Political Economy of Trade Policy*
Devashish Mitra †
Syracuse University & NBER
Prepared for the conference, on the occasion of Professor Jagdish Bhagwati’s 70 th birthday, to be held at
Columbia University on August 5 and 6, 2005.
*
†
Department of Economics, The Maxwell School, Syracuse University, Eggers Hall, Syracuse, NY 13244.
Email: dmitra@maxwell.syr.edu
Professor Bhagwati’s interest in political economy probably dates back to the time he
was writing on directly unproductive profit-seeking (DUP) activities. One could argue
that it started even earlier when he was working on the welfare ranking of policy
instruments with VK Ramaswami. While that research was purely economic in its
content, it did ask a very important political economy question about the existence of
trade protection. This question, specifically in the context of lobbying, was raised in
Bhagwati (1982). In the eighties, it led to the rise of a fairly large political economy
literature on the choice of policy instruments.
In his work on DUP, Professor Bhagwati mentions two categories of DUP activities –
“policy-triggered” and “policy-influencing”. It is the second category of DUP activities I
will be focusing on in my piece. Bhagwati (1980) is a pioneering paper that analyzes how
the operation of interest groups affects a country’s welfare. He further explores such
issues in Bhagwati and Srinivasan (1982). Feenstra and Bhagwati (1982), along with
Findlay and Wellisz (1982), is the first general equilibrium analysis of endogenous
protection. These two papers use what Rodrik (1995) in his handbook chapter calls the
“tariff-formation” function approach. While Findlay and Wellisz use a specific-factors
framework, the set up in Feenstra and Bhagwati is Heckscher-Ohlin. In the FindlayWellisz model, landowners and capitalists (owners of factors specific to food production
and manufacturing respectively) lobby against each other. The size of the tariff is
increasing in the labor devoted to lobbying by the import-competing specific factor
owners and deceasing in the labor into lobbying by the other (export) specific factor. In
1
Feenstra and Bhagwati, it is only labor that lobbies for protection employing both capital
and labor. While most models in the literature treat the government as a monolithic
entity, Feenstra and Bhagwati were farsighted enough to treat the government as a two
layered structure. While one layer in their model is a clearing house for lobbies, the other
is “welfare maximizing”. The way the welfare maximizing or the executive wing is able
to reduce the endogenous tariff is by promising some or part of the tariff revenue raised
as a subsidy to workers in return for accepting the lower tariff. Now, we are again seeing
a departure from the monolithic government to a more realistic structure in the models of
Grossman and Helpman (2004) and McLaren and Karabay (2004).
Furthermore,
Feenstra and Bhagwati incorporate the response to terms of trade movements in their
tariff cost function. More specifically, the government’s willingness to protect a sector is
increasing in the magnitude of the negative terms of trade shock it has received. This is
something that is not directly incorporated in many of the models today.
The literature on lobbying in international trade has evolved from the Findlay-Wellisz
and Feenstra-Bhagwati “tariff-formation function” approach to the Grossman and
Helpman (1994) “political-contributions” model.1 The Grossman-Helpman model is
multisectoral, and it provides microfoundations to the behavior of organized lobbies and
politicians. The government's objective function is a weighted sum of political
contributions and aggregate welfare, while each lobby maximizes its welfare net of
political contributions. Most importantly, especially from the empirical angle, the level of
protection for each industry is derived as an estimable function of industry characteristics
1
Also important were the political support approach of Hillman (1989) and Van Long and Vousden (1991)
and the campaign contributions approach of Magee, Brock and Young (1989).
2
and other political and economic factors. While Grossman and Helpman exogenously
take certain sectors to be politically organized and others to be politically unorganized,
Mitra (1999), within the same framework, allows for the endogenous formation of
lobbies.
Another approach to modeling the political economy of protection that has developed
alongside the lobbying literature is the median-voter approach applied by Mayer (1984).
to the Heckscher-Ohlin as well as specific-factors trade models.
An important political economy issue to which Professor Bhagwati has made
fundamental contributions is regarding the alternative ways of getting to free trade. This
question can be further broken down into two sub-issues – one being the issue of
unilateralism versus reciprocity, and second, if reciprocity is the mode of liberalization,
should it be bilateral (regional) or should it be multilateral. Bhagwati (2002) summarizes
the issue of unilateralism versus reciprocity and the link between the two in three
propositions: (1)“Go alone (that is, cut trade barriers unilaterally) if others will not go
with you.” (2)“If others go simultaneously with you (i.e., there is reciprocity in reducing
trade barriers), that is still better.” (3) “If you must go alone, others may follow suit later:
unilateralism then leads to sequential reciprocity.” While using the tools of standard trade
theory, proposition 1 can be defended on welfare grounds (i.e., the optimal trade policy
for a country, in the absence of any distortions, is free trade), Krishna and Mitra (2005)
focus on the additional gain to the unilaterally liberalizing country coming from the
induced reciprocity from its partner countries. Thus we provide an additional channel for
3
the above proposition 1 to hold. The possibility of such a channel has been discussed in
Bhagwati (2002) and in many of his earlier writings where he mentions how unilateral
trade liberalization by a country might shift the demand for protection in its partner
country.2 While reciprocal reduction in trade barriers can reasonably be expected to occur
in contexts involving trade negotiations between countries, Krishna and Mitra (2005)
examine instead the question of whether unilateral trade liberalization by one country can
induce reciprocal liberalization by its partner in the absence of any communication or
negotiations between the two countries. In this context, they show that unilateral
liberalization by one country can impact the political economy equilibrium in the partner
country, through the formation of an export lobby there, in a manner that induces it to
liberalize trade.3
The literature surrounding the second proposition is also now quite well developed.
Bagwell and Staiger (1996, 1999, 2002) have analyzed the issue of reciprocal trade
liberalization in considerable detail both in bilateral and multilateral settings. 4
Reciprocity, in their models, is a way of eliminating terms-of-trade externalities in the
2
See Bhagwati (1990) for an early discussion of this idea.
3
Coates and Ludema (2001) is another important paper in this strand of literature that looks at this issue of
unilateralism-induced reciprocity. These authors study the impact of unilateral tariff reduction on
negotiation outcomes (specifically the likelihood of success in reaching and ratifying bilateral agreements
in the presence of the “political risk” of domestic opposition to trade agreements) and argue that unilateral
trade liberalization may be the optimal policy for a large country. In their framework, “unilateral
liberalization acts as insurance” by providing a “risk-sharing” role. Unilateral tariff reduction lowers the
political stakes associated with trade liberalization in the foreign country, thereby lowering the overall
political cost of reaching and implementing trade agreements and increasing the probability of successful
agreements. While the work by Krishna and Mitra relies on perfectly non-cooperative interaction between
trading partners, Coates and Ludema use a more cooperative setting where negotiations take place between
countries.
4
See also Hillman and Moser (1996).
4
setting of trade policy. Using the political-contributions approach, Grossman and
Helpman (1995) also analyze trade policy in a setting with two large countries, where
they show an additional terms-of-trade component in the tariff expression in a noncooperative setting. This component gets eliminated in a cooperative setting of
international trade negotiations, and the relative size of protection in any sector in the two
countries then depends on the relative political power of the same industry in the two
countries. Thus there is a rationale for “trade-talks” as opposed to “trade wars”. Using
what is very close to a “political-support” function approach, Bagwell and Staiger (1996,
1999) show that even when political economy considerations are taken into account, the
only rationale for (reciprocal) trade agreements is the elimination of terms-of-trade
externalities. They use this approach to develop a rationale for the GATT/WTO and its
different rules.5
I next move to the issue of regionalism versus multilateralism. A great deal of politicaleconomy research has been done on the question of whether regionalism is a “stumbling
block” or a “stepping stone” to multilateralism. This question was first raised by Jagdish
Bhagwati.6 In his writings, he has provided several reasons why regionalism might not
lead to global free trade. Arguments leading to Professor Bhagwati’s conclusions on this
issue have been formally modeled by Levy (1997) and Krishna (1998). Levy (1997) uses
a Heckscher-Ohlin set up with monopolistic competition and a median-voter approach to
address this issue. He finds that bilateral agreements between countries similar in factor
endowments result in the subsequent blocking of multilateral trade agreements. He also
5
See Bagwell and Staiger (2002) for an in-depth discussion.
6
See for instance Bhagwati (1993, 1994).
5
finds that bilateral agreements can never increase the political support for multilateralism.
Krishna (1998) addresses the same issue in a political economy set up where profits get a
much higher weight than other components of welfare in the government’s objective
function (political-support function approach). The set up is one of Cournot oligopoly. He
finds greater political support for trade-diverting bilateral agreements (regionalism) than
for trade-creating ones. Such agreements can also make previously feasible multilateral
agreements politically infeasible. This effect turns out to be increasing in the magnitude
of the trade diversion that takes place under bilateralism.7
As explained earlier in this paper, the next important political economy application to
international trade of special interest to Professor Bhagwati is the choice of policy
instruments. One of the major propositions of the theory of commercial policy is that if
distortions or policy goals are not directly trade related, then direct subsidies are more
efficient than tariffs.8 One simple explanation for the existence of tariffs despite their low
efficiency is that they generate revenues while subsidies use them up.9
Rodrik (1986) is the first paper that looks at this issue by endogenizing policy. He does
this by using a simplified version of the Findlay-Wellisz model. He argues that since
tariffs are general to an industry and subsidies can, in principle, be firm specific, the free
rider problem in lobbying for tariffs may result in a smaller level of endogenous tariffs
For a purely economic argument that relies on coordination failure based on sector-specifc sunk costs and
“friction” in trade negotiation, see McLaren (2002).
7
8
See Bhagwati and Ramaswami (1963), Johnson (1965) and Bhagwati (1971).
9
See for instance Bhagwati and Ramaswami (1963).
6
than endogenous subsidies, thereby possibly reversing the conventional welfare ranking
of tariffs and subsidies. Grossman and Helpman (1994) argue that when the policy
instrument used for redistribution is more efficient, it creates greater competition among
lobbies and thus results in a larger proportion of the surplus in the hands of the
government. Therefore, lobbies themselves may want to tie the hands of the government
to using relatively inefficient instruments. Wilson (1990) makes a similar argument in a
model with electoral competition. The choice between tariffs and subsidies has also been
considered in a voting framework in a series of papers by Mayer and Riezman (1987,
1989 and 1990). Feenstra and Lewis (1991) argue that tariffs are informationally more
efficient than subsidies. Magee, Brock and Young (1989) propose another informationbased explanation which they call the principle of “optimal obfuscation”. Indirect policies
such as tariffs are less observable by those who bear its costs. Staiger and Tabellini
(1980) argue that the time-inconsistency problem might be less severe with more
inefficient policies.
Thus, we see that over the last two decades political economy models have been used to
analyze various aspects of trade policy. As with many other areas of trade theory and
policy, Professor Bhagwati has been a pioneer in this one as well.
References
Bagwell, K., and Staiger, R., 1996, “Reciprocal trade liberalization,”. NBER, Cambridge, MA,Working
paper No. 5488.
Bagwell, K., and Staiger, R., 1999, “An Economic Theory of GATT”, American Economic Review 89, 21548.
Bagwell, K., and Staiger, R., 2002, The Economics of the World Trading Systerm, MIT Press, Cambridge
and London
Bhagwati, J.., 1971, The generalized theory of distortions and welfare, in: J. N. Bhagwati et al., eds., Trade,
Balance of Payments and Growth , North-Holland, Amsterdam.
Bhagwati, Jagdish N., 1980, “Lobbying and Welfare,” Journal of Public Economics 14, pp. 355-64.
7
Bhagwati, Jagdisg N., 1982, “Directly-Unproductive Profit-Seeking (DUP) Activities,” Journal of Political
Economy 90, pp. 988 – 1002.
Bhagwati, J., 1990, “Aggressive Unilateralism” in Bhagwati, J., and Patrick, H., eds., Aggressive
Unilateralism, Ann Arbor, MI: University of Michigan Press.
Bhagwati, J., 1993, “Regionalism and Multilateralism: An Overview,” in A. Panagariya and J. De Melo,
eds., New Dimensions in Regional Integration, World Bank, Washington, DC.
Bhagwati, J., 1994, “Threats to the World Trading System: Income Distribution and the Selfish Hegemon,”
Columbia University, Department of Economics Working Paper No. 696.
Bhagwati, J., 2002, Free Trade Today, Princeton University Press, Princeton, NJ.
Bhagwati, J. and Ramaswami, V.K., 1963, “Domestic distortions, tariffs and the theory of the optimum
subsidy.,” Journal of Political Economy 71, 44–50.
Bhagwati, J. and Srinivasan, T.N., 1980, “Revenue seeking: a generalization of the theory of Tariffs,”
Journal of Political Economy 88, 1069–1087.
Bhagwati, Jagdish N, and T.N. Srinivasan, 1982, “The Welfare Consequences of Directly Unproductive
Profit-Seeking (DUP) Lobbying Activities: Price versus Quantity Distortions,” Journal of International
Economics 13, pp. 33-44.
Coates, D., and Ludema, R., 2001, “A Theory of Trade Policy Leadership”, Journal of Development
Economics 65(1), 1-29.
Feenstra, R. and Bhagwati, J., 1982, “Tariff Seeking and the Efficient Tariff,” in J. Bhagwati, ed., Import
Competition and Response, University of Chicago Press, Chicago and London.
Feenstra, R.. and Lewis, T., 1991, “Distributing the gains from trade with incomplete information,”,Economics and
Politics 3(1), 21–39.
Fernandez, R., and Rodrik, D., 1991, “Resistance to Reform: Status-Quo Bias in the presence of IndividualSpecific Uncertainty,” American Economic Review 81(5), 1146-1154.
Findlay, R. and Wellisz, S. 1982, “Endogenous Tariffs, the Political Economy of Trade Restrictions and
Welfare,” in J. Bhagwati, ed., Import Competition and Response, University of Chicago Press, Chicago
and London.
Grossman, G. and Helpman, E., 1994, “Protection for Sale,” American Economic Review 84, 833-850.
Grossman, G. and Helpman, E., 1995, “Trade Wars and Trade Talks,” Journal of Political Economy 103,
675-708.
Grossman, G. and Helpman, E., 2004, “A Protectionist Bias in Majoritarian Politics,” NBER Working
Paper No. 11014.
Hillman, A., 1989, The Political Economy of Protection, Harwood Academic Publishers, Chur.
Hillman, A., and Moser, P., 1996, ”Trade Liberalization as Politically Optimal Exchange of Market
Access,” in Canzoneri et al (eds), The New Transatlantic Economy, Cambridge University Press,
Cambridge, UK, 295-316.
Johnson, H. G., 1965, “Optimal trade interventions in the presence of domestic distortions,” in: R. Caves,
H. G. Johnson, and P. Kenen, eds., Trade Growth and Balance of Payments, North-Holland,
Amsterdam, 3–34.
Krishna, P., 1998, “Regionalism and Multilateralism: A Political Economy Approach,” Quarterly Journal
of Economics 113, 227-251.
Krishna, P., and Mitra, D., 2005, “Recioprocated Unilateralism: A political Economy Approach”, Journal
of International Economics.
Levy, P., 1997, “A Political-Economic Analysis of Free-Trade Agreements,” American Economic Review
87(4), 506-519.
Magee, S.; Brock, W. and Young, L., 1989, Black Hole Tariffs and Endogenous Policy Theory, Cambridge
University Press, Cambridge and New York.
Mayer, W., 1984, “Endogenous Tariff Formation,” American Economic Review 74, 970-985.
Mayer, W. and Riezman, R., 1987. “Endogenous Choice of Trade Policy Instruments,” Journal of
International Economics 23, 377-381.
Mayer, W. and Riezman, R., 1989, Tariff Formation in a Multidimensional Voting Model,” Economics and
Politics 1(1), 61-79.
Mayer, W. and Riezman, R., 1990, “Voter Preferences for Trade Policy Instruments,” Economics and
Politics 2(3), 259-273.
McLaren, J, 2002, “A Theory of Insidious Regionalism,” Quarterly Journal of Economics 117, 571-608.
8
McLaren, J. and Karabay, B., 2004, "Trade Policy Making by an Assembly," in D. Mitra and A Panagariya,
eds., The Political Economy of Trade, Aid and Foreign Investment Policies, Elsevier, Amsterdam.
Mitra, D., 1999, “Endogenous Lobby Formation and Endogenous Protection: A Long Run Model of Trade
Policy Determination”, American Economic Review 89, 1116-1134.
Mitra, D., 2000, “On the Endogenous Choice Between Protection and Promotion,” Economics and Politics
12, 33-52.
Rodrik, D., 1986, “Tariffs, Subsidies and Welfare with Endogenous Policy,” Journal of International
Economics 21, 285-296.
Rodrik, D., 1995. Political economy of trade policy. In: Grossman, G., Rogoff, K. (Eds.). Handbook of
International Economics, Vol. 3. North-Holland, Amsterdam, pp. 1457–1494.
Staiger, R., Tabellini, G., 1987. Discretionary trade policy and excessive protection. American Economic
Review 77 (5), 823–837.
Van Long, N., Vousden, N., 1991, “Protectionist responses and declining industries,” Journal of
International Economics 30 (1-2), 87-103.
Wilson, J. 1990, "Are Efficiency Improvements in Government Transfer Policies Self-Defeating in
Political Equilibrium?" Economics and Politics, 2, 241-258.
9