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Transcript of Krugman ch09
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Chapter 9Chapter 9
The Political Economy of Trade PolicyThe Political Economy of Trade Policy
Udayan Roy
International Economics: Theory and PolicyInternational Economics: Theory and Policy, Eighth Edition
by Paul R. Krugman and Maurice Obstfeld
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Slide 9-2
Introduction
The Case for Free Trade
National Welfare Arguments against Free Trade
Income Distribution and Trade Policy
International Negotiations and Trade Policy
Chapter Organization
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Slide 9-3
Introduction
Some gain and some lose from free trade. But the
gains exceed the losses; free trade maximizes national
welfare (i.e., total surplus).
Yet most governments restrict trade in some way or
other.
Why dont governments listen to economists cost-
benefit calculations? Should they?
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Slide 9-4
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
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Slide 9-5
In the case of a small country, free trade maximizes
total surplus.
A tariff causes a net losscalled the deadweight
lossto the economy.
The Case for Free Trade I
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Slide 9-6
World price
plus tariff
World price
Price, P
Quantity, Q
S
D
Consumption
distortion
Production
distortion
Figure 9-1: The Efficiency Case for Free Trade
The Case for Free Trade I
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Slide 9-8
The Cases for Free Trade I
However, because tariff rates are already low for most
countries, estimated benefits of moving to free trade are only a
small fraction of national income for most countries.
So, this argument has become less persuasive, now that tariffsare already significantly lower than before.
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Slide 9-9
The Cases for Free Trade I
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9-10
The Cases for Free Trade (cont.)
Yet 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
number 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 resourcesthrough rent seeking.
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Slide 9-11
The Cases for Free Trade I
And for some countries in some time periods, the estimated
cost of protection was substantial.
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Slide 9-12
The Cases for Free Trade I
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Slide 9-13
In the case of increasing returns to scale, bulkproduction reduces per unit costs.
This benefit from bulk production is calledscale
economies. Protected markets in small countries do not allow firms
to exploit scale economies.
Example: In the auto industry, an efficient scale assembly
should make a minimum of 80,000 cars per year. In Argentina, under a protectionist regime in 1964, 13 firms
produced a total of 166,000 cars per year.
In the presence of scale economies, free trade makesmore varieties available and at lower prices.
The Case for Free Trade II
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Slide 9-14
The Case for Free Trade III
Free trade enables an inventor to sell to a larger
market. As a result, free trade provides a stronger
incentive for innovation.
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Slide 9-15
A political argument
Free trade is the best feasiblepolitical policy, even thoughthere may be better policies in principle
Trade policies that single out certain industries forprotection from imports are in practice dominated by
special-interest politics rather than consideration of
nationalcosts and benefits.
The Case for Free Trade IV
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Slide 9-16
There are two theoretical arguments againstthe
policy of free trade:
The terms of trade argument for a tariffWe have seen this one before!
The domestic market failure argument
National Welfare Arguments
Against Free Trade
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Slide 9-17
The Terms of Trade Argument for a Tariff
For a large country, a tariff lowers the price ofimports.
This benefit of a tariff is called a terms oftrade benefit.
It is possible that the terms of trade benefits of a tariffoutweigh its costs.
Therefore, free trade might not be the best policy for a
large country.
National Welfare Arguments
Against Free Trade I
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Slide 9-18
Terms of Trade Argument for a Tariff
Weaknesses
The argument doesnt work for small countries
Even if a large country benefits from a tariff, thatbenefit will come at the expense of other countries.
The world as a whole would be worse off
This would invite retaliatory tariffs, in which case the
tariff might hurt everybody
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Slide 9-19
1
National welfare
Tariff rateOptimum
tariff, to
Prohibitive
tariff rate, tp
Figure 9-2: The Optimum Tariff
National Welfare Arguments
Against Free Trade
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Slide 9-20
Optimum tariffThe tariff rate that maximizes national welfare
It is always positive but less than the prohibitive rate
that would eliminate all imports.It is zero for a small country because it cannot affect its
terms of trade.
National Welfare Arguments
Against Free Trade
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Slide 9-21
The Domestic Market Failure Argument Against
Free Trade
Consumer and producer surplus ignore the social costs
and benefits ofdomestic market failures such as:Unemployment or underemployment of labor
Technological spillovers from industries that are new or
particularly innovative
Environmental externalities
A tariff may raise welfare if there is a marginal socialbenefit to production of a good that is not captured by
producer surplus measures.
National Welfare Arguments
Against Free Trade II
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Slide 9-22
National Welfare Arguments
Against Free Trade II
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Slide 9-23
The domestic market failure argument against freetrade is a particular case of the theory of the second
best.
The theory of the second best states that a hands-offpolicy is desirable in any one market only if all other
markets are working properly.
If one market fails to work properly, a government intervention
may actually increase welfare.
National Welfare Arguments
Against Free Trade
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Slide 9-24
How Convincing Is the Market Failure Argument?
Domestic distortions should be corrected withdomestic (as opposed to international trade) policies.
Example: A domestic production subsidy is superior toa tariff in dealing with a production-related market
failure.
Market failures are hard to diagnose and measure.
Example: A tariff to protect urban industrial sectors willgenerate social benefits, but it will also encourage
migration to these sectors that will result in higher
unemployment.
National Welfare Arguments
Against Free Trade II
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Slide 9-25
While economists may talk about national welfare or
total surplus, in a democracy, trade policy is
influenced by the difference in political power
between those who lose from free trade and thosewho gain.
There are two main theories in political science about
how governments make decisions:
Median voter theorem Collective action theory
Real World Trade Policy
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Slide 9-26
The Median Voter Theory
There are two competing political parties.
Each party has to decide on the level of the tariff
imposed.Voters differ in the tariff they prefer.
What policies will the two parties promise to follow?Both parties will support the tariff policy that the
median voter (the voter who is exactly halfway up thelineup) prefers.
Real World Trade Policy
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Slide 9-27
Median Voter Theorem Fails
The median voter theorem cannot explain the
widespread use of tariffs
Those who benefit from a tariff are usually few in
number compared to those who are hurt by the tariff.Therefore,
Had the median voter theorem been correct, tariffs
would rarely have been enacted
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Slide 9-28
Voters
Preferred tariff rate
Median
voter
tM
tB
tA
Political support
Income Distribution
and Trade Policy
Figure 9-4: Political Competition
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Slide 9-29
Collective Action
This approach views political activity as a publicgood.
For instance, if one consumers letter to a politicianhelps to stop a tariff, allconsumers would benefit.
This encouragesfree riding. Consequently,
Trade policies that impose large total losses that are
spread among many individual consumers may notface opposition.
Industries that are well organized (or have a small
number of firms) will get protection.
Real World Trade Policy
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Slide 9-30
Sugar import quota, 1990
The U.S. quota on sugar imports
Limits imports to 2.13 million tons, which is half ofwhat it would be under free trade
Keeps the U.S. price at $466 per ton, compared to$280 per ton in world markets
Consumers lose $1.646 billion
Producers gain $1.066 billion
Net loss to the U.S. is $580 million per year
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Slide 9-31
Sugar import quota, 1990
The loss per consumer is $6 per year. This is about $25 per
family.
As the U.S. sugar industry employs about 12,000 workers, the
gains per employee is $90,000 per year. No wonder, the producers are politically organized and the
consumers dont bother!
The final insult: without the quota, between 2000 and 3000
workers would have had to look for jobs elsewhere.
Thus, the cost to the consumer per job saved in the sugar
industry is more than $500,000 per year.
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Slide 9-32
Modeling the Political Process
Interest groups buy policies by offeringcontributions contingent on the policies followed by
the government.
Income Distribution
and Trade Policy
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Slide 9-33
Who Gets Protected?
Two sectors seem to get protected in advancedcountries:
Agriculture Farmers are well organized and the structure of the U.S.
government enhances their political power.
Clothing
Both textiles and apparel have enjoyed substantial protection.This sector employs less skilled workers and it is unionized as
well.
Protection is very likely to diminish in the future inboth sectors (due to international trade negotiations).
Income Distribution
and Trade Policy
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Copyright 2009 Pearson Addison-Wesley. All rights
reserved.
9-34
Table 9-2: Welfare Costs of U.S.
Protection ($ billion)
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Slide 9-35
Effects of trade barriers
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Slide 9-36
International Negotiations
and Trade Policy
Globalization has increased from the mid-1930s
partly because the United States and other advanced
countries gradually removed tariffs and non-tariff
barriers to trade.
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Slide 9-37
International Negotiations
and Trade Policy
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Slide 9-38
GATT and WTO
The removal of trade barriers was facilitated by
institutionalized negotiations among countries
TheGeneral Agreement of Tariffs and Trade was
begun in 1947 as a provisional international
agreement
It was replaced by a more formal international
institution called the World Trade Organization in1995.
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Slide 9-39
International negotiations
Why was it necessary to engage in international
negotiations to get trade barriers reduced?
Why didnt the advanced countries reduce their trade
barriers unilaterally?
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Slide 9-40
The Advantages of International Negotiation
It is easier to lower tariffs as part of a mutualagreement than to do so as a unilateral policy
because:It helps mobilize exporters to support freer trade and
speak up against the import-competing industries
who oppose imports.
It can help governments avoid getting caught indestructive trade wars. (Next two slides.)
It reduces the possibility of an adverse terms-of-trade
effect from a unilateral reduction of tariffs.
International Negotiations
and Trade Policy
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Slide 9-41
International Negotiations
and Trade Policy
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Slide 9-42
In Table 9-4, each country would choose protection.
Even though each country acting individually would
be better off with protection, they would both be
better off if both chose free trade. In game theory, this situation is known as a Prisoners
dilemma.
Japan and the U.S. can establish a binding agreement
to maintain free trade and thereby escape the
prisoners dilemma.
International Negotiations
and Trade Policy
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Bilateral versus Multilateral
Smoot-Hawley tariffs in 1930
Widely recognized to be a mistake that worsened the
Great Depression
But unilateral tariff reduction was politically difficult
Initially bilateral tariff-reducing agreements were
pursued
Later multilateral agreements became popular
Why?
Slide 9-43
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Slide 9-44
Bilateral Trade Liberalization
Suppose the USA and Brazil currently imposetariffs on each others goods and cannotunilaterally remove the tariffs because of thepolitical power of US coffee growers andBrazilian wheat farmers
When bilateralnegotiations begin, the US coffeegrowers (or, Brazilian wheat farmers) resistanceto free trade would be opposed by US wheatfarmers (or, Brazilian coffee growers) eyeing apossible reduction of Brazils (or, the USs) tariffson US wheat (or, Brazilian coffee).
In this way, bilateral negotiations to reduce tariffscan succeed even when unilateral efforts fail.
USA
Brazil
Wheat Coffee
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Slide 9-45
Multilateral Trade Liberalization
In this example, bilateralnegotiations between, say, Angolaand Brazil will not succeed inreducing tariffs.
As Brazil does not export coffee toAngola, there will be no oppositionto Brazilian oil producers demandsfor a tariff on Angolan oil.
However, a multilateral agreement
will be successful. In each country,exporters will organize to opposeimporters resistance to themultilateral agreement.
Angola Brazil
China
Oil
CoffeeWheat
I i l N i i
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Slide 9-46
International Trade Agreements: A Brief History
Internationally coordinated tariff reduction as a tradepolicy dates back to the 1930s (the Smoot-HawleyAct).
The multilateral tariff reductions since World War IIhave taken place under the GeneralAgreement onTariffs and Trade (GATT), established in 1947 andlocated in Geneva.
It is now called the World Trade Organization(WTO).
The GATT-WTO system is a legal organization thatembodies a set of rules of conduct for international trade
policy.
International Negotiations
and Trade Policy
I i l N i i
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Slide 9-47
The GATT-WTO system prohibits the imposition of:
Export Subsidiesexcept for agricultural products
New Import quotasexcept when imports threaten market disruption
New or Higher Tariffsany new tariff or increase in a tariff must be offset by
reductions in other tariffs to compensate the affected
exporting countries
This is called binding of tariffs
International Negotiations
and Trade Policy
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9-48
World Trade Organization
The WTO negotiations addresses trade restrictions
in at least 3 ways:
1. Reduction of tariff rates through multilateralnegotiations.
2. Binding: a tariff is bound by having the imposingcountry agree not to raise it in the future.
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9-49
World Trade Organization (cont.)
3. Prevention of non-tariff barriers: quotas andexport subsidies are changed to tariffs because the
costs of tariff protection are more apparent.
Subsidies for agricultural exports are an exception.
Exceptions are also allowed for market disruptionscaused by a surge in imports.
I t ti l N ti ti
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Slide 9-50
Trade round
A large group of countries get together to negotiate a set of tariffreductions and other measures to liberalize trade.
Eight trade rounds have occurred since 1947:
The first five of these took the form of parallel bilateralnegotiations (e.g., Germany with France and Italy).
The sixth multilateral trade agreement, known as the KennedyRound, was completed in 1967:
This agreement involved an across-the-board 50% reduction intariffs by the major industrial countries, except for specified
industries whose tariffs were left unchanged.
Overall, the Kennedy Round reduced average tariffs by about 35%.
International Negotiations
and Trade Policy
I t ti l N ti ti
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Slide 9-51
The so-called Tokyo round of trade negotiations
(completed in 1979) resulted in:
Reduced tariffs
New codes for controlling the proliferation of non-tariff barriers, such as VERs (or, voluntary export
restrictions).
An eighth round of negotiations, the so-called
Uruguay Round, was competed in 1994.
International Negotiations
and Trade Policy
I t ti l N ti ti
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Slide 9-52
The Uruguay Round
Its most important results are: Trade liberalization
Administrative reforms
Trade Liberalization The average tariff imposed by advanced countries decreased by
almost 40%.
More important is the move to liberalize trade in two important
sectors: agricultural and clothing. From the GATT to the WTO
Much of the publicity surrounding the Uruguay Round focusedon its creation of the WTO.
International Negotiations
and Trade Policy
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Trade liberalization, Uruguay round
Advanced country tariffs reduced by 40%
Agricultural subsidies by exporters reduced by 36%
Volume of subsidized exports reduced by 21%
Agricultural import quotas replaced by bound tariffs
MFA phased out in 2005
All quantitative restrictions gone
Some tariffs remain Government procurement brought under fairer rules
Slide 9-53
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9-54
World Trade Organization
The World Trade Organization 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 inservices (ex., insurance, consulting, legal services,
banking).
Agreement on Trade-Related Aspects of IntellectualProperty: covers international property rights (ex., patents
and copyrights).
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9-55
World Trade Organization
The dispute settlement procedure: a formal procedurewhere 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 theprocedure is not supposed to last more than 15 months.
The panel uses previous agreements by member countriesto decide which ones are breaking their agreements.
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9-56
World Trade Organization
A country that refuses to adhere to the panels decisionmay be punished by allowing other countries to impose
trade restrictions on its exports.
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9-57
World Trade Organization
The GATT/WTO multilateral negotiations, ratified in
1994 (called the Uruguay Round),
agreed that all quantitative restrictions (ex., quotas) on
trade in textiles and clothing as previously specified in theMulti-Fiber Agreement were to be eliminated by 2005.
But as the restrictions were eliminated, China had to
reimpose quotas until 2011 due to political pressure.
International Negotiations
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Slide 9-58
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 theWTO included rules on trade in services (the General
Agreement on Trade in Services (GATS)) and on
international application of international property rights.
The WTO has a new dispute settlement procedure
which is designed to reach judgments in a much shorter
time.
International Negotiations
and Trade Policy
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Slide 9-59
WTO: US v. Venezuela
US laws allowed domestic oil refineries to sell oil with more
pollutants than imported oil
Venezuela, which exports oil to the US, sued the US at the
WTO
Venezuela won. The US had to change its laws to make them
non-discriminatory
This episode showed that the WTO worked
Environmentalists complained that the WTO made it harder
for the US to reduce pollution
Actually, the fault lies with the US law. The WTO should not
be blamed
International Negotiations
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Slide 9-60
Benefits and Costs
The economic impact of the Uruguay Round isdifficult to estimate.
However, estimates of the GATT and of theOrganization for Economic Cooperation andDevelopment suggest a gain to the world economy as awhole of more than $200 billion annually once theagreement is fully in force.
Most economists believe that these estimates are too low.
The costs of the Uruguay Round will be felt by well-organized groups, while much of the benefit will accrueto diffuse populations.
International Negotiations
and Trade Policy
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9-61
WTO Doha Round
In 2001, a new round of negotiations was started in
Doha, Qatar, but these negotiations have failed to
produce an agreement.
Most of the remaining forms of protection are inagriculture, textiles and clothingindustries that are
politically active (see Collective Action above).
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9-62
Table 9-4: Percentage Distribution of
Potential Gains from Free Trade
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9-63
Do Agricultural Subsidies in Rich Countries
Hurt Poor Countries?
We learned in chapter 8 that subsidies lower the worldprice ofproducts because domestic producers are enticed to producemore. So why should poor countries want rich countries to remove their
agricultural subsidies? The likely answer has to do with the desires of farmers in poorcountries who compete with farmers in rich countries.
Yet, urban residents and farmers who do not compete (ex., coffeefarmers) actually benefit from the lower prices of subsidized food onworld markets.
For example, because China imports a lot of food, it would be hurt by theremoval of agricultural subsidies in rich countries (ex., the U.S. andEurope) according to the Doha negotiations.
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9-64
Table 9-5: Percentage Gains in
Income under Two Doha Scenarios
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Slide 9-65
WTO Doha Round
Main sticking point: agriculture subsidies
Rich countries want to protect their farmers
Poor countries want free market access for their
farmers
Countries seem to have given up on WTO
negotiations
Preferential trade agreements seem popular
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Slide 9-66
Nations establish preferential trading
agreements under which they lower tariffs with
respect to each other but not the rest of the world.
The GATT-WTO, through the principle of non-discrimination called the most favored nation
(MFN) principle, prohibits such agreements.
The formation of preferential trading agreements isallowed if they lead to free trade between theagreeing countries.
Preferential Trading Agreements
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Slide 9-67
Free trade can be established among several WTOmembers as follows:
A free trade area allows free-trade among members,but each member can have its own trade policy
towards non-member countries. Example: The North American Free Trade Agreement
(NAFTA) creates a free trade area.
A customs union allows free trade among membersand requires a common external trade policy towards
non-member countries. Example: The European Union (EU) is a full customs
union.
A common market is a customs union with freefactor movements (especially labor) among members.
Preferential Trading Agreements
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Slide 9-68
Are preferential trading agreements good?
It depends on whether it leads to trade creation ortrade diversion.
Trade creation Occurs when the formation of a preferential trading
agreement leads to replacement of high-cost domestic
production by low-cost imports from other members.
Trade diversion
Occurs when the formation of a preferential trading
agreement leads to the replacement of low-cost imports
from non members with higher-cost imports from member
nations.
Preferential Trading Agreements
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Slide 9-69
Summary
There are three arguments in favor of free trade:
The efficiency gains from free trade
The additional gains from economies of scale
The political argument There are two arguments for deviating from free
trade:
The terms of trade argument for a tariff
The domestic market failures
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Slide 9-70
Summary
In practice, trade policy is dominated by considerations
of income distribution.
Political parties adopt policies that serve the interests of
the median voter. Groups that are well organized (or small groups) are often
able to get policies that serve their interests at the expense
of the majority.
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Slide 9-71
Summary
International negotiation helps reduce tariffs inindustrial countries and avoid trade wars.
The GATT is the central institution of the international
trading system. The most recent worldwide GATT agreement also setsup a new organization, the WTO.
Three kinds of preferential trading agreements areallowed under the WTO: free trade areas, customsunions, and common markets.
Preferential trading agreements can be good or baddepending on the magnitude of trade creation and tradediversion effects.
Appendix: Proving that the
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Slide 9-72
Home import demand
Foreign export supply
PF
Price, P
Quantity, Q
P
~
PW
t
Appendix: Proving that the
Optimum Tariff is Positive
Figure 9A-1: Effects of a Tariff on Prices
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