Why Do Governments Restrict Trade? I think an American private citizen or an American company should have the right to visit any place on earth and the right to trade with any other purchaser or supplier on earth. (Jimmy Carter, 2002)

The Goals of This Chapter Review the partial equilibrium, general equilibrium, and growth models and distinguish the distribution of the welfare gains and losses from international trade. Explain the strategic trade and infant industry arguments for protection. Distinguish the assumptions that must be satisfied for the strategic trade and infant industry arguments for protection to be valid. Introduce the political economy models that can help to explain trade policy.

The General Equilibrium Effects of Trade The shift to free trade means that the economy specializes in the production of Y, and production shifts from A to P. The movement of factors from one industry to another implies moving expenses and other costly adjustments. Even if factors do move quickly and with few adjustment costs, their prices will change, thereby changing the incomes of their owners.

A sudden change in relative prices from P to Pw may, in the short run, greatly reduce production of X but not increase output of Y very much. Production thus moves to Ps, below the PPF. Output of X falls from h to m, and output of Y rises only slightly from g to f.

When production moves to Ps, below the PPF, the best consumers can do is to consume at Cs. With production at Ps, the economy can no longer reach even the no- trade indifference curve. Thus, in the short run a shift to free trade may reduce welfare!

Only in the long run does the economy reach the standard free trade triangle linking points P and C. The orange arrows trade dynamic paths from A to P and from A to C. In the short run, welfare declines, in the long run it rises from its pre-trade level.

The dynamic path of trade and specialization after trade liberalization implies a gradually changing trade pattern. In the short run, the brown trade triangle results. In the long run, the economy trades according to the larger orange trade triangle.

Suppose that free trade increases output of Y and decreases output of X. Suppose also that the Y industry employs relatively more labor than the X industry for given factor prices. All other things equal, the increase in industry Ys output therefore increases demand for labor from D to Dy. The decrease in industry Xs output causes the demand for labor to decline by a smaller proportion from D to Dx, all other things equal.

The effect of industry Ys greatly increased labor demand and industry Xs smaller decrease in labor demand is a net increase in overall labor demand from D to Dt. That is, if trade expands the output of the relatively labor intensive industry, the return to labor (the wage w) increases.

In the market for capital, the opposite effects occur as a result of the trades expansion of the Y industry. The effect of the growing industry Ys modestly increased demand for capital and the contracting industry Xs larger decrease in demand is a net decrease in overall capital demand from d to dt. That is, if trade expands the output of the relatively labor intensive industry, the return to capital (the return r) decreases.

The Stolper-Samuelson Theorem The results in the previous slides have been incorporated into what is known as the Stolper Samuelson theorem. This theorem states that when an economy shifts from self- sufficiency to free trade the real income accruing to the factor used relatively intensively in the growing export industry rises and the real income to the factor used relatively more intensively in the shrinking import- competing industry falls. The theorem states that not only does the price of abundant factor rise with free trade, but the real value of the income earned by the abundant factor rises.

Estimating the Distributional Effects of Trade Many studies have estimated the effects of international trade on income distribution, and international trade has only a modest effect on income distribution. One reason for the modest distributional effect is that a portion of international trade among developed economies that is driven by increasing returns to scale rather than factor endowments. Another reason is that most people own more than one kind of factor of production. Furthermore, in the long run, factor price changes cause behavioral changes that mitigate the short run income. Also, in the long run, technological progress and factor accumulation have much greater effects on factor returns than do the short run shifts in production induced by trade.

The Assumptions Underlying the Infant Industry Argument The industry to be protected eventually becomes competitive and gains a comparative advantage (the Mill test). The short run costs of protection are less than the discounted future benefits from enabling the industry to survive (the Bastable test). There is some market failure that prevents private individuals from carrying out investments in industries that will become competitive in the future. The government has accurate information about future comparative advantage at home and abroad, and it objectively acts on this information. There is no foreign retaliation.

The Strategic Trade Argument for Protection Recall the model of increasing returns from Chapter 3. Increasing returns imply that an industry becomes more competitive the higher its level of output. Increasing returns imply that the PPF curve is convex to the origin (bowed in), as shown in the figure on the right.

The Strategic Trade Argument for Protection Recall also how, under increasing returns, two otherwise-identical economies can gain from trade by specializing. It did not seem to matter which country chose to produce books and which one chose pizza. By arbitrarily concentrating on producing one product and then exchanging output, both countries gained welfare.

The Strategic Trade Argument for Protection Notice that each country reaches a higher indifference curve. Each country produces only one good, but both countries seem to consume the same bundle of two different goods. But, do imperfectly competitive increasing returns countries always share the gains from trade so equally?

The Strategic Trade Argument for Protection What if the relative prices at which the trade occurs brings two countries very different gains from trading books and pizza, with Country A gaining relatively less than Country B? Such a case is illustrated in the Figure on the right.

The Strategic Trade Argument for Protection Notice that Country B is able to use trade and specialization to increase its welfare much more than Country A. Country As citizens would have been better off if their country had chosen to specialize in producing pizza. Strategic trade policies are protectionist trade policies to influence the growth of preferred domestic industries.

The Assumptions Underlying the Strategic Trade Argument Governments have accurate information with which to predict the future performance of industries so that they can correctly pick winners. Governments make economic decisions objectively and free from the influence of special interests. Other countries do not retaliate by protecting the same targeted industries.

The Strategic Trade Argument for Protection: Some Difficult Questions Can governments make an informed, unbiased choice between the book industry and the pizza industry? Does anyone know which industry will be most profitable in the future? What happens when both Countries A and B ban imports of pizza in order to promote pizza production at home?

Comparing the Arguments for Protection The strategic trade and infant industry arguments for protection are logically sound and do not deny the gains from comparative advantage. The infant industry and strategic trade arguments require that the discounted value of the gains to the overall economy outweigh the discounted value of the costs incurred. The infant industry and strategic trade arguments assume that government policy makers have accurate and complete information about economic variables today and in the future. All protectionist arguments assume that government policy makers use information objectively and are not influenced by special interests and short-run political expediency. All protectionist arguments assume that there will be no foreign retaliation.

The Political Economy of International Trade The arguments for infant industry protection, strategic trade promotion, sanctions, or national security do not seem firm enough to justify the widespread protectionism that we observe throughout the world. Therefore, in order to understand why governments impose trade barriers we need logical models that explain why national policy makers can institute policies that most likely reduce total national welfare. Several popular models from the field of political economy are useful for understanding trade policy.

Political Economy Models This chapter presents several models to Explain Welfare-Reducing Trade Protection: The median voter model The uninformed voter model The endogenous tariff model The adding machine model

The median voter model predicts that the candidate who proposes policies that favor slightly more than half of the voters, regardless of the size of the gains or losses involved, will win office. The diagram on the right assumes that 60% of the voters each lose welfare from protectionist policies, and 40% each gain an equal amount of welfare. Thus the median voter opposes welfare, and the winning policymaker will be a free trader. Under this scenario, national welfare is enhanced, as the total losses from protection would have exceeded the total gains.

The median voter model does not predict that the winning policymaker will necessarily maximize total national welfare, however. Suppose that 40% of the voters each suffer very large welfare losses from protectionist policies, and 60% gain only a little welfare. The median voter model predicts that protectionist policymakers will be elected. The total losses clearly exceed the total gains under protection. National welfare losses are a possible democratic outcome because votes do not register voter intensity on issues.

The uninformed voter model predicts that the candidate who proposes policies that are very important to some voters will be elected, implying that small special interest groups can have disproportionate political influence. Small special interest groups have a large influence on policies because most voters have little information on most issues that do not directly affect them. As illustrated in Figure 7.7, if the 10% of voters who care a lot about an issue get their way, national welfare may fall; the grey losses area is greater than the green gains area.

The Endogenous Tariff Model By increasing protection, policy makers increase campaign funds to influence uninformed voters. However, higher levels of protection lead uninformed voters to become more informed about the welfare losses from protection. The tariff level settles where the votes gained because of special interest campaign financing is equal to marginal votes lost because people become aware of the cost of tariffs. The model suggests that the political process leads to some protection despite the welfare loss.

The Adding Machine Model The adding machine model links the likelihood that a policy is enacted to the absolute number of people that are directly affected by the policy. This model implies simply that policy makers will prefer to deal with issues that are of concern to large numbers of people rather than issues of importance only to few people. This model contradicts the uninformed voter model and the endogenous tariff model. Evidence does suggest that in the U.S. large industries that employ large numbers of people in concentrated areas tend to enjoy more protection than small, scattered industries.

The U.S. sugar quota is an example of a small group of farmers who gain a lot from protection influencing trade policy over the interests of a very large groups of people, each of which stands to lose a little from protection. A small number of producers gains are a in the Figure; 280 million consumers lose areas a+b+c+d. The nation loses b+c+d.