International Economics ECON 390
Lotta Moberg
Lecture notes – 10 October 6-10: The Political Economy of Trade Policy
Arguments against Free Trade
1. For a large country, a small tariff can lead to increased terms of trade and
hence increase national welfare.
2. Export restrictions can have the same effect.
3. Domestic market failures, like persistently high underutilization of labor,
structures, equipment, and other forms of capital, may cause free trade to
be a suboptimal policy.
4. Government intervention that distorts market incentives in one market may
increase national welfare by offsetting the consequences of market and
government failures elsewhere.
Arguments for Free Trade
1. Domestic policy should be aimed directly at the source of the problem.
2. It is unclear to what extent market failures actually exist in the real world.
3. Government policies to address market failures will likely be manipulated
by politically powerful groups.
4. Producers and consumers allocate resources most efficiently in the absence
of distortions through trade policy.
5. The Efficiency Case for Free Trade (Learn to illustrate this in the supply and
demand framework for a tariff.)
6. Free trade allows firms or industries to take advantage of economies of
scale.
7. Free trade provides competition and opportunities for innovation
8. Free trade avoids the loss of resources through rent seeking.
9. Even if there is a better policy in theory, free trade is the best feasible
political policy.
10. Distorted incentives of producers and consumers mean that trade policy
have unintended consequences that make a situation worse, not better.
International Economics ECON 390
Lotta Moberg
The Infant-Industry Argument (DB 5 and KOM 11)
11. Protect companies while they are growing up and becoming competitive.
12. But protection does not encourage firms to grow up, so they remain
dependent on government support.
13. If a company is set to become profitable, it will find means of financing in
the meantime.
14. It is hard to know when a company is no longer an infant.
15. Politics prevents industry protection from ever being removed.
Export Subsidies
16. The definition is unclear
 How about tax breaks, government funded infrastructure?
17. Governments subsidize the consumption of other countries.
 If temporary, no political measures are warranted.
 If permanent, it is just like a new technology making consumption cheaper.
18. The U.S. and the European Union both subsidize agriculture - but in quite
different ways.
19. There are good arguments both in favor and against these policies.
20. But since national welfare hardly benefits, their persistence seem to be due
to interest politics.
 Tyler Cowen: France requires 40% of TV programming to be native French.
Is this a tariff, quota, or other form of protectionism?
Antidumping
21. One of the most common forms of trade restrictions.
22. A country imposes tariffs against a good from a country, blaming ”predatory
pricing”, which would hurt domestic producers.
23. But if the foreign firm is more efficient, it should charge lower prices.
24. Review the theory on dumping in KOM 8: There are good reasons for a
company to charge a lower price abroad than at home.
International Economics ECON 390
Lotta Moberg
25. The foreigner incurs much higher losses than domestic firms if pricing below
costs.
26. A dumping firm can only monopolizes the market if no new domestic firms
or foreign firms can compete.
The National Defense Argument against Free Trade
27. We need a defense industry in case of war, even if it is not our comparative
advantage
28. But protecting an industry rather risks making it sluggish and outdated
 Better to trade in defense equipment and store it
29. The argument can be extended to almost anything
 Rice is crucial for the Japanese – hence a 778% import tariff on rice
Observations on Trade Policies
30. Much trade policy is a race of giving things away.
31. But exports are not a goal in themselves – they are the price of imports.
32. 1/3 of imports to the U.S. are inputs to goods produced here.
33. The best policy is to receive subsidized or ”dumped” goods with open arms.
The median voter theorem as a Predictor of Trade Policy
34. Political parties pick policies to appeal to the voter in the median voter on
an issue.
35. If two parties, they offer the same tariff policy.
36. So a two-party democracy should enact trade policy based on how many
voters it pleases.
37. But trade policy does not follow this prediction.
Collective Action
38. Consumers benefit from free trade but no individual consumer has the
incentive because his benefit is small compared to the cost and time
required to advocate free trade.
International Economics ECON 390
Lotta Moberg
39. Policies that impose large losses disbursed over society as a whole are
therefore not opposed.
40. Each individual in the group who suffers large losses from free trade has a
strong incentive to advocate against it.
 One congressman will press for trade protection for his district’s industry.
Others may not find it worth the while to oppose it.
The Median Voter and Collective Action Combined
41. While politicians may win elections partly because they advocate popular
policies, they also want campaign funding, which comes from groups who
do not have a collective action problem.
42. There is a trade-off between the reduction in welfare of constituents as a
whole and the increase in campaign contributions from special interests.
International Negotiations of Trade Policy
43. After rising sharply at the beginning of the 1930s, the average U.S. tariff
rate has decreased substantially from the mid-1930s to 1998.
44. Since 1944, international negotiations have reduced many tariffs and other
trade restrictions.
 The General Agreement of Tariffs and Trade (GATT) began in 1947 as a
provisional international agreement and was replaced by the more formal
international institution the World Trade Organization (WTO) in 1995.
Benefits of Multilateral Trade Policy Negotiations
45. The approach counteracts the support for restricted trade by import-
competing groups.
46. Multilateral negotiations also help avoid a trade wars between countries,
where each country enacts trade restrictions.
47. All countries could enact trade restrictions, even if it is in the interest of all
countries to have free trade.
48. Countries need an agreement that prevents a trade war or eliminates the
protection from one.
International Economics ECON 390
Lotta Moberg
The World Trade Organization (WTO)
49. Negotiations aim to reduce tariffs, bind tariff rates and eliminate nontariff
barriers.
50. WTO rules in trade disputes.
 For instance, the U.S. has tried to get away with tariffs against China.
 The Doha round of negotiations started in 2001, but has not yet produced
an agreement.
 Discussions continue about subsidies for food procurement and food-aid
programs as permissible incentives.
51. Boudreaux argues that WTO negotiations are based on the false premise
that tariffs and subsidies benefit a country.
52. In any case, says Lester, we can use our protectionism as a bargaining tool
against others to decrease their trade barriers.
53. The WTO does not allow for Preferential Trading Agreements.
54. Instead, all countries shall pay tariffs no higher than the nation that pays the
lowest. This is the “most favored nation” (MFN) principle.
55. Exemptions to the rule are:
 A free trade areas: Allows for free trade among members, but each member
can have its own trade policy towards non-member countries.
 A customs union: Allows for free trade among members and requires a
common external trade policy towards non-member countries.
Free Trade Agreements
56. Not necessarily good for national welfare.
 May import more expensive products.
57. Increase national welfare when trade is created, but not when existing
trade is merely diverted from other countries.