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BA 187 – International Trade. Krugman & Obstfeld, Chapter 9 Political Economy of Trade Policy. The Arguments for Free Trade . Arguments for Free Trade. Efficiency Perspective Reverse of cost/benefit analysis of a tariff. Free trade eliminates deadweight losses associated with tariff.

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ba 187 international trade

BA 187 – International Trade

Krugman & Obstfeld, Chapter 9

Political Economy of Trade Policy

arguments for free trade
Arguments for Free Trade
  • Efficiency Perspective
    • Reverse of cost/benefit analysis of a tariff.
    • Free trade eliminates deadweight losses associated with tariff.
    • Additional gain to world through economies of scale since protected markets fragment production, raise costs of production.
    • Competition with rest-of-world induces innovation by domestic producers that would not occur in protected market.
  • Political Perspective
    • Free trade, and its implied philosophy towards economic issues, is a good idea in practice even if there are better policies in theory.
    • In practice, trade policies are dominated by special interest groups who gain at expense of national welfare.
  • Summary
    • Costs of deviating from free trade are large.
    • Free trade provides additional benefits that increase protection costs.
    • “Optimal” deviations from free trade will be subverted politically.
fallacious arguments for protection5
Fallacious Arguments for Protection
  • Protection Against Cheap Foreign Labor
    • Even if domestic wages are higher than foreign, domestic labor costs can be lower if domestic labor productivity is sufficiently higher.
    • If not the case, then foreign has comparative advantage and both nation’s gain from trade.
  • Scientific Tariff
    • Tariff rate that makes price of imports equal to domestic price. Argue this allows domestic producers to compete with foreign producers.
    • Distorts comparative advantage, eliminates rationale for trade entirely.
traditional arguments for protection7
Traditional Arguments for Protection
  • Evaluate traditional arguments for protection
    • Present reasons given for why protection necessary.
    • Evaluate the validity of the reasons given.
    • Ask if other instruments better suited to goals.
  • Focus on perspective from which argument made.
  • National Perspective
    • Nation as a whole will benefit from protection.
  • Individual Industry Perspective
    • Individual industry benefits, regardless of national benefit.
  • Particular Factor of Production Perspective
    • Particular factor of production benefits, regardless of other effects.
  • World as a Whole Perspective
    • Welfare in World as a whole will increase as result.
terms of trade argument
Terms-of-Trade Argument
  • Argues national welfare can be enhanced by tariff.
    • Gain comes through favorable change in nation’s terms of trade.
    • Gain at expense of trading partners, termed “Beggar-thy-neighbor”
  • Restrictive trade policy may raise ratio PExports /Pimports and improve nation’s welfare.
    • Occurs because tariff reduces world demand for import good.
    • Only a large country can make this argument successfully.
  • Two effects to imposing a tariff on nation’s welfare.
    • Increase in terms of trade means nation receives more imports for each unit of exports, enhances welfare.
    • But quantity of imports falls with tariff, reduces welfare.
    • Optimum tariff: Rate that maximizes nation’s welfare.
  • Potential problem is retaliatory protection by injured partners, reducing both nation’s welfare relative to free trade.
u s japanese tariff effects
U.S. & Japanese Tariff Effects

Bilateral = increase tariffs on only other nation’s goods.

Multilateral = increase tariffs on goods of all trading partners.

Source: P. Petri, Modeling Japanese-American Trade, 1984

tariff to reduce total unemployment
Tariff to Reduce Total Unemployment
  • Argues tariff can enhance nation’s welfare if during slack times have unemployment.
    • Imposing a tariff shifts demand from imports to domestic goods.
    • Home industry expands output & jobs, reduces aggregate unemployment.
  • Problems:
    • Tariff may create few jobs in Home industries. Possible retaliatory tariffs by trading partners may reduce jobs in export sector, offsets tariff gains .
    • Exports of Home may decline due to lower incomes in trading partners due to fall in their exports to Home.
    • Tariff may lead to appreciation of Home currency, effect will be to reduce jobs in Home export and import-substitute industries.
  • No certainty tariff will work. Better to use monetary or fiscal policies to directly affect unemployment
    • Known as Specificity Principle in setting policy.
to improve the balance of trade
To Improve the Balance of Trade
  • Common argument claims that tariffs will improve the balance of trade by reducing imports without affecting level of exports.
  • Problems:
    • Possible retaliation by trading partners to these tariffs.
    • Tariffs reduce foreign exports, and income, lowering Home exports.
    • If imports were inputs to Home export goods, then Home exports fall.
    • Even if successful, result will be appreciation of Home currency which offsets effect by reducing Home exports, increasing Home imports.
    • May produce inflationary pressures in Home country, as tariff increases demand for home-produced import substitutes.
  • Macroeconomic interpretation of trade deficit:
    • Y = C + I + G + X – Im means Y – (C + I + G) = X – Im
    • Trade deficit results if Domestic Demand (C + I + G) exceeds domestic production Y. Better to reduce demand by fiscal/monetary policies.
national defense argument
National Defense Argument
  • Argues that a particular industry is vital to a nation’s security because of its products or the skills it develops.
  • If trade permitted in industry, foreign imports will dominate, driving Home producers out or reduce size of Home industry.
    • During war, normal trade may be disrupted, cutting off imports.
    • Without adequate supplies, Home country national security threatened.
  • With tariff protection, industry will remain large enough to avoid threat in event of emergency or war.
  • Problems
    • Not easy to identify industries vital to security. (U.S. watch industry?)
    • Other policies may have lower welfare costs for nation as a whole such as stockpiling goods or production subsidy to domestic firms.
    • Costs then borne by all consumers rather than consumers of single good.
domestic market failure arguments
Domestic Market Failure Arguments
  • Market Failure Argument:
    • Situation occurs when additional social benefit to production differs from producer surplus measure.
  • TypicalReasons:
    • Labor used in the sector is under-employed or unemployed.
    • Defects in capital or labor markets prevent resources from moving between sectors rapidly.
    • Possibility of technological spillovers.
  • Theory of the Second Best:
    • A Hands-off Gov’t policy is desirable in any market only if all other markets are working properly.
    • If all markets are not working properly, then a gov’t policy that seems to distort incentives in one market, may actually increase welfare by offsetting consequences of market failure elsewhere.
evaluating market failure arguments
Evaluating Market Failure Arguments
  • Does the market failure argument convincingly undermine the case for free trade? Probably not.
  • Specificity Principle:
    • Domestic market failures are often best corrected by appropriate domestic policies rather than by trade policies.
    • Compare cost-benefit analysis of a domestic production subsidy with that of an import tariff. Domestic subsidy more efficient.
    • Generally this tends to be true, whether the argument be about labor markets, capital markets, or environmental questions.
    • Protection tends to be adopted over domestic policies simply because public fails to understand the true costs of protection.
  • Identifying Market Failures:
    • Market failures are difficult to identify precisely, hence difficult to decide on the appropriate policy response.
    • If uncertainty and disagreement among trade experts, then may have trade policy captured by special interest groups.
infant industry argument
Infant Industry Argument
  • Valid argument for enhancing total world welfare.
    • Relies on Economies of Scale (IRS) in particular industry.
  • Assume growth of new industry inhibited by low-cost imports from foreign country.
    • Temporary protection to domestic industry would allow it to realize IRS, become low cost producer to world.
  • Import Tariff means consumers finance the expansion of the industry but they also reap LR benefits of lower price.
    • Generally argued more by developing countries than developed.
    • Theoretically valid but difficult to identify industries in practice.
    • Empirical evidence does not find many instances of success.
  • Alternative Policies to achieve Goal?
    • Subsidy to domestic industry by gov’t has lower welfare cost.
    • Efficient capital markets should overcome problem.
tariff to reduce unemployment in a specific industry
Tariff to Reduce Unemployment in a Specific Industry
  • Tariff to increase a particular factor of production’s welfare.
  • Tariff in specific industry increases price and quantity of import-competing Home good.
    • Result is increase in employment in specific industry, even though total employment in Home may fall or rise.
  • While argument is true, question is whether tariff is most effective way to achieve goal.
    • Subsidy to production or employment likely to be welfare-superior way to achieve goal.
  • Next table shows high cost of using tariffs to protect jobs in specific industries.
costs of protecting u s jobs 1990
Costs of Protecting U.S. Jobs, 1990

Source: Hufbauer & Elliot, Measuring Costs of Protection in the U.S., 1994

offsetting effects of dumping
Offsetting Effects of Dumping
  • Antidumping argument for tariff asserts that dumping by foreign firms is unfair & threat to Home producers.
    • Imposing a tariff to offset price differential, an “antidumping duty”, offsets foreign firm’s “unfair” price advantage.
  • Three Types of Dumping
    • Persistent Dumping: Good continually sold in Home for more than sold in Foreign’s own market. Tariff lowers welfare in Home.
    • Predatory Dumping: Foreign sells at low price to drive out Home producers, then raises price to monopoly level. Valid argument for tariff to prevent this type of pricing which leads to inefficiency.
    • Sporadic Dumping: Foreign producers have temporary surplus that they export at whatever price can get. Short-term, no tariff justified.
  • U.S. has specific procedures for identifying and responding to dumping by foreign firms.
offsetting a foreign export subsidy
Offsetting a Foreign Export Subsidy
  • Tariff to offset foreign export subsidy argues that this is unfair to Home producers of good.
    • Impose tariff to offset advantage foreign receives from subsidy.
  • Argument valid at the level of world welfare if subsidy lets foreign firm export good in which foreign does not have a comparative advantage.
    • True even though result is higher domestic price to Home consumers.
    • Export subsidy distorts free trade allocation of resources. Offsetting tariff simply restores more efficient outcome.
  • Note the argument is likely to be invalid at the level of national welfare, due to higher price paid by consumers.
  • U.S. has a procedure to determine if foreign export subsidy and what countervailing duty (CVD) should be imposed.
to benefit a scarce factor of production
To Benefit a Scarce Factor of Production
  • More sophisticated argument for tariff to benefit individual factor of production based on H-O model of trade.
    • Tariff on imported good increases returns to scarce factor of production in Home country.
  • Political decision to redistribute income to scarce factor.
    • Country as a whole suffers but individual scarce factor gains.
  • More efficient way to achieve goal would be to directly tax the abundant factor and allocate revenues to scarce factor.
    • Avoids welfare loss at national level associated with tariff.
  • Also if factors not completely mobile, i.e. Specific Factor model is relevant, then this argument does not hold.
    • Tariff increases returns to import-specific factor alone.
models of the political process
Models of the Political Process
  • Electoral Competition.
    • Assume political parties compete for votes to win elections.
    • Each promises whatever it takes to win election. Assume policy characterized by single dimension, say the tariff rate.
    • Both parties try to find the median voter’s preference for the tariff rate, the voter who is exactly halfway along tariff preferences.
    • Does not work for trade policy, since predicts that policy that hurts majority (as a tariff does) should be rejected by both parties.
  • Collective Action.
    • Political activity is a public good, activity by an individual shared by all members of the same group. Incentive to free ride.
    • Policies that result in large total losses, but small losses for any individual, are unlikely to result in political activity.
    • When group is small, well-organized, and benefits to actions larger, easier to get collective action.
    • Seems to explain why protectionist policies successful politically.
who gets protected24
Who Gets Protected?
  • Pressure Group or Interest Group.
    • Industries or factors of production that are highly organized are more likely to receive trade protection than less organized groups.
  • Market Failure.
    • In industrial countries, protection is more likely to go to labor-intensive industries with unskilled, low wage workers who might have great difficulty finding alternative employment.
  • Countervailing Power.
    • Industries producing final consumer goods, as opposed to intermediate inputs, obtain more protection.
  • Geographic Decentralization.
    • Industries with large number of workers that are geographically decentralized receive more protection. Voting power across regions.
  • Status Quo.
    • Industry is more likely to be protected now if protected in past.