Carsten Hefeker
Universität Siegen
Hölderlinstraße 3
57068 Siegen
Carsten.Hefeker@uni-siegen.de
Chapter 1: Trade Policy
Chapter 2: Free Trade
Chapter 3: Choice of Exchange Rate Regime
Chapter 4: Currency Crises

Carsten Hefeker, 2015.
Fall 2015

Trade Policy
1. Introduction
In almost no other area of economic policy the difference between economic theory and political reality is as large as in trade policy. Although trade policy instruments are used by almost every government, standard economic theory maintains that free trade is welfare maximizing (Irwin 1996). This opinion builds on the idea that free trade allows to specialize production according to comparative cost advantages and to import those goods whose production is cheaper abroad than locally. The reason for the existence of comparative advantages in different countries rests on differences in technology, access to resources and factor endowments (such as capital and labor). Moreover, relative price differences between different countries can arise from different preferences and differences in demand. That in turn implies that an incentive to trade will exist as long as disparities in relative prices exist.
Natural trade barriers in the form of transport costs as well as artificial trade barriers in the form of tariffs, quotas and “voluntary” export restrictions hinder the equalization of prices of goods. Therefore, the efficiency gains as a result of production specialization cannot be fully exploited and consumers are forced to pay too much for imported and domestically produced import competing goods. Higher prices, of course, are beneficial for those factors used relatively intensively in the production of these protected goods. As a result of restricted international competition prices are set at a higher level which in turn leads to a higher remuneration of those factors of production used intensively in this production (Stolper-
Samuelson theorem).
Hence, the winners of protection are the factors of production used in protected sectors whereas the losers are the consumers and those factors of production employed in all other sectors. However, because the factors of production used in the protected sector normally constitute only a minority, the immediate question is why protection still exists if a majority suffers from it. In this chapter, we discuss alternative theories explaining protection. As we will see, explanations to a large extent depend on the political system such as direct vs. representative democracy, and on the influence that various interest groups have on policy making (see e.g. Dixit 1996 or Ursprung 1991).
Before discussing in detail alternative approaches, the next section will briefly recall traditional arguments for a (temporary) protectionist policy. It will become clear, however, that these arguments are not sufficient to explain the observed extent of protectionism, which is why we turn to political economic arguments in the rest of this chapter.
1 In section three, we
discuss trade protection in a direct democracy median-voter setup. We then turn to representative democracy and consider interest groups influences before combining both
1 For broad surveys, see Helpman (1997) or Rodrik (1995). For a less exhaustive but more recent survey, see Feenstra (2004).
1

approaches. The fourth section finally considers the choice of protectionist instrument by discussing the choice between tariffs and quotas, and tariffs and subsidies.
2. Traditional Arguments for Trade Restrictions
The classic argument that free trade is always welfare maximizing is based on the use of the so-called Ricardo model with one factor of production only (usually called labor). However, if a second factor is introduced (e.g. capital), as in the Heckscher-Ohlin model, the relatively scarce factor suffers income losses due to free trade, which is triggered by the decline of the relative price of the good in which the factor is used more intensively (Stolper-Samuelson theorem). In general, under free trade the production of the good that can be imported at a lower price will decline which will reduce demand for the factor used more intensively in producing it, reducing its income. The factor that is used more intensively in the export good, instead, sees its income grow. Even though the overall scarce factor, used in the import competing industry, can flow into the export sector, it must accept a decline in its income in order to be fully employed. The statement that free trade is maximizing common welfare is thus true only in the sense that the economy’s aggregate income is rising even though the relatively scarce factor suffers. For all to benefit from this, compensation of losers would be needed.
The specific factors’ model (or Ricardo-Viner model), unlike the Heckscher-Ohlin model, instead assumes that not all factors are fully mobile between industries. For example capital is invested in machines that can only be used for the production of a particular good and can thus not immediately move to another sector. The same is true in reality, of course, for labor, since specific knowledge acquired in one industry is worth less in the context of a different occupation. Thus, adjustment costs incurred due to retraining of labor or depreciation of capital may require a considerable amount of time. A specific factor that is neither flexible nor easily used in other industries is thus concerned about income loss but possibly also by unemployment.
The fact that the free trade can thus generate income loss and/or unemployment leads often to considerations of limiting free trade for social reasons. With the help of trade barriers it is hoped to protect employment and/or to reduce the social costs of structural change.
2
The Optimum Tariff
The so-called optimum tariff argument is probably the most important and theoretically sound argument to qualify the free trade paradigm. Trade theory mostly starts with the assumption of a small open economy which is price taker on global markets. Then, of course, international prices are not affected by the trade policy actions of that country. This is different in case of a large country that has market power and can influence international prices (Corden 1984). If
2 This is only valid for temporary protection, since it is almost impossible to avoid structural change entirely. However, in reality protection is often permanent.
2

the demand for imports in the large economy grows, the world market prices of these goods will go up and, vice versa, if demand declines, world market prices fall. If the demand for an import good is reduced due to the introduction of a tariff, the world market price of the good decreases which in turn improves the terms-of-trade (the ratio between the prices of exported goods (X) and the prices of imported goods (M): P / P ) for this country. For a given
X M number of exported goods, the country can import more goods than before and real income increases.
The optimum tariff is exactly that tariff rate that optimizes the terms-of-trade. However, in order to calculate the appropriate tariff rate in the real world, a precise knowledge of the price elasticity of the import demand for goods is required, because the optimum tariff is given by
 t
=
1 /
( ε −
1
)
with
ε
being the demand elasticity for imports (Krugman and Obstfeld 2003).
Another critical problem in the optimum tariff argument is that other major economies exist which are likely to take retaliatory actions in setting a tariff level that compensates the negative consequences for them. This, in turn, creates the risk that such a policy will lead to a terms-of-trade competition between major countries, gradually driving tariffs up to the level where no imports are allowed and trade completely collapses. Evidently, in this scenario all gains from trade are lost.
This situation can be compared to the famous Prisoners' dilemma. For illustration, consider two countries, A and B. Both can choose from two possible strategies: free trade (FT) or protection (P). The payoff matrix is given by
A\B FT P
FT 3,3 1,4
P 4,1 2,2
Although both players know that protection, if implemented by both sides, will not lead to the best possible outcome, it is still their dominant strategy to choose P. The reason is the assumption that the other player might choose P instead of FT. In case it is impossible to ensure that the players are committed to setting FT, both will in equilibrium choose P, thus reducing their individual and collective welfares.
3
Besides the danger of foreign retaliation, the relevance of the optimal tariff argument is also thrown into doubt by the fact that not only large countries impose tariffs on trading partners.
Indeed, many small countries do protect themselves from competition by introducing tariffs.
3 In the standard case of two small economies, free trade would also be the dominant strategy unilaterally as total welfare increases .
3

This fact together with the difficulty of calculating the optimal tariff level suggests that the optimal tariff argument is hardly a plausible explanation for protection.
4
Tariff protection for "infant industries"
An argument that goes back at least to the 19th century (Irwin 1996) and is still used by trade politicians lies in the necessity to promote certain key industries by introducing protective tariffs. A period of trade protection should enable those industries to develop a comparative advantage over time in order to become internationally competitive. The argument, picked up in the “new trade theory” (Helpman and Krugman 1989), is based on the existence of economies of scale in production.
5
Industries that are characterized by economies of scale yet need time to develop and use them should temporarily be protected by tariffs (or subsidies).
The existence of learning curves implies that industries that have time to evolve without being disturbed will eventually become competitive enough to enter the world market as exporters.
The implication is that certain industries, particularly in the high-tech sector, should be protected by tariffs in order to enable them to “grow up”.
The problem with this argument is twofold. First, it is not clear which industries have the potential to evolve into becoming competitive if provided with support. The government must be able to identify and target the industries that can become internationally successful.
Second, it is not guaranteed that the selected company will remain truly competitive without continuous assistance. There is a risk that firms will depend permanently on the government’s support. Therefore, even some proponents of the “new trade theory” argue that despite all the theoretical exceptions for practical purposes, free trade is still the better solution (Krugman
1989).
Protection as a Social Insurance
Finally, we briefly consider an argument according to which protection is based on a social consensus. In this approach, uncertainty and missing markets are stressed as a reason for protection. Uncertainty is important in the sense that individuals, when they have to decide about the overall direction of trade policy, do not know whether they will later be negatively affected by exogenous price changes in world markets. If individuals are risk-averse, it is possible that a consensus exists among all groups in the economy to compensate negative price developments with protection. Although in such a case still some individuals or industries are negatively affected by protection, uncertainty and risk aversion still lead to the result that a majority votes for protection as “insurance” against adverse shocks. Trade policy
4 However, the terms-of-trade argument continues to be important in trade theory and policy
(see, e.g.
Bagwell and Staiger 2002).
5
This strategy has quite successfully in some East-Asian states, such as Japan, Taiwan and
South Korea, argue some authors (see Wade 2003).
4

thus becomes a social insurance against adverse terms-of-trade shocks which cannot be compensated under free trade. Of course, a price has to be paid for this as in the case of any other insurance. The price lies in forgoing some of the possible gains from free-trade (Eaton and Grossman 1985).
6
This explanation of protection is essentially based on the non-existence of private insurance markets. If it was possible to insure privately and individually against adverse external developments, the necessity to implement measures on the collective level by introducing protection would disappear. Each individual would simply pay a part of her income to an insurance company and be compensated from this fund for income losses in the event of an exogenous price shock. Due to the standard moral hazard and adverse selection problems in insurance, however, such insurance markets do not exist.
The government faces a similar problem. If it is known that in case of exogenous shocks terms-of-trade insurance in the form of tariffs is offered, there is little incentive for negatively affected industry to provide private efforts for adaptation. As a consequence structural change is slowed down and the overall industrial structure is distorted. Therefore, it would generally be optimal for the government to ex-ante limit protection but to nevertheless assist industries ex-post by granting protection to facilitate adaptation. However, knowing that protection will be offered when needed, industries will undertake too little of their own efforts and instead rely on government support. If the government does not manage to credibly commit to free trade, protection will be the equilibrium outcome (Staiger und Tabellini 1987).
But how realistic is the assumption that protection is the result of a social contract? First, one should recall that there are more efficient instruments than tariffs to protect certain industries
(see Rodrik 1995). Granting tax-financed subsidies to affected industries would make more sense since this would not distort import prices. Although the income of consumers would also be reduced through taxes, the consumption decision would not be affected by relative price distortions. Second, it is striking that only certain industries benefit from tariff protection even though other industries as well face the risk of changes in world market price. If the protection of industries in the tradable goods sector was based on insurance, then all industries would have to be protected to the same extent. Third, it protection was based on insurance motives, countries should be able agree to such tariff protection at an international level. In that case, international conflicts related to the trade policy should be absent.
Therefore, as these traditional arguments are not really convincing, we turn to alternative explanations for the existence and form of protection. They are based on the distributional effects of trade policy.
6
A related argument has been developed by Fernandez and Rodrik (1991). They argue that individuals who are uncertain whether they personally benefit or lose from free trade will vote against free trade, even if they would actually win. Thus, uncertainty leads to a bias against economic reforms.
5

3. The Political Economy of Trade Policy
To structure our further discussion is helpful to take a look at figure 1 (adapted from Rodrik
1995). It depicts trade policy as the outcome of an interaction between the supply and demand for protection or free trade. On the one side, there are voters whose individual preferences are determined, analogous to the Stolper-Samuelson theorem, in line with their personal factor endowments. Voters or industries may also be able to form interest groups and pursue their objectives jointly. On the supply side of trade policy are politicians who, depending on the institutional design of the political process, may or may not be able to pursue their own interests. In an ideal (direct) democracy, the politicians' interests do not matter since they will only implement the media voter’s preferred policy (Ursprung 1991). The more imperfect the political process is, however, the more room there is for them to pursue their own interests.
This in turn has an effect on the actual structure of trade policy, meaning that if a particular policy serves the politicians’ own interests, trade policy may not conform to voters’ preferences but to those of particular interest groups. In general, we assume that politicians wish to be reelected and possibly maximize their personal incomes. If interest groups can provide income or votes, politicians will pander to those interests.
The following sections will sequentially address the different combinations depicted in Figure
1. We begin with individual preferences and how they determine trade policy in a direct democracy. Although an extreme example, the case of direct democracy at the same time provides an interesting benchmark to compare it with trade policy in alternative political systems.
Figure 1:
3.1. Trade Policy in Direct Democracy
In basic models of direct democracy it is usually assumed that all individuals participate in the voting procedure and vote according to their own interests. Moreover, all voters are informed
6

about the consequences of a certain policy action on their wellbeing. Finally, it is assumed that the voting is over (single) specific policy measures, not about party programs or policy packages. Politicians are fully informed about voters’ preferences and their distribution so that they can identify the “winning” policy. A vote maximizing politician will then propose a policy that ensures the majority of votes, which is the position of the median voter.
7
The advantage of using this model is that the distributional aspects of trade policy can be determined directly from the utility function of each voter. Thus, the median voter’s gains and losses from a particular trade policy determine trade policy. This also implies that politicians play no active role and that competition between different parties can be neglected. Parties choose the same platform because the position of the median voter cannot be beaten.
8
The government merely follows the preferences of the population which leaves no room for its own interests.
The Model
The classic application of the median voter model in trade policy can be found in Mayer
(1984), which is reproduced in this section. We restrict our discussion to the basic Heckscher-
Ohlin case with two factors of production (capital and labor) which illustrates the idea in the most simple form.
All individuals in the economy are endowed with a given stock of capital (K i
) and labor (L i
), which are used with different intensity in the production of two goods. Both factor are supplied inelastically. There are no financial markets which would allow individuals to diversify their factor endowments, so that individual trade policy preferences depend on the given factor endowments. Two goods, X capital K i
1
and X
2
, are produced where X
1
is the labor intensive and import-competing good. Each individual owns one unit of labor L i =
1 and
≥
0, where index i describes individuals with i = 1…n. Both factors are mobile between the two sectors, all markets are competitive, and the production functions are homogeneous of degree 1. The preferences of individuals are identical and homothetic.
9
The preferences of individual i are given as
7 The median voter is the voter whose position is supported by (N +1)/2 votes, where N represents the total number of voters. A spatial model illustrates the concept most clearly since half of the votes are located to the right and the other half to the left of the median’s position (see Mueller 2003).
8
Strictly speaking, this is only true if there are two parties. With three parties no equilibrium exists whereas four and more parties distribute themselves evenly on the interval of votes
(Mueller 2003).
9 This ensures that a change in income leads to a proportional change in demand for both goods.
7

U i = i
( i
)
(1)
( where U i
describes the utility level of i as a function of the relative price of good 1
P
≡
P / P
1 2
) and her income, measured in units of good 2, Y i
. The total personal income of i consists of labor income ( w ), interest payments ( r ) on her personal capital stock, and the personal share of total tariff revenue T
Y i = + rK i +
T i
. (2)
The tariff revenue is distributed proportional to an individual’s share in total income T i = ϕ i
T with w
+ rK i wL
+ rK
and L
= ∑ n
L i
. Taking into account
∑ n
1 , we can rewrite (2) as
Y i = ϕ i
( wL
+ rK
+
T
) = ϕ i Y (3) where Y is the aggregate income in the economy (in terms of good 2).
Tariff revenue is given as
T
= tMP
*
. (4)
M measures the total amount of imported goods, and P
*
denotes the constant relative world market price of good X
1
. In what follows, we assume that for all tariffs imports take place
(hence, they are not prohibitively high) and that both goods are produced in equilibrium (there is no complete specialization).
The Optimal Tariff
If factor ownership varies across individuals the impact of a tariff changes on their personal incomes varies as well, which is evident from rewriting (1) as
U i = i
( ϕ i
Y
)
.
(5)
The utility of each individual depends thus on her personal share of overall income and the relative price P. If the tariff rate and therefore the relative domestic price changes, all citizens are affected by this price effect. At the same time, however, they are differently affected with respect to their individual income share ϕ i
Y due to the inequality in income distribution. The bigger is ϕ i
the more capital an individual possesses and the larger is his share in tariff revenues.
In order to see how an individual is affected by trade policy, we use P
= *
( + )
in (5) and differentiate the resulting expression with respect to t:
∂
U i
∂ t
=
∂
U i ∂
∂ ∂
P t
+
∂
∂
U
Y i i ∂
Y
∂ t i
. Using Roy's
8

identity ( this and Y i i
= ϕ i Y i
D (P, Y )
= −
∂ i ∂
∂ i i ∂ i
), we can write
and
∂ ∂ =
P
*
, we get
∂
U i
∂
P
= −
D i
∂
U i
∂
Y i
= −ϕ i
D
∂
U i
∂
Y i
. Using
∂
U
∂ t i
=
∂
∂
U
Y i i


− ϕ
1 i *
P
+
∂ϕ i
∂ t
Y
+
∂
∂
Y t ϕ i


.
(6)
D
1
=
M
+
X
1
is the total demand for good 1, composed of imports and domestic production of good 1. To see how tariffs affect utility, we need to see how ϕ i
and Y are affected by tariffs.
First, consider aggregate income Y. It is given by
Y
= wL
+ rK
+ =
PX
1
+
X
2
+
MtP * .
Taking into account P
= *
( + )
and D
1
=
M
+
X
1
, differentiation of (7) yields
(7)
∂
Y
∂ t
= *
P D
1
+ tP
*
∂
M
∂ t
.
(8)
Using this in (6), we get
∂
∂
U t i
=
∂
∂
U
Y i i

 ϕ i * tP
∂
M
∂ t
+
∂ϕ i
∂ t
Y


.
(9)
In order to find the optimal tariff for individual i , we set (9) equal to zero and rewrite
∂ϕ i
∂ t
Y
= −ϕ i * tP
∂
M
∂ t
. The left-hand side shows how the share of national income changes as a result of change in the tariffs while the right-hand side measures the effect of a change in tariff revenue on the income of i . It is straightforward to solve this for the optimal tariff rate of individual i . It is given as
 t i = −
*
Y
P M / t
⋅ ϕ i
/ t
.
(10)
Since
∂
M / t 0 it follows that the optimal tariff rate for an individual can be either positive or negative, depending on whether the share of individual income ϕ i
reacts positively or negatively to the change in tariffs ( sign t
 i = sign
∂ϕ ∂
).
Thus, we next derive
∂ϕ
∂ t i
=
∂ϕ ∂
P
P t
and make some additional simplifications and transformations. Since the personal capital share is crucial to find the optimal tariff policy, we define k = K/L and k i = i
K / L i =
K i
(given that L i =
1 ). To relate our results to the wellknown Stolper-Samuelson theorem, it is also useful to concentrate on relative changes in
9

wages, prices and interest rates, which are defined as ˆx
= dx / x taking into account
∂ ∂ =
P
*
. Using these definitions and
, we finally have (see Appendix A)
∂ϕ i
∂ t
= wL
(
1 t
)( wL
+ rK
)
2
⋅
(
− k i
) (
ˆ
−
ˆ r
)
.
(11)
From the Stolper-Samuelson theorem we know that
(
ˆ
−
ˆ
)
ˆ
is positive (negative) if the imported good is relatively labor (capital) intensive in production (Krugman and Obstfeld
2003). Equation (11) also shows that a tariff rate increases the income share of individual i namely if she is relatively better endowed with labor than the average individual in the economy because ( sign
 ∂ϕ i


∂ t

=
(
− k i
)
). This implies that all individuals whose capital stock is below the average capital endowment of the economy ( k
− >
0 ) prefer a positive tariff. Free trade
 t m =
0 only follows if the capital endowment of the median voter (denoted by superscript m) corresponds to the average capital stock of the entire economy
( k
− k m =
0
)
, see Figure 2.
10
This allows us to summarize the relationship between tariff rates and personal income shares as follows:
•
The optimal tariff rate is positive for individuals who are relatively well endowed with the factor of production that is used intensively in the production of the import competing good. If the imported good is labor-intensive, then the optimal tariff rate is positive for all individuals whose personal capital stock is below the average capital endowment because they derive most of their income from labor.
•
The greater the difference between the personal factor endowments and the average endowment in the economy, the more the individual’s optimal tariff deviates from free trade.
Factor endowments and differences thereof at the individual level are therefore crucial to determine how an individual will vote for a change in tariff rates. An unequal distribution of capital in the economy means that some individuals will always vote for tariff protection while others will be against it. Given that the median voter is decisive, free trade will only follow if his endowment corresponds to the average capital endowment. Given the skewed distribution of capital in most economies, however, this is very unlikely to ever be the case.
10
It also follows, of course, that people relatively well endowed with capital prefer negative tariffs or import subsidies.
10

This “strong” result is due to the strong assumptions of the median voter model (Mueller
2003) which are hardly fulfilled in reality.
11
Therefore, the next question is how to explain trade protection in a representative democracy.
Figure 2: k
> k
<
3.2. Protection in Representative Democracy
In contrast to direct democracy, citizens delegate policy decisions to politicians in a representative democracy. Voters choose a party or a certain politician to whom they entrust policy for the duration of a (mostly) fixed period of time. Consequently, there is usually no way for voters to directly influence policy decisions. If in addition we also give up the assumption of perfect information of voters, politicians have leeway to pursue their own interests and implement policies that need not be consistent with what the majority of voters would prefer. Instead, they might serve particular interest groups if this is beneficial for themselves. This section looks at different possibilities for the interplay of political interests and interest groups. In contrast to deterministic voting in direct democracy, the underlying model is that of probabilistic voting (see Mueller 2003 for details).
11
The most important are that all players know the preferences of all others, and that all voters vote rationally and not strategically.
11

Maximizing Political Support
The simplest model that depicts trade policy in a representative democracy is a direct transfer of regulation theory, pioneered by Stigler and Peltzman, to trade policy (see Mueller 2003). In this approach, politicians are described as being solely interested in maximizing their political support from different groups in society. The policy decisions are hence taken by politicians, as compared to the median voter model where economic agents directly influence the result.
Politicians use the room they have to follow their own goals, in this case to ensure their reelection. Incumbents choose their policies so that they maximize their reelection probabilities and follow no other interests, such as any ideological position. As we concentrate on incumbents, the competition among political party plays no role. Focusing on the simple considerations of incumbents, the political process is more or less a black box, not taking institutional details into account.
The Model
The starting point of the model is a negative world price shock for a particular industry. The discovery of new supplies of raw materials or the appearance of a new competitor on the world market means that the relative price of that good in international markets will fall. If the competing domestic industry cannot adapt to the price change, the production of domestic goods as well as the overall industry will decline. In the Hillman (1982) model, however, government can protect the industry by restricting foreign competition and impose a tariff on imports. At the same time, it also prevents the entry of new domestic competitors into this industry
12 . Given our assumptions, it is clear who will benefit from protection, and it is also
evident that the beneficiaries and losers of any policy intervention can attribute the change in
profits and utility to the government’s policy 13 . Obviously, profits incurred by producers and
workers in this industry come at the cost of other sectors and consumers who lose from an increase in tariffs and higher prices.
If world market prices under free trade are taken as a reference point, profits and losses from trade policy for individual groups can be derived as follows. Specific factors within the protected sector benefit as a result of the increase in prices which in turn increases their factor income. All other specific factor and consumers of this good will lose from the price increase and punish the government by withdrawing their political support. As argued above, we also assume that government is not held responsible for the initial price change but only for its subsequent reaction to it.
12 This assumption prevents the free-rider problem which arises by the entry of new competitors. Due to the fact that each firm’s profits decrease with the entry of more competitors, the existing firms have weaker incentives to exert effort to receive protection.
This problem is analyzed in more detail in section 4.
13 In order to generate political support, it is obvious that personal gains must be directly connected to government activity. Otherwise, agents will not punish or reward the government for individuals gains or losses from price changes.
12

The political support function for the government is then defined as
( ) =
M
P ( ) −
P *
=
M
P ( ) − P ( ) −
P * .
(12) where free trade is taken as the reference point to which government is compared. The first term measures the political support that is gained by an increase of price beyond the world market level ( P
=
P
* + >
P
*
).
14
The second argument reflects the political dissatisfaction from losers from protection. This means that the political support for the government increases in the first argument M
1
>
0 and falls in the second M
2
<
0 . (The subscripts denote the first order derivatives, where 1 and 2 denote the first and second argument in the utility function respectively.) If we also consider diminishing returns of price increases and growing dissatisfaction with rising prices in terms of political support, we also have M
11
<
0 and
M
22
<
0 . In addition, M
12
=
M
21
<
0 reflects a so-called “envy effect”. That is, if the support by one group increases that of the other group falls. Each group punishes the politician for benefiting the other group.
The government will now maximize its objective function by determining the optimal domestic price level and by setting a corresponding tariff to increase the domestic price beyond the world market price ( P = P
*
+ T ). The first order condition is
M
P
=
M
1
P +
M
2
=
0 , (13) so that marginal gains and losses in terms of political support are balanced.
The optimal price follows as
P = − p 2 1
>
0 . (14)
The condition shows that the optimal domestic price balances the marginal gains (from the protected industry) and the marginal losses (from the “losers” of protection) in terms of political support. Thus, to ensure reelection, the government will balance the interests of all affected by the tariff. In equilibrium, the marginal political loss from an action must be equal to the marginal political benefit. The government therefore will set the tariff in such a way that the political gains and losses, arising from a change in trade policy, are exactly balanced.
The marginal gains in political support from the protected industry correspond exactly to the marginal losses in political support from consumers who have to bear higher prices. Since marginal gains and losses are balanced, neither free trade nor autarky are optimal trade policy.
However, even if government compensates part of the exogenous price decline, whether or not the industry shrinks depends on the level of tariff. By choosing the “right” tariff, the government could completely prevent structural change. If P
*
falls, P will fall as well in the absence of a trade policy causing output and employment in the industry to decrease.
However, since P is an argument in the political support function of the government, it will
14 To simplify , the tariff in this case is assumed to be a specific tariff and not an ad-valorem tariff.
13

respond to the change in P
*
correspondingly. Depending on how strong the government's response to the change of world market price is, the exogenous price decline for the affected industry can be just compensated, diminished or even overcompensated.
Since the first order condition (13) still has to hold, the optimal strength of the political reaction to a price decline results follows from dM
P
(
P, P *
)
=
M
PP dP
+
M
PP
*
=
0 as dP
* dP
* dP dP
*
=
−
M
PP
*
M
PP
>
0
(15) where M
PP
=
M
P +
1 PP
M
P +
11 P
M
22
+
2M
P <
12 P
0 and
M
PP
*
= −
(
M
P P +
11 P
P
M
P +
12 P
M
12
P +
P
*
M
22
)
>
0 .
Thus, as (15) shows the domestic price will be allowed to move in the same direction as the world market price. Although government will compensate part of the price change by an opposite movement in the tariff it will not fully compensate. Since all other groups in the economy would benefit from a price reduction, it is not optimal for the government to completely avoid a fall in domestic price. Therefore, part of the exogenous price decline will be allowed to feed into domestic prices and a continuous decline in world market prices thus leads to a gradual shrinking of the protected industry.
Although the domestic relative price will fall in any case, it is so far not clear whether the absolute amount of protection T falls as well. Starting from P
=
P
* +
T , taking into account that dT / dP
* = dP / dP
* −
1 , we consequently get that dT / dP
* >
<
0 if dP / dP
* >
<
1 . It means the change of the domestic price can in principle be larger or smaller than the change of the world market price.
This example shows how motives of political support can prevent the contraction of an industry. It is also conceivable, on the other hand, that the same motives can lead to a sudden collapse of an industry, as we shall see in the chapter on free trade.
Interest Groups and Lobbying
Lobbying and Political Competition
As we have seen in the previous section, trade protection has winners and losers. In this section, we will deal with coalitions of winners and losers from protection and assume that they act as lobby groups and try to influence and persuade the government to adapt policies favorable to them.
An important aspect of these approaches is the problem of organizing such groups. As Olson
(1965) has shown, members of a group have an incentive to behave as free-riders on the efforts of others without contributing their share of effort. This phenomenon is positively
14

correlated with group size since in small groups it is easier to control the contribution of individuals or alternatively to exclude than if they do not contribute. Accordingly, the difficulty of organizing larger groups is often used to explain the fact that consumers who suffer most from protection and restrictions in trade measures do not act against such policies.
The very large group of consumers is simply unable to solve the problem of organization as each individual is hoping that others act so that she can take advantage of the outcome without contributing personally. Therefore, lobbying models usually deal with the industry-level interests (in other words, well-organized groups) only and do not consider consumers as being decisive for policy decisions. In contrast to models of political support, in which all groups are more or less important, here competition takes place among organized (industrial) interest groups only.
In what follows, we assume that the rate of protection chosen is a direct function of the lobbying activities of organized groups (Findlay and Wellisz 1983, Hillman and Ursprung
1988). One can assume that political parties need funds for their election campaigns in order to pay for television commercials or other advertising. The party that is able to invest more financial resources in its campaign thereby increases its chances of being elected. Thus, we assume a positive function of lobbying contribution from interest groups and electoral chances of political parties, which is of course a very stylized representation of political competition.
In the following model of party competition we also assume that the (two) parties are committed to different policy positions. In our case, one party proposes a tariff on imports while the other is in favor of free trade. The “free trade party” can either represent the interests of consumers and the export industries which fear foreign retaliation or maybe the interests of foreign export industries, while the “protectionist party” represents the interests of the domestic importing competing industry. We assume that the competing parties or candidates state their positions without taking into account the behavior of other parties (“Nash behavior”).
15 Firms in turn decide which party to support financially. Specifically, domestic
producers support the protectionist party and foreign exporters support the free-trade party.
16
We assume that first parties choose their election platforms and firms then decide which party to support with how much money. This sequence of events will be reversed in the next subsection where it is assumed that parties choose their policy position in order to maximize the contributions they receive.
The Model
We consider a partial equilibrium model, meaning only one sector, of an import-competing industry in which imported goods and domestic goods are imperfect substitutes. Each individual competes against both domestic and foreign competitors. The domestic (inverse) demand functions for the domestic good and import goods are given as
15 As we will see, this yields different results than the median voter model where parties take the same position.
16 Alternatively, it could be assumed that domestic exporters favour free trade because they fear retaliatory protectionist measures abroad.
15

P
= − bx
+ γ
P
* (16)
P * = − bx * + γ
P (17) where x and x
*
respectively indicate the amount of domestically produced and imported goods, with P and P
*
as their respective domestic prices, and 0
≤ γ <
1 indicates the substitutability between the goods. We assume there are n identical firms in the domestic industry and m identical firms in the foreign export industry. The foreign and domestic firms face two candidates, one of which is a free-trade proponent, while the other promises to raise tariffs on imported goods. The companies have an opportunity to influence the likelihood of victory of their preferred candidate by offering financial support to this candidate or party.
Taken the unit cost of production c as constant and identical for all firms, domestic and foreign firms face the following maximization problem: max x ,L i
P = i
(
P
− ) i
−
L i i=1...n
(18) and max i
*
P =
(
P * − −
) i
* −
L i
* i=1..m
.
(19) where L are the lobbying expenditures of company i . Profits of firms are increasing in production and prices and fall in production costs and lobbying expenditures. The functions are symmetrical, with * denoting the foreign firms. In addition, foreign firms are subject to a potential (specific) import tariff T that lowers their profits.
As indicated above, the success probability of a particular candidate depends on the lobbying contributions that she obtains. The probability that the protectionist candidate will win the election can hence be expressed as:
W
=
L
L
+
L
*
(20) where L
= i
∑
L i
are the total expenditures of all domestic firms and L
* = ∑ i
L
* i
are the total expenditures of foreign firms. The probability of winning the election for the protectionist candidate thus increases with the share of lobbying expenditures he receives. The free-trade candidate will obviously try to minimize W (or to maximize 1-W). We assume that the candidates are “Stackelberg-Leaders” and determine their trade platforms by taking into account the reaction function of the firms. Therefore, as usual, we first have to see how much firms are willing to pay and how this depends on the positions of the candidates.
Firms decide which of the two proposed trade policies will bring them higher profits and, based on this comparison, which candidate they should support. Thus, we first have to see how firms’ profits change conditional on realized trade policy. Notice that they take their production decisions after elections and thus know which candidate has won and thus whether
T = 0 or T> 0 applies.
16

The prices of domestic goods’ are a (negative) function of total foreign supply and total domestic production. Thus, when deciding how much to produce individual firms must take into account the influence of their own supply on prices. When taking their production decision they behave according to the Cournot-Nash assumption, and take the decisions of domestic and foreign competitors as given.
If we combine (16) and (17) and take into account that x
= ∑ i x i
and x
* = ∑ i x i
*
, P and P
*
can be expressed as
P
=
(
1
) a
( i
+
1
− γ 2
∑ j x j
)
− γ bx
* i j
=
1 n i
≠ j and
P * =
(
1
) a
( i
* +
1
− γ 2
∑ j x
* j
)
− γ bx i j
=
1 m i
≠ j
.
Next, we use these expressions in the profit functions of individual firms and optimize (18) and (19) with respect to output, to get the following reaction functions for domestic and foreign firms x i
=
(
1
) a
(
1 2
) c
2b
−
∑ j x j
+ γ x
*
2 i j
=
1 n i
≠ j and x i
* =
(
1
) a
(
1
2b
2
) ( c
+
T
)
−
∑ j x
*
2 j
+ γ x i j
=
1 m i
≠ j
.
In the next step, we make use of the assumption that all domestic and foreign firms are identical and set
∑ j x j
= ( − ) i
and
∑ j x
* j
= ( − ) i
* . Using this and combining the reaction functions of foreign and domestic firms, their quantities follow as: x i
=

( )
1 B 
(
1
2
) bA
 i=1..n
(21) and x
* i
=
( )
1 B
(
1
2
) ( ) bA i=1..m
where A
≡ ( + )( ) mn
γ >
0 and B
(
1
) ( a
− ( ) )
0 .
(22)
These quantities lead directly to the tariff-dependent profits of firms. If (21) and (22) are plugged in (18) and (19), their profit functions follow as
17

P i
=
(
1
− γ 2
)
A
2
{ ( )

(
1
) mT
}
2
(23) and
P i
* =
(
1
− γ 2
)
A
2
{ ( )
1 B
− ( ) (
− γ 2
)
T
}
2
.
(24)
It is immediately obvious that the profits of domestic firms are positively related to the domestic tariff rate while the foreign firms’ profits are negatively affected by them:
∂P ∂ > i
/ T 0, i
/ T 0 . In addition, we see that the number of domestic and foreign competitors matter as well as the degree of substitutability between domestic and foreign goods.
The Lobbying Expenditures of Firms
Since the companies know how their ex-post profits depend on tariffs they will try to influence the probability of their preferred candidate winning the election ex-ante . The expected profits of domestic firms, conditional of election outcome, are
E
P = θ P i i
= θP i
( )
0
−
L i
(
1
)
( ) (
0
) ( ) i
T
1
−
L i i
( )
1
−
L i
(25) where
θ
and (1-
θ
) are the respective probabilities of the free trade and protectionist candidates being elected and and T
0
<T
1
are their respective trade policy announcements. The domestic firms will therefore try to minimize
θ
while the foreign companies try to maximize
θ
.
The success probabilities of the two candidates, as assumed above, are functions of the lobbying expenditures of the firms and can be defined as
θ = *
(
+
L
*
)
and 1
− θ =
(
+
L
*
)
,
(26)
Substituting (26) in (25) and optimizing with respect to Li, leads to:
E i
∂
L i
=
(
L
*
L
+
L
*
)
2
P i
( )
1
− P i
( )
0
1 0 ,
(27) keeping in mind that L and L
*
are the total lobbying expenditures of the industries ( L
= nL i
).
The expected profits of each firm depend therefore on the aggregate spending of all companies. (27) can be rewritten as
(28)
(
L
*
L
+
L
*
)
2
∆P = i
1
18

for domestic firms, where is: i
( ) − P i
( )
. For foreign firms, the respective condition
(
L
L
+
L
*
)
2 i
1
(29) with i i
*
( )
0
− P * i
( )
1
. By combining these two equations, the probability of the protectionist candidate being elected results as a function of the ratio of lobbying contributions
L
L *
=
∆P i
∆P i
*
≡ (
0 1
)
.
(30)
The Decision of the Candidates
The protectionist candidate will then set his platform so that it maximizes
(
+
L
*
)
, which is equivalent to the maximization of L / L *, and the maximization of R (.) in (30). Hence, the interests of the candidates are related to the profit maximization efforts of the firms by (30).
Each of the two candidates will announce the policy that maximizes the profits of his clients, since this maximizes his support and the chance of being elected. The policy platform can be derived evaluating
∆P i
and
∆P i
* , with T o
<
T
1
, and rewriting (30) as:
( o 1
)
T o
<
T
1
=

(
(
)
)
(

+ )
γ +
− ( m
2 γ
+
2
(
)
1
2
(
− γ
1
2
)
− γ
(
2
T
0
+
T
1
) (
)
T
0
+
T
1
)
.
(31)
Differentiating this function with respect to T
0
and T
1
yields
∂ ∂ >
0 as well as
∂ ∂ >
0 . This means that both candidates increase their support and chances of winning if they take extreme positions in their respective policy announcements. The protectionist candidate will choose autarky as a platform while the free-trade candidate will announce a tariff of zero.
17
From (31) we also see how the other parameters influence trade policy in equilibrium. Figure
3 shows the policy outcome for different parameter constallations.
• The higher is
γ,
the stronger is competition between domestic and foreign goods. As a consequence, import-competing firms have a strong interest in high tariffs because the difference in profits under high and low tariffs is correspondingly large in this case. Since the difference in profits (the so-called stakes) also determines their lobbying contributions,
17 Thus, according to this model parties do not choose the same platform as is would the case in the median voter model. Given their ideological leanings candidates will never converge but rather take extreme opposite positions.
19

the sum of lobbying contributions from the side of domestic industry increases. The strong competition means to the foreign industry that the losses from a tariff policy are not high.
Therefore, the contributions from the side of the foreign industry will be small.
• The larger is n, the stronger is competition among domestic firms. In addition, more firms imply a larger free-rider problem because tariffs are a public good for the entire industry.
For an individual firm this implies that the incentive to influence trade policy through the provision of lobbying contributions decreases, and that probability that the free trade candidate will win elections increases. As domestic competition has a more direct effect than that between domestic and foreign goods, the relative influence of n is greater than that of
γ
. That means for a given
γ
the probability of free trade increases in the number of domestic firms n.
•
The same is true for the number of foreign firms m. The greater is the number of foreign firms the larger is their free-rider problem and this increases the probability of the protectionist candidates of being elected.
Figure 3:
The Integration of Lobbying and Political Support
Both models of representative democracy discussed in the previous sections, the maximization of political support and the efforts of industries to affect politicians through lobbying, at the same time are likely to have relevance for explaining trade policy. In reality, a simultaneous combination of both is probably true, and we next to an approach that does just that.
Grossman and Helpman (1994) combined both aspects in a model in which politicians are not only interested in maximizing their lobbying revenues but also try not to lose too much political support from the population. The objective function of politicians is thus a
20

combination of lobbying revenue and political support.
18
To keep the model manageable, it is assumed that there is only one party (or a politician) in office and political competition is excluded. In addition, these authors adopted a different time structure of the game. Instead of politicians setting the platforms and firms then deciding about their lobbying contributions, lobbying groups now first offer payments to the government conditional on their policy platforms. However, governments set their policies with respect how much money that would receive and how much political support they would get or lose.
The change in the formal structure of the game has another important implication: the ruling party (government) is now virtually “selling” trade policy by auctioning it off to the highest bidder.
19 Accordingly, the paper which introduced this model is entitled “Protection for Sale”.
In fact, one could understand this approach as a model of corruption as politicians sell their policies. However, this extreme assumption is partially compensated by the fact that the ruling party is also interested in maintaining political support and chooses a “welfare-maximizing” policy, depending on the relative weight of these two goals.
The Model
We consider a small open economy inhabited by individuals with identical preferences but different factor endowments, just like in the Mayer model.
20
The total population is normalized to 1 and the (quasi-linear) utility function of each person is given as
U
=
X o
+ n ∑
U X i
( ) i
(32) where X
0
is the consumption of a numeraire good 0, and Xi , with i=1...n
, indicates the consumption of all other goods. The sub-utility functions Ui(.) are differentiable and concave in the quantity of goods consumed. The national and world market price of the numeraire is normalized to 1, so that for good X
0
free trade always prevails. For all other goods, national and international prices can differ where P i
is the domestic price and P
* i
is the exogenous and constant international price. Given these preferences, consumption of good i can be expressed as X i
=
D (P ) i i
where demand is the inverse of the derivative of the utility function with respect to the good U'i(Xi) and X
0
= − ∑ i
is the residual demand for the numeraire good and E indicates total income.
18 Grossman und Helpman (1994) denote the second influence as “welfare”. It is a utilitarian summation of the benefits of the various groups. This can also be seen as a political support function in which all groups have the same weight (Potters and van Winden, 1994) .
19 Grossman und Helpman (1994) argue that the support of lobbies does not have to take place in form of direct payments. Moreover, they refer to evidence from the United States which is compatible with this game structure.
20
We follow the setup of the model, developed by Goldberg and Maggi (1999).
21

Indirect utility has the form
( i
) = + n ∑
S P i
( ) i
(33) where i
( ) i
=
P are the domestic prices of the non-numeraire goods and i i
( i
( ) i
)
−
P D P i i i
is consumer surplus, resulting from the consumption of good i . A person's utility is increasing in income E and in consumer surplus S i
.
Good 0 is only produced with the use of labor under constant returns to scale and an inputoutput ratio of 1. Assuming that the labor supply is always large enough to produce a positive amount of good 0 , it follows that the labor wage is also determined as 1. However, the production of all other goods i requires the use of labor and capital where capital is assumed to be sector specific while labor is completely mobile. There are thus a total of n+1 factors of production with n specific factors (the capital in each sector). While perfect competition ensures that wages are fixed at 1, capital receives a rent of
P i
( )
that only depends on the domestic price of good i . The domestic supply of goods follows from the maximization of profits and is given as Y P i
= P i
( )
.
Government has the possibility of either raising specific tariffs on imported goods which are given by T i
= − i
P i
*
, or, respectively, of paying subsidies if these are negative.
21 Total tariff
revenue is the product of the price difference between world market prices and domestic prices and total imports M i
resulting as the difference between demand and domestic production: n ∑ i
= n ∑ (
P i
−
P i
*
) ( ( ) − ( ) )
.
(34)
The income of each voter is determined by his labor income, his possession of specific capital
(by assumption, each person has only one specific type of capital), and by his share of tariff revenue.
Lobbying
To organize themselves and to exert political influence on prices (via tariff policy), owners of sector-specific capital must be able to overcome the free-rider problem. Grossman and
Helpman (1994) simply assume that a subgroup L of the n sectors is able to organize effectively.
22 These organized interest groups coordinate the actions of their members, collect
contributions and communicate the wishes of their lobby group to the government. It means
21 Tariff revenues are distributed lump-sum and subsidies are financed in the same way .
22 The number of groups that are able to solve the organization problem is endogenized in
Mitra (1999).
22

that only the interests that are represented by a lobby will have a hearing in the political process. Without interest groups, individual factor owners are not able to assert political influence via lobby groups.
Each interest group, depending on its preferences and conditional of the promised trade policy, makes its support payments to the government. Since the international prices of goods are given, such payments are simply functions of domestic prices. The higher is P i contribution the government can collect. Thus, C i

 n ∑
P i


the more
denotes the payment that lobby i offers. By assumption, those payments are conditioned on the prices of all goods: A price increase in its own sector will be rewarded with more contributions whereas an increase of all other goods' prices will be “punished“ with lower contributions. To finance these payments, the interest group collects contributions from members, which are then transferred to the politicians.
The net benefit of lobbying is defined as V i
=
W i
−
C i
, where W is the gross benefit, without lobbying contributions, and W i is determined as:
W i
= P + α i

1
+ n ∑
T M i i
+ n ∑
S i


.
(35)
P
measures the profit from the specific capital invested in sector i , and
α i i is the share of total population represented in group i , so that members of this group participate with share
α
in total wages (1 is the sum of all wages given our assumptions), total tariff revenue and i overall consumer. The greater is the share of this interest group in total population, the more it will be negatively affected by higher prices but also benefit from higher tariff revenues. The equation thus tells us that lobby i benefits from the rise of its own prices and from a fall in the price of all other goods. The utility lobby i gets from a reduction of prices j, in turn, falls proportionately to the share of i in population. If lobby i constitutes only a small share of total population, it only receives a small share of tariff revenues and benefits only moderately from cheaper consumption.
The Government
The Government in office has two goals: first, they want to maximize their lobbying income, and, second, they care about their political support. The interest in lobbying revenue is based on the fact that these revenues are used to finance campaigns and thus provide direct benefits.
The political support is of interest to the government because it increases their chances of reelection. The utility function of government is accordingly:
G
= aW
+ n ∑
C i
, a
≥
0,
(36) where W measures the overall policy support that enters the considerations of the government with weight a . It is the sum of aggregated wage income, total profits for capital
P
, the revenue from tariffs and consumer surplus over all sectors
23

W
= + n ∑ P + i n ∑
T M i i
+ n ∑
S i
.
(37)
With these preparations we can now determine the utility-maximizing trade policy for the government and how interest groups determine their lobbying efforts. It is assumed that the lobbies are Stackelberg-Leader against the government but play Nash against each other.
The Provision of Protection
The interest group will determine its contributions by taking the contributions of other lobbies as given. We assume a bargaining solution between government and the lobbies about how high the tariff rate on a particular good will be and what the government receives in turn. If we consider this negotiation as a simple Nash-bargaining game, the result of this negotiation will be such that it maximizes the combined surplus of all players. This joint surplus is given by:
W = aW
+ n ∑
W i
.
(38)
This function is formally that of a welfare-maximizing government that simply sums the utilities of all groups since all groups are considered in W. However, successful lobbies receive a higher weight of (1+a) while other groups (i.e. consumers and the unorganized capital owners) only have weight a . The amount paid in lobbying fees by each group is a function of the parameter values of the negotiation process. Since we do not want to model these in more detail, the contributions cannot be determined precisely. We know, however, that the outcome of negotiations is simply a redistribution process between individual interest groups and the government. The more bargaining power the lobbies have, the less they will have to pay in the form of contributions in order to get the desired result from the government.
Even though the exact division of joint surplus from trade policy is not determined, it is sure that the trade policy will maximize the joint surplus (38). Using (35) and (37) in (38), the result is: a n ∑ ( a
+
I i
) P + n ∑ ( a
+ α
L
)(
T M i i
+
S i
)
.
(39) where
∑ α i
comprises the share of population that possesses specific factors and is organized in lobby groups, and I i
=
1 if sector i is organized in a lobby and I i
=
0 otherwise.
Taking the derivative of (39) yields:
∂
T i
∂
P i
= ( a
+
I i
)
∂P
∂
P i i
+ ( a
+ α
L
)


M i
+
T i
= ( a
+ i
) i
+ ( a
+ α
L
) (
Y i
T M i
' i
+
M i
∂
M i
)
∂
P i
+
∂
∂
S i
P i


(40)
24

where the definitions of M and S as well as
∂
M / P M
' i are used. The first order condition
(40) allows to calculate the optimal tariff for each sector as
T i
=
I i a
− α
+ α
L
L
⋅
−
Y i
M
' i
.
(41)
The result can also be written as
T i
=
I i a
− α
L
+ α
L
⋅ z e i i
(42) with z i
=
Y / M i i
is the ratio of domestic production to imports and e i
= − '
M / M i i
is the elasticity of import demand.
The optimal tariff rate reflects two things. First, if domestic output (Y i
) is large in comparison to imports, the domestic producers have much to gain from trade restriction. Second, sectors with a high import elasticity (e i
) will have lower tariff protection. This is because the government tries to minimize the distortions that arise from implementing tariffs. Since government has to bear the political costs of these distortions (if a> 0), it will try to achieve revenues only in those sectors where distortions are small. In addition, all interest groups j
≠ i are affected by a change in price through i and will fight against it.
4. The Choice of Protectionist Instrument
After having seen how tariffs are set depending on assumptions about the political process, this section will analyze how governments choose among different protectionist instruments to use. Imports may be limited by specific or ad-valorem tariffs, by import quotas, or a combination of both. Other possibilities are “voluntary export restraints”, local content requirements, public procurement rules and other non-tariff restrictions.
23
One decisive factor in the choice of instrument is certainly the restriction of use of certain instruments by international or national regulations and agreements. For example, the World
Trade Organization (WTO) regulates to some extent what instruments should be used and when. The same is true for the EU. In the following, we will neglect such institutional constraints and focus solely on political motives.
A key factor in the choice of the protectionist policy instruments is the degree of transparency and information asymmetries associated with different instruments. In particular, it is often assumed that non-tariff trade barriers, such as quotas or regulations, are not as visible as tariffs and are therefore preferred by politicians. The less visible an instrument is, the argument goes, the less visible are redistributive consequences and the less protest they will evoke. To
23 Non-tariff barriers have become far more important than tariffs, not least because of the influence of GATT and WTO (Bhagwati 1995) .
25

describe this consideration, Magee et al. (1989) introduced the concept of “optimal obfuscation” with respect to the choice of protectionist instrument.
Conventional textbook theory holds that incentive to lobby for quotas can be much larger than that for tariffs (Krugman and Obstfeld 2003). Import-competing industries, if they have market power, strictly prefer a quota to a tariff because a quota enables them to charge monopoly prices because imports beyond the quota are prohibited. Under tariffs, domestic prices are higher but world market supply is total elastic at this price. Thus, only quotas give the change to exploit monopoly power. After quotas are exhausted, domestic companies can act as monopolists and set their prices as such (equating marginal revenue with marginal costs) (see Krugman and Obstfeld 2003). Taking political economic considerations into account, however, we will see that actually a tariff might be more interesting for domestic industries.
There is also yet another reason why lobbying is greater for quotas than for tariffs. This is based, again, on the free-rider problem. Whereas quotas are assigned to a particular enterprise, and are thus a private good to this firm, tariffs are levied on all imported products or product groups. Thus, an individual firm is facing a problem that even if it contributes to lobbying for tariff implementation, the resulting protection is a public good for the whole industry. Even the companies that have exercised no lobbying will enjoy the benefits of the measure if it is adapted. Due to this problem, the extent of lobbying in such a case should be less than in case of quotas.
24
The choice of so-called voluntary export restraints (VERs), finally, can be interpreted as a division of rents between import competing industries and foreign exporters. Since the exporters reduce the supply of goods to the domestic market, they will enjoy a consequential price increase, whereas in the case of tariffs higher prices would only bring benefits to the domestic government. Since the costs of domestic tariff protection are compensated to some extent, the foreign country should definitely prefer VERs to tariffs. Thus, one can interpret
VERs as a way to minimize the risk of retaliation because they benefit both countries.
Tariffs versus Quotas when Governments Maximize Political Support
The following section describes in more detail some of the considerations about the choice of tariffs or quotas. We assume again a political support-maximizing government (Cassing and
Hillman 1986). In this application of the model, we first derive the optimal level of protection and then ask which instrument is preferred by the protected industry, thus providing potentially additional support to the government. Again, political losses from the choice of instruments and political gains are balanced at the margin.
24 From a normative point of view it follows that (a) overall resources spent for lobbying are lower with tariffs, (b) the free-rider problem could be exploited by allowing only tariffs as trade barriers. This would reduce the extent of protection and thus overall economic distortions (Panagariya and Rodrik 1993). This might be the one reason why the WTO is pushing for the use of tariffs rather than other protectionist instruments .
26

Again, government maximizes political support:
M
(

, P

)
(43) where a tilde above a variable indicates its corresponding free trade value. Whereas the industry has increased profits as a result of protection, consumers lose due to higher prices.
The derivative of M with respect to first variable is therefore positive M
1
>
0 , and the second is negative M
2
<
0 .
The profits from protection are a function of the difference between the free trade price and the price under protection:

(
P
− 
)
.
(44)
The optimal level of protection is (analogous to equation (14)):
M
2
M
1
.
(45)
Now, beyond the degree of protection the government can also choose the politically more suitable instrument of protection. As the level of protection, valid for both forms of protection, has been defined in the first step, any quota will be set such that the resulting domestic price will be the same as it would be under tariffs:
( ) = ( ) =
P . The amount produced by the firm is then given by MR (q) = MC, where MR (q) is marginal revenue given a quota and MC indicates the marginal cost for firms.
Some further assumptions are also necessary to obtain an interesting result. First, the government receives all the revenue from tariffs or quotas which are auctioned off. This means that domestic interest groups do not directly benefit from either revenue. This design allows to exclude the revenue motive from the industry’s objectives. Second, it is assumed that the quota rights do not go to the producers of import-competing goods. This ensures that the foreign goods are indeed imported according to the admissible amount set by the quota.
Otherwise, the importers can simply not use up the quota and secure themselves a complete monopoly in the domestic market.
From Figure 4 it is clear that the definition of
( ) = ( ) =
P results in a a shift of the demand for domestically produced goods from D to D(q), meaning that also a shift from MR to MR (q) results. This is the case because a portion of the total domestic demand is met through imports and domestic demand for domestically produced goods, which is relevant for domestic producers, accordingly shift left. The producer will then produce an optimal amount of Q
*
, which leads to a price of P. Thus, the price equivalence of tariffs and quotas is ensured.
In contrast, in the case of tariff protection the output produced domestically would be determined by P = MC and accordingly be at F. Because of higher production, the profits of domestic firms would be larger by the area Q
*
FZ, so that
P
( )
> P
( )
. For the government this implies that for a given level of protection tariffs are a better tool because they ensure higher profits and hence more political support from the protected industry. By
27

contrast the political losses are the same under both instruments since the domestic prices under tariffs and quotas are equivalent.
In contrast to the well-known argument that politicians would rather prefer quotas to tariffs, this example would suggest tariffs are politically more interesting as protectionist tools. The result directly follows from the assumption that domestic prices must be the same for both instruments. In the standard model, however, prices vary and thus prices are higher under quotas which ensures that quotas are preferred by import-competing industries.
Figure 4:
~
P
The clear preference for tariffs will not necessarily follow, however, if government also values the respective revenue from tariffs or quotas. This may be the case because they want to increase their own income or because it allows to reduce general taxes, which may be politically attractive. We thus rewrite the government’s objective function as
V
= ( )
(46) where M is the motive of tariff protection from (43) and R is the revenue from tariffs or selling quotas. We assume V , V
M R
>
0 so that utility is increasing in political support and tariff revenue.
Figure 5 shows that the choice of instrument is no longer obvious when both considerations play a role. On the one hand, we know that political support is higher under tariffs. On the other hand, the amount of goods imported under the quota regime is greater which implies
28

that the revenues for the government are larger because they are a positive function of imports. So, depending on which of the two arguments is more important for the government, it will make its decision for either tariff protection or quota protection. The flatter the indifference curve trading off the two considerations, the higher is the probability of the government actually choosing quotas because the revenue motive dominates.
Figure 5:
A Lobbying Model for the Choice between Tariffs and Subsidies
An alternative way to protect domestic industries from foreign competition is their support through subsidies. Like tariffs, this measure should increase profits, output and employment in the supported industries. In fact, this instrument can also be politically attractive for the government as long as subsidies are less visible than tariffs or more accepted by the population. Also it might be the case that subsidies produce less foreign resistance than tariffs may, although most trade agreements also prohibit the use of subsidies.
The following model focuses on the difference between tariffs and subsidies. However, it does not focus directly on the choice of instrument by the government but considers the effects of the two alternative regimes on the behavior of the affected industries. Thus, the focus shifts away from the politicians to the analysis of the behavior of industries. In particular, we focus on the already several times mentioned free-rider effect among lobbying firms. The lobbying function, in contrast to those used above, is of the “protection-production” variety developed by Findlay and Wellisz (1983) and applied to this context by Rodrik (1986).
We consider two industries where labor is mobile but capital is fixed to a certain industry.
Only one industry (X) needs capital for production while the other (Y) uses only labor. (The second industry is needed to ensure that there is no unemployment). Since labor is completely mobile, the wage w of labor in both sectors is determined by the constant marginal productivity of labor in sector Y.
29

The concave production function of sector X is
X
= (
X
)
. (47) where L
X
is the amount of labor employed in sector X and K is the constant capital stock. The capital is owned by n capitalists who do not work, so that there is a clear separation of workers and capital owners (firm owners).
We consider the behavior of a single firm in sector X, and compare its gains under both tariff protection (TR) and subsidies (SR) to analyze which of the two regimes it will prefer. Without the use of tariffs or subsidies “normal” profits are realized which we normalize to 1.
The “profit multiplier” of firm i in sector X is determined by x i = 


1 t if TR
+ i
1 s if SR
.
(48)
The profit without government intervention is not of interest for the choice of government intervention since it is independent of politics. Thus, we focus only on t s .
The key assumption is that tariffs are a public good. This means that the entire industry will benefit from tariff protection, independent of the fact whether a particular firm has contributed to lobbying for them or not. In contrast, subsidies are assumed to be specific to a particular company. Each company in the industry can receive subsidies (depending on their size or other considerations) which make their respective profits dependent on the amount of subsidies they receive individually. Each company can either undertake lobbying for tariff protection or for subsidies. It decides how much labor it will use for lobbying activities instead of employing it in production. Thus, no funds are spent on lobbying but rather employees of the firms are used to lobby. The total labor force employed by a firm thus equals l
= + l l
(where index x denotes the production of goods and index l denotes lobbying).
For simplicity, we assume that subsidies paid by lump-sum taxation and that tariff revenues are distributed in the same manner. Thus, distributional effects from choosing a particular instrument are excluded. Moreover, capital owners are unaffected as only employees finance subsidies and receive revenues from the tariff. Therefore, we can leave aside this aspect when considering the decision of capital owners.
For the case of tariff protection (TR), the “income multiplier” of firm i can be specified from
(48) as x i
TR
=
1
+ t
= h
( ) i l
= h
( ) l
(49)
We assume that the tariff protection granted to an industry is a concave function h(
.
) of the total lobbying efforts L undertaken collectively by all firms in this industry (L l
). If no lobbying is undertaken, the protective tariff is zero (h (0) = 1).
The lobbying technology for subsidies (SR) is similar and specified as follows
30

x i
SR
= + =
( ) ( )
(50)
Moreover, we make the additional assumption that both regimes produce the same result if firms cooperate and no free-rider problem arises. In this case, lobbying expenditures per firm would be equal under both regimes, maximizing the total profits of the industry ( nl i l
≡
L l
) where n is the number of identical firms in the industry. If g (.) is chosen in this manner, it is ensured that TR and SR will produce the same result if firms cooperate. However, in contrast to equation (49), where the tariff rate depends on the actions of all firms, the subsidy for firm i only depends on its own lobbying activity.
In the next step we consider the decision of capital owners with respect to their lobbying expenditures. The objective of the capital owner is to maximize her profits max l ,l i l i i
Px f
( i l , k x i
) ( i x
+ l l i
)
(51) with respect to i i l , l x l
≥
0 . Each producer takes P, w, and the technology f (.) as given and optimizes the use of labor for production or lobbying.
The first order conditions are
∂P i
∂ l i x
=
Px i
∂ f i
∂ l i x w 0
(52) and
∂P i
∂ l i l
=
Pf i
(
∂ i l i
) w 0
(53) where
∂
∂ x l l i i 

( ) l if TR
( ) if SR
,
(54) in the respective regime, where a prime ' denotes the first derivative. The first order conditions imply the optimal quantities of labor assigned to production and lobbying.
Since firms are identical, we can calculate the total investment for lobbying under both regimes by simply adding up the individual expenses of each firm. From the symmetry assumption it follows that the production function is identical for all firms f l i
(
L / n, K / n
X
) =
L
(
X
)
and that each company produces 1/n of total production
31

f i
(
L / n, K / n
) = ( )
.
25
These expressions are then used in (52) and (54) and to get the total lobbying efforts of industry X in both respective regimes
( ) (
( ) ( l
T
X
X
)
)
− w nw
0
0


=  for TR
(55) and
( ) (
( ) (
X
)
) w 0
S
Ph ' L F L , K l
S
X
− = 

 for SR .
(56)
These expressions describe the total labor allocation to lobbying and production under the respective regime. In the next step, we are able to determine how lobbying expenses of the industry depends on the number of firms in industry X. From a comparison of (55) and (56) it is obvious that the results will be identical for n = 1. The public good problem is obviously not present if there is only one company in the market.
The Influence of Industry Size on Lobbying Expenditures
Differentiation of equation (55) with respect to n and L leads in the following system in matrix form, where the first term on the left side is the Jacobi-matrix (containing the partial derivatives):

 h '' F h ' F h ' F
L hF
LL
L




 dL
T l dL
T
X
 

( )
0


.
(57)
Using Cramer’s rule, this system can be solved for the desired variables, where
∆ ≡ hh '' F F
LL
− ( h ' F
L
)
2 >
0 is the determinant of the Jacobi-matrix. This results in:
∂
∂
L n
T l
=
1
∆
( )
LL
<
0
(58) and
25 Subscripts denote the first derivative of a function with respect to the argument.
32

∂
L T
X
∂ n
= −
1
∆
( )
L
<
0 .
(59)
These results confirm our intuition. The amount of labor used for lobbying decreases in the number of firms active in industry X because of the free-rider problem in tariff protection. As a result, total lobbying expenditures and thus tariff protection go down. Because of the linear relationship between lobbying expenditure and tariff protection it follows that protection will be less in such a case. Accordingly, as (59) shows, the total production of goods in the industry also shrinks since lower protection makes production less profitable.
This does not apply to the subsidy regime because from equation (56) follows
∂
L S l
∂ n
=
∂
L S
X
∂ n
=
0 .
(60)
The expenditures on lobbying in SR are thus independent of n because subsidies create private benefits that are not subject to free-rider behavior. Although the output produced by each firm decreases for each company with an increase in n, the industry-wide production level is constant. This is illustrated in Figure 6.
The upper panel of Figure 6 shows how the price multiplier x i
approaches 1 with growing n in the case of tariff protection, while it remains constantly above 1 for the case of subsidies.
Likewise, the lower panel shows that total production in the industry is decreasing in the number of firms for the case of tariff protection. The larger is n, the closer is the production to the amount that would be produced without lobbying.
Figure 6:
33

The normative implication of this model is that only tariffs should be allowed as a protectionist tool. By exploiting the free-rider problem, one can thus ensure that the level of protection is lower than in the case of subsidies. If we extend this idea, it also follows that all industries should be provided with the same rate of tariff protection (if any). This would in turn ensure that all industries are trying to behave as free-riders on each other. In the case where tariffs are differentiated, they acquire a “private good” properties for industry, increasing the overall lobbying expenditures for the attainment of tariff protection (Panagariya and Rodrik 1993).
6. Conclusions
This chapter has surveyed part of the extensive literature on the political economy of trade policy. Given the huge literature, we have focused on a few basic models, and seen that restrictions on free trade can hardly be explained through the existence of market failures.
Empirically, it has been shown that protection is higher, if
• the industry under consideration is labor intensive and has many employees with low wages,
• the industry faces a high degree of import penetration,
• consumer goods are imported rather than intermediate products,
• production is regionally concentrated,
• the industry is characterized by little intra-industry trade,
• consumers are not very organized, and that
• poor countries have higher tariff protection which decreases with the capital / labor ratio,
• tariff protection is particularly high during economic downturns.
These results strongly suggest that tariff policy is a function of political and economic considerations. If an industry is politically influential (due to high concentrations of labor or due to regional concentration) it is likely to be protected. Intermediate inputs are usually taxed at a lower rate in order not to hurt the industrial users of these products. On the other hand, if the consumers of final products are well-organized, tariff protection is usually relatively low.
The same is true for the case when intra-industry trade is high since the risk of foreign retaliation is high. The fact that tariff protection falls with the capital-labor ratio could be supported by the Mayer model. Finally, the political support maximizing approach would predict that during recessions tariff protection increases because in this case the marginal gains from protection are higher.
34

Protection can be explained with different models for different contexts. We have started with the simplest Heckscher-Ohlin model in a direct democracy, and have shown that the median voter chooses trade restrictions whenever his personal endowment with production factors is different from the average equipment in the economy. Then, we have considered the incentives of the political support-maximizing government that is seeking to equalize the marginal gains and losses from protection. After that, we have focused on the interest groups in order to see how they compete for political influence and try to determine the election results in their favor. Finally, we have combined all these effects in a model of government that takes into account the interests of lobbyists as well as the political support it wants to attain, or even the general “welfare”. It has been shown that there can be many reasons for tariff protection and that the level and structure of tariff protection depends on the political process as well.
Finally, we have briefly addressed the choice of protectionist instruments and considered in more detail the free-rider problem which also appears in the lobbying model of protectionism.
In addition, we have seen in which case the choice of quotas or tariffs as protectionist instrument is more advantageous for the government.
Appendix A:
This appendix demonstrates the derivation of (11). From
∂ϕ
∂ t i
=
∂ϕ ∂
P
P t
=
∂ *
( + )
∂ t
⋅ 
 ∂
( w
+ i
)
∂ ⋅ ( wL
+ rK
) (
( wL
+ rK
( ) ( )
( ) + ( ) i
it follows
) wL
+ ) ∂ ⋅
( w
+ rK i
)
2


. For better comparability with the Stolper-Samuelson theorem, we express the differentials
∂
∂
∂
∂ w r
P
,
∂
∂ r
P
= ⋅
as percentage changes,
P
ˆ
ˆ r
.
ˆ
= dw / w dP / P
and
ˆr
= dr / r dP / P
so that
∂
∂ w
= ⋅
P
ˆ
ˆ
and
Substituting this in the above expression leads to
∂ϕ i
∂ t
=
P
*
( wL
+ rK
)
2
⋅

 wLK i ⋅ r r ˆ
P
+ rK
⋅
P
− wK
⋅
P
− i rK L
⋅
P


. In this expression, we can use k
=
K / L
∂ϕ i
(
P
*
∂ t
=
ˆ + rK
)
2
and
⋅ k i = i
K / L i =
K i
(as
(
− k i
) (
ˆ
−
ˆ r
)
L i =
1 ). Collecting terms, we get
or the expression in the main text.
35

Self-Assessment Questions
1) Briefly describe the arguments in favor of trade restrictions that are based on market failures. How relevant are these arguments?
2) To what extent does a “welfare-maximizing” government face the problem of time inconsistency?
3) Briefly describe the distributional effects of trade in the economy. Do reasons for trade restriction exist in a Heckscher-Ohlin world?
4) Show that in the Mayer model protection results in equilibrium. When and why does this happen?
5) Describe and compare the models of political competition and political influence that you are aware of.
6) How strong will a self-interested government with a political support function respond to exogenous shocks? Why is there a gradual decline of industry?
7) What is the difference between the Grossman/ Helpman and Hillman/ Ursprung models of the interaction between interest groups and politicians? Why can the Grossman / Helpman model be interpreted as a model of corruption?
8) Demonstrate analytically and graphically how the success probability of protectionist candidates in the Hillman / Ursprung model depends on the parameter
γ
(the elasticity of substitution). Interpret and explain the result.
9) Briefly compare the distributional effects of alternative trade restrictions. Why will the foreign industry prefer VERs? How can one make use of the free-rider problem in case of tariffs from a normative point of view?
10) Which instruments of trade policy are preferred by a government? Also, discuss how important the assumptions are for the results. What normative recommendations can be derived from this?
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