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

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-2 Outline Instruments of trade policy continued Political Economy of Trade The cases for and against free trade Presentation on Costs of Protectionism Political models of trade policy Protection for Sale? Global Competitiveness Report

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-3 With export subsidy, domestic price – foreign price = export subsidy An export subsidy can also be specific or ad valorem  A specific subsidy is a payment per unit exported.  An ad valorem subsidy is a payment as a proportion of the value exported. When the government offers an export subsidy, shippers will export the good up to the point where the domestic price exceeds the foreign price by the amount of the subsidy

4. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-4 Export Subsidy: raises price of good in the exporting country Effects of export subsidy similar to a tariff An export subsidy raises the price of a good in the exporting country (shippers will shift supplies to the foreign country) This will make Home’s consumer surplus decrease (making its consumers worse off) and making its producer surplus increase (making its producers better off). Also, government revenue will decrease.

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-5 Export Subsidy Also Lowers Price in Foreign Country, Worsens Terms of Trade An export subsidy raises the price of a good in the exporting country, while lowering it in foreign countries (increasing supply there). In contrast to a tariff, an export subsidy worsens the terms of trade by lowering the price of domestic products in world markets.

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-6

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-7 Export Subsidy Has Negative Effect on Home’s Welfare An export subsidy unambiguously produces a negative effect on national welfare. The triangles b and d represent the efficiency loss.  The subsidy distorts production and consumption decisions: producers produce too much and consumers consume too little compared to the market outcome. The area b + c + d + f + g represents the cost of government subsidy.  In addition, the terms of trade decreases, because the price of exports falls in foreign markets to P * s.

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-8 Export Subsidy in Europe: CAP In the past, EU wanted to guarantee high prices to its farmers and bought their goods whenever agricultural prices fell below a specified level The result was that in 1985, EU had stored 780,000 tons of beef, 1.2 million tons of butter, and 12 million tons of wheat The European Union’s Common Agricultural Policy today sets high prices for agricultural products and subsidizes exports to dispose of excess production. The subsidized exports reduce world prices of agricultural products.

9. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-9 Prices fixed above levels where EU prices would clear; subsidy disposes the surplus

10. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-10 Costs of the subsidy The direct cost of this policy for European taxpayers is almost $50 billion. This is 36% of the EU farm output, twice the US figure But the EU has proposed that farmers receive direct payments independent of the amount of production to help lower EU prices and reduce production.

11. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-11 EC Budget Breakdown: Almost Half to Agriculture

12. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-12 Voluntary Export Restraint A voluntary export restraint works like an import quota, except that the quota is imposed by the exporting country rather than the importing country. However, these restraints are usually requested by the importing country. The profits or rents from this policy are earned by foreign governments or foreign producers.  Foreigners sell a restricted quantity at an increased price.

13. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-13 Voluntary export restraints For instance, in the early 1960s the US, the EU have forced most developing countries to impose export quotas on most kinds of textiles and clothing (this was called “Multi-Fiber Agreement”) The aim was to protect Western textiles producers This agreement stayed in force till 1994

14. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-14 Multi-fiber agreement woes This agreement actually hurts consumers: it raised US clothing prices by about 20% It also hurt developing countries who wanted to export more textiles products to developed states but couldn’t

15. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-15 Agreement on Textiles and Clothing (ATC): No more quotas from 2005 WTO initiated end to Multi-Fiber Agreement in 1995-2005, transition period to cut quotas Under the Agreement, WTO Members have committed themselves to remove the quotas by 1 Jan 2005, integrating the sector fully into GATT rules of nondiscrimination http://www.wto.org/english/tratop_e/texti_e/tex intro_e.htm

16. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-16 Winners Consumers (world prices of textiles were inflated 10-30% due to the quotas) Producers with comparative advantage in textiles (China’s share in world textiles production may rise from 20 to 50%) India also likely to benefit

17. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-17 Losers Textiles producers in developed countries Non-competitive producers in developing countries

18. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-18 Postscript US, EU scared of the surge of China’s textiles imports Used another import restriction, “safeguards”, to “temporarily” protect their local textiles firms in 2003-05 Similar creative restrictions may be used in the future

19. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-19 Local Content Requirement A local content requirement is a regulation that requires a specified fraction of a final good to be produced domestically. It may be specified in value terms, by requiring that some minimum share of the value of a good represent domestic valued added, or in physical units.

20. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-20 Examples Malaysia and other countries force foreign auto manufacturers in their country to use more domestically produced auto components Canada forces foreign TV stations to devote a certain share of their time to shows recorded in Canada EU and France have similar requirements to fight US entertainment industry

21. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-21 Viewpoints of domestic input producers, firms that must buy domestic inputs From the viewpoint of domestic producers of inputs, a local content requirement provides protection in the same way that an import quota would. From the viewpoint of firms that must buy domestic inputs, however, the requirement does not place a strict limit on imports, but allows firms to import more if they also use more domestic parts.

22. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-22 The efficiency loss is priced in to the final good and may be passed on to consumers Local content requirement provides neither government revenue (as a tariff would) nor quota rents. Instead the difference between the prices of domestic goods and imports is averaged into the price of the final good and is passed on to consumers (but most of the goods may be exported, so the local consumer doesn’t have to suffer that much...)

23. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-23 Other Trade Policies Export credit subsidies  A subsidized loan to exporters (Brazil’s PROEX)  US Export-Import Bank subsidizes loans to US exporters. Government procurement  Government agencies are obligated to purchase from domestic suppliers, even when they charge higher prices (or have inferior quality) compared to foreign suppliers. Bureaucratic regulations  Safety, health, quality or customs regulations can act as a form of protection and trade restriction.

24. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-24 Product standards Health, sanitation, safety and environment US government in the past has found hidden health hazards in the way beef cattle are raised in Argentina (although Argentine beef is one of the best in the world) Similarly, the EU has banned imports of beef from cattle that have received growth hormones

25. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-25 GMOs: Frankenstein Food? The debate on genetically modified food: Monsanto’s European subsidiary faced resistance to its efforts to sell GM based soy beans in the UK, Germany (although governments have officially endorsed those products there…)

26. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-26 Bizzare product classification for customs purposes Aim: to define product in such as way that you benefit from lower tariffs/higher subsidies

27. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-27 Carrots are fruits

28. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-28 Snails are fish

29. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-29 X-Men are not Humans

30. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-30 Why? Carrots are fruit because this allowed Portugal to sell its carrot jam in EU without high duties Snail is fish because this allowed EU snail farmers to collect fish farm subsidies X-men aren’t humans because US tariffs on non-human toys are 7%, on “human” toys 12%

31. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-31 Summary TariffExport subsidy Import quota Voluntary export restraint Producer surplus Consumer surplus Government net revenue National welfare Increases No change: rents to license holders IncreasesDecreases No change: rents to foreigners Ambiguous, falls for small country Ambiguous, falls for small country Decreases

32. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-32 Tariff, quota increase home price of imported good, export subsidy increases home price of exported good 1.A tariff decreases the world price of the imported good when a country is “large”, increases the domestic price of the imported good and reduces the quantity traded. 2.A quota does the same. 3.An export subsidy decreases the world price of the exported good when a country is “large”, increases the domestic price of the exported good and increases the quantity produced.

33. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-33 The measures result in efficiency loss 4.The welfare effect of a tariff, quota and export subsidy can be measured by:  Efficiency loss from consumers and producers  Terms of trade gain or loss 5.With import quotas, voluntary export restraints and local content requirements, the government of the importing country receives no revenue. 6.With voluntary export restraints and occasionally import quotas, quota rents go to foreigners.

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

35. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-35 Preview of Political Economy of Trade The cases for free trade Presentation on costs of protectionism The cases against free trade Political models of trade policy Protection for Sale? Global Competitiveness Report International negotiations of trade policy World Trade Organization

36. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-36 The Cases for Free Trade: Don’t Distort Market Prices Through Trade Policy The first case for free trade is the argument that producers and consumers allocate resources most efficiently when governments do not distort market prices through trade policy.  National welfare of a small country is highest with free trade.  With restricted trade, consumers pay higher prices.  With restricted trade, distorted prices cause overproduction either by existing firms producing more or by more firms entering the industry.

37. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-37 Production distortion (higher price of domestic produce); Consumption distortion (some consumers can’t effort it)

38. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-38 Effects of tariffs on producers, consumers Production distortion: because of the higher price of domestic production as a result of protection, some domestic consumers will be buying products for a higher price then they would for imports The higher price due to tariff will also prevent some consumers with limited budget to buy the product at all

39. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-39 But tariff rates are already low 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.

40. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-40 US Tariff Rates

41. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-41 A move to worldwide free trade would increase world GDP by 1%: is that much?

42. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-42 Developing Countries Benefit More From Free Trade, Suffer More from Protectionism Yet for some countries in some time periods, the estimated cost of protection was substantial.

43. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-43 Costs of Protectionism up to 10% of GDP

44. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-44 Economies of scale, competition 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 dynamic benefits would not be reflected in static estimates of the elimination of efficiency losses of producers, caused by distorted prices and overproduction.

45. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-45 Free trade is best feasible political policy: danger of special interest manipulation 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. Any policy that deviates from free trade would be quickly manipulated by special interests, leading to decreased national welfare.

46. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-46 The Cases Against Free Trade 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 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.

47. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-47 Large country’s optimum tariff improves TOT to compensate for efficiency loss

48. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-48 Optimum tariff maximizes welfare 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.

49. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-49 Counter-Argument: Retaliation For some countries like the US an import tariff 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.

50. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-50 Presentation Costs of Protectionism Copying with Protectionism

51. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-51 Market imperfections A second argument against free trade is that domestic market failures may exist that cause free trade to be a suboptimal policy.  The economic efficiency loss calculations using consumer and producer surplus assume that markets are functioning efficiently.

52. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-52 Types of market failures:  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 (positive externalities)  Environmental costs for society from additional production that are not paid for by individual firms (negative externalities)

53. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-53 Example: Promoting High-Tech Innovative, cutting edge industries may bring positive spillovers to the rest of the economy and society Thus many governments offer tariff protection to home industries in this segment or provide tax breaks and other subsidies to foreign investors in high- tech

54. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-54 Tariff increasing domestic production may bring extra marginal social benefits Economists calculate the marginal social benefit to represent the additional benefit to society from additional production.  In each of the market failure cases, marginal social benefit is not accurately measured by the producer surplus of private firms, so that economic efficiency loss calculations are misleading. It is possible that a tariff raises domestic production, thereby increasing the benefit to domestic society because a market failure.

55. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-55

56. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-56 The Theory of Second Best The domestic market failure argument against free trade is an example of a more general argument called the theory of the second best. This theory states that government intervention which distorts market incentives in one market may increase national welfare by offsetting the consequences of market failures elsewhere.  The best policy would be to fix the market failures themselves, but if this is not feasible, then government intervention in another market may the “second-best” way of fixing the problem.

57. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-57 Counter-Arguments: First-Best Policy Economist supporting free trade counter- argue that domestic market failures should be corrected by a “ first-best ” policy: a domestic policy aimed directly at the source of the problem (this is called a “ specificity rule ” ).  If persistently high under-employment of labor is a problem, then the cost of labor or production of labor-intensive products could be subsidized by the government.  These subsidies could avoid the economic efficiency loss for consumers due to a tariff.

58. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-58 Market Failure Hard To Judge: Politically Powerful Groups May Benefit 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. Because it distorts the incentives of producers and consumers, a trade policy may have unintended consequences that make a situation worse, not better.

59. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-59 Political Models of Trade Policy How is trade policy determined? Models that address this question: 1. Median voter theorem 2. Collective action 3. A model of trade policy that combines aspects of collective action and the median voter theorem

60. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-60 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.

61. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-61 Some voters prefer low tariffs, others high; election will be decided by voters who prefer medium tariff: parties will court them Assumptions of the model: 1. There are two competing political parties. 2. The objective of each party is to get elected by majority vote (not to maintain ideological purity). What policies will the parties promise to follow?  Both parties will offer the same tariff policy to court the median voter (the voter in the middle of the spectrum) in order to capture the most votes on either side of the median voter.

62. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-62 Too high or too low tariff proposed would likely lead to an electoral failure

63. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-63 Median Voter Theorem also implies parties will support low tariffs as more people benefit from them, few are hurt Thus, the median voter theorem implies that a two-party democracy should enact trade policy based on how many voters it pleases.  A policy that inflicts large losses on a few people (import-competing producers) but benefits a large number of people (consumers) should be enacted into law. But trade policy doesn’t seem to follow this prediction.

64. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-64 Collective Action Problem 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 not large compared to the cost and time 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.

65. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-65 Groups To Be Hurt By Trade Have Incentive To Organize and Lobby However, for those groups who may suffer large losses from free trade (for example, unemployment), each individual in that group has a strong incentive to advocate the policy he desires.  In this case, the cost and time required to advocate restricted trade is small compared to the cost of unemployment.

66. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-66 A Model of Trade Policy: Both Popular Support and Campaign Finance Matter 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. Models of policy making try to measure the trade off between reduction of overall welfare of constituents in return for additional campaign contributions.

67. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-67 Protection For Sale Grossman and Helpman 1994 (Model) Goldberg and Maggi 1999 (Test) Baldwin and Magee 1998 (Test)

68. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-68 Grossman and Helpman 1994: More organized Sectors More Protected Industries will have a higher rate of protection if they are politically organized (provide a lot campaign finance)

69. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-69 Baldwin and Magee 1998: Politicians Are For Sale Vote for NAFTA Vote for GATT Actual229283 Predicted by model229290 Without labor contributions 291346 Without business contributions 195257 With no contributions256323

70. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-70 Contributions have notable impact In the case of NAFTA, labor contributions induced 62 (292-229) representatives who would otherwise supported the bill to vote against Business contributions moved 34 (229- 195) representatives the other way

71. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-71 Goldberg and Maggi 1999: 98% weight on welfare, 2% weight on contributions They find that the government attaches 98% weight to the national welfare and 2% weight to the campaign contributions This result consistent with the fact that trade barriers are rather low in the US

72. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-72 Which Industries Are Protected? Agriculture: in the US, 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.

73. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-73 Which Industries Are Protected? (cont.) Clothing: textiles (fabrication of cloth) and apparel (assembly of cloth into clothing).  Import licenses for textile and apparel exporters are specified in the Multi-Fiber Agreement between the US and many other nations.

74. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-74 Apparel & textiles made for 5/6 of overall welfare costs of protection in US in 1990

75. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-75 Global Competitiveness Report Produced every year by Swiss-based World Economic Forum, organizer of the Davos meeting of world leaders

76. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-76 Switzerland, Sweden and Finland moving ahead, US falling behind

77. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-77 Components of the Index

78. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-78

79. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-79 US Falling Behind… Why? Weaknesses:  Institutional Environment  Macroeconomic imbalances

80. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-80 US Weaknesses: inefficient use of public resources, bias to vested interests Business leaders pointing to the inefficiency in using public resources (27 th place) Insufficient even-handedness on the part of government officials in their dealings with private sector interests (39 th place)

81. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-81 US Weaknesses: Low integrity of public officials… Inadequate level of trust on the part of the business community in the financial integrity of public officials (24 th place) Health and primary education (40 th place) Macroeconomy (69 th place)

82. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-82 Weak public institutions in the US

83. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-83 International Negotiations of Trade Policy The average US 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.

84. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-84 International Negotiations of Trade Policy (cont.)

85. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-85 International Negotiations of Trade Policy (cont.) Multilateral negotiation mobilize exporters to support free trade if they believe export markets will expand.  This support would be lacking in a unilateral push for free trade.  This support counteracts the support for restricted trade by import-competing groups.

86. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-86 International Negotiations of Trade Policy (cont.) Multilateral negotiations also help avoid a trade war between countries, where each country enacts trade restrictions. If each country has a political interest (due to political pressure) to protect domestic producers, regardless of what other countries do,  then 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.

87. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-87 International Negotiations of Trade Policy (cont.)

88. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-88 International Negotiations of Trade Policy (cont.) In this simple example, each country acting individually would be better off with protection, but both would be better off if both chose free trade. If Japan and the US can establish a binding agreement to maintain free trade, both can avoid the temptation of protection and both can be made better off.

89. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-89 World Trade Organization The WTO negotiations addresses trade restrictions in at least 3 ways: 1.Reduction of tariff rates through multilateral negotiations. 2.Binding: a tariff is “bound” by having the imposing country agree not to raise it in the future.

90. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-90 World Trade Organization (cont.) 3.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 surge in imports.

91. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-91 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 (e.g., insurance, consulting, legal services, banking).  Agreement on Trade-Related Aspects of Intellectual Property: covers international property rights (e.g., patents and copyrights).

92. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-92 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.

93. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-93 World Trade Organization (cont.)  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.

94. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-94 World Trade Organization (cont.) The GATT/WTO multilateral negotiations ratified in 1994 (called the Uruguay Round),  agreed that all quantitative restrictions (e.g., 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 (mostly in 2005), political pressure to again restrict trade in textiles and clothing has grown.

95. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-95 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.

96. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-96 Preferential Trading Agreements (cont.) There are two types of preferential trading agreements 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 towards non-member countries  An example is the North America Free Trade Agreement (NAFTA).

97. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-97 Preferential Trading Agreements (cont.) 2.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.

98. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-98 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.

99. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-99 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.

100. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-100 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

101. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-101 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.

102. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-102 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.

103. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-103

104. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 9-104