International Economics: Theory and Policy, Eighth Edition Chapter 9 The Political Economy of Trade Policy Udayan Roy International Economics: Theory and Policy, Eighth Edition by Paul R. Krugman and Maurice Obstfeld

Chapter Organization Introduction The Case for Free Trade National Welfare Arguments against Free Trade Income Distribution and Trade Policy International Negotiations and Trade Policy

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?

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

The Case for Free Trade I In the case of a “small” country, free trade maximizes total surplus. A tariff causes a net loss—called the deadweight loss—to the economy.

The Case for Free Trade I Figure 9-1: The Efficiency Case for Free Trade Price, P Quantity, Q S D Production distortion Consumption distortion World price plus tariff World price

The Cases for Free Trade I

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.

The Cases for Free Trade I

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.

The Cases for Free Trade I And for some countries in some time periods, the estimated cost of protection was substantial.

The Cases for Free Trade I

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

The Case for Free Trade IV 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.

National Welfare Arguments Against Free Trade 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 I 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.

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

National Welfare Arguments Against Free Trade Figure 9-2: The Optimum Tariff National welfare Tariff rate 1 Optimum tariff, to Prohibitive tariff rate, tp

National Welfare Arguments Against Free Trade 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 II 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

National Welfare Arguments Against Free Trade 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 II 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.

Real World Trade Policy 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 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.

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

Figure 9-4: Political Competition Income Distribution and Trade Policy Figure 9-4: Political Competition Voters Preferred tariff rate Political support tA tB Median voter tM

Real World Trade Policy 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.

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

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.

Income Distribution and Trade Policy Modeling the Political Process Interest groups “buy” policies by offering contributions contingent on the policies followed by the government.

Income Distribution and Trade Policy 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).

Table 9-2: Welfare Costs of U.S. Protection ($ billion) Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Effects of trade barriers

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.

International Negotiations and Trade Policy

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.

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?

International Negotiations and Trade Policy 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.

International Negotiations and Trade Policy

International Negotiations and Trade Policy 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?

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

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

International Negotiations and Trade Policy 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.

International Negotiations and Trade Policy 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

World Trade Organization The WTO negotiations addresses trade restrictions in at least 3 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.

World Trade Organization (cont.) 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.

International Negotiations and Trade Policy 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%.

International Negotiations and Trade Policy 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.

International Negotiations and Trade Policy 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

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).

World Trade Organization 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.

World Trade Organization 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.

World Trade Organization 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.

International Negotiations and Trade Policy 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.

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

International Negotiations and Trade Policy 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.

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).

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

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.

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

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

Preferential Trading Agreements 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 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.

Preferential Trading Agreements 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.

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

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.

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.

Appendix: Proving that the Optimum Tariff is Positive Figure 9A-1: Effects of a Tariff on Prices Price, P Quantity, Q Foreign export supply P ~ t PF PW Home import demand

Appendix: Proving that the Optimum Tariff is Positive Figure 9A-2: Welfare Effects of a Tariff Price, P Quantity, Q S D P ~ Q2 D2 Loss PF Q1 D1 Gain PW