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More on the Difference Between Losses and Costs

The final version of my paper “Should Trade’s ‘Losers’ Be Compensated?: An Exploration of the Welfare Economics of the Losses and Costs of Economic Change” is published in the Journal of Law, Economics & Policy and is available on-line free of charge. Beneath the fold is a slice (footnotes and subheading deleted).

Begin by noting that the law cannot simultaneously protect the physical integrity of individuals’ properties and the market values of those properties. To allow individuals to physically use their properties as they wish – on condition that these uses do not interfere with other property-owners’ physical uses – necessarily is to allow property owners to act in ways that will change the market values both of their own properties and that of other persons’ properties.

To allow Smith to erect a new residential-apartment building on his land is to allow Smith to change his land’s market value. If his new building is a success – as determined by the eagerness of tenants to rent space in it – the market value of his property rises. If the building is a failure, the market value of his property falls. More importantly for our discussion, to allow Smith to erect a new apartment building on his land is to allow him to change the market values also of other people’s properties. If Smith’s building is a success, the market values of nearby apartment buildings might fall as owners of these other buildings must lower their rents or increase their maintenance expenses in order to compete for tenants. Implicit in – indeed, inseparable from – the law’s ‘decision’ to protect people’s physical uses of property is the law’s ‘decision’ not to protect properties’ market values.

The law’s ‘choice’ between protecting physical integrity and uses or protecting market values is not a toss-up. It is not the case that the law could as easily, or almost as easily, have ‘chosen’ instead to protect market values while not protecting owner’s physical uses of property. This truth is difficult to see if focus is limited to any one instance considered in isolation, such as Smith and the apartment building. It appears obvious that the existing value of Smith’s own land, as well as the values of nearby apartment buildings, can be protected by prohibiting Smith from physically changing the uses to which he puts his land.

But appearances here are deceiving. To protect the market values of all of these pieces of land requires far more than restrictions on what Smith and other existing landowners may do with their properties. Such protection of market values would require, in addition, an unfathomably large number of other physical restrictions. Tenants must be prohibited from moving out of their spaces (or at least from failing to continue to pay their monthly rents). Yet because tenants cannot be prohibited from dying, government must have the power to somehow ensure that all units once occupied by now-deceased tenants are immediately rented by others.

How would government achieve this outcome? Several different schemes are imaginable, but none that does not involve a high probability of bringing about precisely what the law aims to avoid, namely, reductions in the market values of some people’s properties. The law could, for example, compel residents of other neighborhoods to move into apartments that are vacated due to death. But this move would reduce the market value of apartment buildings in these other neighborhoods. Alternatively, government could simply take over responsibility for paying the rents previously paid by tenants now dead. This scheme would reduce the real incomes of those who are taxed to supply the necessary funds, and this reduction in real incomes reduces the market values of those assets, including human capital, owned by the affected taxpayers.

We need not extend the example further. Sober consideration of what the law would have to do in a determined pursuit of the goal of protecting market values rather than protecting physical uses quickly reveals the goal of protecting market values to be impossible. In happy contrast, the goal of protecting physical uses is not only possible, but one that better ensures that real market values of assets generally rise over time. That is, the protection of physical uses rather than of market values, while resulting in many specific instances in decreases in the market values of particular assets, enables individuals to use their assets in ways that, over time, have the best prospect of ensuring the highest possible value of these assets.

This outcome is not ironic. In a world of scarce resources, changes in market values are necessary to attract resources to those particular uses in which they will be of greatest use – of greatest ‘value’ – to humankind and, hence, away from those particular uses that are not as useful. In a world in which property owners are protected from suffering reductions in the values of their resources and assets, owners have little incentive to release their resources and assets from relatively unproductive uses, and are severely restricted by law from seeking different, more-productive uses for their resources and assets. The result over time is economic stagnation. Per-capita incomes fall. Standards of living fall. And property values in the aggregate are lower than they would be in an alternative world in which the law does not protect market values.

Of course, a policy in which trade’s ‘winners’ compensate trade’s ‘losers’ is imaginable without the law switching over entirely to the protection of all market values instead of physical uses. And if such compensation is practically possible, perhaps it is also advisable as a means of further ensuring that the rising tide of prosperity created by free trade does indeed lift all boats. At the very least we can ask: Why shouldn’t trade’s ‘winners’ compensate trade’s ‘losers’?

The short response is to ask: Why should trade’s ‘winners’ compensate trade’s ‘losers’? More fully: Why should property owners have the values of their properties protected from one specific source of potential decline if these values are not protected from other sources of decline? Unless there is something unique about economic change fueled by commerce that crosses political borders, the case for the ‘winners’ from international trade compensating the ‘losers’ from international trade is a loser.

And there is indeed nothing about commerce that crosses political borders that differs in any essential economic respects from commerce that occurs exclusively within the confines of a country’s national borders. This conclusion, it can be fairly said, is a sound summary of economists’ teachings about trade and trade policy since Adam Smith first put quill to parchment.

There simply is nothing unique about trade that crosses political borders at creating what are called ‘winners’ and ‘losers.’ All economic change does so, and in a modern commercial economy it does so incessantly. Implementation in California of a newly discovered lower-cost process for producing aluminum will destroy some jobs in Ohio’s steel factories. The harms suffered by American workers who thus lose their jobs, as well as the harms suffered by American steel-company shareholders whose portfolios thus take a hit, are no less real or harsh than are the harms they would have suffered had the demand for their outputs instead been reduced by a lowering of American tariffs on steel imports from Brazil or China. Therefore, to say that international trade has winners and losers – or that a lowering of trade barriers creates winners and losers – is to imply incorrectly that there is something unique about international trade at destroying jobs and businesses in the home country.

This fact alone renders unsupportable the claim, such as made above by Dani Rodrik, that the economic case for free trade rests on the assumption that trade’s ‘losers’ be compensated by trade’s ‘winners.’ Because no one believes that every source of economic change, even those that are purely domestic, are justified only if ‘winners’ compensate ‘losers,’ to single out economic change that is manifested through international trade as alone having to satisfy this requirement is unwarranted both as a matter of economics and of ethics.

Those who are reluctant to accept this conclusion might ask themselves this question: Should the lowering of legal and cultural barriers to women working in the market have been conditioned on the resulting ‘winners’ compensating the ‘losers’? After all, the entry of more women into the market certainly destroyed some particular jobs held by men and worsened the bottom lines of some particular businesses owned by other men. Everyone who would reject the assertion that the case for allowing women to work in the market is premised on the assumption that the resulting ‘winners’ will compensate the ‘losers’ should also reject, and for the very same reasons, the assertion that allowing freer trade is premised on the requirement of paying such compensation.

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