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Trade Policy. The Economics of Trade Agreements. Why do governments form trade agreements? What can they achieve with a trade agreement that they cannot achieve by setting trade policies unilaterally? Answer 1: Nothing, really. It’s an elaborate ruse leading to a good outcome.

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Trade Policy


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    1. Trade Policy

    2. The Economics of Trade Agreements • Why do governments form trade agreements? What can they achieve with a trade agreement that they cannot achieve by setting trade policies unilaterally? • Answer 1: Nothing, really. It’s an elaborate ruse leading to a good outcome. • Answer 2: Trade agreements solve a problem that arises when trade policies are set unilaterally.

    3. Answer 1: Useful nonsense • Two illustrative quotations: • “It was a fruitful lie, this idea that the gains from trade come mainly from the exports you sell, not the imports you buy. But it was still a lie; the textbook case for [unilateral] free trade is really correct…the whole process – the GATT, the WTO, all that stuff – was just a ruse.” Clive Crook (The Atlantic Monthly, October 2006). • “There is no generally accepted label for the theoretical underpinnings of the GATT. I like to refer to it as ‘GATT-Think’ – a simple set of principles that is entirely consistent, explains what goes on in negotiations, but makes no sense in terms of economics.” Paul Krugman, 1991. • The success of the GATT/WTO is measured by how close it gets the world to global free trade.

    4. Answer 2: Solving a problem • Approach: Identify a well-defined problem that a trade agreement might solve. • Commitment theory: trade agreement facilitates domestic commitments to the private sector. • International externality theory: trade agreement facilitates an escape from a Prisoners’ Dilemma that reflects the international externalities associated with trade policies. • The success of GATT/WTO is measured by how well it facilitates a solution to one or both of these problems. • Most research in economics focuses on international externalities.

    5. Perceptions of problem prior to GATT • Smoot-Hawley Tariff Act of 1930 • “the postwar design for international trade policy was animated by a single-minded concern to avoid repeating the disastrous errors of the 1920’s and 1930’s.” (Hudec, 1991) • The problem as described in a League of Nations report • “trade was consistently regarded as a form of warfare, as a vast game of beggar-my-neighbour, rather than as a co-operative activity from the extension of which all stood to benefit.” (1942)

    6. Our general plan • Determine the purpose of a trade agreement: Identify the international externality. • Interpret and evaluate the design of GATT/WTO: According to the theory, do mutually advantageous arrangements among governments entail reciprocal reductions in trade barriers and non-discrimination? • Government welfare functions: Adopt a general specification. Governments may maximize national economic welfare, but they may also have political and distributional motivations.

    7. The General-Equilibrium Model • Standard GE Model • Two goods: x and y • Two countries: Home and Foreign (*) • Trade pattern: Home imports x and exports y • Production: Competitive • Prices • Local Prices: and • World (offshore) Price: • Home terms of trade: • Foreign terms of trade: • Tariffs • Ad valorem: and • Define: and

    8. Economic Relationships Prices and tariffs and Balanced trade Market Clearing (y) determines : Assume that countries are large with standard price effects: and

    9. Government Preferences • Abstract form • and • All prices satisfy economic relationships from last slide. • Key Assumption • Holding fixed local prices, each government enjoys an improvement in its terms of trade. • Formally: • Unrestricted. • No assumption regarding preferences over local prices. • Formally : • Includes: • National economic welfare • Political concerns and constraints • No commitment issues or information problems.

    10. Illustrating Government Preferences A Suppose that tariffs are , with line P(A) depicting the iso-local price locus and line depicting the iso-world price locus

    11. Illustrating Government Preferences B A Now holding local prices constant, give home a terms of trade gain. The assumption is that this move is valued by the government.

    12. Nash Tariffs • Nash (Unilateral) tariffs • Home • Foreign Define ,

    13. Illustrating Trade Policy A Suppose that Home raised its tariff

    14. International Externality B A • The rise in tariffs would raise the world price, . • The move from A to B represents the benefit for the home government that comes at the expense of foreign countries, or , which is (+) • At the same time, the local price would rise in response to the tariff.

    15. Domestic Effects P C B A The move from B to C is the change in government welfare from both the costs of the domestic distortion in production and consumption and the domestic political befits of altering the local price. This is the portion of welfare.

    16. Politically Optimal tariffs • Politically optimal tariffs are the unilateral tariffs that governments would choose if, hypothetically, they didn’t value gains associated with changes in the terms of trade. • Efficient Tariffs are those tariffs that satisfy the Pareto criterion relative to government preferences.

    17. Terms of Trade Motivations P C D A • Suppose a government is considering a tariff that will result in point C from A. • If terms of trade motivations exist then the government will be aware that the cost of the higher local price can be born by its foreign trading partner, and tariffs will be inefficiently high. • If the government doesn’t care about terms of trade, point C is only preferred in cases that D is also preferred to A. The move from A to D does not have a first order effect on foreign.

    18. Purpose of trade agreements: main findings • Result 1: Nash tariffs are inefficient • Result 2: Starting from Nash, a trade agreement can offer mutual gains to governments only if each government reduces its tariff. • Result 3: Politically optimal tariffs are efficient. • Whether or not governments have political preferences, the purpose of a trade agreement is to facilitate the escape from a terms of trade driven Prisoners’ Dilemma problem. • Mutual gains require (perhaps slight) reciprocal reductions in tariffs. • Not all reciprocal tariff cuts lead to mutual gains.

    19. Note: FT= (1,1)

    20. Reciprocity in GATT • Preamble and Negotiation Norm (“Reciprocity down”) • Reciprocal, mutually advantageous tariff cuts • Negotiate a balance of concessions • Renegotiation (GATT Article XXVIII) and Authorized Retaliation (DSU 22.4) (“Reciprocity up”) • Article XXVIII: withdrawal of a substantially equivalent concession • DSU 22.4: authorization to suspend concessions equivalent to the level of the nullification and impairment • Key Question: If we define reciprocity in terms of equivalent concessions, does reciprocity make economic sense?

    21. The Meaning of Reciprocity • The Principle of Reciprocity: Mutual changes in trade policy that bring about changes in the volume of each country’s imports that are of equal value to changes in the volume of its exports. • Formal Definition: Suppose trade policies are changed from to . Let and . The tariff change satisfies the principle of reciprocity iff: • Where , • Using balanced trade conditions, the tariff change satisfies reciprocity iff. • Implication: Principle of reciprocity fixes the world price, and thus neutralizes the problem.

    22. Reciprocity and Trade Negotiations (Reciprocity Down) • Result 4: Beginning at the Nash tariffs, trade liberalization that satisfies the principle of reciprocity raises each government’s welfare, at least initially. • Interpretation • Nash tariffs leave all governments wanting more trade volume at the fixed world price • Unilateral liberalization is unattractive, due to implied terms of trade loss. • Reciprocal liberalization fixes the world price and thus leads to mutual gains. • A path for reciprocal tariff cuts that is sure to lead to mutual gains.

    23. Reciprocal Negotiations to reach Politically Optimal tariffs If the countries are symmetric, the iso-world price locus that runs through the Nash point N also runs through the politically optimal point PO. As government liberalize, they gain welfare up until they hit their politically optimal level of tariffs and no terms of trade driven protection remains.

    24. Asymmetric Case In this case the two countries are asymmetric, reciprocal negotiation will only get to point Z, at which time home arrives at its preferred local price, whereas foreign no longer has anything to offer. If negotiations must be strictly reciprocal, the trade agreement might not reach efficiency.

    25. Reciprocity and Renegotiation (Reciprocity Up) • Which (if any) efficient tariff pair is robust to the possibility of renegotiation as allowed under GATT Article XXVIII? • Result 5: The politically optimal tariffs are the only efficient tariffs that are robust to the possibility of renegotiation as allowed under GATT Article XXVIII. • Intuition: Both governments have their preferred local prices at the political optimum, and renegotiation under GATT Article XXVIII prevents any government from improving its terms of trade.

    26. Renegotiation Under Article XXIII A’ A Consider an initial agreement at point A. Consider the case that the foreign government prefers to move to A’ where it achieves its locally preferred price. This means that the agreement is not robust to the type of renegotiationavailable under Article XXIII.

    27. Zoom in to Examine Tariff Changes A’ A

    28. What is renegotiation? A’ 2. Retaliation A 1. Initial Violation 1. If Foreign wants to get to A’ under Article XXIII, first it just has to raise its tariff. Then Home can take Foreign to the WTO and sue, easily winning its case. 2. Finally, once the WTO Panel (or Appellate Body) rules in its favor, Home will be authorized to raise its own tariff to point A’, making the relative prices the same as under agreement A.

    29. What about Home’s incentive to Renegotiate? A’ A B’ B Similarly, points such as B are not robust to renegotiation by home to move to point B.’

    30. What sorts of Agreements Survive? A’ A Reasoning in this way, we can exclude all possible agreements from A to PO, along the tangency to the welfare curve .

    31. Renegotiation Under Article XXIII A’ A B’ B Combined with a similar process for Home, we get that the politically optimal tariff pair, the only tariffs on the efficiency locus at which both governments achieve their preferred local price, is the only tariff pair that survives renegotiation.

    32. Answer to Key Question • General answer : Reciprocity neutralizes the “problem” by fixing the terms of trade. It thereby promotes efficiency and makes good economic sense. • Reciprocity down: provides a path toward greater efficiency. • Reciprocity up: de-stabilizes most efficient points, but the political optimum is robust. • Missing ingredient so far: Perhaps reciprocity up is about providing flexibility in response to preference shocks (shifts in the efficiencyfrontier location) while allowing for balanced retaliation as a means of deterring opportunism.

    33. Optional Material on Dispute Settlement

    34. Dispute Settlement Procedure • In the WTO, a government can allege that some measure either violates an obligation or nullifies or impair a negotiated market access concession. • The case goes to a panel, and then if appealed, to the Appellate Body. • If the measure is found to be in violation, then the dispute settlement procedures move through three potential stages • Compliance • Compensation (MFN tariff reduction on other goods) • Authorized retaliation (of “equivalent” level, under DSU 22.4) • Possible roles for retaliation: compliance and rebalancing.

    35. Retaliation Role 1: Inducement of compliance (broadly defined) • A trade agreement is a self-enforcingagreement (incentive compatible). • At efficient tariffs, each government has a short-run incentive to cheat • each government’s tariff is below its optimal unilateral level. • a higher tariff would raise a government’s welfare in the short run. • But each government also perceives a long-run cost from cheating • cheating may lead to a future deterioration in cooperation • if the rules (and rulings) are not respected, the agreement is undermined, perhaps leading to a return to unilateral Nash tariffs. • It is this “balance of terror” (Dunkel) that is the final backstop that restrains extensive cheating. • But this suggests retaliation should be severe and not “equivalent.” Actual retaliation in the agreement is about more than compliance

    36. Retaliation Role 2: Retaliation as Rebalancing, cont. • One approach: Implement a liability rule system so as to facilitate efficient breach and deter inefficient breach. • Such a system would compensate the party that does not breach, so as to keep that party whole. • If the promisor stills want to breach after compensating the promisee, then the breach is efficient and warrants approval. • WTO context: Monetary compensation is rarely used. Compensation with MFN tariff reductions on other goods is also uncommon. • Instead, when one government raises its tariff above the bound level, its trading partner is ultimately entitled to achieve “compensation” by withdrawing an equivalent concession of its own. • So, if the Home government raises its tariff and the Foreign government reciprocally withdraws an equivalent concession, is the Foreign government made whole?

    37. Retaliation Role 2: Retaliation as Rebalancing, cont. • Not quite. • The good news: the foreign government maintains its initial terms of trade by reciprocally withdrawing an equivalent concession. • The bad news: by retaliating, the foreign governments also raises the local price of its import good and thus reduces trade volume. • If the Foreign government had its preferred trade volume or preferred greater trade volume, at the initial terms of trade, then the reciprocal tariff increase will induce an “internal inefficiency” leading to lower welfare for the Foreign government.

    38. Retaliation Role 2: Retaliation as Rebalancing, Upshot • Retaliation with the reciprocal withdrawal of equivalent concessions preserves the terms of trade and thus provides some compensation. • It is not a perfect means of facilitating efficient breach, however. • But a perfect rule would depend on the particular features of government welfare functions and would be hard to implement in practice. • Absent greater use of monetary compensation, perhaps rules achieve rebalancing about as well as is practically possible.

    39. DSU Reform: Tradable Retaliation? • Issue: Small countries cannot retaliation effectively • Response 1: Dismissive. Then they have not offered anything of value. • Response 2: Accommodative. Various proposals (monetary payments, tradableretaliation, cross retaliation, collective retaliation) • Mexican proposal: trade the right of retaliation. • Suppose small country wins case against US and auctions retaliation right. • Potential benefits: facilitates compensation and thus rebalancing, induces greater compliance, and perhaps allocates retaliation to country that would most benefit from a tariff hike.

    40. DSU Reform, TradableRetaliation, cont. • Unusual auction: An .auction with externalities.. • Could induce free riding among bidders and auction failure. • Suppose offending country (US) is allowed to bid to retire the right of retaliation against it. • Could facilitate monetary payment from large to small country. • Upshot: Intriguing proposal worthy of further study, but may have un-modeledconsequences and should be approached with caution

    41. Empirical Applications of Optimal tariff Theory

    42. Optimal Tariffs and Market Power • Do governments actually set tariffs so as to influence global prices in their favor? • Despite wide use of terms-of-trade explanations for trade agreements, little research on the subject. • Krugman and Obstfeld argue that based on anecdotal evidence, the terms of trade theory has little practical importance. • Broda, Limaoand Wienstein 2008 evaluate the importance of market power in setting tariff policy. • The paper estimates elasticities of export supply by 15 importer countries and find that prior to joining the WTO, they have higher tariffs in goods with more market power. • In the U.S., goods without tariff bindings are those with high U.S. market power. • These effects are robust to controlling for political economy variables

    43. Trade Data and Elasticity Estimates • Broda, Limao and Wiensteinuse the TRAINS database of tariffs at the six-digit HS level for 15 countries. • Trade data comes from COMTRADE, which has bilateral flows for all countries, 1994-2003. • They define a good as a four digit HS category, and a variety as a six digit good from a particular exporter. • Despite talk of “large” and “small” countries, actual tariff policy is quite heterogeneous, as shown in the following charts.

    44. Results of correlations between Optimal Tariffs and Market Power • There is a strong positive relationship between the median tariff in a country and market power in the typical good, as measured by its median inverse elasticity. • By regressing tariffs on various functions of market power, Broda et al. are able to show significant confirmations of positive relationships between tariffs and market power, both across countries and across goods.

    45. Offshoring and the Role of TradeAgreements • Offshoring an increasingly dominant feature of the world economy. • Initiate study of trade agreements in the presence of offshoring

    46. AntràsStaiger 2011 • Emphasize two features of offshoring that follow from the prominence of relationship-specific investments and incomplete contracts and distinguish offshoring from traditional trade flows: • Terms of trade determined by bilateral bargaining between foreign suppliers and domestic producers; and • Potential for international hold up. • Show that these features have important implications for the nature and purpose of trade agreements.

    47. Main Findings • The rise in offshoring will complicate the task of trade agreements. • If governments seek to maximize real national income, then the purpose of a trade agreement is to mitigate international cost-shifting motives, as in Terms of trade theory, but: • The mechanism for international cost-shifting extends to a wider set of policies, i.e., those that can affect bilateral bargaining outcomes; • Traditional market access concerns too narrow for efficiency.

    48. Political Economy Externality • If governments have political economy motives, then there is a new problem for a trade agreement to solve, distinct from cost-shifting/TOT problem: • A “political externality”; must internalize direct impact of trade policies on political goals of trading partner; • If political economy motives are widespread and varied, then underlying problem that must be addressed varies with political preferences of governments; • Difficult for governments to rely on simple and general rules such as reciprocity and non-discrimination.