Chapter 10 The Political Economy of Trade Policy Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy, Sixth Edition by Paul R. Krugman and Maurice Obstfeld

Chapter Organization Introduction The Case for Free Trade Income Distribution and Trade Policy International Negotiations and Trade Policy Copyright © 2003 Pearson Education, Inc.

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 Copyright © 2003 Pearson Education, Inc.

The Case for Free Trade Free Trade and Efficiency The efficiency argument for free trade is based on the result that in the case of a small country, free trade is the best policy. A tariff causes a net loss to the economy (i.e. deadweight loss). A move from a tariff equilibrium to free trade eliminates the efficiency loss and increases national welfare. Copyright © 2003 Pearson Education, Inc.

Figure 9-1: The Efficiency Case for Free Trade The Case for Free Trade 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 Copyright © 2003 Pearson Education, Inc.

The Case for Free Trade Economies of scale in production Protected markets in small countries do not allow firms to exploit economies of scale. Example: In the auto industry, an efficient scale assembly should make a minimum of 80,000 cars per year. In Argentina, 13 firms produce a total of 166,000 cars per year. The presence of scale economies favors free trade that generates more varieties and results in lower prices. Free trade, as opposed to “managed” trade, provides a wider range of opportunities and thus a wider scope for innovation. Copyright © 2003 Pearson Education, Inc.

The Case for Free Trade Political Argument for Free Trade A political commitment to free trade may be a good idea in practice. Trade policies in practice are dominated by special-interest politics rather than consideration of national costs and benefits. Copyright © 2003 Pearson Education, Inc.

Income Distribution and Trade Policy Who Gets Protected? Two sectors 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. Copyright © 2003 Pearson Education, Inc.

International Negotiations and Trade Policy How was the removal of tariffs politically possible? The postwar liberalization of trade was achieved through international negotiation. Governments agreed to engage in mutual tariff reduction. The Advantages of 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. It can help governments avoid getting caught in destructive trade wars. Copyright © 2003 Pearson Education, Inc.

International Negotiations and Trade Policy Table 9-3: The Problem of Trade Warfare Japan U.S. Free trade Protection 10 20 -10 20 -10 -5 Protection Copyright © 2003 Pearson Education, Inc.

International Negotiations and Trade Policy In Table 9-3, each country has a dominant strategy: Protection. Even though each country acting individually would be better off with protection, they would both be better off if both chose free trade. Japan and the U.S. can establish a binding agreement to maintain free trade. Copyright © 2003 Pearson Education, Inc.

International Negotiations and Trade Policy International Trade Agreements: A Brief History 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 WTO system is a legal organization that embodies a set of rules of conduct for international trade policy. Copyright © 2003 Pearson Education, Inc.

GATT Eight Rounds of Trade Negotiations Year Place/name Subjects covered Countries 1947 Geneva Tariffs 23 1949 Annecy 13 1951 Torquay 38 1956 26 1960-1961 Dillon Round 1964-1967 Kennedy Round Tariffs and anti-dumping measures 62 1973-1979 Tokyo Tariffs, non-tariff measures, “framework” agreements 102 1986-1994 Uruguay Round Tariffs, non-tariff measures, rules, services, intellectual property, dispute settlement, textiles, agriculture, creation of WTO, etc 103 Copyright © 2003 Pearson Education, Inc.

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 Trade Related Aspect of Intellectual Property Rights (TRIPs). The WTO has a new “dispute settlement” procedure which is designed to reach judgments in a much shorter time. Copyright © 2003 Pearson Education, Inc.

Principles of the WTO Trading System Trade without discrimination A. Most-favored-nation:     Under the WTO agreements, countries cannot normally discriminate between their trading partners. Cannot grant someone a special favor. B. National treatment:     Imported and locally-produced goods should be treated equally at domestic market. The same should apply to foreign and domestic services, and to foreign and local trademarks, copyrights and patents. Copyright © 2003 Pearson Education, Inc.

Freer trade: gradually, through negotiation Lowering trade barriers is one of the most obvious means of encouraging trade. The barriers concerned include tariffs and measures such as import quotas. Predictability: through binding and transparency Sometimes, promising not to raise a trade barrier can be as important as lowering one, because the promise gives businesses a clearer view of their future opportunities. With stability and predictability, investment is encouraged, jobs are created and consumers can fully enjoy the benefits of competition choice and lower prices. Copyright © 2003 Pearson Education, Inc.

Economic Integration A free trade area allows free-trade among members (no tariffs), but each member can have its own trade policy towards non-member countries. A customs union allows free-trade among members and requires a common external trade policy (common tariff) towards non-member countries. A common market is a customs union with free mobility of factors of production (capital and labor) among members. A monetary union is a common market with common currency and common monetary policy. Copyright © 2003 Pearson Education, Inc.

Stages of Economic Integration Elimination of Tariffs Unified External Tariff Free Movement of Factors Common Currency and Monetary Policy Preferential Agreement Free Trade Area √ Customs Union Common Market Monetary Union

Main Regional Agreements EU NAFTA EFTA GAFTA APEC GCC CAFTA SAFTA WAEMU ASEAN COMESA Mercosur