It is generally claimed that state trading, or centrally controlled tr

It is generally claimed that state trading, or centrally controlled trading will tend to reach a lower economic welfare than would be reached by allowing market forces to determine trade flow directions and terms of trade.

Illustrate a counter-example to this proposition.

ANSWER

In general, if we begin with any suboptimal distortion, the theory of the second best tells us that an additional “distortion” may move a country in the correct direction of a welfare improvement. For example, If a country has an overvalued exchange rate (that is, its currency is overpriced in the foreign exchange markets), it is possible that it will find itself in an autarkic equilibrium (that is, it might “overprice itself out of the international market”). In such a case it is easy to demonstrate that if the government exports the goods in which the country enjoys comparative advantage, and imports the other (bypassing market prices and mechanisms), the country’s economic welfare will improve.