ABSTRACT
In previous chapters we have seen that free trade may not make a country better off if other distortions exist in the economy, such as monopoly power. Another important distortion is an externality, that is, an effect from the production or consumption of a good that is not taken into account in its market price. An example of a positive externality that we considered in Chapter 4 was an external economy of scale: costs for all firms fall when one firm expands output. While the individual firm ignores this benefit to others, the economy as a whole gains as industry output expands. When this externality exists in the production of the export good, trade creates an additional gain by allowing output to increase and more of the external economy of scale to be achieved. When this externality exists in an importcompeting good, however, trade reduces domestic output and the benefits from this externality. A trade barrier might improve the country’s welfare by promoting an expansion of industry output.
