Chapter 9
The Political
Economy of
Trade Policy
Slides prepared by Thomas Bishop
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Preview
• The cases for free trade
• The cases against free trade
• International negotiations of trade policy and
the World Trade Organization
• Spotlight on Chinese Subsidiaries (Case)
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The Cases for Free Trade
• The first case for free trade is the
argument that producers and consumers
allocate resources most efficiently
when governments do not distort market
prices through trade policy.
National welfare of a small country is
highest with free trade.
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Fig. 9-1: The Efficiency Case for Free
Trade
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The Cases for Free Trade (cont.)
• A second argument for free trade is that it
allows firms or industry to take advantage of
economies of scale.
• A third argument for free trade is that it
provides competition and opportunities
for innovation.
.
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The Cases Against Free Trade
• For a “large” country, a tariff or quota lowers
the price of imports in world markets and
generates a terms of trade gain.
 This benefit may exceed the losses caused by
distortions in production and consumption.
• In fact, a small tariff will lead to an increase in
national welfare for a large country.
 But at some tariff rate, the national welfare will
begin to decrease as the economic efficiency loss
exceeds the terms of trade gain.
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Fig. 9-2: The Optimum Tariff
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The Cases Against Free Trade (cont.)
• A second argument against free trade is that
domestic market failures may exist that
cause free trade to be a suboptimal policy.
 The economic efficiency loss calculations using
consumer and producer surplus assume that
markets function well.
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The Cases Against Free Trade (cont.)
• Economists calculate the marginal social
benefit to represent the additional benefit to
society from private production.
 With a market failure, marginal social benefit is not
accurately measured by the producer surplus of
private firms, so that economic efficiency loss
calculations are misleading.
• It is possible that when a tariff increases
domestic production, the benefit to domestic
society will increase due to a market failure.
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9-9
The Cases Against Free Trade (cont.)
• The domestic market failure argument against free
trade is an example of a more general argument
called the theory of the second best.
• This theory states that government intervention which
distorts market incentives in one market may increase
national welfare by offsetting the consequences of
market failures elsewhere.
 The best policy would be to fix the market failures
themselves, but if this is not feasible, then government
intervention in another market may the “second-best” way
of fixing the problem.
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Which Industries Are Protected?
• Agriculture: in the U.S., Europe, and Japan
farmers make up a small fraction of the
electorate but receive generous subsidies and
trade protection.
 Examples: European Union’s Common Agricultural
Policy, Japan’s 1000% tariff on imported rice,
America’s sugar quota.
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Which Industries Are Protected? (cont.)
• Clothing: textiles (fabrication of cloth) and
apparel (assembly of cloth into clothing).
 Until 2005, quotas licenses granted to textile and
apparel exporters were specified in the Multi-Fiber
Agreement between the U.S. and many other
nations.
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International Negotiations of Trade Policy
• The average U.S. tariff rate on dutiable imports
has decreased substantially from 1920–1993.
• Since 1944, much of the reduction in tariffs and
other trade restrictions came about through
international negotiations.
 The General Agreement of Tariffs and Trade was
begun in 1947 as a provisional international
agreement and was replaced by a more formal
international institution called the World Trade
Organization in 1995.
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Fig. 9-5: The U.S. Tariff Rate
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International Negotiations
of Trade Policy (cont.)
• Multilateral negotiations also help avoid a trade
war between countries, where each country enacts
trade restrictions.
• A trade war could result if each country has a political
interest (due to political pressure) to protect domestic
producers, regardless of what other countries do.
 All countries could enact trade restrictions, even if it is in the
interest of all countries to have free trade.
• Let’s use a simple example to illustrate this point.
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International Negotiations of Trade Policy
(cont.)
EU
Free Trade
Free Trade
$10B
$10B
Protection
$20B
-$10B
Protection
-$10B
$20B
US
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-$5B
-$5B
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International Negotiations
of Trade Policy (cont.)
• In this simple example, each country acting
individually would be better off with protection,
but both would be better off if both chose free
trade.
• If Japan and the U.S. can establish a binding
agreement to maintain free trade, both can
avoid the temptation of protection and both
can be made better off.
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The Fordney-McCumber Tariff Act
• Congress passed the temporary Emergency Tariff Act
in 1921, followed a year later by the FordneyMcCumber Tariff Act of 1922. The FordneyMcCumber Tariff Act raised tariffs above the level set
in 1913; it also authorized the president to raise or
lower a given tariff rate by 50% in order to even out
foreign and domestic production costs. One
unintended consequence of the Fordney-McCumber
tariff was that it made it more difficult for European
nations to export to the United States and so earn
dollars to service their war debts.
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• It did nothing to foster cooperation
among nations in either the economic or
political realm during a perilous era in
international relations. It quickly became
a symbol of the "beggar-thy-neighbor"
policies of the 1930s. Such policies,
which were adopted by many countries
during this time, contributed to a drastic
contraction of international trade.
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• For example
• U.S. imports from Europe declined from
a 1929 high of $1,334 million to just
$390 million in 1932
• U.S. exports to Europe fell from $2,341
million in 1929 to $784 million in 1932
• Overall, world trade declined by some
66% between 1929 and 1934
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So shall we “buy American”?
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World Trade Organization
•
The WTO negotiations addresses trade
restrictions in at least 3 ways:
1. Reduction of tariff rates through
multilateral negotiations.
2. Binding: a tariff is “bound” by having the
imposing country agree not to raise it in the
future.
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World Trade Organization (cont.)
3. Prevention of non-tariff barriers: quotas
and export subsidies are changed to tariffs
because the costs of tariff protection are
more apparent.
 Subsidies for agricultural exports are an
exception.
 Exceptions are also allowed for “market
disruptions” caused by a surge in imports.
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World Trade Organization (cont.)
• The World Trade Organization was founded in
1995 on a number of agreements
 General Agreement on Tariffs and Trade: covers
trade in goods
 General Agreement on Tariffs and Services: covers
trade in services (ex., insurance, consulting, legal
services, banking).
 Agreement on Trade-Related Aspects of
Intellectual Property: covers international property
rights (ex., patents and copyrights).
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World Trade Organization (cont.)
 The dispute settlement procedure: a formal
procedure where countries in a trade dispute can
bring their case to a panel of WTO experts to rule
upon.
 The cases are settled fairly quickly: even with
appeals the procedure is not supposed to last
more than 15 months.
 The panel uses previous agreements by member
countries to decide which ones are breaking their
agreements.
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World Trade Organization (cont.)
 A country that refuses to adhere to the panel’s
decision may be punished by allowing other
countries to impose trade restrictions on its exports.
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Spotlight on Chinese Subsidies
-------A Typical WTO Case
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• In recent years, a number of complaints have been
made to the World Trade Organization (WTO)
concerning the Government of China’s involvement in
the marketplace
• In particular, the wide range of alleged subsidies are
offered to domestic producers and exporters by the
Government of China
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• Canadian businesses in the Chinese marketplace will
want to follow these developments closely as the
conditions of competition in Canada, in China and in
other economies worldwide will be affected by the
outcome of this proceeding.
• More importantly, Canadian companies producing or
purchasing from China should also stay on top of the
issues and developments.
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China’s Adherence to WTO Obligations
• All WTO countries have agreed to abide by
international agreements that establish ground rules
for trade.
• Under these agreements, all WTO countries must
provide non-discriminatory treatment, eliminate
dual-pricing practices and ensure that price controls
are not used to safeguard domestic industries.
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Subsidies Provided by the Chinese
Government
• Chinese enterprises with some foreign
investment are offered refunds, reductions
or exemptions from taxes or other
payments due to the Chinese government.
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• The subsidies that increase the capacity of Chinese
producers to export, enable them to offer lower prices
and thereby gain a greater market share in foreign
economies.
• Subsidies provide a protectionist barrier to entry into the
Chinese market, hindering the ability of foreign exporters
to compete in that particular market.
• The end result of these measures is that the goods
produced by China are positioned advantageously in
comparison to foreign goods, rendering competition
between the Chinese and the imported goods
inequitable.
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Response From China
• At an October 25 meeting of the WTO’s subsidies
committee, China stated that it has endeavored to
comply with its 2001 WTO accession commitments.
• It contended that the success of its industries were
not a result of subsidies; instead, these successes
resulted from the country’s comparative advantage in
production costs.
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Dispute Settlement at the WTO
• When a WTO member provides subsidies that, in the
view of another WTO member, are contrary to
international obligations, recourse is made to the
WTO’s dispute settlement system.
• First, a complaining WTO member engages in
consultations with the allegedly non-compliant
member. If the issue is not resolved through these
initial consultations, the complainant can ask the
dispute settlement body (DSB) to establish a panel.
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• Within roughly six months’ time (or sometimes longer
depending on the complexity of the legal issues), the
panel will produce a report containing its findings and
recommendations.
• Any party to the dispute can appeal the panel’s decision
to the WTO Appellate Body.
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• The DSB adopts the panel’s report within 60 days after it
is issued, or in the case of an appeal, the DSB adopts
the Appellate Body’s report within 30 days of its issuance.
•
• Thirty days after the adoption of the panel or Appellate
Body’s report, the offending party must inform the DSB
of its intentions to implement the recommendations.
• If it is impracticable to comply immediately, the member
must comply within a “reasonable period of time”.
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WTO Panel to Examine Chinese
Subsidy Programs
• On February 2, 2007, the U.S. requested consultations
with China concerning certain subsidies provided by the
Government of China.
• In the view of the U.S., China’s subsidies are
inconsistent with Article 3 of the Subsidies and
Countervailing Measures Agreement (SCM) in that they
provide refunds, reductions or exemptions from taxes
and other payments owed to the government by
enterprises in China on the condition that those
enterprises purchase domestic over imported goods or
on the condition that those enterprises meet certain
export performance criteria.
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• The U.S. also claims that China’s favorable treatment of
domestic goods contravenes Article III:4 of the General
Agreement on Tariffs and Trade (GATT) and Article 2
of the Trade-Related Investment Measures
Agreement (TRIMs).
• Furthermore, the U.S. alleges that China’s actions are
not in compliance with Part I of its Accession Protocol,
which forms part of the terms of accession between
China and the WTO and is an integral part of the
Marrakesh Agreement Establishing the World Trade
Organization.
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• A number of countries joined in the consultations with
China, including Canada, the European Communities,
Australia, Japan and Mexico.
• Following certain amendments by China to its income
tax legislation, supplementary consultations were
requested; however, these were unable to successfully
resolve the disputed issues
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• On August 31, 2007, at the request of the U.S. and
Mexico, the WTO set up a panel to examine China’s
subsidy programs.
• The Government of Canada, as a third party in the
proceeding, has the right to be heard by the panel and
make written submissions.
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China’s Obligations Under the Accession
Agreement
• At the heart of this WTO dispute is the question of
whether China is violating the obligations it signed
onto when it joined the WTO in December 2001.
• Under the Protocol of Accession of the People’s
Republic of China, China officially became a member
of the WTO. As a member of the WTO, China adopted
and agreed to implement the WTO’s multilateral trade
agreements, including the SCM, GATT, and TRIMs.
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China’s Obligations Under Article III:4 of the
GATT
• Article III:4 of the GATT specifies that contracting
countries must provide national treatment. Essentially,
this means that imported goods must be treated no
less favourably than domestically-produced goods in
respect of all laws, regulations and requirements
affecting their internal sale, offering for sale, purchase,
transportation, distribution or use.
• The U.S. and Mexico argue that the provision of
subsidies by the Government of China afford
favourable treatment to Chinese industries to the
detriment of foreign competitors.
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China’s Obligations Under the TRIMs
Agreement
• The TRIMs Agreement stipulates that no contracting
party shall apply any TRIM that is inconsistent with
Articles III (national treatment) and Article XI (prohibition
of quantitative restrictions) of the GATT.
• Appended to the agreement is a list of prohibited
measures. Measures that require enterprises to procure
a certain percentage of goods locally (“local content
requirements”) and measures that restrict the volume or
value of imports that an enterprise can purchase or use
to an amount related to the level of products it exports
(“trade balancing requirements”) are expressly prohibited.
The agreement calls for the elimination of these
measures.
• The U.S. and Mexico argue that certain Chinese taxes,
refunds and other payments that stimulate Chinese
exports and cause buyers to choose Chinese products
violate the TRIMs Agreement.
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Obligations Under the SCM Agreement
• The SCM Agreement places certain restrictions on the
ability of WTO members to provide subsidies that give
an unfair trade advantage to certain corporations or
industries within its borders.
• The SCM Agreement addresses subsidies that are
available only to an enterprise or industry, or group of
enterprises or industries within the jurisdiction of the
authority granting the subsidy.
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• Actionable subsidies are subsidies that have an adverse
effect on another WTO member.
• Subsidies that cause “serious prejudice” to the interests
of another WTO member by causing them to lose market
share in a third country market are one example of
actionable subsidies.
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• The U.S. and Mexico, in their complaints to the WTO,
allege that China provides a number of industry-specific
prohibited and actionable subsidies that are inconsistent
with China’s international obligations.
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• In requesting a WTO panel, the complainants are
seeking a finding of WTO inconsistency that will cause
the Government of China to terminate these
subsidization programs.
• The panel’s conclusions and recommendations in this
regard are expected to be released in 2008.
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• The Importance of this Dispute to Businesses
Engaged in Trade
•
In response to foreign trade-related criticisms, the
Chinese government has initiated a number of policies in
an effort to “even” the playing field. They include:
• revamping its enterprise income tax to phase out
favourable treatment to foreign-invested enterprises; and
• tightening administration in a number of areas, including
labour and intellectual property rights.
• The Chinese government has also put in place policies
to discourage investment in lower-end processing and in
resource-consuming industries where the price of water
and power are government controlled or "subsidized."
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• Nevertheless, the importance of this dispute to Canadian
businesses cannot be overstated.
• China, which consistently ranks among the top export
destinations for foreign businesses, represents a huge
potential market for exports from abroad and a wealth of
opportunities for foreign businesses who seek to
establish operations in China.
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• For Canadian businesses, a WTO panel ruling that
Chinese subsidies are WTO-inconsistent could result in
significant market openings arising from changes to
Chinese laws.
• For the Chinese government and Chinese business, a
negative panel ruling could place severe constraints on
Chinese funding programs and fiscal measures in
support not only of Chinese companies but also of
foreign companies based in China.
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• In consequence, any measures taken by the
international community or, for that matter, the Chinese
government, to reduce the competitiveness of its export
industry could hurt foreign (Canadian) invested
manufacturers as much as it hurts their Chineseinvested counterparts.
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