, which helps
the exports of final goods. When demand for final goods increases
as trade barriers against final goods disappear, the demand for theintermediate inputs that go into those final goods also grows. If a
country that imports final goods also produces intermediate inputs,
it may be able to increase the exports of intermediate inputs as aresult. Furthermore, ships, aircraft and other means of transportation
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COVER STORY 5

normally take on other cargo after they unload their original cargo.
Since logistics businesses would like to carry full loads on both legsof a two-way journey, it is conceivable that an increase in imports
will lead to an increase in exports.

Why Progress on Free Trade Is Stalled— the Political Economy Perspective
According to a questionnaire survey that asked 10,000 Japanese
their opinions on the statement “Imports should be more liberalized”(E. Tomiura, B. Ito, H. Mukunoki and R. Wakasugi, “IndividualCharacteristics, Behavioral Biases, and Trade Policy Preferences:
Evidence from a Survey in Japan”, Review of International
Economics, 24(5), 2016), 51.5% of the responders chose “Stronglyagree” or “Somewhat agree” against more than the 31.5% whochose “Strongly disagree” or “Somewhat disagree”. The reason why
protectionist trade policy is more readily maintained or adopted eventhough people who favor import liberalization are in the majority
must be because it is more difficult to have the views of the“winners” of import liberalization incorporated in the policymaking
process, while it is easier to have those of the “losers” incorporated.
It is also notable that 17% responded “Cannot choose or Unsure”,
showing that they did not or were not able to provide a clear opinion.
These numbers indicate that the downside of trade protectionism
is not fully understood. It is mainly the consumer who loses fromprotectionist trade policies. However, there is little awareness among
consumers that they are bearing the burden of tariffs or that they are
the losers when it comes to protectionist trade policies. One thingthat is little understood is that the effect of tariffs is equal to thecombined effect of a production subsidy and a consumption tax.
Tariffs raise not only the prices of imported products but also theprices of domestically produced products that compete with them.
But since the retail prices at storefronts already include the price hiketo accommodate tariffs, it is difficult for consumers to discern how
much the prices (of domestic products in particular) are being driven
up by tariffs.
Food product prices are increased in Japan because agricultural
22 Japan SPOTLIGHT • January / February 2017

products and food products are burdened with high tariffs. Since theproportion of food in household expenditures, or Engel’s coefficient,tends to have a negative correlation with income, the low income
class suffers relatively larger losses from trade protectionism, a factthat unfortunately does not appear to be widely recognized by theJapanese public.
Economic theory usually posits maximizing overall national
economic welfare as the purpose of government, a necessary andindispensable presumption in considering “what government shoulddo” from a normative point of view. However, careful observation ofgovernment objectives and behavior is required to figure out why it
is difficult to make progress on trade liberalization in the real world.
The key point is that the actual policies are also affected by theimpact of the policies on the politicians and government officials
themselves. For example, a politician, mindful of the next election, islikely to adopt policies that lead to winning votes. A typical example
is that Hillary Clinton had promoted the Trans-Pacific Partnership(TPP) as secretary of state, but flipped completely when she becamea presidential candidate and turned against it.
Gene Grossman at Princeton University and Elhanan Helpman at
Harvard University analyzed trade policy by explicitly incorporating
campaign contributions from producers into their trade models. The
existence of political financing means that the objective ofgovernment is no longer the simple maximization of economic
welfare of the nation as a whole. If industries competing withimports make contributions, the government will give more weight tothe interests of those industries within the overall economic welfare
when designing trade policies. Progress for free trade is stalled as
the result.
People involved in the agriculture industry form the core of theopposition to free trade in Japan. Why do they maintain their politicalinfluence despite the fact that the agricultural sector has been
shrinking? This can be explained convincingly by collective action
theory, developed by Mancur Olsen.
Suppose that there are 100 million people (winners) who will gainfrom trade liberalization with collective benefits that add up to 10
trillion yen, and 1 million people (losers) who will suffer losses that

add up collectively to 8 trillion yen. The economy as a whole will
acquire a net benefit of 2 trillion, so it stands to reason that it is betterto liberalize trade, yet it proves to be difficult to achieve. This isbecause the benefit accruing to the winners is 100,000 yen each while
the loss accruing to each loser is the princely sum of 4 million yen.
The key here is that there may be a net benefit to the economy as awhole, but that is often widely shared and consequently thinly
spread, while the losses are concentrated among a small number ofpeople. Since the amount of loss per loser is large, the losers acquiresignificant political power by taking active political action such as
petitioning Diet members and providing political funds. If the amountof the loss is the same but the number of losers decreases, the loss
accruing to each individual becomes larger. In other words, theincentive to resort to political action could become stronger when
the number of losers becomes smaller. Moreover, the smaller thegroup, the easier it is to mobilize the vote. In this case, Dietmembers can secure political funds and votes more easily and moresecurely by siding with the losers.
According to collective action theory, political action by special
interest groups created by the minority sustains protectionist trade
policies. Now, one may think that the majority should prevail when it
comes to actual elections, so things shouldn’t have to end up theway collective action theory says. But the same mechanism ascollective action theory is at work in elections as well. For example,
suppose that there are two candidates standing for election in aparticular district, one who supports free trade, and the other whoopposes it. Also suppose that the majority of the eligible votersbenefit from free trade and the others lose. If all eligible voters vote,the candidate who supports free trade should be elected.
However, it is important to take note of the fact that voting itself
entails costs. The voter bears not only the transportation cost of
going to the voting station but also the opportunity cost of giving up
other things he/she could have done such as going for a drive. Sincevoting comes with a cost, the voter will only vote when the benefitsof voting are greater than the cost of voting. Since the benefits offree trade are widespread but individually small, many voters in thegroup of people who will gain from free trade will not show up tovote, creating the very real chance that the candidate who opposes
free trade is elected.

Conclusion
In this essay, I began my discussion of the benefits of free tradefrom an economic perspective. However, liberalizing trade makes forhard going in the real world, the reasons for which I explained interms of political economy. I would like to conclude with a few morecomments.
First, free trade is not without its merits from a political economy
perspective as well. A government that is staunchly committed tofree trade will be able to reduce the opportunity for rent-seeking. In
other words, if free trade is unshakable despite political pressure, thepressure itself will subside, with the result that resources will not bewasted. It is also necessary to note that if the government seeks toadopt a trade policy that actively maximizes economic welfare, anenormous amount of information becomes necessary, which in turnincurs enormous costs. This leads to the argument that free trade
should be adopted as a second-best solution to avoid the cost of
acquiring that information.
Behavioral economics also offers explanations for the difficulty inmaking progress on free trade. Human beings tend to overvalue
losses compared to gains. Even when the gains from free trade are
greater than the losses, people will oppose free trade if they
overvalue the losses. The tendency to value losses over gains also
leads to status quo bias. This leads to the tendency to avoid altering
the status quo (in this case liberalizing trade) unless there isconsiderable dissatisfaction with it.Jota Ishikawa is professor of International Economics at the Graduate Schoolof Economics & the Faculty of Economics at Hitotsubashi University. He
received his Ph.D. in Economics from the University of Western Ontario in1990.

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