Trade Adjustment Costs in Developing Countries: - World Bank ...

Taking Advantage of Trade: The role of distortions 309sector can afford the indivisible), which keeps demand for workers and wages inthe state run sector too low for workers there to afford the indivisible. In thisway, an FMD together with indivisibilities can give rise to two equilibria: a goodone where all agents can afford the indivisible and a bad one, where only a selectfew can do so.Where are such multiple equilibria likely to occur and when is there a uniqueequilibrium? Multiple equilibria tend to occur when the economy is productive,but not too productive. If the economy is too unproductive, then it just has notgot the resources to produce enough to meet high demand levels so that the goodequilibrium cannot exist. If the economy is too productive, then costs are so lowthat everyone can always afford the indivisible 11 so that only the ‘good’equilibrium exists in autarky. In between lies the realm of multiple equilibria.Thus, it may be that in developing countries, like China in the past, the goodequilibrium might not have been viable at all. However, the good equilibriummight have been a possibility in the former Soviet Union, where despite all theinefficiencies of the system, the standard of living was reasonably high before itscollapse.In such a setting, there is reason to expect trade to have large adverse welfareeffects for the distorted economy. Why? Well, think of this distorted closedeconomy in the good equilibrium. Even though costs are high in the distortedsector, the high wages in the state run sector (where wages per worker have to(where wages per worker have to be lower than those in the non-distorted sectoras all workers could choose to work in the latter) ensure that everyone has theability to buy a stove, or refrigerator or scooter,.... 12 Now think of opening theeconomy up to trade. As the distorted economy has higher costs, and hence acomparative disadvantage in indivisibles, this good equilibrium cannot surviveafter opening up to trade. Indivisibles will be imported, at lower prices, but thiswill not help the less able who have lost their well paying jobs. Of course, theabler will be better off but society as a whole will be worse off when the loss ofwelfare of the less able is taken into account. If the world price under trade isclose to the autarky cost of indivisibles in the distorted economy (as it would beif the distorted economy was ‘large’ so that its autarky prices prevailed) thenthere could even be a weak Pareto loss in welfare from opening up to trade.While these models are special, the ideas that emerge from them make sense ata basic level. Maybe the citizens of the former Soviet Union did not have accessto the luxuries and the quality of products in the West, but before its fall they hada pretty decent standard of living. Once the economy opened up, no one wanted11 If the economy is too unproductive, then this good equilibrium where everyone can afford theindivisible cannot be supported: it takes more workers than are available in the economy to makeenough of the indivisible for everyone.12 Although the economy is distorted, the less able gain a lot from this distortion, though the ablerlose as they pay higher prices for the indivisible.