If justice someday prevails, and Jagdish Bhagwati (my great guru) is finally awarded the Nobel Prize in Economics, it will mark a shamefully belated recognition for the most important international trade economist of his generation—that generation falling between Bertil Ohlin and James Meade, who shared the prize in 1977, and Bhagwati’s student, Paul Krugman, who won solo in 2008. (Robert Mundell, my other guru, won the prize solo in 1999, but that was principally for his work in international monetary economics rather than international trade.)
From a voluminous and influential oeuvre, if one had to select a single scientific paper of Bhagwati’s on which to make a case for the Nobel, it would be, without doubt, Domestic Distortions, Tariffs, and the Theory of Optimum Subsidy, written with the late V.K. Ramaswami and published in the Journal of Political Economy in 1963, which remains a landmark in the postwar theory of commercial policy.
Bhagwati and Ramaswami’s 1963 paper marks a watershed because it establishes clearly, and for the first time, rigorously specified conditions under which free trade is, and is not, optimal, in the presence of market failures—what the authors term distortions.
Before their paper, there was a consensus that free trade is always best for a small economy (that is, which is a price-taker in world markets) in which domestic market failures are absent, and that, for a large economy, which can influence the prices of the goods it buys and sells but is otherwise free from market failures, the best policy is an optimal tariff.
Where the confusion lay was in deciding the optimal policy for an economy characterized by domestic market failures—say, the presence of externalities in production or consumption or labour market rigidities such as wages.
It was understood that a tariff could improve a nation’s welfare in such a case—which appeared to vitiate the case for free trade. After all, most real world economies are characterized by one or more domestic market failures, so the case for free trade would appear to a theoretical curiosity, and tariff protection would appear to make sense in the majority of situations.
It was vaguely realized that a tariff might not be optimal, though, and there might be a better way to correct the domestic market failure without tampering with free trade.
Bhagwati and Ramaswami elegantly cut through the thickets of confusion in one fell swoop, and established what has come to be known in the literature as the targeting principle: the optimal policy intervention is that which targets the market failure directly, rather than indirectly. Thus, if the market failure is an externality in production, the best policy response will be a production subsidy which boosts the production of a good which confers a positive externality or retards the production of one which confers a negative externality.
Crucially, they showed that if the optimal policy intervention is used, the second best case for tariff protection disappears, and the economy gets back to its original, so-called first best situation.
The upshot is that the case for protection is heavily circumscribed and could only apply in those cases where the market failure is truly international (as in the large country, optimal tariff case), or in which the optimal domestic policy intervention is, for some reason, unavailable.
This, and subsequent contributions inspired by Bhagwati and Ramaswami’s seminal paper, constitute the fundamental intellectual rationale for free trade that economists and policymakers rely on to this day. On the strength of this single contribution alone, Bhagwati deserves that long overdue midnight call from Stockholm.
Vivek Dehejia is a professor of economics at Carleton University in Ottawa, Canada. He is a former student of Jagdish Bhagwati.
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