In the literature, fair trade expansion has drawn criticism from across the political spectrum. Economic arguments against fair trade address price distortions and market inefficiencies caused by price floors. Economic counter arguments address the inequality of the market power of the buyer and seller and that comparisons to efficiency in a competitive market is inappropriate. The conditions in rural developing countries is further from the assumptions of perfect competition when one considers asymmetry of information, limited access of credit, and inability to switch production techniques and outputs in response to market signals. Similarly they argue that economists frequently ignore product differentiation and quality differences. Economic arguments also include the distortion caused by the insider-outsider markets. The argument claims that aim to help marginalized producers impacts other producers (including marginalized producers of non fair trade commodities). Counter arguments incorporate the joint gain to all producers gained from access of better information, greater access to credit and markets, and the increased ability to learn production techniques. At the other end of the political spectrum is the argument that fair trade is a movement within the market system and fails to address the equity and fairness of the resulting market. This is effectively the counter to the economic concerns for efficiency in that equity is the concern.
In order to study the welfare effects of fair trade, we develop a general equilibrium model where citizens endogenously choose to enter the formal economy (which generates a positive externality), the informal economy, or may become bureaucrats who regulate and impose fines on the informal economy. The model is intended to capture economies such as Columbia's where individuals may choose between farming coffee (the formal economy), the drug trade (the informal economy), or work for the government. Within the formal economy individuals may choose to sell their product at the market price, or a fair trade price (that is above the market price). The government endogenously raises revenues through taxes and fines that either finances public goods or may be used for the ruler’s personal gain. We use this model to examine to study the welfare implications of fair trade policies. Our key intuition is that fair trade can serve as a policy tool to subsidize and expand the socially beneficial formal sector, especially when the alternatives are socially harmful activities in the informal sector (such as drug trafficking). This affect will be especially productive when the government 's ability to deter the informal sector is weak (or when the benefits from the informal sector are large). Thus, depending on the economic context, fair trade may be welfare enhancing in economies such as Columbia's.