1. Chapter 10: The Political Economy of Trade Policy
Udayan Roy
ECO 41 International Economics
October 2011

2. Contents The case for free trade The case against free trade
Political models of trade policy
International negotiations over trade policy and the World Trade Organization

3. Arguments for free trade
Tariffs and quotas have deadweight losses and encourage rent-seeking; free trade allows large-scale production, and provides more incentives for innovation; even when barriers to free trade make economic sense, these policies are often corrupted by interest groups
Arguments for free trade

4. Free trade makes the world more efficient
Scarce resources are used most efficiently when governments do not interfere with the way free markets work.
National welfare of a small country is highest under free trade.
Under restricted trade, consumers pay higher prices.
Under restricted trade, prices for domestic producers are artificially high. This causes overproduction either by existing firms producing more or by more firms entering the industry.

5. Fig. 10-1: The Efficiency Case for Free Trade
As these efficiency gains from free trade are small—mostly because tariff rates are already quite low—they are not a persuasive argument for free trade.
However, there are other arguments in favor of free trade
Table 10-1: Benefits of a move to worldwide free trade (percent of GDP)

6. Free trade reduces rent seeking
Quotas can lead to rent seeking behavior that is economically wasteful
In India in the 1950s and 1960s, the amount of resources that a business was allowed to import was tied to how big the business was. This gave businesses an artificial incentive to over-invest and be big
Tuna importers to the United States were allowed to bring in a limited amount of tuna on a first-come-first-served basis. Tuna importers spent a lot of money to stockpile tuna in December, in order to be first in line in January
Such wasteful activities that are provoked by quirks in the laws are called rent seeking

7. Free trade boosts dynamic efficiency
Free trade allows firms to take advantage of economies of scale.
Example: In the auto industry, to operate at efficient scale, an auto plant should make a minimum of 80,000 cars per year.
In Argentina, under a protectionist regime in 1964, 13 firms produced a total of 166,000 cars per year.
Free trade provides
Increased competition, and
Greater incentives for innovation.

8. Free trade keeps special-interest politics at bay
Free trade is the best feasible political policy, even though there may be better policies in principle
We’ll soon see some examples where barriers to free trade may make economic sense
But such policies often require selective intervention
This opens the door to political squabbling
Trade policies that single out certain industries for protection from imports are in practice dominated by special-interest politics rather than consideration of national costs and benefits.

9. Economic arguments against free trade
Terms of trade argument and domestic market failure argument
Economic arguments against free trade

10. Terms of trade argument: optimum tariff
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.
So the ideal or optimum tariff is greater than zero but less than the prohibitive tariff that stops all imports

11. Fig. 10-2: The Optimum Tariff

12. Terms of trade argument: optimum export tax
An export tax (a negative export subsidy) that completely prohibits exports leaves a country worse off, but an export tax rate may exist that maximizes 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, increasing the terms of trade.

13. Terms of trade argument: flaws
The argument doesn’t work for small countries
Even if a large country benefits from a tariff, that benefit comes at the expense of other countries.
The world as a whole would be worse off
This would invite retaliatory tariffs, in which case the tariff might hurt everybody

14. Domestic market failure argument
The economic efficiency loss calculations using consumer and producer surplus assume that markets function well
But markets can fail
In such cases, the usual arguments for free trade may not work

15. Domestic market failure
Persistently high under-employment of workers
surpluses that are not eliminated in the market for labor because wages do not adjust
Persistently high under-utilization of structures, equipment and other forms of capital
surpluses that are not eliminated in the market for capital because prices do not adjust
Technological benefits for society discovered through private production, but from which private firms can not fully profit
Environmental costs for society caused by private production, but for which private firms do not fully pay
Property rights that are not well defined or well enforced
Sellers that are not well informed about the (opportunity) cost of production or buyers that are not well informed about value from consumption

16. Domestic market failure argument for tariffs and quotas
Figure 10-3: Production of a good yields extra social benefits—area (c) in panel (b)—not captured in producer surplus
A tariff or quota can increase domestic output from S1 to S2.
This might raise total surplus if the external social benefit (c) exceeds the deadweight loss (a + b).

17. Domestic market failure argument: flaws
A production subsidy would have the positive features of a tariff but not its negative features
Because it is unclear when and to what degree a 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.

18. How special-interest groups that are against free trade can capture political power and the special-interest groups that favor free trade are sidelined
Anti-trade politics

19. Politics We have seen the arguments for and against free trade
The case for free trade is very strong
Yet actual national policies are often against free trade
We need to understand the political process that leads to trade barriers

20. Political Theories of Trade Policy
How is trade policy determined?
Here are some theories:
Median voter theorem
Collective action
A model of trade policy that combines aspects of collective action and the median voter theorem

21. Median Voter Theorem
The median voter theorem predicts that democratic political parties may change their policies to court the voter in the middle of the ideological spectrum (i.e., the median voter).
Suppose that this ideological spectrum is defined only by a tariff rate policy.
And suppose that voters can be ranked according to whether they desire high or low tariff rates.

22. Median Voter Theorem (cont.)
The median voter theory assumes:
There are two competing political parties.
Each party has to decide on the level of the tariff imposed.
Voters differ in the tariff they prefer.
What policies will the two parties propose?
Both parties will support the tariff policy that the median voter (the voter who is exactly at the middle of the ideological spectrum) prefers.

23. Median Voter Theorem Fails
The median voter theorem cannot explain the widespread use of tariffs
Those who benefit from a tariff are usually few in number compared to those who are hurt by the tariff. Therefore,
Had the median voter theorem been correct, tariffs would rarely have been enacted

24. Collective Action
Political activity is often described as a collective action problem
This approach views political activity as a public good.
For instance, if one consumer’s letter to a politician helps to stop a tariff, all consumers would benefit.
This encourages free riding. Consequently,
Trade policies that impose large total losses that are spread among many individual consumers may not face opposition.
Industries that are well organized (or have a small number of firms) will succeed in blocking foreign competition

25. Sugar import quota, 2005 The U.S. quota on sugar imports
Limits imports to 1.4 million tons
under free trade imports would be an estimated 3.7 million tons
Keeps the U.S. price at $418 per ton, compared to $210 per ton in world markets
Consumers lose $1.674 billion
Producers gain $0.853 billion
Net loss to the U.S. is $883 million per year

26. Sugar import quota, 2005
The loss per consumer is $6 per year. This is about $20 per family.
As the U.S. sugar industry employs about 38,000 workers, the gains per employee is $20,000 per year.
No wonder, the producers are politically organized and the consumers don’t bother!
The final insult: without the quota, about 12,000 workers would have had to look for jobs elsewhere.
Thus, the cost to the consumer per job saved in the sugar industry is more than $200,000 per year.

27. The political process
In reality the median voter theory and the collective action theory may both be true
While politicians may win elections partly because they advocate popular policies as implied by the median voter theorem, they also require funds to run campaigns.
These funds may especially come from groups who do not have a collective action problem and are willing to advocate a special interest policy.

28. 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.
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.

29. Table 10-2: Welfare Costs of U.S. Protection ($ billion)
2002 Estimate
2013 Projected
Total
14.1
4.6
Textiles and apparel
11.8
2.3
Source: U.S. International Trade Commission

30. International negotiations over trade policy
How export industries can be brought into politics on the side of free trade
International negotiations over trade policy

31. International Negotiations over 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.
Why did it take international negotiations?
Why didn’t these countries reduce their tariffs unilaterally?

32. Fig. 10-5: The U.S. Tariff Rate

33. The Advantages of International Negotiations
It is easier to lower tariffs as part of a mutual agreement than to do so as a unilateral policy because:
It helps mobilize exporters to support freer trade and speak up against the import-competing industries who oppose imports.
It can help governments avoid getting caught in destructive trade wars.
It reduces the possibility of an adverse terms-of-trade effect from a unilateral reduction of tariffs.

34. Multilateral negotiations: the export industries enter the fight!
Multilateral negotiations mobilize exporters to support free trade if they believe that their export markets will expand when other countries reciprocate by embracing free trade.
This support would be lacking in a unilateral push for free trade.
This support counteracts the support for restricted trade by import-competing groups.

35. Multilateral negotiations: trade wars avoided
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.

36. Multilateral negotiations: trade wars avoided
TABLE 10-3
Dominant strategy for Japan
Dominant strategy for USA

37. Multilateral negotiations: trade wars avoided
In Table 10-3, each country would choose protection.
Even though each country acting individually would be better off with protection, they would both be better off if both chose free trade.
In game theory, this situation is known as a Prisoner’s dilemma.
Japan and the U.S. can establish a binding agreement to maintain free trade and thereby escape the prisoner’s dilemma.

38. History: Bilateral versus Multilateral
Smoot-Hawley tariffs in 1930
Widely recognized to be a mistake that worsened the Great Depression
But unilateral tariff reduction was politically difficult
Initially bilateral tariff-reducing agreements were pursued
Later multilateral agreements became popular
Why?

39. Bilateral Trade Liberalization
Suppose the USA and Brazil currently impose tariffs on each other’s goods and cannot unilaterally remove the tariffs because of the political power of US coffee growers and Brazilian wheat farmers
When bilateral negotiations begin, the US coffee growers’ (or, Brazilian wheat farmers’) resistance to free trade would be opposed by US wheat farmers (or, Brazilian coffee growers) eyeing a possible reduction of Brazil’s (or, the US’s) tariffs on US wheat (or, Brazilian coffee).
In this way, bilateral negotiations to reduce tariffs can succeed even when unilateral efforts fail.
USA
Wheat
Coffee
Brazil

40. Multilateral Trade Liberalization
In this example, bilateral negotiations between, say, Angola and Brazil will not succeed in reducing tariffs.
As Brazil does not export coffee to Angola, there will be no opposition to Brazilian oil producers’ demands for a tariff on Angolan oil.
However, a multilateral agreement will be successful. In each country, exporters will organize to oppose importers’ resistance to the multilateral agreement.
China
Wheat
Coffee
Angola
Brazil
Oil

41. International Negotiations and Trade Policy: History
International trade negotiations began after World War II
The initial agreement among 23 major countries was called the General Agreement on Tariffs and Trade (GATT)
In 1995 the World Trade organization (WTO) was established to organize further negotiations

42. The GATT-WTO system
The GATT-WTO system tries to reduce trade restrictions in 3 main ways:
Reduction of tariff rates through multilateral negotiations.
Binding: a tariff is “bound” by having the imposing country agree not to raise it in the future.
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 sudden surge in imports.
Successive “rounds” of negotiations are held to gradually reduce trade barriers

43. 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).

44. 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.
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.

45. World Trade Organization (cont.)
The GATT/WTO multilateral negotiations, ratified in 1994 (called the Uruguay Round),
agreed that all quantitative restrictions (ex., quotas) on trade in textiles and clothing as previously specified in the Multi-Fiber Agreement were to be eliminated by 2005.
But as the restrictions were eliminated, China had to reimpose quotas until 2011 due to political pressure.

46. WTO: US v. Venezuela
US laws allowed domestic oil refineries to sell oil with more pollutants than imported oil
Venezuela, which exports oil to the US, sued the US at the WTO
Venezuela won. The US had to change its laws to make them non-discriminatory
This episode showed that the WTO worked
Environmentalists complained that the WTO made it harder for the US to reduce pollution
Actually, the fault lies with the US law. The WTO should not be blamed

47. World Trade Organization (cont.)
In 2001, a new round of negotiations was started in Doha, Qatar, but these negotiations have failed to produce an agreement.
Most of the remaining forms of protection are in agriculture, textiles and clothing—industries that are politically active

48. Table 10-4: Percentage Distribution of Potential Gains from Free Trade

49. Do Agricultural Subsidies in Rich Countries Hurt Poor Countries?
We learned in chapter 8 that subsidies lower the world price of products because domestic producers are enticed to produce more.
So why should poor countries want rich countries to remove their agricultural subsidies?
The likely answer has to do with the desires of farmers in poor countries who compete with farmers in rich countries.
Yet, urban residents and farmers who do not compete (ex., coffee farmers) actually benefit from the lower prices of subsidized food on world markets.
For example, because China imports a lot of food, it would be hurt by the removal of agricultural subsidies in rich countries (ex., the U.S. and Europe) according to the Doha negotiations.

50. Table 10-5: Percentage Gains in Income under Two Doha Scenarios

51. Preferential Trading Agreements
Preferential trading agreements 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:
Each country in the WTO promises that all countries will pay tariffs no higher than the nation that pays the lowest: called the “most favored nation” (MFN) principle.
An exception to this principle is allowed only if the lowest tariff rate is set at zero.

52. Preferential Trading Agreements (cont.)
There are two types of preferential trading agreements in which tariff rates are set at or near zero:
A free trade area: an agreement that allows free trade among members, but each member can have its own trade policy towards non-member countries
An example is the North America Free Trade Agreement (NAFTA).

53. Preferential Trading Agreements (cont.)
A customs union: an agreement that allows free trade among members and requires a common external trade policy towards non-member countries.
An example is the European Union.

54. Preferential Trading Agreements (cont.)
Are preferential trading agreements necessarily good for national welfare?
No, it is possible that national welfare decreases under a preferential trading agreement.
How? Rather than gaining tariff revenue from inexpensive imports from world markets, a country may import expensive products from member countries but not gain any tariff revenue.

55. Preferential Trading Agreements (cont.)
Preferential trading agreements increase national welfare when new trade is created, but not when existing trade from the outside world is diverted to trade with member countries.
Trade creation
occurs when high cost domestic production is replaced by low cost imports from other members.
Trade diversion
occurs when low cost imports from non-members are diverted to high cost imports from member nations.

56. Trade Diversion in South America
Argentina, Brazil, Paraguay, and Uruguay formed a free trade area in 1991 called Mercosur
Within four years, trade among these countries tripled
A 1996 World Bank study, however, argued that this trade creation was probably exceeded by trade diversion, and that the overall effect of Mercosur was probably negative
Argentina began importing Brazilian cars because those inefficiently produced cars faced no tariffs
Had Argentina imported other cars, it could have earned large tariff revenues