Compensation Principle

If tariff reform combined with lump sum transfers could make everyone better off, then we accept the tariff reform itself as a worthwhile policy, even when the transfers are not made.

This criterion for evaluating a reform is called the "compensation principle" (Chapman 1987).

Theorem (Grinols and Wong 1991; Ju and Krishna 2000)

When the prices changes from p0=p*0+t0 to p1=p*1+t1, suppose that the government transfers the following amount to each individual:

.
Provided that
,
then no individual is worse off and the government budget is balanced.

Two Key Sources of Welfare Improvements

(1) Terms of Trade

(2) Efficiency (Tariff Revenue)


Corollary

(1) Starting in autarky and moving to trade with tariffs and subsidies makes no one worse off provided that the tariffs and subsidies raise nonnegative revenue (t1'm1≥0). ("self-financing" tariffs condition, Ohyama 1972)

(2) For a small country with constant world prices, p*0=p*1, a change in tariffs and subsidies makes no one worse off provided that t1'(m1-m0)≥0.

Corollary (1) implies that free trade is better than autarky (Samuelson 1962; Kemp 1962, check the case where t1=0)

Corollary (2) implies that free trade is better than restricted trade for a small country (check the case where t1=0).


R. Feenstra, 2004, "Advanced International Trade," p.188-191