DE ECONOMIST 150, NO.

3, 2002

HOW FAIR IS FAIR TRADE? **

BY ROBBERT MASELAND AND ALBERT DE VAAL*

Summary

This paper investigates to what extent fair trade programmes, are indeed fair. This is accomplished by comparing fair trade with free trade and protectionist trade regimes on their compliance of the criteria set by the fair trade movement itself. This comparison is made using comparative cost based models and economies of scale models. It is found that whether or not fair trade is superior to free trade or protectionism is highly dependent on a number of characteristics of the products to which fair trade is applied as well as on the context within which international trade takes place. 1 INTRODUCTION

A long-standing debate in development economics has been the one between advocates of free trade and proponents of protectionism in developing countries. While the former argued that free trade would offer large opportunities for poor countries to improve their situation, the latter considered trade to be harmful to poorer countries and typically preferred a combination of protectionism and development aid. This opposition tended to dominate the discussion about the role of international trade in the Third World. Bhagwati 1993, Krueger 1990 However, in recent years, a third position has come up. This position maintains that international trade can be benecial to developing countries as long as it is performed in a just manner. The idea behind this is that, in conducting trade, we have a moral obligation to pay decent prices for products that have been produced under decent conditions. In many western countries organisations have emerged which conduct trade in such a way and which succeed in selling products for a price above market level, because of their guarantee that the extra money is directly going to the producers. Such organisations, which include for example Oxfam in the United Kingdom, Max Havelaar in the Netherlands or Solidarmonde in France, have become known as Fair Trade Organisations

* University of Nijmegen. Mailing Address: A. de Vaal, Nijmegen School of Management, University of Nijmegen, PO Box 9108, 6500 HK Nijmegen, the Netherlands; a.devaal@nsm.kun.nl. ** The authors would like to thank Marcel Wissenburg, Harry Garretsen, Eelke de Jong, Richard Nahuis, and three anonymous referees for their helpful comments on an earlier version of this paper. De Economist 150, 251272, 2002. 2002 Kluwer Academic Publishers. Printed in the Netherlands.

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FTOs. 1 The past two decades saw a strong growth of the market share of these organisations as well as of the range of products they offer. In addition, the type of conduct they embody fair trade has succeeded in gaining widespread acceptance among the public as being an effective tool for alleviating poverty and a reasonable alternative to aid and free trade Beuningen 2000. 2 The idea that paying higher prices for products from Third World countries will help developing countries may have a certain intuitive appeal, but if one looks beyond the direct income transfer effect, it is far from evident that this would be the case. One can imagine that the practice of fair trade organisations might lead to market distortions that cause adverse effects if one takes on a more broad perspective. In spite of this, these organisations claim that trade conducted the way they do is fair, which is a view that is widely shared among the public. In this paper we would like to study the validity of this claim. In order to do this we rst need to make clear what fair trade exactly is. Confusing in this respect is the fact that the term fair trade nowadays is used to indicate two entirely different positions. The rst of these is the fair trade that calls for protectionist measures by developed countries against products that have been produced in poorer countries at prices developed countries cannot compete with because of their different economic circumstances. Protectionism is defended by arguing that trade should only be conducted on a level-playing eld. Products that have been produced cheaper in a country because of specic favourable circumstances have to be excluded from trade in this view. Taken to the extreme, this would mean that all trade based upon comparative advantage should be abolished; in practice, the argument is mostly used to protect domestic industries in developed economies against cheaper imports from countries with low labour costs. This argument has been attacked convincingly in Bhagwati 1993. This protectionist stance is completely different from the concept of fair trade we will discuss. The fair trade with which we will deal here is a manner of conduct by consumers, engaged in pro-poor trade with developing countries. Instead of prohibiting trade in products produced with, for example, cheaper labour in developing countries, this kind of fair trade attempts to redress the income consequences of such differences through trade. Fair trade in this paper refers to the consumer movement that has come up in several Western countries in the past decades, in which people feel obliged to pay prices above market level for products produced under certain conditions in Third World countries. Crucial in this practice is that restricting oneself to goods produced under these conditions
1 Although this movement is a relatively recent phenomenon, it shows some resemblance with much older pre-capitalist ideas about economy and society. The idea of a morally just price, for example, was one of the hurdles capitalism had to take before becoming established in Western Europe. See, for example, Thompson 1971. 2 Although recently the growth seems to have stagnated, as can be deduced from following the media.

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and paying higher prices are both considered to be moral obligations rather than preferences; only this type of conduct is considered to be just. The fact that fairtrading is a moral obligation means that there is no trade-off possible between these principles and consumer preferences. This could be compared with certain religious prohibitions: the prohibition to eat pork for a Muslim, for example, is absolute, and it will hold no matter how much utility could be gained by eating pork. Such principles can be seen as ideological constraints, analogous to a budget constraint; preferences have to be weighed within such constraints, which are themselves not part of a utility function. The moral obligation to act in this fair trade manner stems from an idea of justice that lies underneath the fair trade concept. The conduct called fair trade, in other words, is an operationalisation of an idea of what just trade would be. Whether this underlying idea of justice is correct or not is a question that lies far beyond the scope of economics and we will therefore not address it here. One could question, however, whether fair trades operationalisation of the idea of justice in trade is correct or not; does the practice of fair trade indeed comply with the ideas of justice behind the fair trade concept? In other words, is fair trade fair according to its own standards in comparison with free trade and protectionism? This question will be studied from the two analytical angles that are central stage in international trade theory. First, we will answer it using a HeckscherOhlin framework, focusing on comparative cost based inter-industry trade. In such models, trade is typically superior to no-trade on a country level of analysis, but there are strong effects on the income distribution within countries. Second, we will discuss the question from the point of view of trade models where intraindustry trade and scale economies play a role. In such models, income distribution effects within countries are generally absent unless they also incorporate comparative advantage elements, but then the gains from trade on a country level are not always positive. 3 The outline of this paper will be as follows. In section 2 we discuss ideas of justice behind the fair trade concept. Section 3 is devoted to the question whether fair trade constitutes an improvement to free trade and protectionism in comparative cost based models. In section 4 we deal with the same question for models based on scale economies. Section 5, nally, concludes.

3 This is mainly true for models that incorporate external economies of scale, which are either directly modelled e.g. Ethier 1979, or come about as a result of pecuniary externalities that are generated by the interaction of returns to scale at the rm level and the existence of transportation costs e.g. Krugman 1991, Krugman and Venables 1995.

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2 THE IDEAS BEHIND THE FAIR TRADE CONCEPT

To answer the question whether fair trade is fair according to its own standards we rst need to make clear which ideas of justice lie underneath the fair trade approach. A problem with this is that adherents of fair trade are organised in a myriad of organisations, which all have their own particular understanding of what fairness in trade constitutes or should constitute. Upon inspection of many of the arguments raised it is possible though to come up with a crude categorisation of fair trade arguments in: a arguments that relate to certain conditions under which trade, and the production of traded goods, should minimally take place, and b arguments that deal with the consequences of trade. 4 With respect to the rst group of arguments, the main arguments are that there are moral prohibitions against for example employing child labour, causing damage to the environment, and any actions that deny people a life of freedom and dignity. Trade by itself is not bad, but it should be conducted in compliance with these basic prohibitions. If it does this, trade will be considered fair in its method. It is immediately clear that only a strict refusal to buy any goods not produced under these conditions truly fulls this demand, so that in this respect fair trade is better than both free trade and protectionism. The reasoning follows out of the Kantian distinction between acting in accord with rules and acting out of regard for rules. To be merely acting in accord with rules might be the result of weighed preferences, or even an unintended side-effect of an action, but it is not a recognition of the absolute character of rules. Applied to the case, the absence of child labour is not the same as the fullment of the prohibition of child labour; for that to be the case, child labour should not only be absent, it should not be an option at all. Free trade can cause an absence of child labour or environmentally harmful production methods, but since it lacks a self-regulating mechanism to ensure their absence, this outcome would always be dependent on certain conditions. Their absence is a matter of weighed preferences only, and not of a recognition of the ban on them. This is thus at odds with the fundamental nature of a prohibition, which is that a prohibited action is not an option at all. Turning to protectionism, the principle of the prohibition of coercion is deed. 5 Moreover, since protectionism only amounts to a shift of trade from the

4 This categorisation is based on a comparison of the information brochures and home pages of a number of alternative trade organisations and/or their umbrella organisations, e.g. the International Federation for Alternative Trade IFAT, www.ifat.org and the Fairtrade Foundation www.fairtrade.org.uk. The main arguments we mention are those that seem to be common understanding for most of these organisations. 5 Note that this also applies to the co-ordinated protectionism of the GATT/WTO framework. Even though national governments consent in keeping particular protectionist measures in place, it still constrains the freedom of individual agents.

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international to the domestic arena, it offers no basic changes in the conditions of trade and is therefore subject to the same objections as free trade. In other words, with respect to the conditions of production and trade, fair trade indeed offers the best operationalisation of justice. Whether it does so with respect to the consequences of trade the second group of ideas about justice is a more difficult question. As the fair trade movement opposes to the current practice of international trade because of its consequences, it does so on the basis of a rejection of efficiency as the main criterion. Fair traders propose another criterion to judge the consequences of international trade, which is called rather vaguely fairness. What is efficient, they argue, may not be fair for considerations of equality. The fair trade movement does not resist the market mechanism nor inequality in principle, but objects to inequality in outcomes as a result of unjustied unequal starting positions. 6 It argues that inequality caused by systems and institutions that reward people differently on basis of natural or social differences rather than by differences in effort, is not morally defendable. The fact that the current international division of labour does result in such inequality makes it a problematic and unjustiable system, according to fair trade advocates. There are two possible answers to this problem; the rst one is that one could redistribute input factors to eliminate inequalities as a result of differences in endowments. This is the traditional answer of socialism, which is problematic for a number of reasons. First, in removing differences in endowments, one takes away a main reason for trade, thereby reducing trade and its benets signicantly. Secondly, as a result, this solution may lead to an equality by which nobody gains; everybody may enjoy an equal income, but this might be lower than the income the poorest segments of world society enjoyed before redistribution. Third, to redistribute social input factors is one thing, but genuine equality of opportunity would demand an equal distribution of natural characteristics as well, which is impossible. Fair trade, on the other hand, opts for the second possibility; changing the institutions that reward differently on the basis of inequality in endowments. In a world of inequalities in initial position, fair trade proposes to conduct trade in such a way that no one is harmed by inequalities in initial position; in other

6 This is perhaps the one and only argument that the fair trade approach has in common with the recent discussion on harmonisation as a prerequisite for free trade, which has been extensively dealt with in Bhagwati and Hudec 1996 and which in the public debate is also dubbed fair trade. However, as will be shown, the focus of the fair trade approach goes beyond a simple harmonisation of the rules of the game levelling the playing eld. Fair trade, as understood by Bhagwati, is concerned with so-called equality before the law; trade should be limited to products produced and traded under similar circumstances. Fair trade, in the sense as it is conducted by FTOs, is concerned with equality after the law; they attempt to conduct trade in such a way that consequences of differences in circumstances are redressed.

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words, not the inequalities themselves are redressed, but the negative consequences of them. 7 In the words of the Fair Trade Foundation, by requiring companies to pay above market prices, fair trade addresses the injustices of conventional trade, which traditionally discriminates against the poorest, weakest producers. 8 The demand that no one is harmed by initial inequalities does not rule out inequality in outcome whatsoever; it only rules out those outcomes that are disadvantageous to the poorest groups in society. In other words, if a certain manner of trade results in inequalities in outcome, but comprises an improvement to the least advantaged, it is not considered unjust. The fair trade movement thus argues that international trade constitutes an improvement if it has benecial consequences for the poorest groups in the world. This is the moral criterion fair trade uses to judge the consequences of trade. 9 Now we have established a criterion for judging the consequences of trade, the question arises whether the fair trade practice of paying prices above market level for goods produced in Third World countries is indeed the best way in this respect. This question we will address in the remainder of this paper; is fair trade fair in its consequences, in comparison with free trade and protectionism? In the comparison we will limit ourselves in two ways. First, we study only the effect of the fair trade practice of paying higher prices. We do this because, in the fair trade concept, this practice is motivated by the alleged effects it has on income, whereas the other elements of fair trade practice are considered to be boundary conditions with an intrinsic value. In our comparative analysis we will therefore only consider trade within these boundary conditions. After all, if the prohibitions on trade in goods produced using child labour, coercion or environmentally damaging production methods are not met, it makes no sense to talk about fairness in the rst place. Second, we will limit ourselves in focusing only on income effects of trade. We choose to go by on the effects that international trade might have on other factors, that are not expressed in real income terms but
7 In other words, fair trade programmes see the way trade takes place as the heart of the problem. Obviously, there are many other reasons one could think of to explain the adverse position of the poor in developing countries e.g. market failure. In our analysis, we will ignore this issue and follow the fair trade angle. This is not to say that we principally disagree with other opinions on this matter. 8 http://www.fairtrade.org.uk 9 This position has some similarity with the ideas of John Rawls about social justice. Rawls rejects inequality of reward on basis of natural or social differences between people, since one cannot attribute these differences to peoples efforts or intentions. He states that the only inequality a rational individual would accept is the minimum inequality necessary to improve the situation of the least well off in society. An important difference, however, is that Rawls combines the demand of Pareto optimality with this idea rather than replacing it. Furthermore, Rawls notion of justice is more fundamental as he is concerned with the basic structure of society, whereas fair trade ideas consider only the distribution of income. See Rawls 1971.

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do inuence well-being, such as consequences for environment or health. This limitation is defendable by the fact that it is the angle taken by most international trade models, and by the fact that it can be shown that distribution problems due to such externalities of economic action in principle can be solved by creating marketable property rights for these factors. 10
3 FAIR TRADE AND COMPARATIVE ADVANTAGE TRADE MODELS

To investigate the fairness of fair trade, we rst consider it in models where trade is based on comparative cost differences between countries. It is well-known that in such models trade is mutually benecial at a macro level, but that at the micro level not everyone will gain from trade. 11 These income distribution effects show up most clearly in a Heckscher-Ohlin type of world and are summarised by the Stolper-Samuelson theorem. This theorem states that in a world where trade is solely based on differences in factor endowments between countries, a countrys abundant factor will gain from opening up to trade, both in nominal terms and in real terms, whereas the scarce factor will lose. 12 The presence of income distribution effects, makes the Heckscher-Ohlin model a suitable framework to investigate the fairness of fair trade. All we have to do is to verify whether the income distribution effects of fair trade are in favour of the least well-off in the world. 13 If this is the case, we can conclude that fair trade is fair. This does not imply, however, that fair trade is best for the least well-off, since this depends on how they would have fared in a world without fair trade principles. A full comprehension of the fairness of fair trade therefore not only includes a judgement on the consequence fairness of fair trade per se, but also on its superiority with respect to free trade. The rules we thereby follow are very simple: If fair trade leads to consequence fairness, whereas free trade does not,
10 See Coase 1966. 11 See e.g. Ethier 1995 for a basic text book treatment of these issues. An advanced treatment can be found in Bhagwati and Srinivasan 1983 and Bowen et al. 1998. 12 A country will export import the good that uses its abundant scarce production factor relatively intensively. Trade therefore increases demand for a countrys abundant production factor, whereas the demand for its scarce production factor declines. Factor market clearing then requires a nominal increase in the reward for the abundant factor and a nominal decrease in the scarce factor s reward. By linking these changes to the price changes of goods due to trade, one can show that also in real terms the abundant factor gains and the scarce factor loses. 13 By focussing on the income group that is actually worst off in the world before trade we stay as closely as possible to the basic idea of consequence fairness that trade should benet the least-well off in the global society. One could also opt for a way to look at the consequence fairness of trade that is more in line with the operationalisation of this concept by the fair trade movement, viz. that trade should be fair for those least well-off in the poor countries in the world. As will become clear, the particular set-up of our analysis makes this distinction to a large extent redundant. See Maseland and De Vaal 2001 for an explicit account how the verdict on the consequence fairness of free and/or fair trade depends on the particular view chosen.

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then we will call fair trade superior to free trade. If, however, both fair trade and free trade lead to the same outcome in terms of consequence fairness, say both are fair, then we will call the one superior that leads to the highest gain for the initially worst off. We will restrict our analysis to a standard formulation of the Heckscher-Ohlin model, which exhibits 2 goods, 2 factors and 2 countries. This is done not only to facilitate tractability, but also since many of the theorems that are linked to the Heckscher-Ohlin model do not straightforwardly generalise to a more-factor, more-country, more-good framework. 14 Moreover, to gear the analysis to the practice of fair trade, we will assume that one of the countries in the model is rich, while the other one is poor. That is, we assume that next to differences in relative endowments between the two countries the basis for trade in the model one country also has a higher total income. In a Heckscher-Ohlin setting this implies that we assume that the relative factor endowments are such that the real reward of the rich countrys abundant factor is higher before trade than that of the poor countrys abundant factor. This also implies that we know that before trade commences the least well off are always the owners of the abundant production factor in the poor country. 15 To facilitate the analysis on the consequence fairness of fair trade, we furthermore assume that the fair trade principles are adhered to only in the rich country and that these principles apply to the products that are imported from the poor country. 16 Moreover, we assume that all people in the rich country adhere to the fair trade principles. Moral obligations can be seen as a reection of societal norms and values, which can be seen as being the same within the connes of country borders. As a consequence, the duty to pay a decent price is invariant to differences in income or professional activity. We also assume that the decent price to be paid is higher than the price that would result from the free interplay of market forces. 17 Note that this decent price is an absolute measure and is therefore only qualitatively related to the actual level of the free market price.
14 See Ethier 1984 for an overview and discussion of the higher-dimensional issues of the Heckscher-Ohlin model. 15 This follows from the one-to-one relation that exists in the Heckscher-Ohlin model between the physical denition of factor abundance and the price denition of factor abundance, which implies that it must always be the owners of an abundant production factor somewhere that face the lowest real reward before trade. Our denition of poorness then implies that this must be the abundant factor in the poor country. 16 This assumption makes sense, since these products use the poor countrys abundant factor intensively. Fair trade would not focus on a sector in another country, if the owners of the factor of production used intensively in this sector would be worse off in ones own country. 17 Obviously, such a denition can be criticised, and rightfully so!, on lacking any analytical foundation whatsoever. At the same time it does justice to the feelings that are widespread among adherents of the fair trade movement, i.e. that market forces do not lead to the right prices. Therefore, if we put fair trade on the stand, then it is also plausible to use their implied opinion on what a decent price is.

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To compare free trade, protectionism and fair trade on how they fare on the consequence fairness criterion of the fair trade movement, we note that by applying the Stolper-Samuelson theorem, it immediately follows that free trade is fair in its consequences as it improves the situation of the abundant factors of the world, thus also that of the poor countrys abundant factor. Moreover, free trade is always superior to protectionism, as the latter would always lead to a lower gain to the abundant factor of the country one imports from than free trade does compared to autarky. This is not to say, however, that protectionism is unfair. Provided the level of protection is non-prohibitive, even protectionism is good for the abundant factors of a country. For a part, we can apply the same type of reasoning to the comparison between free trade and fair trade. Paying a higher price for the export products of the poor country has more or less the same effects as imposing an import quota for this product. Whereas under free trade the poor country would start to export the goods which use its abundant factor intensively until price differences between the countries would be completely eliminated, now it can only export until the price in the rich country has fallen to the fair trade level. Exports and international trade are thus limited by the fair trade programme. The effects of this for the income positions of the abundant factor in the poor country then also follow from the Stolper-Samuelson theorem. Trade leads to gains for the abundant factors and losses for the scarce factors, so limitations of trade lead to limitations of these gains and losses. In comparison to free trade the abundant factors are therefore hurt by fair trade, whereas the scarce factors win. As was the case for protectionism, however, this does not imply that fair trade is unfair in its consequences. Provided some trade still occurs, also fair trade is fair. This line of reasoning ignores the fact, however, that apart from the negative income effect of reduced trade, the poor countrys abundant factor also captures the rents of the fair trade measure. Whether or not this positive factor outweighs the negative effects of the reduction in trade depends on the specic price elasticity of demand for the product in question. If this elasticity is sufficiently low, the abundant factor in the poor country is better off with fair trade than with free trade. This implies that the superiority of fair trade hinges on the particular type of product it targets at. This is not the case when we compare fair trade with protectionism, since under a regime of protectionism the rents accrue to the owners of the scarce factor in the rich country. For the Heckscher-Ohlin model of trade we therefore conclude that fair trade is always superior to protectionism, but that its superiority to free trade depends on the price elasticity of demand of the product it targets at. Unless this is specied, we cannot be sure whether or not fair trade is the fairer option.

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4 FAIR TRADE IN NEW TRADE MODELS

In this section we analyse the fairness of trade in models where intra-industry trade and economies of scale play a role. The model we will use for our purposes is the static version of the economic geography model of Fujita et al. 1999. We choose this particular model since it not only incorporates scale economies at the rm level and intra-industry trade, but also economies of scale that are external to the rm. As such, the model is a good representation of new trade theory. 18 We explicitly note that we use the static version of the model, as we will discuss the impact of trade on the income distribution within countries for a given distribution of labour over countries. That is, we deliberately ignore the consequences of potentially emerging core-periphery patterns on wages when labour is allowed to move between countries. To underscore this, we will henceforth refer to the model as either a new economic geography trade model or as a static economic geography model. The standard exposition of the model sees the world as consisting of two regions or countries, we will use these terms interchangeably, which each produce a homogenous agricultural good, which serves as numraire, and a heterogeneous manufactured good. The agricultural good is produced under constant returns to scale, whereas the manufactured good incurs positive scale economies. Labour is sector-specic and in the short run, which we conne ourselves to also immobile between regions. Trade in agricultural products is costless, but trade in manufactured goods incurs transportation costs. Both regions are equally large in terms of agricultural labour, but typically not in manufacturing labour. The standard result in such a setting is that free trade always means higher nominal manufacturing wages in the large country and, by symmetry, vice versa for the small country, but that the exact post-trade wage level depends highly on the level of transportation costs. In fact, for the large country manufacturing wages are an inverse U-shaped function of falling transportation costs, such that when trade is completely free, nominal wages are the same in both countries. 19 The relation between real manufacturing wages and transportation costs only partly
18 The trade literature that deals with scale economies typically makes a distinction between trade based on internal economies of scale and trade based on external economies of scale. Among other things, this distinction is important for the welfare effects of free trade on a country level. Whereas in models where trade is solely based on internal scale economies, trade is benecial for all countries involved, this not longer holds true when trade is based on external economies of scale. Due to path dependency issues, trade is not necessarily welfare improving in the latter type of models. The problem with these types of models, however, is that while it is history that matters, history is not specied. In addition, these models do not specify the external economies of scale. Both of these drawbacks are mended for in new economic geography models. 19 The results of the standard setting carry over to more complicated versions of new economic geography trade models as well. It is beyond the scope of this paper to give a detailed explanation of the reasons behind this pattern. See Fujita et al. 1999, Neary 2001 and Peeters 2001 for a detailed analytical account.

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reects this pattern, as then we also have to acknowledge the impact of the falling transportation costs on the price index of manufactured goods. In fact, whereas for a given level of transportation costs the price index is always lower in the larger region because of its lower dependence on transportation costs including imports, see Neary 2001 this advantage for the larger region declines when transportation costs decrease. Thus, real wages are bound to start converging at a higher level of transportation costs than was the case for nominal wages. The same applies to real wages in agriculture: given the constant nominal wage of agricultural labour numraire, the development of the price indices in both countries when transportation costs fall implies that also agricultural real wages become equal at completely free trade. This is exactly what is shown in Figure 1, in which manufacturing real wages and agricultural real wages are depicted as a function of falling transportation costs. Figure 1 is based on simulation results for the standard version of the economic geography model as presented in Fujita et al. 1999, chapter 5, including the normalisations they have chosen. 20 The parameter conguration underlying Figure 1 is such that both regions are equally large in terms of the numraire sector, but that region 1 is the larger region in terms of manufacturing labour. The share of manufacturing labour in total labour supply is 60%. The economies of scale in manufacturing are intermediate substitution elasticity of 5, whereas consumers in both regions spend 60% of their income on manufactured goods. Figure 1 gives the results for one parameter conguration only, but extensive sensitivity analysis shows that the particular curvature of the real wage curves is indeed as general as the brief description of the main results from the economic geography literature above indicates. However, the relative position of the real wage curves depends to a large extent on the parameter conguration chosen. Especially the share of manufacturing in consumption is important in this respect as has been widely acknowledged in the new economic geography literature, in particular the fact that it is assumed equal to the share of manufacturing in the total labour supply. 21 22 For our analysis this is important, since it will depend on the exact parameter conguration chosen which group is worst-off before trade. In Figure 1 this is clearly agricultural labour in the small region, but a
20 See the appendix for a brief exposition of the model. Note that due to several non-convexities it is impossible to derive analytical results in new economic geography trade models. Numerical simulations are therefore part of the standard tool kit of new economic geographers. 21 Also the substitution elasticity in consumption of manufactured goods has been acknowledged as being an important parameter. However, changes therein do not affect the relative position of the real wage curves. 22 When the expenditure share on manufactured goods increases, this will drive up down nominal wages in the large small region. The concomitant change in the price index is obviously a weighted average of these wage developments, but it depends on the level of transportation costs whether or not in a certain region this change is positive or negative. A priori it is therefore unclear how real wages are affected and whether or not these developments are in the same direction in both regions.

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Figure 1 Real wages and transportation costs

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relatively small change in the share of manufacturing labour in the world from 60% to 70%, ceteris paribus, would make manufacturing labour in the large region initially worst off. The small regions overall real income is always lower than that of the large region, though. 23 The reason for this is that the small regions price index is always lower than that of the larger region. As a consequence, the real income earned in the agricultural sector of the small region is lower than that in the large region. Being numraire, the nominal rewards are the same in both regions, whereas both regions are equally large in agricultural labour. The difference in price indices also works to the disadvantage of real wages in the small regions manufacturing sector. However, this effect may be mitigated by a higher nominal reward, depending on the level of transportation costs. It is possible therefore that the real manufacturing wage is higher in the small region, but if this is the case it will be a relatively small advantage. Moreover, the impact of this potentially higher real wage on the small regions total income is reduced as the manufacturing sector is relatively small since that is what makes the small region small. For the way we operationalise the fair trade principles, this implies that we again assume that all consumers in the large, rich region are willing to pay a higher price for products they import from the small, poor region. We furthermore assume that these higher prices are paid on agricultural imports, which is in line with the main thrust of fair trade programmes. The above then already makes clear that this focus on agricultural products is not necessarily the right one for fair trade programmes. As we have discussed above, a slight permutation in the parameter conguration could even make manufacturing labour in the rich country initially worst off. In that case, even within the poor country agricultural labour is not worst off initially, since also there manufacturing labour has the lowest real income before trade. This qualication is important when comparing the consequence fairness of free trade, fair trade and protectionism. To make the comparison, we will therefore consider two parameter congurations, viz. the benchmark parameter conguration underlying Figure 1 and the alternative parameter conguration which instead features a manufacturing share in the worlds labour supply of 70%. Before we can make the comparison, we have to calculate real wages for the situation in which consumers in the large region adhere to the fair trade principles. This requires an amendment of the model in the sense that we have to alter our choice of numraire. Due to zero transportation costs in agricultural products, price differences between agricultural products across the world were not possible in the original model. Thus, in the fair trade version of the model
23 That is, for all parameter congurations we have investigated. Since the model cannot be analytically solved we cannot be sure that the small region always has the lower real income. By linearising around the symmetric equilibrium, as in Fujita et al. 1999, it can be shown that the reasoning followed in the main text at least holds for small differences in size between regions.

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we choose the agricultural product in the large region as numraire, with a price one, so that the price of agricultural goods in the small region can yield a different price. Next, we assume that the latter are consumed by consumers in the large region only by virtue of their principles while consumers in the small country simply buy agricultural goods where it is cheapest which will be the large region. 24 These assumptions imply that consumers in both regions maximise utility under the additional constraint that they only buy agricultural goods from the other region. 25 With agricultural goods in the large region numraire, the market for agricultural goods clears via adjustments in the wage rate of agricultural labour in the small region. The price of agricultural products in the small region is therefore endogenous. 26 As, in our set-up, agricultural labour is evenly spread across countries, whereas for the parameter conguration under analysis the large region has the higher income, the market for agricultural goods always clears at a price level for the poor regions agricultural produce that is well above one. To judge whether or not fair trade is superior to free trade and/or protectionism, we have plotted in Figure 2 the development of real wages in the small region as a function of falling transportation costs for the standard trade version of the static economic geography model reiteration of results in Figure 1 and for the fair trade version of the model. In Panel A we do so for the benchmark parameter conguration underlying Figure 1; in Panel B we present the results for the alternative parameter conguration. Though for the latter parameter conguration it is actually manufacturing labour in the large country that is initially worst off, we momentarily ignore this fact for expositional reasons and focus on the distribution effects of the fair trade programme in the small, poor region. At the end of our exposition we will come back to this point, though. A quick glance at both panels of Figure 2 then makes clear that fair trade is always superior to free trade in the poor region. For any non-prohibitive level of
24 As a consequence, all agricultural produce of the small country is exported to the large country and all produce of the larger region will go to consumers of the small region. As the transportation costs of agricultural goods are zero, this only seems a waste of resources. 25 Due to their fair trade principles consumers in the large region do no longer see agricultural products as homogenous goods. For them, agricultural products from poor countries are clearly different from agricultural products produced at home, in the sense that the former is entitled to receive a decent price. We therefore do not explicitly model a choice between home and foreign agricultural goods for consumers in the large country. Our assumption that consumers in both regions only buy in the other region is in line with this reasoning, and with the fact that consumers in the poor region base their choice on comparing prices, but also serves to circumvent the modelling of intricate rationing schemes when the supply of agricultural produce in one region is insufficient to meet the demands of consumers of the other region. 26 This is therefore not in line with the fair trade practice to pay an absolute decent price. Ideally, one should therefore posit a xed, minimum price to be paid for agricultural products from the poor country. Such could be easily accomplished, however, by making agricultural goods in the small region numraire. For the results this obviously does not matter.

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Figure 2 Is Fair Trade Fair? A. Benchmark conguration for the poor countries

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Figure 3 Is Fair Trade Fair? B. Alternative conguration for the poor countries

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transportation cost, fair trade leads to a higher real wage position for both income groups in the poor region. Even when the fair trade programmes do not target the sector that is initially worst off in the poor region manufacturing, it nevertheless improves the real wage position in that sector. This makes sense as fair trade increases agricultural wages in the small country. As an initial effect, this will increase the costs of living in the large country and real wages there decline. In the small country, there is no initial impact on the costs of living as consumers buy agricultural goods at the same nominal price as before. This implies that the higher wage for agricultural labour directly translates into a higher real wage. Manufacturing labour in the small region also prots from the higher agricultural wages due to increased local demand. As Figure 2 makes clear, the extent to which this is the case depends on the level of transportation costs. Roughly speaking, the wedge between real wages in the fair trade case and the standard case increases up till a certain level of transportation costs, to remain constant thereafter. This reects the changing balance of standard geography effects when transportation costs change. When transportation costs are high, both countries are relatively insulated from cross-border real income effects. This becomes less when transportation costs decline. Ultimately, when transportation costs are zero, there are full cross-border spillovers of income effects and the wedge can be fully explained by the initial impacts addressed above. Fair trade is not always superior to protectionism. To see that, we note that protectionism can be interpreted as any move to the left along the standard trade curve. Transportation costs are partly due to articial barriers to trade protectionist measures and partly due to natural barriers to trade distance per se. As a consequence, free trade can be seen as a reduction in the overall transportation costs, whereas protectionism can be seen as an increase in it. This also implies that free trade the complete removal of articial barriers to trade can be seen as a move from a prohibitive level of transportation costs to any non-prohibitive level of transportation costs depending how big the remaining natural barriers to trade are. 27 For the comparison of protectionism with free trade, we then only have to consider how the real wages of those that were initially worst off are affected by a move to the left along the standard trade curve. For the comparison
27 As the agricultural sector is the numraire sector and bears no transportation costs, the opening up to trade in manufacturing goods always implies a complete opening up to trade in agricultural goods. Likewise, autarky in manufacturing goods implies autarky in agricultural goods as well. Moreover, we leave aside the issue how much of the total transportation costs is due to natural barriers to trade and how much is due to articial barriers to trade. As such, when free trade implies a jump from prohibitive transportation costs to zero transportation costs, we implicitly assume that the whole of transportation costs consists of articial barriers to trade. When, alternatively, there would be no articial barriers to trade at all, autarky is actually the natural state of affairs. In our analysis, we will only consider situations in between these two extremes. Note also that in line with the purpose of our analysis, we always consider a move towards free trade, that is from autarky to a non-prohibitive level of transportation costs. We will not consider a move towards freer trade, that is a reduction in transportation costs in general.

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of protectionism with fair trade, we must compare the real wage position of those initially worst off somewhere at the fair trade curve with a point on the standard trade curve more to the left. For the benchmark parameter conguration in Panel A we then see that protectionism is never superior to either free trade or fair trade, since the standard trade curve is monotonically rising in the decline of transportation costs. 28 For the alternative parameter conguration in Panel B, however, it depends on the remaining natural barriers to trade whether or not protectionism is superior to either of the two trade alternatives. When the remaining barriers to trade are negligible, panel B shows free trade to be superior to protectionism. When the remaining barriers to trade are, say, intermediate, protectionism is superior to free trade though. The same applies, but to a lesser extent, for the comparison between protectionism and fair trade. The range of natural trading barriers for which protectionism might be a better option diminishes when there is fair trade. To summarise our results, it thus follows that for the income distribution in the poor region fair trade is superior to free trade, but that it depends on the particular parameter conguration under analysis whether or not it does better than protectionism as well. This makes the verdict on the superiority of fair trade highly case dependent. This is even more so when we take a global perspective on the income distribution. We recall that for the alternative parameter conguration it was actually manufacturing labour in the rich country that was initially worst off. Our calculations then show that their position deteriorates more with fair trade than with free trade. It is therefore fair to conclude that in models where both internal and external economies of scale play a role, the verdict on the superiority of fair trade hinges even more on the way the world looks like and on the products fair trade programmes target at than it did in comparative cost based models.
5 SUMMARY AND CONCLUDING REMARKS

This paper has put the fair trade concept on the stand by comparing its alleged fairness with the fairness of other approaches to trade, such as free trade and protectionism. The notion of fairness we thereby used stems from the fair trade movement itself and says that trade is fair when it comes to the advantage of the least well off in society. Fair trade adherents feel morally obliged to live up to this notion of consequence fairness, which is typically put into practice by paying a higher, decent price for certain commodities of less developed countries. The other notion of fairness behind the fair trade movement an absolute pro28 This is also why we did not introduce transportation costs in the Heckscher-Ohlin model of trade in the previous section. In comparative cost based models the real wage impact of a move from autarky to free trade does not qualitatively depend on whether or not there are natural barriers to trade.

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hibition of certain types of behaviour in production has been ignored in this paper, since these are boundary conditions for trade, beyond which it is not useful to talk about fairness in the rst place. We addressed the question on the fairness of fair trade from the two main analytical angles that comprise contemporary trade theory. First, we asked whether free trade, fair trade or protectionism was the better option in the comparative cost based Heckscher-Ohlin model of trade. Secondly, we discussed the relative performance of the three approaches in a model where economies of scale play a central role, more precisely the static version of a standard new economic geography model. In both models it became clear that fair trade is clearly not always a good option; fair trade sometimes has effects that actually consist of a deterioration according to its own criterion of consequence fairness. On the other hand, neither free trade nor protectionism has been shown to be optimal in all cases either; there are cases in which fair trade is the better option. Perhaps the most striking result therefore is that in most cases it is not possible to say a priori whether free trade, fair trade or protectionism is an improvement or not. The effects of fair trade were shown to be highly dependent on the characteristics of the sector in question. In the Heckscher-Ohlin model, for instance, the effects were to a large extent determined by the characteristics of the goods traded. Fair trade was found to be always superior to protectionism, but its superiority with respect to free trade depended on the price elasticity of demand of the product it targets at. In the static version of the economic geography model, the remaining level of transportation costs appeared to be a key variable, whereas the results also depended highly on other characteristics, such as the expenditure share on manufacturing goods. The verdict on the superiority of fair trade was found to be highly case dependent. The overall conclusion must therefore be that it is by no means clear that fair trade initiatives are always fairer than other options. However, it is also clear that there are cases in which this is true. These conclusions bring important implications for the policies of fair trade organisations with them. Fair trade organisations have a valuable concept to offer to producers in developing countries; in some cases, fair trade is a superior alternative to the options of free trade and protectionism. However, instead of taking it for granted that fair trade is always good, fair trade organisations should study the characteristics of the markets they consider to enter and assess whether fair trade would mean an improvement or not. If this is not the case, these organisations would do better to focus on other markets. Of course, there are strong moral arguments for the other element of the fair trade practice, refusing on principle to trade in products not produced under minimal decent conditions. However, this is not a reason to pursue the second element, i.e. the payment of prices above market level, as well. Instead, fair trade organisations might consider a second line of action for some products, in which

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these products are sold against market prices but with the guarantee that some basic principles are respected. 29 Two remarks should yet be made, however. In our analysis of consequence fairness, we have only studied the short run effects of fair trade programmes. Fair trade organisations, however, point to the longer run benets of their programmes as well. These may indeed very well exist; trade itself might have a negative effect on transaction costs, for example due to the reduction of cultural barriers or the establishment of networks, which would make fair trade in the long run a better solution to divergence problems. This way, fair trade programmes could be seen as a vehicle for developing countries to exploit their comparative advantage. On the other hand, a problem with the inception of fair trade programmes might be that it changes the relative position of income groups in society, which could make the continuation of fair trade programmes unfair. Those that were worst off initially are not necessarily the ones who are worst off now. Moreover, since the dynamic effects of fair trade might alter the circumstances under which trade takes place, a continuous reassessment of the focus of fair trade programmes is warranted. Secondly, we have studied the effects of fair trade programs only in two specic general equilibrium models of international trade. Although these two models form the heart of contemporary trade theory, they have little attention for the specic circumstances under which production by small-scale producers in Third World countries takes place. When one considers these circumstances, it is imaginable that fair trade has a function in redressing the structural market failures that characterise the agrarian economy in many developing countries. Before giving a denite verdict on the fairness of fair trade, it would therefore be justied to analyse these possibilities in future research.

APPENDIX: THE STANDARD ECONOMIC GEOGRAPHY MODEL This appendix gives the equilibrium conditions of the standard economic geography model by Krugman 1991 and as employed in chapter 5 by Fujita et al. 1999. The world it describes consists of two regions or countries; these terms can be used interchangeably, which each can produce two types of goods. One good is a constant returns to scale, homogeneous agricultural good; the other good is a heterogenous manufacturing good, which exhibits increasing returns to scale. Both goods are produced with sector specic factors of production that are in xed supply, that is: each region has a xed amount of agricultural and manufacturing labour and in the instantaneous equilibrium there is neither cross-region nor cross-sector factor mobility. Consumers in both regions have identical pref29 Or for which the higher price only reects the extra cost respecting these principles brings along and is not an instrument to raise income.

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erences which are Cobb-Douglas regarding the choice between the two types of goods and Dixit-Stiglitz CES regarding the choice between different varieties of the manufactured goods including imported varieties. The agricultural product is costlessly tradeable and serves as numraire; varieties of the manufactured good carry iceberg-type of transportation cost, that is: upon transportation to the other region, part of the good melts away. This is to avoid the modelling of a separate transportation industry. Agricultural labour is divided equally among regions; the amount of manufacturing labour may differ between regions. Equilibrium is contained in the following set of equations for i, j 1,2 and i j: P ii bw i / P ij bw i / m ii / m ij p ii / p ij 1 / 1 fw i / 1 p ii m ii p ij m ij fN i / 1 i lL A.1 A.2 A.3 A.4 A.5

w i i lL 1l L/2 N i p ii m ii N j p ji m ji

In these equations w i denotes the wage rate of manufacturing labour in region i; p ij and m ij, respectively, denote the f.o.b. price and f.o.b. quantity delivered by a manufacturing producer from region i that sells in region j, and N i denotes the number of manufacturing varieties produced in region i. Total labour supply in the world is L, of which a share l is manufacturing labour and a share il manufacturing labour in region i i 1. Agricultural labour is equally divided between regions. The parameters b and f are, respectively, the marginal and xed labour cost of manufacturing production; is the share of expenditures on manufacturing goods; denotes substitutability in consumption between different manufacturing varieties 0 1 and 1/1 1 is the elasticity of substitution; and 1 denotes the iceberg-type of transportation costs. The equilibrium conditions represent goods market and labour market equilibrium, while taking into account optimum producer and consumer decisions and the fact that free entry and exit in industry imply zero prots for manufacturing producers. In our simulations benchmark, we have chosen the following normalisations following Fujita et al. 1999 and parameter values: l 0.6; b 0.8; f / 1 3; 1 0.6; 2 0.4 and L 1. The fair trade version of our model is obtained by substituting A.5 by

w 1 1 lL 1l L/2 N 1 p 11 m 11 N 2 p 21 m 21
A w 2 2 lL 1l Lw 2 /2 N 2 p 22 m 22 N 1 p 12 m 12

A.6a A.6b

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A where w 2 is now the endogenous wage rate of agricultural labour in region 2 the small region, and adding A /2 1 w 1 1 lL 1l L/2 1l Lw 2

A.7

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