The Political Economy of Trade Policy

The Political Economy of Trade Policy
Topic 5 The Political Economy of Trade Policy

Preview The cases for free trade The cases against free trade
Political models of trade policy International negotiations of trade policy and the WTO Preferential trading agreements Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

The Cases for Free Trade
Few countries have anything like free trade. Hong Kong is the only modern city with no quotas or tariffs. Yet, economists have argued since Adam Smith that governments should pursue free trade. Why? We will discuss three reasons. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

The Cases for Free Trade
First case for free trade: 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, higher prices cause overproduction either by existing firms producing more or by more firms entering the industry. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Fig. 1: The Efficiency Case for Free Trade
A small country cannot influence foreign export prices. The tariff only distorts consumer and producer decisions. A move toward free trade eliminates these distortions and raises national welfare.

Table 1: Benefits of a Move to Worldwide Free Trade (percent of GDP)
Because tariff rates are already low for most countries, the estimated benefits of moving to free trade are only a small fraction of national income for most countries.

The Cases for Free Trade (cont.)
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 quantity 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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

E.g., U.S. imports of canned tuna are protected by a “tariff-rate quota:” a small Q of tuna (4.8% of C) can be imported at a tariff of 6%; but any imports beyond that face a tariff of 12.5%. There are no import licenses and the right to M tuna at the low tariff rate is given on a first come, first served basis. This results in a costly race to get tuna into U.S. as fast as possible. Importers stockpile large Q of canned tuna in warehouses in late Dec. and release the product as soon as the calendar year begins. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Second case for free trade: it produces benefits beyond the elimination of production and consumption distortions. Allows firms or industry to take advantage of economies of scale. Need to deter massive entry into industries with falling AC and the resulting inefficient scale of production. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Protection ↓competition and ↑profits domestically → encourages too many firms to enter the industry → each firm produces on a small scale where AC is higher. E.g., An efficient scale auto assembly plant should produce 80,000 to 200,000 autos/year. Yet, in 1964, Argentina protected its auto industry and produced 166,000 cars with 13 firms! Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Free trade provides competition and opportunities for innovation. Free trade gives entrepreneurs an incentive to export or compete with imports → giving more opportunities for learning and innovation than a system of “managed trade” where government dictates imports and exports. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

E.g., Until 1990s, India pursued an extreme form of ISI. This forced resources into the production of goods that were far more expensive and of lower quality than what could be bought abroad. India was a very “closed” economy with X = 5% of GDP, which was among the lowest of any major nation. GDP per capita growth rate = 1.3%. In 1990s, India liberalized trade and encouraged foreign I. By 2005, X = 20.3% of GDP and GDP per capita growth rate = 7.7%. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

These additional gains from trade (i.e., economies of scale and opportunities for innovation) are dynamic benefits, unlike the static benefits of eliminating the efficiency losses from over-production and under-consumption. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Third case is 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. Economists might be able to show in theory that a set of tariffs and export subsidies could lead to higher national income. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

However, a government that tries to follow such a sophisticated trade policy would probably be captured by interest groups and converted into a program that redistributes income to politically powerful industries. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

The Cases Against Free Trade
First argument 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 the losses caused by distortions in production and consumption. In fact, a small tariff will increase national welfare for a large country. But at some tariff rate, the national welfare will begin to decrease as the efficiency losses exceed the tot gain. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Fig. 2: The Optimum Tariff
Prohibitive tariff leaves the country worse off than free trade where tariff = 0. ↑tariff rate beyond tP has no impact on national welfare. Optimal tariff is greater than zero, but less than a rate that would prohibit all imports. Free trade

The Cases Against Free Trade (cont.)
A tariff rate that completely prohibits imports leaves a country worse off, but tariff rate t0 may exist that maximizes national welfare: an optimum tariff. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

An export tax that completely prohibits exports leaves a country worse off, but an export tax rate may exist that maximizes national welfare through the terms of trade gain. An export subsidy lowers the tot for a large country; but an export tax raises the tot. An export tax may raise the price of exports in the world market, increasing the tot. E.g., Saudi Arabia and other oil exporters tax oil exports, raising oil prices on world markets. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Counter-Argument For some countries, like the U.S., an import tariff or an export tax 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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

A second argument against free trade is that domestic market failures may exist that cause free trade to be a suboptimal policy. The efficiency loss calculations using CS and PS assume that markets function well. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Types of market failures include: Labor used to produce the import-competing good would be unemployed otherwise. Production in labor-intensive (import-competing) industries helps the economy reach full employment. There are technological spillovers from the import-competing industry to other industries. Production of the import-competing good will improve technology in the country, but firms in the industry can’t earn revenues from this; and therefore, don’t take this into consideration when deciding output. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Economists calculate the marginal social benefit to represent the additional benefit to society from private production. With a market failure, MSB is not accurately measured by PS of private firms, so that efficiency loss calculations are misleading. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Fig. 3: The Domestic Market Failure Argument for a Tariff
Fig. 3(a) Fig. 3(a) shows the conventional cost-benefit analysis of a tariff in a small country. Fig. 3(b) shows the MSB from production not taken into account by PS. Tariff ↑P → ↓D and ↑S → distortions labeled a and b. But this ignores the possibility that ↑S → social benefit labeled c. If the tariff is small enough, c > a + b and welfare rises. Fig. 3(b)

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 be the “second-best” way of fixing the problem. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

E.g., If the labor market is not at full employment, then a policy of subsidizing L-intensive industries, which is undesirable in full employment, may be a good idea with high unemployment. Better to fix the labor market by making wages more flexible! But if this can’t be done, then intervening in other markets may be the “second-best” way to alleviate unemployment. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Counter-Arguments Economists 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. If national welfare increases with a tariff because it ↑Q which has social benefits, then ↑Q with a production subsidy. A production subsidy does not ↑P to consumers, so the under-consumption efficiency loss (due to the tariff) disappears. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Counter-Arguments (cont.)
E.g., In U.S., VER on autos was supported to save jobs of autoworkers. Advocates argue that labor markets are too inflexible for autoworkers to remain employed by cutting wages or finding jobs elsewhere. Purely domestic policy: subsidize firms that hire autoworkers. Political opposition: require large payments → ↑federal budget deficit or ↑income taxes. Autoworkers are among the highest paid manufacturing workers, so public would object to this. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

VER is even more expensive: while bringing about the same level of employment, it also distorts consumer choice. Difference in two policies: costs are less visible with VER → ↑Pautos vs. direct G outlays. Critics of domestic market failure argument for protection argue that this case is typical. Most deviations from free trade are adopted because the public does not understand the true costs and not because benefits of protection > costs. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

In the real world, market failures are hard to identify, so it’s difficult to be certain about the appropriate policy response. E.g., Urban UE in developing countries. What is the best policy? Tariff to protect urban industrial sector will draw UE into work. Or might this policy encourage more rural-urban migration that will raise urban UE? Economic theory explains properly functioning markets but provides little guidance for market failure. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Political Models of Trade Policy
How is trade policy determined? Models that address this question: Median voter theorem Collective action And a model of trade policy that combines aspects of both Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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

Median Voter Theorem (cont.)
Assumptions of the model: There are two competing political parties. 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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Fig. 4: Political Competition
Voters are lined up in order of the tariff they prefer. If one party proposes a high tariff tA, the other party can win over the most voters by offering a somewhat lower tariff, tB. This political competition drives both parties to propose tariffs close to tM, the tariff preferred by the median voter.

Median Voter Theorem (cont.)
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! Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Collective Action 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 for society as a whole but small losses on each individual may therefore not face strong opposition. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Collective Action (cont.)
However, for those groups who may suffer large losses from free trade (e.g., UE), 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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Collective Action (cont.)
E.g., sugar quota costs the typical U.S. family $30/yr. Loss is small and most voters are unaware of the quota. One individual’s letter of protest won’t change policy and the small annual loss doesn’t justify the effort. By contrast, the sugar producers are well organized and they are aware that the quota is worth thousands of dollars to an individual producer. They lobby Congress and make political contributions, so we end up with a trade policy whose costs > benefits. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

A Model of Trade Policy 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 trade restriction policy try to measure the trade off between the reduction in welfare of constituents as a whole and the increase in campaign contributions from special interests. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Which Industries Are Protected?
Agriculture: in the U.S., Europe, and Japan farmers make up a small fraction of the electorate but receive generous subsidies and trade protection. E.g., European Union’s CAP; Japan’s 1,000% tariff on imported rice; and America’s sugar quota. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Which Industries Are Protected? (cont.)
Clothing: textiles (fabrication of cloth) and apparel (assembly of cloth into clothing). Until 2005, quota licenses granted to textile and apparel exporters were specified in the Multi-Fiber Agreement between the U.S. and many other nations. In 2005, U.S. and China signed an MOU that established quotas on China’s exports of various types of textiles and clothing. E.g., China agreed to limit sock exports to million in 2006. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Table 2: Welfare Costs of U.S. Protection ($ billion)
In 2002, with the MFA still in effect, clothing restrictions were responsible for more than 80% of the overall welfare costs of U.S. protectionism. With the expiration of the MFA, the costs of clothing protection and hence the overall costs of U.S. protection are expected to fall sharply. The end of MFA brought a surge in Chinese clothing exports. E.g., in Jan. 2005, China shipped 27 million pairs of cotton pants to U.S. –up from 1.9 million a year earlier. There was fierce political opposition from clothing makers in the U.S. It remains to been seen whether the liberalization of clothing trade will prove politically sustainable!

International Negotiations of Trade Policy
The average U.S. 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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Fig. 5: The U.S. Tariff Rate The average U.S. tariff rate fell from 60% in mid-1930s to 5% in 2000.

International Negotiations of Trade Policy (cont.)
Multilateral negotiations 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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Multilateral negotiations also help avoid a trade war between countries, where each country enacts trade restrictions. A trade war could result if each country has a political interest (due to political pressure) to protect domestic producers, regardless of what other countries do. 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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Table 3: The Problem of Trade Warfare
In game theory, this is known as a prisoner’s dilemma. Each government making the best decision for itself chooses to protect, leading to the outcome (-5,-5). Yet, both governments are better off if neither protects: (10,10) is a higher payoff. Japan and U.S. need to agree to refrain from protection. Each government is better off by limiting its own freedom of action, provided the other country does the same.

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 U.S. can establish a binding agreement to maintain free trade, both can avoid the temptation of protection and both can be made better off. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

World Trade Organization
WTO negotiations address trade restrictions in at least 3 ways: Reduction of tariff rates through multilateral negotiations. Multilateral negotiations are more effective than bilateral negotiations. Benefits from a bilateral negotiation may “spill over” to countries that have not made any concessions. E.g., if U.S. ↓tariffs on coffee because of a deal with Brazil → Colombia will also gain from the ↑P of coffee. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

World Trade Organization (cont.)
Binding: a tariff is “bound” by having the imposing country agree not to raise it in the future. A country can only raise a tariff if it gets agreement of other countries, which usually means providing compensation by reducing other tariffs. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Prevention of non-tariff barriers: quotas and export subsidies are not allowed. Subsidies for agricultural exports are an exception. Existing quotas were “grandfathered” in. There is an ongoing effort to remove or convert such quotas to tariffs. New quotas are forbidden. Exceptions are allowed for “market disruptions” caused by a surge in imports. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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

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

A country that refuses to adhere to the panel’s decision may be punished by allowing injured countries to impose trade restrictions on its exports. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

In March 2002, U.S. imposed 30% tariff on steel. U.S. claimed it was facing a surge in imports and needed time to restructure. In reality, steel is concentrated in “swing states” and Bush was worried about the 2004 pres. election. Europe, Japan, China, and South Korea filed suit against the U.S. and the WTO ruled in their favor in July 2003. Europe (with WTO approval for retaliatory action) threatened to impose tariffs on more than $2 billion in U.S. exports. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Europeans targeted their proposed tariffs on goods produced in political swing states! U.S. complied with the WTO ruling in Dec Some claimed this was a test for the WTO. Would a large country, like the U.S., comply with its rulings? Not a great test, as Europe is a large country that can effectively retaliate against the U.S. As of June 2008, U.S. has not complied with the March 2005 WTO ruling (for Brazil) against U.S. subsidies to cotton producers. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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, China had to re-impose quotas until 2011 due to political pressure. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

In 2001, the ninth round of world trade negotiations was started in Doha, Qatar, but these negotiations have failed to produce an agreement. Potential gains were modest because barriers to trade in most goods are now trivial –due to success of 8 previous rounds. Most of the remaining forms of protection are in agriculture, textiles, and clothing -industries that are politically active. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Table 4: Percentage Distribution of Potential Gains from Free Trade
Table 4 shows estimates of where the welfare gains from full liberalization (i.e., elimination of all trade barriers and export subsidies) would have come from and how they would be distributed across countries. Agricultural products account for less than 10% of world trade, yet liberalizing agriculture would account for 63% of the world total gains from free trade. These gains are very politically hard to get at!

Do Agricultural Subsidies in Rich Countries Hurt Poor Countries?
Recall: subsidies ↓world price of products because they encourage domestic producers to ↑Q. So why should poor countries want rich countries to remove their agricultural subsidies? Because farmers in poor countries compete with farmers in rich countries. Yet, urban residents and farmers who do not compete (e.g., coffee farmers) actually benefit from the lower prices of subsidized food on world markets. E.g., Because China imports a lot of food, it would be hurt by the removal of agricultural subsidies in rich countries (e.g., U.S. and Europe) according to the Doha negotiations. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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

Preferential Trading Agreements (cont.)
Two types of preferential trade agreements: 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. E.g., NAFTA A customs union: an agreement that allows free trade among members and requires a common external trade policy towards non-member countries. E.g., EU Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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

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

In Fig. 6 and 7, if Britain forms a customs union with France, tariff against France is removed but tariff against U.S. remains. Is this good or bad for Britain? In Fig. 6, Britain’s initial tariff was high enough to exclude imports from France or U.S. Formation of a customs union is welfare improving. In Fig. 7, Britain’s initial tariff was low enough to allow imports from the U.S. –the lowest cost producer. Formation of a customs union means that French imports will replace U.S. imports. Britain will no longer receive tax revenues and its welfare declines. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Fig. 6: Trade Creation S British Wheat Market P D Q
Tariff = $5 (prohibitive) PT U.S. = $9 PT France = $11 Welfare effects of customs union: ∆CS = a + b ∆PS = -a ∆Net welfare = + b $8 a b CU = $6 D SCU DCU Q Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Fig. 7: Trade Diversion S British Wheat Market P D Q
Price in U.S. = $4 Price in France = $6 Price in Britain = $8 Britain is a small country. Tariff = $3 Welfare effects of customs union: ∆CS = a + b + c + d ∆PS = -a ∆G rev = -(c + e) ∆Net welfare = (b + d) - e Q P $8 D CU = $6 PU.S.= $4 SCU ST DCU DT a b c d e British Wheat Market PT U.S. = $7

The Political Economy of Trade Policy

Similar presentations

Presentation on theme: "The Political Economy of Trade Policy"— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

The Political Economy of Trade Policy

Similar presentations

Presentation on theme: "The Political Economy of Trade Policy"— Presentation transcript:

Similar presentations

About project

Feedback