Chapter 9 The Political Economy of Trade Policy Udayan Roy International Economics: Theory and Policy International Economics: Theory and Policy, Eighth

Chapter 9Chapter 9The Political Economy of Trade PolicyThe Political Economy of Trade Policy

Udayan Roy

International Economics: Theory and PolicyInternational Economics: Theory and Policy, Eighth Edition

by Paul R. Krugman and Maurice Obstfeld

Slide 9-3

Introduction

Some gain and some lose from free trade. But the gains exceed the losses; free trade maximizes national welfare (i.e., total surplus).

Yet most governments restrict trade in some way or other.

Why don’t governments listen to economists’ cost-benefit calculations?

Should they?

Slide 9-7

The Cases for Free Trade I

Slide 9-8


However, because tariff rates are already low for most countries, estimated benefits of moving to free trade are only a small fraction of national income for most countries.

So, this argument has become less persuasive, now that tariffs are already significantly lower than before.

Slide 9-9


9-10

The Cases for Free Trade (cont.)

Yet when quotas are used instead of tariffs, costs can be magnified through rent seeking.• To seek quota licenses or the rights to sell a restricted

number of imports and the profit that they will earn, individuals or institutions need to spend time and other resources.

Thus, another reason why trade allocates resources efficiently is that it avoids the loss of resources through rent seeking.

Slide 9-11


And for some countries in some time periods, the estimated cost of protection was substantial.

Slide 9-12


Slide 9-13

• In the case of increasing returns to scale, bulk production reduces per unit costs.

– This benefit from bulk production is called scale economies.

• Protected markets in small countries do not allow firms to exploit scale economies.

– Example: In the auto industry, an efficient scale assembly 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.

• In the presence of scale economies, free trade makes more varieties available and at lower prices.

The Case for Free Trade II

Slide 9-14

The Case for Free Trade III

Free trade enables an inventor to sell to a larger market. As a result, free trade provides a stronger incentive for innovation.

Slide 9-15

A political argument• Free trade is the best feasible political policy, even though

there may be better policies in principle

• 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.

The Case for Free Trade IV

Slide 9-16

There are two theoretical arguments against the policy of free trade:• The terms of trade argument for a tariff

– We have seen this one before!

• The domestic market failure argument

National Welfare Arguments Against Free Trade

Slide 9-17

The Terms of Trade Argument for a Tariff• For a “large” country, a tariff lowers the price of

imports. – This benefit of a tariff is called a terms of trade benefit.

• It is possible that the terms of trade benefits of a tariff outweigh its costs.

– Therefore, free trade might not be the best policy for a large country.

National Welfare Arguments Against Free Trade I

Slide 9-18

Terms of Trade Argument for a Tariff

Weaknesses• The argument doesn’t work for small countries

• Even if a large country benefits from a tariff, that benefit will come 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

Slide 9-21

The Domestic Market Failure Argument Against Free Trade• Consumer and producer surplus ignore the social costs

and benefits of domestic market failures such as:– Unemployment or underemployment of labor

– Technological spillovers from industries that are new or particularly innovative

– Environmental externalities

• A tariff may raise welfare if there is a marginal social benefit to production of a good that is not captured by producer surplus measures.

National Welfare Arguments Against Free Trade II

Slide 9-22


Slide 9-24

How Convincing Is the Market Failure Argument?• Domestic distortions should be corrected with

domestic (as opposed to international trade) policies.– Example: A domestic production subsidy is superior to

a tariff in dealing with a production-related market failure.

• Market failures are hard to diagnose and measure.– Example: A tariff to protect urban industrial sectors will

generate social benefits, but it will also encourage migration to these sectors that will result in higher unemployment.


Slide 9-25

While economists may talk about national welfare or total surplus, in a democracy, trade policy is influenced by the difference in political power between those who lose from free trade and those who gain.

There are two main theories in political science about how governments make decisions:• Median voter theorem

• Collective action theory

Real World Trade Policy

Slide 9-26

The Median Voter Theory– 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 promise to follow?– Both parties will support the tariff policy that the

median voter (the voter who is exactly halfway up the lineup) prefers.


Slide 9-27

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

Slide 9-29

Collective Action• 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 get protection.


Slide 9-30

Sugar import quota, 1990

The U.S. quota on sugar imports • Limits imports to 2.13 million tons, which is half of

what it would be under free trade

• Keeps the U.S. price at $466 per ton, compared to $280 per ton in world markets

• Consumers lose $1.646 billion

• Producers gain $1.066 billion

• Net loss to the U.S. is $580 million per year

Slide 9-31

Sugar import quota, 1990

The loss per consumer is $6 per year. This is about $25 per family.

As the U.S. sugar industry employs about 12,000 workers, the gains per employee is $90,000 per year.

No wonder, the producers are politically organized and the consumers don’t bother!

The final insult: without the quota, between 2000 and 3000 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 $500,000 per year.

Slide 9-33

Who Gets Protected?• Two sectors seem to get protected in advanced

countries:– Agriculture

– Farmers are well organized and the structure of the U.S. government enhances their political power.

– Clothing– Both textiles and apparel have enjoyed substantial protection.

This sector employs less skilled workers and it is unionized as well.

• Protection is very likely to diminish in the future in both sectors (due to international trade negotiations).

Income Distribution and Trade Policy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

9-34

Table 9-2: Welfare Costs of U.S. Protection ($ billion)

Slide 9-36

International Negotiations and Trade Policy

Globalization has increased from the mid-1930s partly because the United States and other advanced countries gradually removed tariffs and non-tariff barriers to trade.

Slide 9-37


Slide 9-38

GATT and WTO

The removal of trade barriers was facilitated by institutionalized negotiations among countries

The General Agreement of Tariffs and Trade was begun in 1947 as a provisional international agreement

It was replaced by a more formal international institution called the World Trade Organization in 1995.

Slide 9-39

International negotiations

Why was it necessary to engage in international negotiations to get trade barriers reduced?

Why didn’t the advanced countries reduce their trade barriers unilaterally?

Slide 9-40

The Advantages of International Negotiation• 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. (Next two slides.)

– It reduces the possibility of an adverse terms-of-trade effect from a unilateral reduction of tariffs.


Slide 9-41


Slide 9-42

In Table 9-4, 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.


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?

Slide 9-43

Slide 9-44

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

Brazil

Wheat Coffee

Slide 9-45

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.

Angola Brazil

China

Oil

CoffeeWheat

Slide 9-46

International Trade Agreements: A Brief History• Internationally coordinated tariff reduction as a trade

policy dates back to the 1930s (the Smoot-Hawley Act).

• The multilateral tariff reductions since World War II have taken place under the General Agreement on Tariffs and Trade (GATT), established in 1947 and located in Geneva.

– It is now called the World Trade Organization (WTO).

– The GATT-WTO system is a legal organization that embodies a set of rules of conduct for international trade policy.


Slide 9-47

The GATT-WTO system prohibits the imposition of: • Export Subsidies

– except for agricultural products

• New Import quotas – except when imports threaten “market disruption”

• New or Higher Tariffs – any new tariff or increase in a tariff must be offset by

reductions in other tariffs to compensate the affected exporting countries

– This is called “binding” of tariffs


Slide 9-50

Trade round• A large group of countries get together to negotiate a set of tariff

reductions and other measures to liberalize trade.

Eight trade rounds have occurred since 1947:• The first five of these took the form of “parallel” bilateral

negotiations (e.g., Germany with France and Italy).

• The sixth multilateral trade agreement, known as the Kennedy Round, was completed in 1967:

– This agreement involved an across-the-board 50% reduction in tariffs by the major industrial countries, except for specified industries whose tariffs were left unchanged.

– Overall, the Kennedy Round reduced average tariffs by about 35%.


Slide 9-51

The so-called Tokyo round of trade negotiations (completed in 1979) resulted in:• Reduced tariffs

• New codes for controlling the proliferation of non-tariff barriers, such as VER’s (or, voluntary export restrictions).

An eighth round of negotiations, the so-called Uruguay Round, was competed in 1994.


Slide 9-52

The Uruguay Round• Its most important results are:

– Trade liberalization – Administrative reforms

Trade Liberalization• The average tariff imposed by advanced countries decreased by

almost 40%.– More important is the move to liberalize trade in two important

sectors: agricultural and clothing.

From the GATT to the WTO• Much of the publicity surrounding the Uruguay Round focused

on its creation of the WTO.


Trade liberalization, Uruguay round

Advanced country tariffs reduced by 40% Agricultural subsidies by exporters reduced by 36%

• Volume of subsidized exports reduced by 21%

• Agricultural import quotas replaced by bound tariffs

MFA phased out in 2005• All quantitative restrictions gone

• Some tariffs remain

Government procurement brought under fairer rules

Slide 9-53

9-54

World Trade Organization

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).

9-55


• 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.

9-56


• 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.

9-57


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.

Slide 9-58

• How different is the WTO from the GATT?– The GATT was a provisional agreement, while the WTO

is a full-fledged international organization.

– The GATT applied only to trade in goods, while the WTO included rules on trade in services (the General Agreement on Trade in Services (GATS)) and on international application of international property rights.

– The WTO has a new “dispute settlement” procedure which is designed to reach judgments in a much shorter time.


Slide 9-59

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

Slide 9-60

Benefits and Costs• The economic impact of the Uruguay Round is

difficult to estimate.– However, estimates of the GATT and of the

Organization for Economic Cooperation and Development suggest a gain to the world economy as a whole of more than $200 billion annually once the agreement is fully in force.

– Most economists believe that these estimates are too low.

– The costs of the Uruguay Round will be felt by well-organized groups, while much of the benefit will accrue to diffuse populations.


9-61

WTO Doha Round

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 (see “Collective Action” above).

9-62

Table 9-4: Percentage Distribution of Potential Gains from Free Trade

9-63

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.

9-64

Table 9-5: Percentage Gains in Income under Two Doha Scenarios

Slide 9-65

WTO Doha Round

Main sticking point: agriculture subsidies• Rich countries want to protect their farmers

• Poor countries want free market access for their farmers

Countries seem to have given up on WTO negotiations

Preferential trade agreements seem popular

Slide 9-66

Nations establish preferential trading agreements under which they lower tariffs with respect to each other but not the rest of the world.

The GATT-WTO, through the principle of non-discrimination called the “most favored nation” (MFN) principle, prohibits such agreements.• The formation of preferential trading agreements is

allowed if they lead to free trade between the agreeing countries.

Preferential Trading Agreements

Slide 9-67

• Free trade can be established among several WTO members as follows:

– A free trade area allows free-trade among members, but each member can have its own trade policy towards non-member countries.

– Example: The North American Free Trade Agreement (NAFTA) creates a free trade area.

– A customs union allows free trade among members and requires a common external trade policy towards non-member countries.

– Example: The European Union (EU) is a full customs union.

– A common market is a customs union with free factor movements (especially labor) among members.


Slide 9-68

Are preferential trading agreements good?• It depends on whether it leads to trade creation or

trade diversion.– Trade creation

– Occurs when the formation of a preferential trading agreement leads to replacement of high-cost domestic production by low-cost imports from other members.

– Trade diversion – Occurs when the formation of a preferential trading

agreement leads to the replacement of low-cost imports from non members with higher-cost imports from member nations.


Slide 9-69

Summary

There are three arguments in favor of free trade:• The efficiency gains from free trade

• The additional gains from economies of scale

• The political argument

There are two arguments for deviating from free trade:• The terms of trade argument for a tariff

• The domestic market failures

Slide 9-70

Summary

In practice, trade policy is dominated by considerations of income distribution. • Political parties adopt policies that serve the interests of

the median voter.

• Groups that are well organized (or small groups) are often able to get policies that serve their interests at the expense of the majority.

Slide 9-71

Summary

International negotiation helps reduce tariffs in industrial countries and avoid trade wars.

The GATT is the central institution of the international trading system.• The most recent worldwide GATT agreement also sets

up a new organization, the WTO. Three kinds of preferential trading agreements are

allowed under the WTO: free trade areas, customs unions, and common markets.

Preferential trading agreements can be good or bad depending on the magnitude of trade creation and trade diversion effects.

Slide 9-72

Home import demand

Foreign export supply

PF

Price, P

Quantity, Q

P~

PW

t

Appendix: Proving that the Optimum Tariff is Positive

Figure 9A-1: Effects of a Tariff on Prices

Slide 9-73

PF

PW

Price, P

Quantity, Q

S

D

P~

Gain

Loss

Q1 D1Q2 D2

Figure 9A-2: Welfare Effects of a Tariff

Appendix: Proving that the Optimum Tariff is Positive

Documents

Chapter 9 The Political Economy of Trade Policy Udayan Roy International Economics: Theory and Policy International Economics: Theory and Policy, Eighth