Text of Chapter 9 The Political Economy of Trade Policy Udayan Roy International Economics: Theory and...
Chapter 9 The Political Economy of Trade Policy Udayan Roy International Economics: Theory and Policy International Economics: Theory and Policy, Eighth Edition by Paul R. Krugman and Maurice Obstfeld
Slide 9-2 Introduction The Case for Free Trade National Welfare Arguments against Free Trade Income Distribution and Trade Policy International Negotiations and Trade Policy Chapter Organization
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 dont governments listen to economists cost- benefit calculations? Should they?
Slide 9-4 Introduction What reasons are there for governments not to interfere with trade? There are three arguments in favor of free trade: Free trade and efficiency Economies of scale in production Political argument
Slide 9-5 In the case of a small country, free trade maximizes total surplus. A tariff causes a net losscalled the deadweight lossto the economy. The Case for Free Trade I
Slide 9-6 World price plus tariff World price Price, P Quantity, Q S D Consumption distortion Production distortion Figure 9-1: The Efficiency Case for Free Trade The Case for Free Trade I
Slide 9-7 The Cases for Free Trade I
Slide 9-8 The Cases for Free Trade I 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 The Cases for Free Trade I
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 The Cases for Free Trade I And for some countries in some time periods, the estimated cost of protection was substantial.
Slide 9-12 The Cases for Free Trade I
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 doesnt 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 9-19 1 National welfare Tariff rate Optimum tariff, t o Prohibitive tariff rate, t p Figure 9-2: The Optimum Tariff National Welfare Arguments Against Free Trade
Slide 9-20 Optimum tariff The tariff rate that maximizes national welfare It is always positive but less than the prohibitive rate that would eliminate all imports. It is zero for a small country because it cannot affect its terms of trade. National Welfare Arguments Against Free Trade
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 National Welfare Arguments Against Free Trade II
Slide 9-23 The domestic market failure argument against free trade is a particular case of the theory of the second best. The theory of the second best states that a hands-off policy is desirable in any one market only if all other markets are working properly. If one market fails to work properly, a government intervention may actually increase welfare. National Welfare Arguments Against Free Trade
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. National Welfare Arguments Against Free Trade II
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. Real World Trade Policy
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 9-28 Voters Preferred tariff rate Median voter tMtM tBtB tAtA Political support Income Distribution and Trade Policy Figure 9-4: Political Competition
Slide 9-29 Collective Action This approach views political activity as a public good. For instance, if one consumers 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. Real World Trade Policy
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 dont bother!