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BA 187 – International Trade

Krugman & Obstfeld, Chapter 9

Political Economy of Trade Policy

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The Arguments for Free Trade

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Arguments for Free Trade Efficiency PerspectiveEfficiency 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 PerspectivePolitical 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.

SummarySummary– 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.

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Fallacious Arguments for Protection

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Fallacious Arguments for Protection

Protection Against Cheap Foreign LaborProtection Against Cheap Foreign Labor– Even if domestic wageswages are higher than foreign, domestic

labor costs 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 TariffScientific 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.

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Traditional Arguments for Protection

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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 PerspectiveNational Perspective

– Nation as a whole will benefit from protection.

Individual Industry PerspectiveIndividual Industry Perspective– Individual industry benefits, regardless of national benefit.

Particular Factor of Production PerspectiveParticular Factor of Production Perspective– Particular factor of production benefits, regardless of other effects.

World as a Whole PerspectiveWorld as a Whole Perspective– Welfare in World as a whole will increase as result.

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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”“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: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.

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U.S. & Japanese Tariff Effects

Billions of 1980$ Effect on U.S. Real Effect on U.S. Real IncomeIncome

Effect of Japan’s Real Effect of Japan’s Real IncomeIncome

10% Increase in Tariffs10% Increase in Tariffs

Bilaterally by U.S. $2.5

(0.10%)

$-4.5

(-0.43%)

Multilaterally by U.S. $15.7

(0.60%)

$0.7

(0.07%)

Bilaterally by Japan $-1.1

(-0.04%)

$1.0

(0.10%)

Multilaterally by Japan $0.5

(0.02%)

$8.7

(0.84%)

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

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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: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 PrincipleSpecificity Principle in setting policy.

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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: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:Macroeconomic interpretation of trade deficit: – Y = C + I + G + X – Im means Y – (C + I + G) = X – ImY – (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.

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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.

ProblemsProblems– 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.

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Market Failure Arguments for Protection

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Domestic Market Failure Arguments Market Failure Argument:Market Failure Argument:

– Situation occurs when additional social benefit to production differs from producer surplus measure.

TypicalTypical ReasonsReasons::– 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: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.

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Evaluating Market Failure Arguments Does the market failure argument convincingly undermine the

case for free trade? Probably not. Specificity Principle: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: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.

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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.

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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.

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Costs of Protecting U.S. Jobs, 1990Industry withIndustry with

Import RestraintImport Restraint Jobs SavedJobs Saved

Consumer Cost Consumer Cost per Job Savedper Job Saved

Annual Welfare Annual Welfare Cost to U.S. Cost to U.S.

Ball Bearings 146 $ 438,356 $ 1,000,000

Benzoid Chemicals 216 > 1,000,000 10,000,000

Costume Jewelry 1,067 96,532 5,000,000

Dairy products 2,378 497,897 104,000,000

Frozen Concentrated OJ 609 461,412 35,000,000

Glassware 1,477 180,095 9,000,000

Luggage 226 933,628 26,000,000

Machine Tools 1,556 348,329 35,000,000

Polyethylene resins 298 590,604 20,000,000

Rubber Footwear 1,701 122,281 12,000,000

Softwood lumber 605 758,678 12,000,000

Women’s footwear 3,702 101,567 11,000,000

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

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Offsetting Effects of Dumping

AntidumpingAntidumping argument for tariff asserts that dumping by foreign firms is unfair & threat to Home producers.– Imposing a tariff to offset price differential, an “antidumping dutyantidumping duty”,

offsets foreign firm’s “unfair” price advantage.

Three Types of DumpingThree Types of Dumping– Persistent Dumping:Persistent Dumping: Good continually sold in Home for more than

sold in Foreign’s own market. Tariff lowers welfare in Home.

– Predatory DumpingPredatory 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 DumpingSporadic 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.

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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)countervailing duty (CVD) should be imposed.

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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.

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Who Gets Protected?

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Models of the Political Process Electoral Competition.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’smedian 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.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.

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Who Gets Protected?

Pressure Group or Interest Group.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.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.Countervailing Power.– Industries producing final consumer goods, as opposed to intermediate

inputs, obtain more protection.

Geographic Decentralization.Geographic Decentralization.– Industries with large number of workers that are geographically

decentralized receive more protection. Voting power across regions.

Status Quo.Status Quo.– Industry is more likely to be protected now if protected in past.