The Myth of Fair Prices:
A Graphical Analysis
Dennis Yanchus and Xavier de Vanssay
Abstract: The issues of fair trade and in particular fair price policies, have been
neglected in most international trade courses. The authors show how the latter
can be explained to undergraduate students applying the simple graphical methods
normally used in general equilibrium trade theory. They show that fair pricing
strategies can be looked upon as a suboptimal device for redistributing the
gains from trade as compared with a transfer of funds.
Key words: fair prices, foreign aid, international trade theory
JEL codes: A2, F11, O1
As the number of unilateral and multilateral trade agreements has grown, calls
by labor movements and environmental groups for minimum labor and environmental
standards have increased. To address the concerns and questions raised by
these groups, trade economists have written at length--in the relatively new area
of fair trade theory--on the possible effects of standards, both labor and environmental,
and on related questions regarding the so-called "race to the bottom"
(e.g., Bhagwati and Hudec 1996). On the demand side of this phenomenon, there
has been an increased call on the part of consumers in the developed world for
products for which a guaranteed fair price has been paid to workers in the developing
world.
Products such as ethical fruit juices, fair-price teas and coffees and other foodstuffs,
and raw materials have appeared on the market to cater to this increased
demand. Freeman (1996, 91), in addressing this new demand, has argued that
these ethical products constitute an "extended product" because ". . . The consumer
who cares whether the worker makes products in a palace or sewer consumes
not only the physical good but the associated work conditions." Despite
Freeman's assertion that these extended products provide a valid avenue for raising
labor standards, additional questions need to be addressed regarding these
extended products. For example, are there other effects of channeling wealth to
developing countries through consumer goods prices? That is, despite the particular
reason one expounds for using fair prices (to raise labor standards), are they
the best way to achieve one's goals? Outside of Freeman, little economic analysis
of these questions regarding fair prices or labeling policies has been done,
Dennis Yanchus has a BA in economics from Glendon College, York University. Xavier de Vanssay
is an associate professor of economics at Glendon College, York University, Toronto (e-mail:
devanssay@glendon.yorku.ca). The authors wish to thank Steven Easton and two anonymous referees
for helpful comments.
Summer 2003 235
especially in the teaching of trade theory. We argue that it may be less efficient
to pay fair prices than it is simply to donate funds directly to the targeted countries.
The reader may recognize this argument as an application of Harry Johnson's
(1965, 5) two propositions. First, the solution to domestic distortions
should not be found in protectionism. Second, protection, if introduced to correct
domestic distortions, may lead to a suboptimal outcome from an economic welfare
perspective, even when compared with the original free trade situation.
We define what a fair price is and then look at the costs stemming from the use
of fair prices to the rest of the world and to the country targeted. Finally, we outline
the possibility of a more efficient approach to assistance.
FAIR PRICE?
What does it mean to pay a fair price for coffee? One definition could be that a
fair price may be said to be equal to the market-determined price of a good plus
an additional premium that consumers are willing to pay for the guarantee that
specific inputs are paid at a certain socially acceptable rate. Therefore, fair prices
allow consumers in the developed world to redistribute a certain proportion of
their gains from trade to a country (or factors within the country) from which they
have imported a good or service. By extension, this means that goods sold at fair
prices must be goods produced in countries by individuals whom consumers in the
developed world have targeted as in need of assistance. For example, by targeting
coffee from South America for the payment of fair prices in North America, North
American consumers are channeling a proportion of their personal share of the
gains from trade directly to these coffee growers.1
To be clear, only some countries
that produce coffee are so favored. Therefore we assume that the world price
of coffee (which is the price that is paid to nontargeted coffee-growing countries)
remains unchanged. This is where the problem arises.
When assistance is targeted to some developing countries through the payment
of fair prices, relative prices in these countries are changed; this leads to a change
in incentives. Using coffee as an example, we show in Figure 1 what results when
consumers decide to use their purchases of coffee to channel assistance to certain
growers in the developing world.2
The payment of fair prices for coffee raises the price of coffee relative to that
of other goods produced in the developing country. This leads to a shift in productive
resources in the targeted developing country away from the production of
other goods toward the production of coffee. The higher price received for coffee
in the targeted developing country improves its terms of trade and leads to an
increase in its aggregate income at world prices (a movement from Y0
to Y1
). The
developing country will now maximize its consumption at B--the point at
which the indifference curve Y1
is tangent to BB. At B, the value, in terms of
other output, of this new consumption bundle at world prices is 0T. Because consumption
increases from A to B, the developing country as a whole benefits
unambiguously from being the target of fair pricing. However, the cost of fair
pricing to the rest of the world is more complicated and can be divided into three
components.
236 JOURNAL OF ECONOMIC EDUCATION
COSTS TO THE REST OF THE WORLD FROM FAIR PRICING
The first cost component to the rest of the world from fair pricing stems directly
from the difference between the fair price of coffee and the market-determined
price of coffee.3
The decision on the part of consumers in the developed world to
pay a premium above the market-determined price of coffee results in a donation
channeled through the price of the targeted good (a sort of donation per unit) to
the growers in the developing country. Measured at world prices, revenue
attained through a fair-price policy would be collected theoretically at B. Thus
this transfer of fair-price revenue shown by UT in Figure 1 is the first cost component
of fair prices.
The second cost component results from the change in the price of the targeted
good itself. The voluntary action of the consumer in the developed world
results in an increase in the export price received by the targeted growers, leading
to a shift in productive resources toward the production of coffee (in Figure
1, the shift from A to B).4
This shift in production priorities on the part of targeted
growers in the developing country allows for a maximization of domestic consumption.
The value, in terms of world prices, of the new aggregate production
Summer 2003 237
FIGURE 1. Fair prices and the developing world.
Other
output
Coffee
point B reflects world resource costs. The value of B is lower than the original
production point A; production in terms of other output has decreased from 0U
to 0V. Thus, the second cost component to the rest of the world of fair pricing
arises from the increase in the production of coffee sold at fair prices. This is
shown in Figure 1 by VU. The total direct cost of the fair price for the developed
country, in terms of other output, is VT.
A third indirect but often ignored effect of fair pricing flows from the observation
that the overall world consumption of coffee --like other foodstuffs and
natural resources--is inelastic. In the fair price model described above, the production
of coffee at fair prices increases, which leads to a reduction in coffee produced
by nontargeted countries. Targeted growers are made better off, but nontargeted
growers must reduce their output.
INTERNAL EFFECTS
Fairly priced coffee means higher coffee prices in targeted countries and higher
income for their coffee growers; growers are made unambiguously better off.
If we were to stop there, industries other than coffee and industries in other nontargeted
countries would be neglected. In the context of a specific factor model
in which land is specific to coffee production, as the return to the targeted grower's
land increases, the return to any factor specific to an activity that is not targeted
such as fruit farmers, coffee growers in a nontargeted country, factory
workers would fall by a magnified amount. This would happen because the nontargeted
specific factors must still compete with the targeted coffee growers for
shared factors such as water and electricity (Ruffin and Jones 1977).
Finally, because fair prices distort information about a country's long-term
comparative advantage, fair pricing may lead a developing economy down a dangerous
path of dependence on the premiums from fair prices. This internal distortion
as well as the internal distortions in nontargeted countries5
may yet induce
the highest costs from fair pricing.
A MORE EFFICIENT APPROACH TO ASSISTANCE
What would happen if consumers did not channel their assistance through
commodity prices but rather through direct transfers to the country? First, the
size of the transfer needed to bring about the same increase in aggregate income
in the developing country would be smaller UT versus VT (Figure 1).
Second, the transfer, unlike the payment of fair prices, does not target certain
groups within the developing country. It spreads the donation throughout the
economy, leaving price incentives unchanged. One can argue that we are ignoring
the revenue raising cost in the donor country and the distribution cost in the targeted
country. However, as in the case of costs associated with monitoring and
enforcing whether fair prices are truly fair--whether the workers receive what is
intended--the costs associated with revenue raising and distribution in the case of
a donation may not be trivial. Which of the two policies--donation versus fair
pricing--has the lowest cost in this regard is an empirical question rather than a
238 JOURNAL OF ECONOMIC EDUCATION
theoretical one. Thus, the empirical question aside, the use of a transfer rather than
a fair price to channel assistance to a developing country removes the price distortion,
which removes the incentive to (inappropriately, from a world resource
cost perspective) reallocate resources.
Third, the use of a transfer is more beneficial to the developing country. Unlike
the situation under the regime of fair pricing, the developing country is not
required to maximize its consumption relative to distorted domestic prices, but
instead, maximizes its consumption relative to world prices. This allows it to
obtain a higher level of aggregate income (shown by point C on indifference
curve Y2
in Figure 1).
Finally, by not distorting coffee prices, the nontargeted growers will not be
forced to alter their production decisions, and the third cost component of fair
pricing disappears.
CONCLUSION
Fair pricing, despite making a targeted country unambiguously better off, has
serious costs when the country's internal production incentives are taken into
account. Both import competing and other exporting sectors could be made worse
off. Once fair pricing policies are put into effect, there is an opportunity over time
for these targeted countries to become dangerously dependent on these policies.
Ultimately, if the developed world would like to help developing countries, the
most effective way to do so may be by direct transfer. Although the impetus for fair
pricing may be noble and intuitively appealing, fair pricing is inefficient for both
the receiver and the donor and must be considered an inefficient device for the
redistribution of wealth. The fair price policy attempts to raise incomes by distorting
prices, whereas a simple transfer more efficiently reaches the same objective.
The issue of fair pricing can be used as a powerful teaching tool in international
trade courses. Fair pricing provides a good example for outlining the workings
of the price system and price incentives, the merits of the specific factor
model in analyzing policy, the graphical approach to trade theory, and, if one
wishes, the question of enforcement costs of standards or the revenue raising and
distribution costs of the donation.
NOTES
1. We assume throughout the article that the targeted workers get what is intended for them. However,
the cost of ensuring and enforcing that ethical products are in fact ethical should by no means
be considered trivial and should be factored into any discussion of fair prices.
2. In Figure 1, we assume homothetic preferences. This assumption simplifies the discussion, but in
no way does it alter the conclusions.
3. Recall, for simplicity, that we assume that the producer who is being helped is sufficiently small
that world coffee prices do not change in consequence.
4. We have said nothing about the level of exports. For example, it may well be that if the income
effect is very strong, the developing country may actually export less. This intriguing possibility
does not affect our results.
5. With a specific factor model, one could imagine the converse situation occurring in nontargeted
countries. The nontargeted coffee grower sees his or her return drop by a magnified amount as
other industries, which see their relative returns increase, are able to obtain a larger share of the
common factors.
Summer 2003 239
REFERENCES
Bhagwati, J. N., and R. E. Hudec, eds. 1996. Fair trade and harmonization: Prerequisites for free
trade? Cambridge, Mass.: MIT Press.
Freeman, R. B. 1996. International labor standards and world trade: Friends or foes? In J. J. Schott,
ed. The world trading system: Challenges ahead. Washington D.C.: Institute for International Economics:
87­112.
Johnson, H. G. 1965. Optimal trade intervention in the presence of domestic distortions. In R. E.
Baldwin, et al. Trade, growth and the balance of payments. Essays in honor of Gotfried Haberler.
Chicago: Rand McNally: 3­34.
Ruffin, R., and R. W. Jones. 1977. Protection and real wages: The neoclassical ambiguity. Journal of
Economic Theory 14 (April): 337­48.
240 JOURNAL OF ECONOMIC EDUCATION
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