The Theory of Second Best
An exercise in humility
One thing you will have learned from all the recent tariff talk—assuming you did not know it already—is that economists generally do not like tariffs. In fact, they tend to despise tariffs. Many of us belong to the “let free trade rule and all your wildest dreams will come true” tribe. Why is this? Two reasons: theory and evidence.
The theoretical case against tariffs is laid out beautifully by ASU economist Domenico Ferraro here. Start off in a “perfect” world—the first best. Then add a distortion, like a tariff. No surprise, everyone is made worse off.1 I like this thought experiment because it identifies very clearly the incentive effects of tariffs and how they are likely to influence the decisions made by households and firms. But it’s not where the analysis should end.
And, indeed, this is not where Domenico ends his analysis. The very next section of his article is labeled “A Case for Moderate Tariffs.” Suppose we start off in a less-than-perfect world. Ferraro takes as his example the “new trade theory”—a body of literature that emphasized non-competitive market structures. When one starts off in a less-than-perfect situation, adding a price distortion like a tariff need not make the situation worse. Indeed, the situation may even improve. And so, there may be a case to be made for “moderate” tariffs.2 He is quick to caution, however, that these moderate benefits are likely to disappear if countries engage in retaliatory measures.
In any case, the subject of this post deals with the second step in Domenico’s analysis—the idea that introducing a tariff (a distortion in the system) might actually improve economic welfare. The phenomenon is much more general, as Richard Lipsey (my former colleague!) and Kelvin Lancaster pointed out back in their 1956 article The General Theory of Second Best. Here’s an excerpt:
An implication of this theorem is that if the economic system is subject to a policy-induced distortion, removing the distortion will not necessarily improve overall economic efficiency. It may. But it may not. We cannot say a priori without further information. In the same vein, the application of an additional distortion to an already distorted system will not necessarily reduce economic inefficiency. Indeed, it may improve it. We cannot say a priori one way or another (hence, an exercise in humility).
Domenico cites a literature that focuses on distortions attributable to market power. But there are many other “distortions” or “frictions” (e.g. incomplete markets, incomplete information, asymmetric information, lack of commitment, etc.) one can consider. The effect of any given tariff may vary depending on the way economies are structured and organized.
At the end of the day all this means is that economists need to be careful in assessing policy proposals that appear “distortionary.” Basic theory can be used to identify their direct impact on decision-making (e.g., substitution effects). Extended theory tailored to model important details of the current environment can be used to assess robustness and likely welfare implications. While empirical evidence can also be brought to bear on the question (e.g., here and here), the findings may be of limited applicability to the United States—a large, diversified, and vibrant economy that also supplies the global reserve currency (exorbitant privilege).
I sometimes wonder whether America would get on well enough without much international trade (abstracting from painful adjustment costs of returning to that scenario). There is a feeling among many that America’s exorbitant privilege (manifesting itself as large and persistent trade deficits) has not served America—at least, certain parts of it—very well. If so, then might tariff policy be a “second-best” way of reducing persistent trade imbalances (encouraging domestic production and employment in the tradeable goods sector)? Most economists (e.g. here) argue that tariffs will not reduce the trade deficit because any reduction in imports is likely to be offset by a reduction in exports (assuming any tariff will cause an appreciation of the US dollar). The argument seems a little slippery to me. A sufficiently large tariff would be equivalent to a blockade. Not that I’m recommending such a policy, but surely this would have the effect of eliminating imports. If it eliminates exports as well, the trade balance goes to zero.
The Theory of Second Best is something to keep in mind when evaluating policy. I’m not sure how applicable it is to the theory of bargaining, which is what really seems to be going on with the new administration these days. Perhaps belligerence in international negotiations is fashionable these days. The uncertainty that the approach is generating seems hard to rationalize even from a second-best perspective.
More generally, some individuals may gain at the expense of others, but with the gains insufficient to compensate the losses incurred by others.
I am not sure what justifies the use of “moderate” in this context. Presumably it is based on what is found in quantitative versions of this class of models.