Global Journal of Economics Vol. 1, No. 1 (June 2012) 1250008 (9 pages) World Scientific Publishing Company DOI: 10.

1142/S2251361212500085

THE GAINS FROM INTERNATIONAL TRADE AND INTERNATIONAL AID IN THE PRESENCE OF PUBLIC GOODS

MURRAY C. KEMP
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University of New South Wales, Sydney, NSW 2032 murraykemp@optusnet.com.au BINH TRAN-NAM School of Taxation and Business Law, University of New South Wales, Sydney, NSW 2032 b.tran-nam@unsw.edu.au It is well known that if the autarkic and free-trade equilibria are perfectly competitive with market distortions limited to non-negative taxes on imports and exports then free trade is potentially (after country-specific lumpsum compensatory transfers) beneficial for each trading country. It can now be shown that, even in a context of public goods of any kind, free trade (after country-nonspecific lumpsum compensatory transfers) is potentially beneficial for each trading country, whether or not the countries also extend aid in public goods to each other. Keywords: Gains from trade; gains from aid; public goods; public goods association. JEL Classification: F11, F13, H41

1. Introduction It was shown by Kemp and Wan (1972) that free trade is potentially (after countryspecific compensatory lumpsum transfers) beneficial for each trading country if the autarkic and (post-compensation) free-trade equilibria are perfectly competitive and if market distortions are limited to non-negative taxes on imports and exports. However the KempWan conditions are merely sufficient; it has recently been shown by Kemp and Shimomura (2001) that free trade is potentially beneficial for each country in any CournotNash equilibrium in which the strategic variables of
* Paper presented at the 9th Biennial Pacific Rim Conference of the Western International Economic Association hosted by the Queensland University of Technology, April 26 29, 2011. An earlier version of Section 2 may be found in Kemp (2011). The present paper offers a fairly complete analysis of finite normative trade theory in the presence of public goods. We are grateful to Geoffrey Fishburn, Ngo Van Long and Henry Y Wan, Jr for their helpful comments on earlier drafts.

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each household are elements of its consumption and output vectors and of its vector of derived demands for factors of production, and from which variable returns to scale are not excluded. The new proposition is quite general in scope. It accommodates arbitrary numbers of industries, primary factors of production and trading countries. Moreover, preferences, technologies and factor endowments may differ arbitrarily among the households of the world; even returns to scale may differ from household to household. Most important, the proposition does not require that perfect competition prevails in each country: oligopolistic behaviour is now the rule; indeed the proposition even accommodates trade-induced changes in the strategies of individual households. In short, there is now available a substantial new result in the normative theory of international trade. Our primary purpose in writing the present paper is to show that a second new result, of vastly different content, is also available. The additional result is concerned with competitive economies that produce and/or consume public as well as private goods. It can now be shown that, even in the context of public goods of any kind, free trade (after country-nonspecific lumpsum compensatory transfers) is potentially beneficial for each trading country, whether or not the countries also extend aid in public goods to each other.1 Under autarky a country may consume public goods that are produced at home or are produced abroad and on which the home country freely rides. Moreover it is now generally accepted that if under autarky countries produce and/or consume pure (non-excludable and non-rivalrous) public goods then only under special circumstances is competitive free trade potentially (after compensation) beneficial for all countries; and it is also known that this is true whether or not the voluntaryfinancing mechanism of Lindahl (1919) is independently functioning in each country.2 Indeed these statements are valid for public goods of any kind: they may be consumption goods, intermediate goods or both; and they may be strictly local
1 The

normative trade theory of 1972 (produced by Kemp and Wan, and Grandmont and McFadden) was derived from the Walras ArrowDebreu McKenzie (closed-economy) model of general equilibrium. That model is based on three dubious assumptions: each household is constrained by its preferences and a single (financial) budget; each household is a price taker; and all commodities are private goods. The present paper is concerned only with the last of these assumptions. The remaining assumptions are considered in a companion paper (Kemp, 2012). Of the quartet (Walras, Arrow, Debreu, McKenzie) only Walras recognized explicitly that his analysis was based on the complete neglect of public goods. This is clear from the definitive edition of the Cours, translated by Jaff in 1954; see p. 257 of Jaffs translation. That Walras was explicit on this point in all editions has been confirmed by Docks et al. (1988). 2 Lindahls analysis of 1919 was based on the earlier work of Wicksell (1896) and has been especially influential in the closed-economy version of public economics. However, it has no role to play in normative trade theory. Suga and Tawada (2007) have provided an example in which competitive free trade subject to the Wicksell Lindahl mechanism is not potentially beneficial for all countries. Samuelson (1954) has emphasized that the application of Lindahls mechanism requires more information than is generally available to governments. Suga and Tawada have shown that the mechanism fails in open economies even with information of the type assumed by Lindahl.

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(appreciated only in countries the governments of which have provided them) or partially cosmopolitan. However there are now available two alternative sufficient conditions for potentially beneficial free trade for all perfectly competitive countries in a context of public goods. Building on the earlier work of Wan (1972) on externalities and the gains from trade, Kemp (2001:6162) has noted that free trade remains potentially beneficial for all countries under. Condition :
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In each country, the aggregate net production vector of pure public goods under free trade is maintained at its autarkic level. Given condition , it follows that the consumption of public goods by any country under free trade is the sum of that countrys aggregate net production of public goods and any free riding by that country on the aggregate net production vectors of other countries. The sufficiency of condition follows from the convexity of each countrys set of private production possibilities after allowing for the constancy of each countrys net production vector of public goods. The second sufficient condition is of a different kind and requires a longer exposition. Building on the earlier findings of Kemp and Shimomura (2001), Shimomura (2007) has shown that free trade remains potentially beneficial for all countries under Condition : (a) all public goods are both pure and strictly local; (b) benevolent governments play a CournotNash game with the public goods as strategic variables; and (c) the game has a solution, not necessarily unique. However, it is difficult to take seriously the assumption that all public goods are strictly local. In the modern world, non-local or cosmopolitan public goods are of considerable importance: one thinks of the maintenance and improvement of a common language and a common commercial law, of telecommunication facilities, of medical facilities available in one country to citizens of all countries, of measures to improve public health and, in particular, to curb epidemics, of scientific and artistic discoveries, of anti-pollution and anti-global-warming measures, of the maintenance of infrastructure to support the production and transportation of other goods and of expenditure on defence and anti-terrorist activities. Moreover, in each country, local and non-local public goods are technologically and preferentially

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inter-related. In such a world, free trade may fail to benefit trading countries, even when the provision of public goods is the outcome of a CournotNash game played by benevolent but parochial governments. On the other hand, not every non-local public good is fully cosmopolitan, that is, appreciated in every trading country. This simple fact will play a significant role in the formal analysis of Section 2, but at this stage it is noted only that while each of the two sufficient conditions, taken by itself, is quite severe, nevertheless, taken together, each in weakened form, they provide a simple but general sufficient condition for potentially beneficial free trade in the context of pure public goods. 2. Analysis: The Gains from Trade Throughout the present section, tradition is followed in that all public goods are assumed to be pure; however, at the end of the analysis, it will be noted that the assumption is not necessary. Moreover, it is assumed that each country contains only representative households, that is, households that are identical in their preferences and endowments (including technological information and share holdings). As Shimomura emphasized in his Remark 1, this assumption was not necessary for his purposes; nor is it necessary here. Finally, it is assumed that in each country the aggregate production set is closed and convex. In view of Shimomuras recent finding, we depart from tradition in assuming that all pure public goods are non-local or cosmopolitan. However, not all public goods need be fully cosmopolitan. Without undue stretching of the imagination, one may suppose that there exists a proper subset of pure and non-local public goods, say G, and a subset of two or more trading countries, say C, such that G contains the effective non-local public goods for each member of C but for no non-members of C. Given a suitable system of Scitovszky (1941) lumpsum transfers among the members of C, the latter will behave like a single country in choosing a mixed vector of private and newly localized public goods. Equipped with the Scitovszky transfers, the members of C will be referred to as a Public Goods Association or PGA. With less confidence, one may suppose that several PGAs co-exist, each with its own system of Scitovszky lumpsum transfers, each choosing its own mixed vector of private and newly localized public goods and accommodating all countries and all public goods. In this way, Shimomuras model in terms of individual countries and public goods localized by country is transformed into an alternative model in terms of PGAs and public goods localized by PGA; in short, the world economy is completely localized.3

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3 In

more conventional terminology, the public goods localized by a PGA have become club goods; see Buchanan (1965) and, for a recent evaluation of the concept, Sandler and Tschirhart (1997).

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The collective governments of the PGAs play a CournotNash game in their newly-localized public goods. Each government relies on lumpsum taxes and subsidies to finance its purchases of public goods and to effect its Scitovszky transfers. The game is played in two stages: in stage 1, the collective governments choose the vectors of public goods to be provided and, in stage 2, the competitive households and firms of all countries determine the prices both of private and of public goods. Thus any solution to the game is a subgame-perfect equilibrium. Proposition 1. If the world economy is completely localized, free trade is potentially beneficial for each country.
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Proof. After the substitution of individual PGAs (each with its own system of Scitovszky transfers) for individual countries, the required proof can be seen to follow that of Shimomura (2007). Thus the restricted proposition provided by Shimomura can be extended to accommodate non-local public goods. Indeed the extended proposition can be further extended to accommodate impure public goods, the properties of which depend on the number of households consuming them. Evidently the number of public goods in each country then increases, as does the difficulty in forming a PGA. However, in principle, it is possible to further extend Shimomuras proposition. Thus the above Proposition is valid whatever the world-wide mixture of pure and impure, local and non-local public goods. In view of the lack of precise information about the extent, distribution and composition of public goods, this is a comforting thought. Reliance has been placed on systems of Scitovszky transfers, one system for each PGA, with no transfers from or to non-member countries. Given intra-PGA transfers of this kind, each PGA will be prepared to play the CournotNash game presupposed in the above Proposition. International transfers were not needed in the derivation of earlier propositions concerning the gains from trade; see, for example, Grandmont and McFadden (1972), Kemp and Wan (1972, 1993), Kemp and Shimomura (1997, 2001) and Shimomura (2007). The transfers now introduced are a measure of the international cooperation that suffices to ensure that trade is always gainful even in a context of non-local public goods.4

4 Towards the end of his paper, Shimomura (2007:953) remarked that conditions under which the GFT [Gains from Trade] proposition survives international spillover effects is an important topic for future research. Earlier he had proposed, as suitable conditions, (a) that all international spillovers positively affect each countrys preferences and technologies and (b) that in each country the vector of public goods consumed under free trade is not smaller than the vector consumed under autarky. Evidently (a) and (b) make no allowance for international cooperation but can be accepted as rather severe sufficient conditions. Condition (b) should not be confused with condition .

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3. Analysis: The Gains from Trade and Aid A large proportion of foreign aid takes the form of public goods, either public consumption goods (such as medical facilities) or public infrastructure (such as educational facilities, highways and railroads, dockyards and reservoirs). Perhaps for this reason, each donors choice of aid package is normally made after consultation with potential recipient governments and with other potential donors. The trend itself is understandable in view of the long-term needs of most less developed countries. While donor governments finance such projects, the actual provision of public goods is usually left to private firms, which bid or tender for the privilege. Access to the tendering process is often restricted by the donor government to firms that, in some sense, are from the donor and/or recipient countries; the provision of aid is tied in this sense. However, there is now a substantial measure of agreement among leading donor governments that, without loss of control and with some gain in world efficiency, firms from any country might be allowed to bid for any aidfinanced contract; see, for example, OECD (2001:2). Indeed this has been the operating policy of the UK since 2001; and, more recently, the European Union (EU) has moved in a similar direction by passing legislation unconditionally untying its aid to the least developed countries and by untying all its aid on a reciprocal basis with other donor nations, whether or not they are members of the EU: If you allow our firms to bid for your aid-financed contracts, we will allow your firms to bid for our aid-financed contracts.5 Evidently, if all donor countries accept this principle then each donor government will be freed of the need to determine the home of a firm that has tendered for that governments aid-financed contracts. It is noted also that Canada has untied all of its food aid since 2008 and has announced that it plans to untie all remaining aid by 20122013; see CIDA (2008). The untying of aid has been welcomed both by aid recipients and by other donor nations. For example, the untying of all aid has been described by an Australian Government White Paper (Australian Government, 2006:23) as international best practice. However, to determine whether the UK or the EU or Canada has indeed adopted international best practice appeal must be made to a model of the world economy which accommodates public goods in a suitably restrictive manner. Such a model has been provided in Section 2. On the basis of that model, it will be now shown that free trade in private goods combined with foreign aid in public goods is potentially (after appropriate compensation)

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5 See

Regulation (EC) No 2110/2005 of The European Parliament (2005) and the Council of the EU on access to Community external assistance.

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beneficial to each country whether the aid is tied or untied and whether the country is a donor or recipient.6 As in Section 2, it is assumed that several PGAs coexist, each with its own system of Scitovszky lumpsum transfers, each choosing its own mixed vector of private and newly localized public goods and accommodating all countries and all public goods. Thus, the world is again completely localized.7 Let us now recall the suggestion of Kemp and Shimomura (2002) that foreign aid be recognized as a public good both by the donor and by the recipient. Without this recognition, it is difficult to understand why countries should ever extend aid to each other. Accepting their suggestion, then, aid from one country to another within the same PGA can be readily accommodated by the analysis of Section 2; only the Scitovszky transfers within each PGA may need adjustment. Given that each PGA has its own distinct set of public goods, each country will be left potentially better off by its adjusted trade-cum-aid; moreover, each country is potentially better off with reciprocally untied aid than with tied aid and potentially better off with unconditionally untied aid than with reciprocally untied aid. Proposition 2. Free trade in private goods combined with foreign aid in the form of public goods ( from one country to another within the same PGA) is potentially beneficial for each member country whether the aid is tied, reciprocally untied or unconditionally untied. Moreover, each country is potentially better off with reciprocally untied aid than with tied aid and potentially better off with unconditionally untied aid than with reciprocally untied aid. Like Proposition 1, Proposition 2 can be readily extended to accommodate impure public goods. 4. Final Remarks The reasoning of Sections 2 and 3 has been as brief as possible. However, to avoid possible misunderstanding, several additional remarks are now added. (a) In discussions of the gains from free trade, theorists usually assume that the international distribution of technical skills or human capital is arbitrarily given, perhaps by the earlier decisions of each countrys ministry of education. However the decisions of governments concerning education, and therefore concerning the international distribution of human capital, are ultimately controlled by the electorates, at least in democratic countries. Education can be viewed as a public good the consumption of which is compulsory up to the secondary level of schooling
6 For

earlier attempts to answer questions like those posed in the present section; see Kemp and Abe (1994) and Kemp (1995, Chapter 29). 7 See footnote 3.

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and voluntary thereafter. Thus education is accommodated both in Proposition 1 and in Proposition 2. (b) The game played by the PGAs in Sections 2 and 3 is of the simplest non-repetitive type, in keeping with the gains-from-trade propositions of 1972 and later. Thus no reliance has been placed on the so-called folk theorem of repeated games. (c) The reasoning employed in Sections 2 and 3 can be applied also to the analysis of a closed economy with public goods that are effective only in a proper subset of that countrys states or municipalities or only in a proper subset of its industries. Those states, municipalities or industries that are members of the same national PGA can free themselves of market distortions related to public goods by jointly choosing an optimal vector of public goods, financed by lumpsum transfers among members of that PGA. Evidently neighbouring states, municipalities and technology- or preference-related industries are most likely to share membership in a national PGA. References
Australian Government (2006). Australian Aid: Promoting Growth and Stability. Canberra: Commonwealth of Australia. Buchanan, JM (1965). An economic theory of clubs. Economica, 32(1), 114. Canadian International Development Agency (CIDA) (2008). Canada is Committed to Building a New Aid Relationship. Ottawa: CIDA. Docks, P, PH Goutte, C Hbert, C Mouchot, JP Potier and JM Servet (eds.), (1988). Auguste et L eon Walras. Oeuvres  economiques compltes. Paris: Economica. Grandmont, JM and D McFadden (1972). A technical note on classical gains from trade. Journal of International Economics, 2(2), 109125. Kemp, MC (1995). The Gains From Trade and the Gains From Aid. London: Routledge. Kemp, MC (2001). International Trade and National Welfare. London: Routledge. Kemp, MC (2011). A unified analysis of trade gains in the presence of public goods. Japanese Economic Review, 62(3), 425429. Kemp, MC (2012). Normative trade theory. In MC Kemp, H Nakagawa and T Uchida (Eds.), Positive and Normative Analysis in International Economics: Essays in Honour of Hiroshi Ohta. Basingstoke, New Hampshire: Palgrave Macmillan. Kemp, MC and K Abe (1994). The transfer problem in the context of public goods. Economics Letters, 45(2), 223226. A revised version of this paper with Makoto Tawada as a co-author appears in Kemp (1995:360364). Kemp, MC and K Shimomura (1997). Trade gains: A unified exposition based on duality. Japanese Economic Review, 48(2), 121131. Kemp, MC and K Shimomura (2001). Gains from trade in a CournotNash general equilibrium. Japanese Economic Review 52(3), 284302. Reprinted in Kemp (2001:134159). Kemp, MC and K Shimomura (2002). A theory of voluntary unrequited international transfers. Japanese Economic Review, 53(3), 290300.

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Kemp, MC and HY Wan, Jr (1972). The gains from free trade. International Economic Review, 13(3), 509522. Kemp, MC and HY Wan, Jr (1993). The Welfare Economics of International Trade. Chur: Harwood Academic Publishers. Lindahl, E (1919). Die Gerechtigkeit der Besteuerung, Lund: Gleerup. Pages 8598 have been translated as Just TaxationA Positive Solution in RA Musgrave and AT Peacock (Eds.), 1958. Classics in the Theory of Public Finance. London: Macmillan. Organisation for Economic Cooperation and Development (OECD) (2001). Untying aid to the least developed countries. Policy Brief, Paris: OECD. Samuelson, PA (1954). The pure theory of public expenditure. Review of Economics and Statistics, 36(4), 387389. Sandler, T and JT Tschirhart (1997). Club theory: Thirty years later. Public Choice, 93(34), 335355. Scitovszky, T (1941). A note on welfare propositions in economics. Review of Economic Studies, 9(1), 7788. Shimomura, K (2007). Trade gains and public goods. Review of International Economics, 15(5), 948954. Suga, N and M Tawada (2007). International trade with a public intermediate good and the gains from trade. Review of International Economics, 15(2), 284293. The European Parliament (2005). Regulation (EC) No 2110/2005 of the European Parliament and of the Council on Access to Community External Assistance. Official Journal of the European Union, L 344/1344/14. Walras, L (1874). El ements d economie politique pure, Lausanne: Corbaz. The definitive edition of 1926 was translated by William Jaff as Elements of Pure Economics, London: Allen and Unwin, 1954. Wan, HY, Jr (1972). A note on trading gains and externalities. Journal of International Economics, 2(2), 173180. Wicksell, K (1896). Finnanztheoretische Untersuchung, Jena: Gustav Fisher. Part of the Foreword and most of the second essay have been translated as A New Principle of Just Taxation in RA Musgrave and AT Peacock (Eds.). 1958, Classics in the Theory of Public Finance. London: Macmillan.

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