Topic 5
The Political
Economy of
Trade Policy
Slides prepared by Thomas Bishop
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Preview
• The cases for free trade
• The cases against free trade
• Political models of trade policy
• International negotiations of trade policy and
the WTO
• Preferential trading agreements
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9-2
The Cases for Free Trade
•
Few countries have anything like free trade.
 Hong Kong is the only modern city with no
quotas or tariffs.
•
Yet, economists have argued since Adam
Smith that governments should pursue free
trade.
•
Why? We will discuss three reasons.
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9-3
The Cases for Free Trade
• First case for free trade: producers and
consumers allocate resources most
efficiently when governments do not distort
market prices through trade policy.
 National welfare of a small country is highest with
free trade.
 With restricted trade, consumers pay higher prices.
 With restricted trade, higher prices cause
overproduction either by existing firms producing
more or by more firms entering the industry.
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9-4
Fig. 1: The Efficiency Case for Free Trade
A small country
cannot influence
foreign export prices.
The tariff only distorts
consumer and
producer decisions.
A move toward free
trade eliminates these
distortions and raises
national welfare.
Table 1: Benefits of a Move to Worldwide Free
Trade (percent of GDP)
Because tariff rates are already low for most countries, the
estimated benefits of moving to free trade are only a small fraction
of national income for most countries.
The Cases for Free Trade (cont.)
• When quotas are used instead of tariffs, costs
can be magnified through rent seeking.
 To seek quota licenses or the rights to sell a
restricted quantity of imports and the profit that
they will earn, individuals or institutions need to
spend time and other resources.
• Thus, another reason why trade allocates
resources efficiently is that it avoids the loss
of resources through rent seeking.
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9-7
The Cases for Free Trade (cont.)
• E.g., U.S. imports of canned tuna are protected by a
“tariff-rate quota:” a small Q of tuna (4.8% of C) can
be imported at a tariff of 6%; but any imports beyond
that face a tariff of 12.5%.
• There are no import licenses and the right to M tuna
at the low tariff rate is given on a first come, first
served basis.
• This results in a costly race to get tuna into U.S. as
fast as possible.
• Importers stockpile large Q of canned tuna in
warehouses in late Dec. and release the product as
soon as the calendar year begins.
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9-8
The Cases for Free Trade (cont.)
•
Second case for free trade: it produces
benefits beyond the elimination of production
and consumption distortions.
a) Allows firms or industry to take advantage of
economies of scale.
 Need to deter massive entry into industries with
falling AC and the resulting inefficient scale of
production.
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The Cases for Free Trade (cont.)
•
Protection ↓competition and ↑profits
domestically → encourages too many firms
to enter the industry → each firm produces
on a small scale where AC is higher.
 E.g., An efficient scale auto assembly plant
should produce 80,000 to 200,000 autos/year.
Yet, in 1964, Argentina protected its auto industry
and produced 166,000 cars with 13 firms!
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The Cases for Free Trade (cont.)
b) Free trade provides competition and
opportunities for innovation.
•
Free trade gives entrepreneurs an incentive
to export or compete with imports → giving
more opportunities for learning and
innovation than a system of “managed
trade” where government dictates imports
and exports.
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9-11
The Cases for Free Trade (cont.)
• E.g., Until 1990s, India pursued an extreme form of
ISI. This forced resources into the production of
goods that were far more expensive and of lower
quality than what could be bought abroad.
• India was a very “closed” economy with X = 5% of
GDP, which was among the lowest of any major
nation. GDP per capita growth rate = 1.3%.
• In 1990s, India liberalized trade and encouraged
foreign I. By 2005, X = 20.3% of GDP and GDP per
capita growth rate = 7.7%.
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The Cases for Free Trade (cont.)
• These additional gains from trade (i.e.,
economies of scale and opportunities for
innovation) are dynamic benefits, unlike the
static benefits of eliminating the efficiency
losses from over-production and underconsumption.
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9-13
The Cases for Free Trade (cont.)
• Third case is called the political argument
for free trade, says that free trade is the best
feasible political policy, even though there
may be better policies in principle.
 Economists might be able to show in theory that a
set of tariffs and export subsidies could lead to
higher national income.
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9-14
The Cases for Free Trade (cont.)
• However, a government that tries to follow
such a sophisticated trade policy would
probably be captured by interest groups and
converted into a program that redistributes
income to politically powerful industries.
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9-15
The Cases Against Free Trade
• First argument against free trade: for a “large”
country, a tariff or quota lowers the price of
imports in world markets and generates a
terms of trade gain.
 This benefit may exceed the losses caused by
distortions in production and consumption.
• In fact, a small tariff will increase national
welfare for a large country.
 But at some tariff rate, the national welfare will
begin to decrease as the efficiency losses exceed
the tot gain.
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9-16
Fig. 2: The Optimum Tariff
Prohibitive tariff leaves
the country worse off
than free trade where
tariff = 0.
↑tariff rate beyond tP
has no impact on
national welfare.
Optimal tariff is greater
than zero, but less than
a rate that would
prohibit all imports.
Free
trade
The Cases Against Free Trade (cont.)
• A tariff rate that completely prohibits imports
leaves a country worse off, but tariff rate t0
may exist that maximizes national welfare: an
optimum tariff.
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The Cases Against Free Trade (cont.)
• An export tax that completely prohibits exports
leaves a country worse off, but an export tax
rate may exist that maximizes national welfare
through the terms of trade gain.
 An export subsidy lowers the tot for a large
country; but an export tax raises the tot.
 An export tax may raise the price of exports in the
world market, increasing the tot.
 E.g., Saudi Arabia and other oil exporters tax oil
exports, raising oil prices on world markets.
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9-19
Counter-Argument
• For some countries, like the U.S., an import
tariff or an export tax could improve national
welfare at the expense of other countries.
• But this argument ignores the likelihood that
other countries may retaliate against large
countries by enacting their own trade
restrictions.
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9-20
The Cases Against Free Trade (cont.)
• A second argument against free trade is that
domestic market failures may exist that
cause free trade to be a suboptimal policy.
 The efficiency loss calculations using CS and PS
assume that markets function well.
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The Cases Against Free Trade (cont.)
• Types of market failures include:
 Labor used to produce the import-competing good
would be unemployed otherwise.
• Production in labor-intensive (import-competing)
industries helps the economy reach full employment.
 There are technological spillovers from the importcompeting industry to other industries.
• Production of the import-competing good will improve
technology in the country, but firms in the industry can’t
earn revenues from this; and therefore, don’t take this into
consideration when deciding output.
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The Cases Against Free Trade (cont.)
• Economists calculate the marginal social
benefit to represent the additional benefit to
society from private production.
 With a market failure, MSB is not accurately
measured by PS of private firms, so that efficiency
loss calculations are misleading.
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9-23
Fig. 3: The Domestic
Market Failure Argument
for a Tariff
Fig. 3(a)
Fig. 3(a) shows the conventional
cost-benefit analysis of a tariff in a
small country.
Fig. 3(b) shows the MSB from
production not taken into account by
PS.
Tariff ↑P → ↓D and ↑S → distortions
labeled a and b.
But this ignores the possibility that
↑S → social benefit labeled c.
If the tariff is small enough, c > a + b
and welfare rises.
Fig. 3(b)
The Cases Against Free Trade (cont.)
• The domestic market failure argument against free
trade is an example of a more general argument
called the theory of the second best.
• This theory states that government intervention which
distorts market incentives in one market may increase
national welfare by offsetting the consequences of
market failures elsewhere.
 The best policy would be to fix the market failures
themselves, but if this is not feasible, then government
intervention in another market may be the “second-best” way
of fixing the problem.
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The Cases Against Free Trade (cont.)
• E.g., If the labor market is not at full employment, then
a policy of subsidizing L-intensive industries, which is
undesirable in full employment, may be a good idea
with high unemployment.
 Better to fix the labor market by making wages more flexible!
But if this can’t be done, then intervening in other markets
may be the “second-best” way to alleviate unemployment.
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Counter-Arguments
• Economists supporting free trade counterargue that domestic market failures should be
corrected by a “first-best” policy: a domestic
policy aimed directly at the source of the
problem.
 If national welfare increases with a tariff because it
↑Q which has social benefits, then ↑Q with a
production subsidy.
 A production subsidy does not ↑P to consumers, so
the under-consumption efficiency loss (due to the
tariff) disappears.
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9-27
Counter-Arguments (cont.)
• E.g., In U.S., VER on autos was supported to save
jobs of autoworkers.
• Advocates argue that labor markets are too inflexible
for autoworkers to remain employed by cutting wages
or finding jobs elsewhere.
• Purely domestic policy: subsidize firms that hire
autoworkers.
 Political opposition: require large payments → ↑federal
budget deficit or ↑income taxes.
 Autoworkers are among the highest paid manufacturing
workers, so public would object to this.
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Counter-Arguments (cont.)
• VER is even more expensive: while bringing about the
same level of employment, it also distorts consumer
choice.
• Difference in two policies: costs are less visible with
VER → ↑Pautos vs. direct G outlays.
• Critics of domestic market failure argument for
protection argue that this case is typical.
 Most deviations from free trade are adopted because the
public does not understand the true costs and not because
benefits of protection > costs.
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9-29
Counter-Arguments (cont.)
• In the real world, market failures are hard to identify,
so it’s difficult to be certain about the appropriate
policy response.
 E.g., Urban UE in developing countries. What is the best
policy? Tariff to protect urban industrial sector will draw UE
into work. Or might this policy encourage more rural-urban
migration that will raise urban UE?
• Economic theory explains properly functioning
markets but provides little guidance for market failure.
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9-30
Political Models of Trade Policy
•
How is trade policy determined?
•
Models that address this question:
1. Median voter theorem
2. Collective action
3. And a model of trade policy that combines
aspects of both
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Median Voter Theorem
• The median voter theorem predicts that
democratic political parties may change their
policies to court the voter in the middle of the
ideological spectrum (i.e., the median voter).
• Suppose that this ideological spectrum is
defined only by a tariff rate policy.
 And suppose that voters can be ranked according
to whether they desire high or low tariff rates.
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Median Voter Theorem (cont.)
•
Assumptions of the model:
1. There are two competing political parties.
2. The objective of each party is to get elected by
majority vote (not to maintain ideological purity).
•
What policies will the parties promise to
follow?
 Both parties will offer the same tariff policy to
court the median voter (the voter in the middle of
the spectrum) in order to capture the most votes
on either side of the median voter.
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9-33
Fig. 4: Political Competition
Voters are lined up in
order of the tariff they
prefer.
If one party proposes a
high tariff tA, the other
party can win over the
most voters by offering a
somewhat lower tariff, tB.
This political competition
drives both parties to
propose tariffs close to
tM, the tariff preferred by
the median voter.
Median Voter Theorem (cont.)
• Thus, the median voter theorem implies that a
two-party democracy should enact trade
policy based on how many voters it pleases.
 A policy that inflicts large losses on a few people
(import-competing producers) but benefits a large
number of people (consumers) should be enacted
into law.
• But trade policy doesn’t seem to follow this
prediction!
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Collective Action
• Political activity is often described as a
collective action problem:
 While consumers as a group have an incentive to
advocate free trade, each individual consumer has
no incentive because his benefit is not large
compared to the cost and time required to
advocate free trade.
 Policies that impose large losses for society as a
whole but small losses on each individual may
therefore not face strong opposition.
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Collective Action (cont.)
• However, for those groups who may suffer
large losses from free trade (e.g., UE), each
individual in that group has a strong incentive
to advocate the policy he desires.
 In this case, the cost and time required to advocate
restricted trade is small compared to the cost of
unemployment.
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9-37
Collective Action (cont.)
• E.g., sugar quota costs the typical U.S. family $30/yr.
Loss is small and most voters are unaware of the
quota. One individual’s letter of protest won’t change
policy and the small annual loss doesn’t justify the
effort.
• By contrast, the sugar producers are well organized
and they are aware that the quota is worth thousands
of dollars to an individual producer. They lobby
Congress and make political contributions, so we end
up with a trade policy whose costs > benefits.
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9-38
A Model of Trade Policy
• While politicians may win elections partly because
they advocate popular policies as implied by the
median voter theorem, they also require funds to
run campaigns.
• These funds may especially come from groups who
do not have a collective action problem and are
willing to advocate a special interest policy.
• Models of trade restriction policy try to measure the
trade off between the reduction in welfare of
constituents as a whole and the increase in campaign
contributions from special interests.
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Which Industries Are Protected?
• Agriculture: in the U.S., Europe, and Japan
farmers make up a small fraction of the
electorate but receive generous subsidies and
trade protection.
 E.g., European Union’s CAP; Japan’s 1,000% tariff
on imported rice; and America’s sugar quota.
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Which Industries Are Protected? (cont.)
• Clothing: textiles (fabrication of cloth) and
apparel (assembly of cloth into clothing).
 Until 2005, quota licenses granted to textile and
apparel exporters were specified in the Multi-Fiber
Agreement between the U.S. and many other
nations.
 In 2005, U.S. and China signed an MOU that
established quotas on China’s exports of various
types of textiles and clothing.
• E.g., China agreed to limit sock exports to 772.8 million in
2006.
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9-41
Table 2: Welfare Costs of U.S. Protection ($
billion)
In 2002, with the MFA still in effect, clothing restrictions were responsible
for more than 80% of the overall welfare costs of U.S. protectionism.
With the expiration of the MFA, the costs of clothing protection and hence
the overall costs of U.S. protection are expected to fall sharply.
The end of MFA brought a surge in Chinese clothing exports. E.g., in Jan.
2005, China shipped 27 million pairs of cotton pants to U.S. –up from 1.9
million a year earlier. There was fierce political opposition from clothing
makers in the U.S. It remains to been seen whether the liberalization of
clothing trade will prove politically sustainable!
International Negotiations of Trade Policy
• The average U.S. tariff rate on dutiable
imports has decreased substantially from
1920–1993.
• Since 1944, much of the reduction in tariffs
and other trade restrictions came about
through international negotiations.
 The General Agreement of Tariffs and Trade
was begun in 1947 as a provisional international
agreement and was replaced by a more formal
international institution called the World Trade
Organization in 1995.
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Fig. 5: The U.S. Tariff Rate
The average U.S. tariff rate fell from 60% in mid-1930s to 5% in 2000.
International Negotiations
of Trade Policy (cont.)
• Multilateral negotiations mobilize exporters to
support free trade if they believe export
markets will expand.
 This support would be lacking in a unilateral push
for free trade.
 This support counteracts the support for restricted
trade by import-competing groups.
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9-45
International Negotiations
of Trade Policy (cont.)
• Multilateral negotiations also help avoid a trade
war between countries, where each country enacts
trade restrictions.
• A trade war could result if each country has a political
interest (due to political pressure) to protect domestic
producers, regardless of what other countries do.
 All countries could enact trade restrictions, even if it is in the
interest of all countries to have free trade.
• Let’s use a simple example to illustrate this point.
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9-46
Table 3: The Problem of Trade Warfare
In game theory, this is known as a prisoner’s dilemma.
Each government making the best decision for itself chooses to protect,
leading to the outcome (-5,-5). Yet, both governments are better off if neither
protects: (10,10) is a higher payoff.
Japan and U.S. need to agree to refrain from protection. Each government is
better off by limiting its own freedom of action, provided the other country
does the same.
International Negotiations
of Trade Policy (cont.)
• In this simple example, each country acting
individually would be better off with protection,
but both would be better off if both chose free
trade.
• If Japan and U.S. can establish a binding
agreement to maintain free trade, both can
avoid the temptation of protection and both
can be made better off.
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9-48
World Trade Organization
•
WTO negotiations address trade restrictions
in at least 3 ways:
1. Reduction of tariff rates through
multilateral negotiations.
•
Multilateral negotiations are more effective than
bilateral negotiations.
•
Benefits from a bilateral negotiation may “spill over” to
countries that have not made any concessions. E.g., if
U.S. ↓tariffs on coffee because of a deal with Brazil →
Colombia will also gain from the ↑P of coffee.
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World Trade Organization (cont.)
2. Binding: a tariff is “bound” by having the
imposing country agree not to raise it in the
future.
•
A country can only raise a tariff if it gets
agreement of other countries, which usually
means providing compensation by reducing
other tariffs.
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9-50
World Trade Organization (cont.)
3. Prevention of non-tariff barriers: quotas
and export subsidies are not allowed.
 Subsidies for agricultural exports are an
exception.
 Existing quotas were “grandfathered” in. There is
an ongoing effort to remove or convert such
quotas to tariffs.
 New quotas are forbidden. Exceptions are
allowed for “market disruptions” caused by a
surge in imports.
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9-51
World Trade Organization (cont.)
• WTO was founded in 1995 on a number of
agreements:
 General Agreement on Tariffs and Trade: covers
trade in goods.
 General Agreement on Tariffs and Services: covers
trade in services (e.g., insurance, consulting, legal
services, banking).
 Agreement on Trade-Related Aspects of
Intellectual Property: covers international property
rights (e.g., patents and copyrights).
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World Trade Organization (cont.)
The dispute settlement procedure: a formal
procedure where countries in a trade
dispute can bring their case to a panel of
WTO experts to rule upon.
The cases are settled fairly quickly: even
with appeals, the procedure is not
supposed to last more than 15 months.
The panel uses previous agreements by
member countries to decide which ones are
breaking their agreements.
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World Trade Organization (cont.)
• A country that refuses to adhere to the panel’s
decision may be punished by allowing injured
countries to impose trade restrictions on its
exports.
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9-54
World Trade Organization (cont.)
• In March 2002, U.S. imposed 30% tariff on steel.
• U.S. claimed it was facing a surge in imports and
needed time to restructure.
• In reality, steel is concentrated in “swing states” and
Bush was worried about the 2004 pres. election.
• Europe, Japan, China, and South Korea filed suit
against the U.S. and the WTO ruled in their favor in
July 2003.
• Europe (with WTO approval for retaliatory action)
threatened to impose tariffs on more than $2 billion in
U.S. exports.
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World Trade Organization (cont.)
• Europeans targeted their proposed tariffs on goods
produced in political swing states!
• U.S. complied with the WTO ruling in Dec. 2003.
• Some claimed this was a test for the WTO. Would a
large country, like the U.S., comply with its rulings?
• Not a great test, as Europe is a large country that can
effectively retaliate against the U.S.
• As of June 2008, U.S. has not complied with the
March 2005 WTO ruling (for Brazil) against U.S.
subsidies to cotton producers.
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9-56
World Trade Organization (cont.)
• The GATT/WTO multilateral negotiations,
ratified in 1994 (called the Uruguay Round),
 agreed that all quantitative restrictions (e.g.,
quotas) on trade in textiles and clothing as
previously specified in the Multi-Fiber Agreement
were to be eliminated by 2005.
• But as the restrictions were eliminated, China
had to re-impose quotas until 2011 due to
political pressure.
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9-57
World Trade Organization (cont.)
• In 2001, the ninth round of world trade
negotiations was started in Doha, Qatar, but
these negotiations have failed to produce an
agreement.
 Potential gains were modest because barriers to
trade in most goods are now trivial –due to
success of 8 previous rounds.
 Most of the remaining forms of protection are in
agriculture, textiles, and clothing -industries that
are politically active.
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9-58
Table 4: Percentage Distribution of Potential
Gains from Free Trade
Table 4 shows estimates of where the welfare gains from full liberalization
(i.e., elimination of all trade barriers and export subsidies) would have
come from and how they would be distributed across countries.
Agricultural products account for less than 10% of world trade, yet
liberalizing agriculture would account for 63% of the world total gains from
free trade. These gains are very politically hard to get at!
Do Agricultural Subsidies in Rich
Countries Hurt Poor Countries?
• Recall: subsidies ↓world price of products because
they encourage domestic producers to ↑Q.
• So why should poor countries want rich countries to
remove their agricultural subsidies?
• Because farmers in poor countries compete with
farmers in rich countries.
• Yet, urban residents and farmers who do not compete
(e.g., coffee farmers) actually benefit from the lower
prices of subsidized food on world markets.
 E.g., Because China imports a lot of food, it would be hurt by
the removal of agricultural subsidies in rich countries (e.g.,
U.S. and Europe) according to the Doha negotiations.
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Preferential Trading Agreements
• Preferential trading agreements are trade
agreements between countries in which they
lower tariffs for each other but not for the rest
of the world.
• Under the WTO, such discriminatory trade
policies are generally not allowed:
 Each country in the WTO promises that all
countries will pay tariffs no higher than the nation
that pays the lowest: called the “most favored
nation” (MFN) principle.
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Preferential Trading Agreements (cont.)
•
Two types of preferential trade agreements:
1.
A free trade area: an agreement that allows free
trade among members, but each member can have
its own trade policy towards non-member countries.
 E.g., NAFTA
2.
A customs union: an agreement that allows free
trade among members and requires a common
external trade policy towards non-member
countries.
 E.g., EU
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Preferential Trading Agreements (cont.)
• Are preferential trading agreements
necessarily good for national welfare?
• No, it is possible that national welfare
decreases under a preferential trading
agreement.
• How? Rather than gaining tariff revenue from
inexpensive imports from world markets, a
country may import expensive products from
member countries but not gain any tariff
revenue.
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9-63
Preferential Trading Agreements (cont.)
• Preferential trading agreements increase national
welfare when new trade is created, but not when
existing trade from the outside world is diverted to
trade with member countries.
• Trade creation
 occurs when high cost domestic production is replaced by
low cost imports from other members.
• Trade diversion
 occurs when low cost imports from non-members are
diverted to high cost imports from member nations.
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9-64
Preferential Trading Agreements (cont.)
• In Fig. 6 and 7, if Britain forms a customs union with
France, tariff against France is removed but tariff
against U.S. remains.
• Is this good or bad for Britain?
 In Fig. 6, Britain’s initial tariff was high enough to exclude
imports from France or U.S. Formation of a customs union is
welfare improving.
 In Fig. 7, Britain’s initial tariff was low enough to allow imports
from the U.S. –the lowest cost producer. Formation of a
customs union means that French imports will replace U.S.
imports. Britain will no longer receive tax revenues and its
welfare declines.
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9-65
Fig. 6: Trade Creation
S
British Wheat Market
P
Tariff = $5 (prohibitive)
PT U.S. = $9
PT France = $11
Welfare effects of
customs union:
$8
a
∆CS = a + b
b
∆PS = -a
CU = $6
∆Net welfare = + b
D
SCU
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DCU
Q
9-66
Fig. 7: Trade Diversion
S
British Wheat Market
P
Price in U.S. = $4
Price in France = $6
Price in Britain = $8
Britain is a small country.
Tariff = $3
$8
Welfare effects of
customs union:
PT U.S. = $7
CU = $6
a
c
b
∆CS = a + b + c + d
d
∆PS = -a
e
PU.S.= $4
∆G rev = -(c + e)
D
SCU
ST
DT
DCU
∆Net welfare = (b + d) - e
Q