1. Slides prepared by Thomas Bishop Chapter 9 The Political Economy of Trade Policy

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-2 Preview The cases for free trade The cases against free trade Political models of trade policy International negotiations of trade policy and the WTO

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-3 The Cases for Free Trade The first case for free trade is the argument that producers and consumers allocate resources most efficiently under free trade.  National welfare of a small country is highest with free trade. Measured by consumer surplus and producer surplus.  With restricted trade, consumers pay higher prices & consume less.  Also, the distorted (higher) prices cause over- production.

4. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-4 The Cases for Free Trade (cont.)

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-5 The Cases for Free Trade (cont.) However, because tariff rates are low for many countries, estimated benefits of moving to free trade (zero tariff) are only a small fraction of national income.  Total deadweight loss is not substantial for many countries.  Yet, for some countries in some time periods, the estimated cost of protection was substantial.

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-6 The Cases for Free Trade (cont.)

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-7 The Cases for Free Trade (cont.)

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-8 The Cases for Free Trade (cont.) There exist dynamic benefits of free trade which are not reflected in static estimates of the of efficiency losses, caused by distorted prices and overproduction.  A second argument for free trade is that 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.  These benefits arise over time.

9. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-9 The Cases for Free Trade (cont.) A fourth argument, called the political argument for free trade, says that free trade is the best feasible political policy, even though there may be better policies in principle (theory).  Any policy that deviates from free trade would be quickly manipulated by special interests, leading to decreased national welfare.

10. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-10 The Cases Against Free Trade There are two theoretical arguments against the policy of free trade:  The terms of trade argument (for tariff).  The domestic market failure argument. 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 production and consumption distortions. In fact, a small tariff can lead to an increase in national welfare for a large country (appendix to Ch9).  However, national welfare begin to decrease above some tariff rate, as the efficiency loss exceeds the terms of trade gain.

11. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-11 The Cases Against Free Trade (cont.)

12. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-12 The Cases Against Free Trade (cont.) A tariff rate that completely prohibits imports leaves a country worse off, but tariff rate t 0 may exist that maximizes national welfare: an optimum tariff.

13. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-13 The Cases Against Free Trade (cont.) Similarly, export tax, with certain tax rate, may increase national welfare through the terms of trade effect.  An export subsidy lowers the terms of trade for a large country; an export tax raises the terms of trade for a large country. An export tax may raise the price of exports in the world market, by restricting its export supply.

14. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-14 Counter-Argument For some large country like the US, import tariff or/and export tax could improve national welfare at the expense of other countries. But this argument ignores the likelihood that other countries may retaliate against large countries by enacting their own trade restrictions.

15. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-15 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 sub-optimal policy.  The economic efficiency loss calculations using consumer and producer surplus assume that markets are functioning efficiently.  There can arise other benefits or costs to the society than just the consumer and producer surplus of one market.

16. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-16 The Cases Against Free Trade (cont.) Types of market failures include  Persistently high under-employment of labor  Persistently high under-utilization of capital  Technological benefits for society from additional production that are not captured by individual firms  Environmental costs for society from additional production that are not paid for by individual firms

17. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-17 The Cases Against Free Trade (cont.) Marginal social benefit represents the ‘additional benefit to society’ from additional production of a good.  In market failure cases, marginal social benefit is not accurately measured by the producer surplus of the firms, so that efficiency loss calculations are misleading.  eg. production of a good improve the technology of the economy as a whole, but the firms in that sector can’t reap this benefit. Consequently, the production would be smaller than (socially) optimal level. It is possible that a tariff raises domestic production, thereby increase the benefit to whole society, based on market failure.

18. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-18 The Cases Against Free Trade (cont.)

19. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-19 Counter-Arguments Free trade supporters counter- argue that domestic market failures should be corrected by a domestic policy, aimed directly at the source of the problem.  If persistently high under-employment of labor is a problem, then production of labor-intensive products could be subsidized by the government.  These subsidies could avoid the economic efficiency loss for consumers due to tariff.

20. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-20 Counter-Arguments (cont.) Because it is unclear when and to what degree market failure exists in the real world, it is unclear when and to what degree government policies should respond.  Government policies to address market failures are likely to be manipulated by politically powerful groups.  Because it distorts the incentives of producers and consumers, a trade policy may have unintended consequences that make a situation worse, not better.

21. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-21 Political Models of Trade Policy How is trade policy determined? Models that address this question: 1. Median voter theorem (skip) 2. Collective action 3. A model of trade policy combining aspects of collective action and the median voter theorem (skip).

22. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-22 Collective Action Political activity is often described as a collective action problem:  While consumers as a group have an incentive to advocate free trade, each individual consumer has no incentive because his benefit is small compared to the cost required to advocate free trade.  Policies that impose large losses in for society as a whole but small losses on each individual may therefore not face strong opposition.

23. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-23 Collective Action (cont.) However, for those groups who may suffer large losses from free trade, each individual in that group has a strong incentive to advocate the protectionist policy.  In this case, the cost required to advocate restricted trade is small compared to the cost from trade.

24. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-24 Which Industries Are Protected? Agriculture: in the advanced countries, farmers make up a small fraction of the population but receive generous subsidies and trade protection.  Examples: EU’s Common Agricultural Policy, Japan’s 1000% tariff on imported rice, America’s sugar quota. Clothing: textiles and apparel.  Well organized union in clothing sector.  Import licenses for textile and apparel exporters were specified in the Multi-Fiber Agreement among many nations. Protection is likely to diminish in the future in both sectors (due to international trade negotiations).

25. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-25 Which Industries Are Protected? (cont.)

26. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-26 International Negotiations of Trade Policy The average US tariff rate on imports has decreased substantially since 1930s. Since 1944, much of the reduction in tariffs and other trade restrictions came about through international negotiations.  The General Agreement of Tariffs and Trade (GATT) was begun in 1947 as a provisional international agreement  GATT was replaced by a more formal international institution called the World Trade Organization (WTO) in 1995.

27. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-27 International Negotiations of Trade Policy (cont.) Multilateral negotiation mobilize exporters to support free trade if they believe export markets will expand. Multilateral negotiations also help avoid a trade war between countries, where each country enacts trade restrictions. If each country has a political interest to protect domestic producers, regardless of what other countries do,  then all countries enact trade restrictions, even if it is in the interest of all countries to have free trade.  Use a simple example (‘a game’) to illustrate this point.

28. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-28 International Negotiations of Trade Policy (cont.)

29. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-29 International Negotiations of Trade Policy (cont.) In this simple example, each country acting individually would be better off with protection  However, both would be better off if both chose free trade.  If the two countries can establish a binding agreement (like WTO agreements) to maintain free trade, both can avoid the temptation of protection, being better off.

30. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-30 World Trade Organization The WTO addresses trade restrictions at least in 3 ways : 1.Reduction of tariff rates through multilateral negotiations. 2.Binding concession: a tariff is “bound” by the imposing country agreeing not to raise it in the future. 3.Prevention of non-tariff barriers: quotas and export subsidies are to be changed into tariffs, because the costs of tariff protection are more clear.  Subsidies for agricultural exports are exception.  Exceptions also allowed for “market disruptions” caused by a surge in imports.

31. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-31 World Trade Organization (cont.) The WTO was founded in 1995, on a number of agreements  General Agreement on Tariffs and Trade (GATT): covers trade in goods  General Agreement on Trade in Services (GATS) : covers trade in services e.g., consulting or legal services, banking, insurance, etc.  Agreement on Trade-Related Aspects of Intellectual Property (TRIPs): covers intellectual property rights e.g., patents, copyrights, trademarks, etc.

32. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-32 World Trade Organization (cont.) The dispute settlement procedure strengthened:  a formal procedure where countries in a trade dispute can bring their case to a panel of 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 the WTO agreements to decide which ones are breaking their agreements.  A country refusing to accept the panel’s decision may be punished by allowing other countries to impose trade restrictions on its exports

33. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-33 Preferential Trading Agreements Preferential trading agreements (PTAs) are trade agreements between countries in which they lower tariffs for each other but not for the rest of the world. Under the WTO, such discriminatory trade policies are generally not allowed:  All countries pay tariffs no higher than that of a nation paying the lowest: called the “most favored nation” (MFN) principle. It is not allowed for country A to have lower tariffs on imports from country B than on those from country C.  An exception to this principle is allowed, only if the tariff rate is set at zero among a few (two) countries.

34. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-34 Preferential Trading Agreements (cont.) There are two types of PTAs in which tariff rates are set at or near zero: 1.A free trade area: an agreement that allows free trade among members, but each member can have its own trade policy (eg. tariff rates) towards non- member countries  An example is the North America Free Trade Agreement (NAFTA). 2.A customs union: an agreement that allows free trade among members and requires a common external trade policy (eg. tariff rates) towards non- member countries.  An example is the European Union (even further progressed forming an economic union).

35. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-35 Preferential Trading Agreements (cont.) Are PTAs good for national welfare?  Not necessarily,  it is possible that national welfare decreases under a PTA. How?  Rather than gaining tariff revenue from inexpensive imports from world markets, a country may import expensive products from member countries without any tariff revenue.

36. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-36 Preferential Trading Agreements (cont.) Two contrasting effects arise due to PTAs. (1) Trade creation effect  occurs when high cost (inefficient) domestic production is replaced by low cost (efficient) imports from members. (2) Trade diversion effect  occurs when low cost (efficient) imports from non-members are diverted to high cost (inefficient) imports from members. PTAs can increase national welfare when trade creation effects are larger than trade diversion effects.  But the reverse situation can happen as well.

37. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-37 Summary 1.The cases for free trade are that  It allows consumers and producers to allocate their resources freely and efficiently, without price distortions.  It may allow for economies of scale.  It increases competition and innovation. 2.The cases against free trade are that trade restrictions may allow  terms of trade gains  a government to address a market failure when better policies are not feasible

38. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-38 Summary (cont.) 3.Models of policy making for trade policy consider incentives to adopt popular policies as well as incentives to adopt unpopular policies if these policies are advocated by groups that make political contributions. 4.Agricultural and clothing industries are the most protected industries in many countries.

39. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-39 Summary (cont.) 5.Multilateral negotiations of free trade may mobilize domestic political support for free trade, as well as make countries agree not to engage in a trade war. 6.The WTO and its predecessor have reduced tariffs substantially in the last 50 years, and the WTO has a dispute settlement procedure for trade disputes. 7.A preferential trading agreement is beneficial for a country if it creates new trade but is harmful if it diverts existing trade to higher cost alternatives.