12 - Aid and transfers

Summary

Introduction

Chapter 6 made use of a proposition that may appear counterintuitive. The proposition is that if country H makes a gift or transfer to country L, then it is entirely possible that as a result country H may be made better off, and country L worse off. It may indeed be more blessed to give than to receive.

This phenomenon has long been recognized in international economics, though our understanding of it has been advanced greatly in recent years. Because the basic result is surprising, and because it is important for understanding the complications associated with aid and loans, we present below a simple geometric explanation. First, however, we provide an intuitive discussion of the underlying economics.

The point is actually very simple and hinges on the relative magnitudes of income and substitution effects, and on the response of market prices to a policy change. Suppose H to make a gift to L. Obviously, if prices stay constant, H is poorer and L is richer, so H can consume less and L more: H loses and L gains.

Now suppose in addition that L consumes very intensively good A, so that most of L_s extra wealth is spent on good A Obviously, we expect the price of A to rise as a result of the transfer: Wealth has been redistributed toward consumers with a strong demand for A. Finally, assume that country H, the donor country, is the main supplier of good A.