Macroeconomics, Trade, and Social Welfare

Since the collapse of the Bubble in the early 1990s, the expenditures of the government of Japan have continued to expand for more than 20 years, but have failed to improve business conditions, leaving the national rate of unemployment at high levels. In the meantime, the government deficit increased and consequently the balance of the government bond accumulated enormously. This experience cast doubt on the effectiveness of fiscal policy intended to increase the aggregate income and employment in Japan. The Keynesian multiplier theory that originated in the midst of the great depression of the 1930s has served as the cornerstone of fiscal policy in the standard textbooks for a long time. It emphasized multiplier effects of government deficit expenditure on national income and employment, symbolizing the Keynesian revolution in the history of macroeconomic policy. The recent experience of the stagnation of Japan and other countries, however, has revealed that the multiplier effect was not so large as believed in the past. Moreover, frequent use of fiscal policy undermined government fiscal discipline, giving rise to inefficient resource allocation in Japan as well as in many other countries.

We have witnessed at least two distinct types of economic depression in the current century, aptly named “stagnation” and “stagflation,” respectively. Stagnation refers to the situation in which the general price level (or the rate of inflation) declines together with the quantitative indices of aggregate economic activities such as output and employment. Needless to say, a most important example of stagnation is the Great Depression, which began in 1929 and extended into the 1930s. In contrast, an economy is said to suffer from stagflation when the general price level (or the rate of inflation) rises in the face of falling output and employment. This form of depression was observed most typically in industrialized countries from the late 1960s and through the 1970s when they were exposed to wage explosions, oil price hikes, and other cost-increasing pressures.

In his 1939 article, Samuelson initiated the modern discussion of the gains from trade. Concerning himself with a small price-taking country and basing his cases on the compensation principle and the axiom of revealed preference, he established that the introduction of external trade could make all citizens better off. His approach received a considerable amount of notice, but no further result came of it for some time. It was not until two decades later that Kemp (1962), along with Samuelson (1962), revived the subject by showing, under a more general condition, that the consumption possibility frontier of the post-trade situation lies uniformly outside that of the pre-trade situation. Their findings, however, seem to call for further generalization.

The theory of tariffs, which evolved from the classical controversy over free trade and protectionism, occupies an important position in the study of trade and welfare. Early in the present century Bickerdike (1906, 1907a, b) formalized the proposition that a country is able to increase its real income by imposing a tariff on imports. The theme, labeled by Edgeworth (1908) as “poison,” was later revived by Kaldor (1940) and thus achieved general recognition in the literature. Known today as the optimal tariff argument, it postulates fully competitive conditions, and relies crucially upon the assumption that the tariff-imposing country is potentially capable of affecting the international prices by restricting the volume of trade. In the absence of such national monopoly power, however, the argument ends up in endorsing the doctrine of free trade as the best policy for the country.

The transfer problem has attracted much attention in the literature of international trade theory since the famous controversy between Keynes and Ohlin in the late 1920s. Practically, the international transfer of purchasing power is widely observed in various guises such as private remittance, reparation, and economic aid. Theoretically, it poses an interesting question concerning the income effect of income transfers between countries. This question lurks also in the analysis of currency devaluation, often conceived as an attempt to affect the international terms of trade to create a trade surplus. Discussing the German reparation problem, Keynes (1929) held the position that the expenditure of the German people will be reduced, not only by the amount of reparation, but also by a decrease in their gold-rate of earnings. As Ohlin (1929) pointed out quickly, however, Keynes thereby failed to pursue the logic of his own argument: “if ₤ 1 is taken from you and given to me and I choose to increase my consumption of precisely the same goods as those of which you are compelled to diminish yours, there is no transfer problem.” (See Keynes 1929, p. 2.) Later analysis, notably Samuelson (1952, 1954) and Johnson (1955), elucidated the implications of this logic in the context of a two-country, two-commodity model of trade. They showed that the direction of change in the terms of trade depends crucially upon the relative magnitude of the marginal propensities to consume between the two countries. There is, however, no presumption about this relative magnitude under free trade with no trade impediments.

Innovation plays a key role in the theory of economic growth, but it contains different elements. Roughly, these can be divided into two distinct categories: process innovations and product innovations. The former may also be named “cost-reducing innovations” in the sense that they take place through the discovery of new processes to produce the old products at lower costs. In contrast, the latter may be called “quality-improving innovations” because they occur through the creation of new products with higher qualities. Both categories of innovations are of course important as the engines of economic development, but their implications for economic welfare can be vastly different from time to time and from place to place. In poor economies in the early stage of development, process innovations in the daily necessities contribute significantly to the life of people. In affluent societies in the modem age, however, “it would be a terribly dull life if innovations only reduced costs of producing the same menu of goods and services that now populate their markets (Oi 1997, p. 134).” Product innovations are crucially important in such a situation. This chapter compares the welfare implications cost-reducing and quality-improving innovations in the context of modern international economies in which both poor and affluent countries coexist. Standard textbooks on trade theory teach that a growth in a country’s export industry could be a curse rather than a blessing for its economic welfare. They argue that it brings about a deterioration of its terms of trade, thereby necessarily benefiting its trading partner but possibly damaging its own welfare when the direct gain from the innovation is relatively small. This proposition is, however, based on the implicit assumption that the growth occurs through a cost-reducing innovation and is definitely untenable if it is the outcome of a quality improving innovation. In fact, a quality-improving innovation in any product will generally increase its demand and lead to a rise in its relative price. The traditional literature on trade and growth has apparently overlooked this point because of its unwarranted preoccupation with cost-reducing innovations. In the real world, there are many important quality-improving innovations as well as cost-reducing innovations. For instance, the high rate of growth of the Japanese economy in the 1960s and 1970s may be explained by a series of both types of innovations achieved in important modern manufacturing industries such as steel, automobiles, electric machinery, precision and machine tool instruments, etc., originally imported from the West. The stagnation of the Japanese economy since the 1980s may be attributable to the decrease of quality-improving innovation after the completion of the process of catching up to the West. In the twenty-first century, however, we will perhaps witness a new surge of product innovations related to the conservation of energy and environment such as solar generators and electric vehicles.

In the traditional theory of international trade, it is customary to assume that the factors of production are prohibited from moving from country to country for some reason or another. This assumption of factor immobility has an important function, especially in the theory of comparative advantage. The standard Heckscher–Ohlin theory explains the pattern of commodity trade in terms of factor endowment proportions of different countries on the assumption that no factors of production are internationally mobile (for an excellent recapitulation and generalization of the doctrine, see Dixit and Woodland 1982). In reality, however, some factors are known to move across national borders, as exemplified by the international transfer of entrepreneurial resources and labor services (often through direct investment), as well as by international capital movements.

Free trade agreements (FTA) have surged after the advent of the EU and the NAFTA in the 1990s. On the other hand, the World Trade Organization (WTO) was started in the mid-1990s to succeed and strengthen the General Agreement on Tariffs and Trade (GATT) as the organization to promote global free trade. For the time being, the FTA and the WTO, the seemingly inconsistent organizations, are serving as the twin engines of international trade. The important question is how they can be made compatible to each other and under what conditions. Bagwell and Staiger (2002) argued convincingly that the view of the WTO as a forum for expanding and securing market property rights serves to deal with global labor and environmental issues it faces. In this chapter, we shall also argue that the FTAs conformable with the same view of WTO are potentially beneficial to the welfare of the world.

The recent theoretical research in economics has paid much attention to imperfect competition and increasing returns to scale, uncovering new and useful findings about the market behavior of firms and their implications for economic welfare. More often than not, the analysis of these phenomena has been carried out within the framework of partial equilibrium models. This is a notable, and perhaps inevitable, turnabout from the dominance of general equilibrium analysis in the 1950s to 1970s. The traditional general equilibrium models à la Arrow and Debreu (1954) and McKenzie (1959) are appropriate for the proof of the existence of general equilibrium, but their generality restricts the comparative-static (or dynamic) analysis of practical economic problems even under the assumption of perfect competition. The same comment applies, a fortiori, to Negishi’s (1961) ingenious extension of the Arrow–Debreu model to the case of monopolistic competition. Although partial equilibrium models are useful for the analysis of a single industry (or a set of closely related industries), they are inadequate in addressing its relationships with the rest of the economy, both through their negligence of income effects and because of their loose recognition of the inter-industry flow of resources. I need to develop tractable general equilibrium models incorporating imperfect competition and increasing returns at the expense of generality. The present chapter takes a small step forward in this direction.

In recent years, we have witnessed a number of critics and commentators who argue that the pursuit of efficiency spoils the realization of social values such as security, health, environment, and fairness. Is it really true that the pursuit of efficiency impedes social values? What are the social values to begin with? Are they to be distinguished from the individual values in the narrow sense defined in economics? In this chapter, we intend to review the relevant concepts and elucidate the relationship between social values and efficiency.

The fundamental theorems of welfare economics prove under stringent conditions that the free market mechanism leads to the efficient allocation of economic resources. It is highly regarded as a theoretical underpinning of the “invisible hand” (Adam Smith), but generally inapplicable to the real economies in modern societies where externalities abound that cannot be addressed by the market mechanism. First, social needs for public goods are increasing in the face of rapid industrialization and urbanization. They call for construction and maintenance of stronger industrial infrastructure and further improvement of environmental and educational facilities. Second, governments are often required to employ taxes and subsidies to alleviate pollution, congestion, and depletion of natural resources stemming from Marshallian externalities interacted among a large number of citizens. The purpose of this chapter is to provide a comprehensive theoretical framework for mixed economies facing the problems of externalities and public goods.