Political Economcy of Protectionism

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The Political Economy of Protectionism

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PRINTED FROM OXFORD SCHOLARSHIP ONLINE (www.oxfordscholarship.com). (c) Copyright Oxford University Press, 2014.All Rights Reserved. Under the terms of the licence agreement, an individual user may print out a PDF of a single chapter of amonograph in OSO for personal use (for details see http://www.oxfordscholarship.com/page/privacy-policy ). Subscriber: ColumbiaUniversity; date: 12 May 2014

University Press Scholarship Online

Oxford Scholarship Online

Handbook of Trade Policy for DevelopmentArvid Lukauskas, Robert M. Stern, and Gianni Zanini

Print publication date: 2013

Print ISBN-13: 9780199680405

Published to Oxford Scholarship Online: January 2014

DOI: 10.1093/acprof:oso/9780199680405.001.0001


Arvid Lukauskas

DOI:10.1093/acprof:oso/9780199680405.003.0008

Abstract and Keywords

Arvid Lukauskas explores the political underpinnings of protectionism and trade

liberalization. Lukauskas argues that political factors fundamentally influence commercial

policy design and implementation, including the decisions to impose or remove barriers

to trade such as tariffs, quotas, and non-tariff barr iers. Trade liberalization is most likely

to occur when protected industries themselves no longer desire trade barriers or

politicians determine that the political costs of protectionism have increased. Deepening

globalization has increased the costs of maintaining highly protected markets, giving

public officials an incentive to undertake trade reform. To be successful, liberalization

must be accompanied by complementary reforms in other economic policy areas,

particularly those concerning factor markets. Lukauskas also shows that the international

political and economic context in which trade takes place is critical for understanding

trade policy as it generates a powerful set of constraints and incentives that policymakers

must consider when formulating strategy.


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Keywords: Protectionism, trade, political economy, trade liberalization, complementary reforms,

globalization, tariffs, non-tariff barriers, quotas, reform

I. IntroductionDo governments formulate trade policies solely on the basis of economic rationality? The

evidence indicates overwhelmingly that they do not. Though public officials usually claimthat their commercial policies are designed to advance the national interest, a closer

examination reveals that they often favor select narrow groups at the expense of

aggregate social welfare. In many countries, politics intrudes into trade policymaking in

profound ways, and the resultant policies are often characterized more by political than

economic efficiency. This chapter explores various dimensions of the political economy of

trade policymaking, illuminating how political factors fundamentally influence commercial

policy design and implementation, including the decisions to impose or remove barriers

to trade such as tariffs, quotas, and non-tariff barriers.

I begin by examining the numerous economic rationales proffered for implementingprotectionist measures. Are these rationales a sound basis for erecting import barriers?

If so, then we might reasonably expect our analysis of trade policy to remain firmly in the

realm of economics. Policymakers might occasionally deviate from a trade policy that

promotes the national interest, but by and large they are seeking to obtain legitimate

economic goals using appropriate tools when they impose trade barriers. Unfortunately,

it appears that import barriers are usually a second-best solution to the problems that

policymakers claim to be remedying. Moreover, the rationales offered often seem like an

excuse for politicians to implement policies that are primarily intended to benefit a narrow

set of constituents or themselves.

The next section explores the politics of protectionism. It relies on the premise that

protectionism hurts some groups but benefits others, so some private actors have a

vested interest in securing or retaining trade barriers. Trade policy analysis frequently

focuses on this demand side of protectionism, that is, the pressure that social actors

apply on public officials to regulate trade. The supply side of trade policy, that is, the

(p.224) complex balancing act among competing interests that public officials must

undertake in designing strategy, is equally important though often overlooked.

I then analyze the international political and economic context in which trade takes place.

The structure of the trade game generates a powerful set of constraints and incentivesthat policymakers must also consider when formulating trade strategy. States have ample

reason to be cautious in removing trade barriers, so much so that widespread

protectionism has characterized economic relations among states and liberal trading

orders have only flourished in two historical periods.

Over the course of the last 50 years, many countries, starting in the developed world,

have slowly dismantled their import barriers and adopted relatively free trade policies.

The final section examines the factors that have led policymakers to liberalize trade as well

as implement the complementary reforms needed to achieve success. While political

economists generally agree why public officials impose protectionism, they are more


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divided on why they seek to liberalize trade.

II. Rationales for ProtectionismThis section analyzes the most important arguments advanced for protecting domestic

markets. Are any of these valid reasons for imposing import barriers? If so, then we

might think of policymakers as seeking legitimate social goals through the best availablecommercial policy instruments. If, on the other hand, policymakers routinely design trade

policy that hurts the public interest, we will be forced to consider other explanations for

why public officials so often implement protectionism.

The arguments for protectionism are divided into two groups.Domestic rationalesfocus

on the desired effects of protection on attaining various objectives within the home

country. These objectives may be economic, such as addressing domestic market

failures, or non-economic, such as promoting national security.International rationales

concern government efforts to use trade barriers to affect the countrys economic

relations with other nations. Naturally, some arguments for protection straddle thisdomestic/international divide, so the categories should not be viewed too rigidly.

Moreover, this is not an exhaustive list of rationales, though other common motives for

protection resemble the ones examined here.

Domestic Rationales

Infant Industry

The infant industry argument is one of the oldest and most frequently cited rationales for

protectionism, dating back at least to the late eighteenth century and the writings of

Frederick List and Alexander Hamilton. If government officials believe a domestic

industry lies within the countrys long run comparative advantage, they may choose to

(p.225) protect it temporarily to give domestic firms time to catch up to more

competitive foreign firms.1Firms will presumably develop in a sheltered domestic market

until they are able to lower their production costs to the level of their rivals and become

ready to compete in international markets.2Alternatively, the infant industry argument is

sometimes applied to situations in which protection prevents an otherwise viable

domestic industry from going bankrupt due to an exogenous shock, such as a

productivity increase that allows a foreign firm to lower its costs with respect to its rivals.

Temporary protection permits an increase in output and reduction in future costs

sufficient to allow the domestic firm to survive. In either case, once the industry hasachieved long-run comparative advantage or adjusted to a shock, the government should

lift import barriers and allow domestic and foreign firms to compete on an equal footing.

To be successful the supply curve of the targeted industry should shift out

endogenously due to innovation or other improvements in productivity (e.g., learning by

doing effects). Figure 8.1 illustrates this point. The increase in production from QOto QTshould be due to more efficient operations (supply curve shifts out to S*) that permit the

domestic firm to produce QTat world prices (PW); it should not be due solely to the

incentive to produce QT created by the rise in prices to PT(world price plus tariff).


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Figure 8.1 Infant industry effect on supply

(p.226) The infant industry argument assumes that some sort of market failure ordistortion prevents the industry from developing without government assistance. If an

industry has a long-run comparative advantage, one would expect efficient capital

markets to be willing to lend to firms until they develop sufficiently to become profitable.

Capital market failures, however, may mean that firms need to earn profits in each

reporting period to avoid bankruptcy, because financial entities do not lend to firms to

cover current losses against the expectation of future profits. Alternatively, if the

industry generates positive externalities for the rest of the economy (e.g., technological

spillovers) for which it is not fully compensated, the industry might be insufficiently

funded in the absence of government assistance. In both instances, however, import

protection is a second-best policy for assisting the industry. From an efficiencystandpoint, the optimal policy would be to provide firms with a subsidy on output, since

this would allow firms to realize their long-run comparative advantage or enable society

to capture positive externalities without provoking the consumption costs of a tariff or

quota.3In the next section, we examine these costs in detail.

Most developed countries have applied the infant industry argument during their early

stages of economic development, suggesting that despite its efficiency costs, the policy

played a key role in their modernization. During the nineteenth century, for instance, the

United States protected nascent industries like textiles from stiff British competition

behind high tariffs walls. In the post-World War II period, many developing countriesadopted the infant industry argument through a strategy of import substitution

industrialization. This strategy was based on the belief that developing countries could

and should develop their own industries in key sectors behind protectionist walls to avoid

reliance on imports. The features of import substitution industrialization and its mixed

record of success are discussed in the appendix at the end of the chapter.

The proper economic criterion for assessing the ultimate success of an infant industry

policy is not whether the protected industry is able to increase its production, become

profitable, or compete effectively in international markets. Instead, it is whether the

present discounted value of the benefits generated by protecting the industry


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(principally, its future profits, adjusted for inflation) exceed the consumption and

production costs generated by protectionism. This criterion, called the MillBastable test,

is generally difficult to meet. Costs occur from the start and are likely to be quite high;

benefits, on the other hand, will appear only in the future. Consequently, the revenue

stream, properly discounted for inflation, will have to be considerable to offset the

immediate costs of the policy.

In fact, the infant industry strategy has generally not fared well in practice. In many

instances, protected firms, enjoying guaranteed profits and believing that the

government will be reluctant to remove import barriers (since it fears the loss of jobs

and (p.227) output that might arise), have little incentive to improve their productivity.

Therefore, several years after the implementation of import barriers firms are often no

closer to competing internationally than they were at the start. More importantly, as the

industry becomes established, its political power and ability to resist policy changes it

does not like grows, a point we turn to later. More successful use of an infant industry

policy, such as in East Asia, has hinged upon the governments ability to push firms to

meet performance targets, especially in the area of exports.4

National Defense and Security

Protecting industries that produce goods critical for national defense or to confront

national emergencies is a popular rationale for imposing import barriers, particularly in

developed countries. The reasoning is that the country must be able to generate its own

supply of such goods to prevent being cut off at critical times, such as in the event of war.

A related argument is to restrict the export of goods that might aid potential adversaries

in improving their military capability. The United States in conjunction with its allies, for

example, set up CoCom in 1949 to limit or prohibit the export of sensitive goods to

Eastern Bloc countries. Some policymakers in the United States wished to push this policy

a step further by restricting the export of any good that might aid in the economic

development of rival countries.5

Governments, especially in developing countries, also cite national security concerns or

the need to safeguard political independence as a motive for protecting strategic

sectors, such as finance, communications, energy, and food, from import competition or

foreign direct investment. National leaders fear that foreign producers may come to

dominate these sectors and make decisions based on calculations of short-term profit, not

on what is in the best long-term national interest. In the ongoing Doha Round

negotiations, food security has emerged as an important issue in talks aimed at

liberalizing agricultural trade. Some developing countries have contended that if they

open their markets fully, domestic agriculture may be decimated by foreign competition,

and domestic production of key foodstuffs will diminish to dangerous levels. In the event

of external shocks that reduce the global supply of foodstuffs, the countrys populace

may be left without adequate provisions of food, contributing to starvation or

malnourishment.

The national defense argument is easily abused. Many industries are likely to deem

themselves as essential to national defense and will demand protection. In addition, this


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argument ignores the possibility that critical goods can be stored in advance or be

purchased from friendly countries in the event of hostilities or another emergency.

Governments can also subsidize production of critical goods that are deemed (p.228)

to be at risk of shortfalls to ensure sufficient supply and maintain productive capacity.

Moreover, evidence is scarce that foreign firms make decisions that are more

detrimental to the national interest in so-called strategic sectors. Foreign owned banks,

for example, have a better track record than domestic banks in most developing

countries and often improve financial efficiency and stability.

Government Revenue

Governments may implement tariffs (or export taxes) to raise revenue to finance

spending. Tariffs are attractive in countries that find it difficult, for administrative or

political reasons, to raise revenue through other means of taxation, such as income,

value-added, or sales taxes, since collecting duties on foreign goods is relatively easy and

straightforward. Nonetheless, governments face a limit on how much revenue they can

obtain in this fashion: high tariff levels suppress imports and prohibitive tariffs generate

no revenue at all. Historically, tariff duties have been an important source of revenue in

many countries, including most advanced industrial countries, well into the twentieth

century. They remain a highly significant revenue source for many developing (but not

developed) countries today; for instance, in 1995, trade tax revenue as a percentage of

GDP in non-OECD countries was 4.3 per cent.6

As tariffs generate consumption and production dead-weight costs, they are not the best

means of raising revenue, especially when the governments financing needs are large, as

is the case for the majority of contemporary states. Broad-based taxes, such as income,

value added, or sales taxes, are less distortionary, enabling governments to raise

significant amounts of revenue without generating excessive dead-weight losses. As a

result, most governments rely less on tariff revenue as their financing needs become

greater and they develop the administrative capacity to implement more efficient forms of

direct taxation.

Income Redistribution

Trade barriers affect the distribution of income, so protection might be advocated on the

grounds that it favors disadvantaged social groups and thereby promotes greater

income equality. The validity of this argument depends in part on the theoretical trademodel used. In the HeckscherOhlin model, per the StolperSamuelson theorem,

protectionism increases the income of the relatively scarce factor of production and

reduces that of the abundant factor. If labor is the scarce factor, for instance, trade

barriers will increase the income of workers relative to that of holders of capital; since

factors of production are assumed to be perfectly mobile, this process will happen

quickly.7Nonetheless, trade (p.229) barriers generate dead-weight losses, so any

redistribution that occurs takes place at the expense of social welfare.

In the RicardoViner model, on the other hand, the ability to use commercial policy to

effect redistribution across factors of production is limited. This model posits that factors


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of production are specific to a particular industry in the short (and perhaps medium) run

and, thus, have little mobility across activities. In the short run, both the scarce and

abundant factors of production in the protected industry will benefit at the expense of

those in the unprotected sectors; only in the long run may the scarce factor of

production in both industries become relatively better off.

In either model, therefore, commercial policy is at most a second-best instrument for

achieving redistributive goals. Superior policies to influence income redistribution are a

lump sum transfer to disadvantaged groups or a tax policy that discriminates in their

favor since these are more accurate and have short-run effects. In addition, though

these measures may create distortions of their own, they do not cause consumption and

production losses that lower aggregate national income to the extent that protectionist

barriers do.

Protection of Jobs

The desire to protect jobs is a strong motive for protection in many developed countries.

Domestic firms confronting increased imports typically have to decrease their costs

and/or level of production, and workers may lose their jobs as a result (unless wages are

able to adjust downwards). If imports are from countries where wages are lower,

demands for import barriers will intensify since domestic workers will claim that they

cannot compete against foreign workers earning less. The use of import barriers to

protect jobs is most likely in countries where state-owned industrial firms are large

employers and labor unions are strong.

The loss of jobs due to import competition certainly imposes costs, such as relocating or

retraining workers. Compensating workers who become unemployed through a lump-

sum payment or public employment training is a far better means of managing the

disruptive effects of trade. These policies do not generate the consumption or production

costs associated with trade barriers and do not hinder the ability of trade to create new

jobs throughout the economy, which are often more numerous than those lost to trade

competition.8In fact, empirical estimates of the cost of saving jobs by imposing protection

indicate that it is a very costly proposition. For example, Hufbauer, Berliner, and Elliot

(1986) found that consumer losses due to protectionism per job saved in the United

States were over $100,000 in more than half of the sectors that they examined and

reached $1,000,000 in the case of specialty steel. Finally, the contention that firms paying

workers higher wages cannot compete effectively against firms paying less for the

(p.230) same work is fallacious. If the difference in worker productivity is greater than

the difference in wages, than higher paid workers are actually more competitive.9

International Rationales

Terms of Trade

The terms of trade argument applies when a country is such a large consumer or

supplier of a good that it has the ability to affect world prices through the imposition of a

tariff or export tax, respectively, and, thereby, improve its terms of trade (that is, offer

fewer exports for the same amount of imports). In principle, a country can calculate the


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level of tariff or export taxthe optimum tariffthat would maximize the terms of trade

benefit from restricting trade. The optimum tariff reduces the volume of trade, creating

both consumption and production dead-weight losses for the country but, under certain

circumstances, the terms of trade benefit can outweigh these losses.

The terms of trade argument applies to very few situations, since countries rarely

possess the market power to alter world prices; even if they do, this power will be limited

to a small number of goods. For a small developing country, the optimal tariff is typically

zero. The only exception might be where a country has a near monopoly in the

production of an essential primary product. In this case, an export tax could improve the

countrys terms of trade allowing it to obtain more imports for the same amount of

exported good. In principle, a group of countries producing the same commodity could

act as a cartel to limit its production, which would have the same effect as imposing an

export tax. But such collusion is extremely hard to achieve in practice and we can point to

perhaps only one successful case in the 1970s: the Organization of Petroleum Exporting

Countries (OPEC), which limited the supply of oil driving up its price.

Calculating the optimum tariff in a world of constantly changing market conditions is no

easy task and failure to apply the correct level of tariff or export tax will likely cause more

harm than good. Moreover, applying a tariff to improve ones terms of trade may

provoke retaliation on the part of other countries, potentially leading to a trade war. In

the event of retaliation, the country imposing an optimal tariff is likely to be worse off than

in a situation of free trade.

Balance of Payments

In recent years, demands for protection in order to improve a countrys balance of

payments have become commonplace, especially in the United States where record trade

(p.231) deficits have been recorded repeatedly, especially with respect to China. Trade

barriers are intended to eliminate balance of payments deficits by suppressing imports.

Commercial policy is, however, an ineffective means of addressing trade deficits. Import

barriers are at best slow-acting policy instruments, as the volume of imports does not

usually drop immediately in response to higher prices. Once in place, trade barriers are

difficult to remove, even when the balance of payments concerns that engendered them

have eased. More importantly, while trade barriers reduce imports, they also cause

exports to decrease by a similar amount, generating no significant change in the net

balance of payments. Thus, deficits are best managed by other means, particularly,

through macroeconomic policy adjustments that balance savings and investment as well

as government spending and taxation.

Strategic Trade

The theoretical justification for engaging in a strategic trade policy when international

markets for a product are characterized by oligopoly and firms face decreasing average

costs has been analyzed in detail elsewhere in this volume. As Krugman (1984) has

shown, governments implementing a strategic trade policy can employ import barriers as

well as subsidies to target priority sectors for promotion. Although the theoretical case


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for strategic trade policy is plausible, its practical relevance in economic terms is limited,

and it would be difficult to implement because of informational problems. Moreover, the

risk that such a policy would fall victim to politics is high in most countries, so that

decisions about who receives government assistance become based more on political

rather than economic criteria. In addition, if rivals also implement a strategic trade policy

in retaliation, the prospects for welfare gains are poor.

III. The Political Economy Explanation for ProtectionismThe economic arguments advanced for imposing import barriers are often problematic.

Trade barriers are the first-best instruments when a country has monopoly power in

international markets and wants to improve its terms of trade, but they are not the best

for achieving domestic economic goals. Indeed, import barriers, even if they achieve their

objective, typically lower aggregate social welfare, imposing both consumption and

production losses, and hurt economic efficiency. If this is the case, why do governments

implement tariffs? Are there reasons for protectionism derived solely from the domestic

political context?

The political economy explanation for protectionism concentrates on the motives that

drive private groups to seek trade barriers and the political calculations that encourage

politicians to impose them. It takes as its starting point the distributional effects of

protectionist barriers. Tariffs, quotas, and non-tariff barriers create societal (p.232)

winners and losers who have a vested interest in seeking or opposing protectionist

barriers. Nonetheless, analysis that views commercial policy as simply reflecting the

demandsof dominant social groups or emerging from the struggle among competing

interest groups for influence will be incomplete; the factors that influence the supplyof

protection by politicians are equally important. Below, we look at three separate forms of

protectionismtariffs, quantitative restrictions, and non-tariff barriersto highlight

important though subtle differences in the political economy of each.

Tariffs

Distributional Consequences of Tariffs

Tariffs can take a variety of forms, but in all cases they are essentially a government duty

or tax on an imported good that raises its domestic price. For instance, an ad valorem

tariff of 50 per cent increases the price of an imported good with a world price of $100 to

$150 in the domestic market.

The price increase caused by a tariff has several distributional impacts that can be seen in

Figure 8.2.10The imposition of a tariff causes the price to increase from PWto PT, causing

imports to fall from (DW SW) to (DT ST) as the amount of the good supplied

domestically increases from SWto ST. The big losers from tariffs are consumers, who pay

more for the good; in addition, they may be limited to a smaller variety of goods or be

forced to settle for goods of inferior quality. In the diagram, the loss of consumer surplus

is equal to the area of A + B + C + D. The government obtains tariff revenue equivalent to

area B. Among private actors, domestic producers are the big beneficiaries from tariffs,

as their profits increase; indeed, tariffs may make it possible for domestic producers to


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expand their businesses or avoid bankruptcy. Consequently, the shareholders,

managers, and employees of import-competing firms will experience an increase in their

incomes. In the diagram, producer surplus increases by area A. Areas C and D represent

dead-weight losses. Since tariffs increase the domestic price of the good, some resources

currently used by non-protected industries will flow to the protected one, attracted by

the possibility of higher relative prices. This lowers economic output since scarce factors

of production are now being utilized by less efficient final users; that is, the social return

on capital and labor in these sectors will be lower.

Finally, tariffs hurt export industries though one cannot discern this point directly from

the figure. The domestic relative price of importable (and, most likely, non-tradable)

goods will increase relative to that of exportable goods (whose price (p.233)

Figure 8.2 Effects of a tariff

continues to be set in world markets); in effect, tariffs act like a tax on exportablegoods.11 This will draw resources away from export industries into protected ones,

increasing production of importables and lowering that of exportables. In addition, export

industries that use the protected good as an input into their production will see their

costs increase and, consequently, may lose competitiveness in international markets.

Finally, tariffs contribute to exchange rate appreciation by lowering the demand for

foreign currency; an appreciated exchange rate makes it more difficult for export

industries to compete in world markets (and contributes to the lower domestic price of

exportable goods).

Societal Demand for TariffsBased on the preceding analysis, producers of import-competing goods should seek

tariffs as they increase producer surplus; consumers, on the other hand, should oppose

them as they reduce consumer surplus.12It is not sufficient, however, to identify the

interests of various actors and assume they will be able to act upon them. One might

suppose, for instance, that politicians would resist pressure for protectionism because

the social losses from tariffs exceed their benefits, and the number of actors who benefit

(p.234) from tariffs is much smaller than those harmed. Yet, this is usually not the case.

Actors, such as consumers, may share a common objective yet be unable to organize

adequately to pursue it effectively. In the political economy literature, this is called the

dilemma of collective action. Thus, policy analysis requires examining how well groups are


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able to organize into effective lobby groups and overcome their collective action

problems. We also need to explain which groups government officials will choose to

respond to and why.

Historically, the identity of winners and losers from tariff policy has been strikingly similar

across nations and time: producer interests generally have won out over consumer

interests, and the producers of finished goods have enjoyed higher tariffs than those of

primary or intermediate goods.13The most persuasive explanation for this pattern,

based on the interest group approach, suggests that tariffs are implemented because

those who favor them are well organized and able to apply effective pressure on

policymakers while those hurt by tariffs are less well organized and unable to oppose

them. Producers tend to be small in number and relatively concentrated, more so in the

case of finished than intermediate goods. Their stake in protectionism is high and easy to

identify; in some instances, the imposition of a tariff may mean the difference between

bankruptcy and solvency for firm owners and, for workers, between having and losing a

job. Therefore, producers face small collective action problems in organizing and are

often willing to expend considerable amounts of money and time to lobby governments

on tariff policy. Moreover, their decision on which politicians to support will be

determined largely by candidates stances on tariff policy. Consumers of most goods, on

the other hand, are large in number and often not geographically or otherwise

concentrated; thus, their costs of organization are high. In addition, consumers are

typically poorly informed of the features and consequences of commercial policy.

Although the aggregate effect of a tariff on consumer welfare is large, an individuals stake

in whether it is imposed is relatively small. That is, a tariff will increase the cost of

consumption, but not affect welfare significantly unless the good is an important element

of the overall consumption bundle and the price increase is very large. Consequently,

consumers are unlikely to become effective lobbyists of government officials on tariff

policy. Furthermore, their voting decisions will probably be based on candidates

positions on public policy issues other than commercial policy.

A variety of factors may influence the intensity of social demands for protectionism. It is

well documented, for instance, that demands for protectionism increase when

macroeconomic conditions deteriorate (Cassing, McKeown, and Ochs, 1986). When the

economy is vibrant, import-competing industries tolerate competition from abroad

because they are earning solid profits. With economic distress, however, firm profitsdrop and become more uncertain. Under these conditions, domestic firms feel the

competition from foreign producers more keenly and will seek protection from imports.

During the mid 1970s and 1980s when the global economy struggled through a

prolonged period (p.235) of stagflation, levels of protectionism, especially in the form

of non-tariff barriers, jumped dramatically, leading to a slowdown in the growth of global

trade.

Endogenous Tariffs

Thus far, we have focused on the demand side for protection. But why do politicians

supply protectionism? Do they merely respond to lobbying from societal groups or do


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Grossman and Helpman suggest that the first approach is most useful for explaining the

broad contours of commercial policy (whether a country is protectionist or free trade),

whereas the second, which they employ, is best at explaining its specific characteristics

(particularly, which industries receive the most protection). The protection for sale model

has found empirical support in several studies of the United States (Goldberg and Maggi,

1999) and other countries (reviewed by Gawande and Krishna, 2003).

In the Grossman and Helpman model, a rational governing party sets levels of protection

to maximize the number of votes it can obtain. This means that it must maximize a

weighted sum of total contributions from producers, which it can use to sway voters, and

consumer welfare. The higher the tariff it supports, the greater the level of contributions

it can obtain from producer-lobbies. Nonetheless, the higher the tariff it imposes, the

greater the opposition it will face from general voters, who may decide to vote incumbent

politicians out of office if consumer welfare drops sufficiently. The opposition of general

voters arises because high tariffs result in obvious redistribution away from consumers

to producers, higher prices for items in their consumption bundle and, most generally,

greater inefficiency that will act as a drag on national economic performance.

This result can be shown graphically in Figure 8.3.15The votes gained through

contributions offered by those that desire tariffs are shown in curve OC (contribution

effect). The votes lost due to the disaffection of general voters because of the

consumption and production dead-weight losses generated by the tariff are shown by

curve OL (distortion effect). Politicians will choose a tariff that maximizes the

difference between votes gained (VG) because of the contribution effect and votes lost

due (p.237) to the distortion effect (VL); that is, they will choose a tariff T*that

generates V*. The countrys tariff schedule will reflect the politically optimal choice of a

tariff for each import-competing good.

Although scholars developed the endogenous tariff model based on the US political

context, it can be applied, with some caveats, to countries with different political

institutions. In other democracies, politicians have to calculate how their commercial

policies will affect their electoral support. But countries differ greatly in the extent to

which politicians rely on contributions and, thereby, the extent to which producers can

influence elected officials through this channel. Also, different electoral rules influence

politicians to place greater or less emphasis on appealing to narrow interest groups (such

as producers) or general voters in seeking electoral support (Lukauskas, 1997) affecting

the balance they strike between the two types of constituencies. The endogenous tariff

model may also useful for thinking about commercial policy in a non-democratic regime,

as politicians in authoritarian contexts must also weigh the political support they receive

from the general citizenry as opposed to producer interests; without votes to measure

support, however, it is difficult to formalize the political calculations involved using this

model.

Of course, government officials may also seek tariffs in order to enjoy the revenue they

yield, especially in countries where it is difficult to raise revenue through other less

distortionary forms of taxation. As already noted, tariffs have been an important source of


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government revenue in many countries. Imposing tariffs is an attractive means of raising

revenue because it permits politicians to lower the rate of direct taxation of firms and

households, which is administratively or politically difficult in many countries.

Why Not Subsidies?

Subsidies often accomplish the same purpose as a tariff but more efficiently; they are

usually the first-best instrument for domestic policy objectives as they produce fewer

distortions or dead-weight losses for the economy. For example, a government may

impose import barriers to promote an infant industry; alternatively, it can provide the

industry with a production subsidy sufficient to offset the cost advantage of foreign firms,

enabling consumers to continue to enjoy the good at world prices.16Although subsidies

are often a superior instrument, their use is far less frequent than that of import

barriers. Governments seeking to promote an infant industry or aid a struggling mature

industry typically opt for protectionism. One reason for this choice is that subsidies

require a direct and immediate expenditure by the government whereas a tariff

generates revenue for the state. The government might recoup much of the cost of the

subsidy through taxes collected on the industry (or other parts of the economy that

experience faster growth), but the immediate expenditure may be infeasible due to fiscal

or political constraints. In many developing countries, chronic fiscal deficits or the

(p.238) inability to use monetary instruments to finance subsidies limit their use.

Furthermore, raising the additional revenue needed for a subsidy may create

distortions in factor or product markets.

Second, the costs of a subsidy are explicit and the recipients are easy to identify. In

contrast, the costs of protectionism are far more difficult to quantify, and the ultimate

winners and losers from trade barriers (especially, quantitative restrictions and non-tariff

barriers) may be difficult to ascertain. Public officials (and the beneficiaries of commercial

policy) often prefer to conceal government support for specific producers in order to

prevent public resentment.

Finally, in some countries, singling out an industry or firm for a budget outlay (as

opposed to tariff protection) raises issues of fairness and may incite claims for

government subsidies from other industries. Rodrik (1986) argues that subsidies

generate more lobbying than tariffs because they are allocated to specific firms, giving

individual firms a strong incentive to pressure government officials. Tariffs, on the other

hand, provide protection for all firms in the industry regardless of individual lobbying

efforts, creating a free-r ider problem that reduces lobbying.

Quantitative Restrictions

Quotas and other quantitative restrictions (such as voluntary export restraints or

orderly marketing arrangements) have similar though not identical distributional

consequences as tariffs. The exact identity of the beneficiary of quotas will vary

depending on the particular instrument employed and the means by which quota rents

are allocated. In general, producers, whether domestic or foreign, benefit in the form of

higher profits, at the expense of consumers, who not only pay higher prices but also see


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the supply of the good in question diminish.

Figure 8.4 illustrates the effects of imposing a quota.17The diagram closely resembles

Figure 8.2, which examined the consequences of a tariff, and this highlights the basic

similarity in the impact of quotas and tariffs. At PW, imports equal DW SW. If the

government imposes a quota limiting imports to MQ(DQ SQ), the domestic price rises

to PQ. Consumer welfare declines due to the price increase and the corresponding loss

of consumer surplus equals A + B + C + D. Domestic producers enjoy an increase in

producer surplus equal to area A. As in the tariff case, quotas generate dead-weight

production and consumption losses indicated by B and D.

Area C corresponds to the rents generated by the quota. Those with access to the good

in international markets pay Pwfor the good, but are able to sell it domestically for PQ.

The identity of the beneficiary will vary considerably depending on the nature and

(p.239)

Figure 8.4 Effects of a quota

implementation of the quantitative restriction. The government can appropriate quota

rents by auctioning off import licenses to the highest bidder, thereby capturing most of C

(in which case, the quota has the same distributional effects as a tariff). Instead,

government officials may allocate the import licenses to private groups according to

various economic criteria, such as in proportion to previous imports or according to

demonstrated ability to process imports, and rents will accrue to the firms that receive

quota allotments. Alternatively, they may distribute them in direct exchange for political

support or bribes. In this way, quotas (or any policy instrument that creates scarcity ofhighly desirable goods) can become an important tool for the support or rent-maximizing

politician seeking to attain personal goals. If the quantitative restriction occurs in the form

of a voluntary export restraint (VER) agreement or orderly marketing arrangement, in

which foreign countries agree to limit their exports to the country, quota rents will

mainly accrue to foreign firms (or governments).18

The imposition of quotas is also prone to creating what Bhagwati (1982), building on the

seminal paper by Krueger (1974), first called directly unproductive rent seeking (DUP).

As import rights or licenses are valuable, private actors will expend considerable time

and resources lobbying government officials to obtain them. This lobbying results in


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income gains for the recipients of licenses (though not for non-recipients) but,

unfortunately, it contributes nothing to national economic output. Empirical estimates of

DUP costs have varied considerably. Early calculations assumed that competition for

import licenses and the like would be open and intense, contributing to high DUP

expenditures, potentially equivalent to the quota rents generated (area C in Figure 8.4).

Bhagwati and Srinavasan (1980), however, pointed out that well-connected actors are

likely to prevail in these competitions (what the authors call (p.240) the brother-in-law

theorem), deterring other actors from expending resources to seek these rents. In any

case, DUP costs are significant enough to be another reason to avoid policy instruments

like quantitative restrictions that artificially create scarcity of highly desired goods.

The problems with quantitative restrictions have led most trade economists to argue in

favor of replacing quantitative restrictions with equivalent tariffs. Even at the same level of

protectionism, tariffs impose fewer social costs (such as DUP) and governments capture

revenue as opposed to rents accruing to other groups. Tariffs are also more transparent

and fair. In practice, conversion of quantitative restrictions into tariffs has been a central

focus of the multilateral trade regime, such as recent efforts to replace quotas on

agricultural goods with tariffs.

Non-Tariff Barriers

The distributional consequences of non-tariff barriers (e.g., safety regulations, customs

procedures, government procurement practices, and domestic content rules) are similar

to those of tariffs and quotas, but the identity of winners and losers as well as their

general welfare effects are often more difficult to determine. Their impact on prices and

quantities imported (or exported) are more ambiguous and difficult to define a priori. Asnoted previously, the use of non-tariff barriers increased dramatically starting in the mid

1970s as governments sought to find ways to increase levels of protectionism during a

period of economic distress without violating their formal commitments to lower tariff

levels through the GATT.

Non-tariff barriers are attractive to governments and their beneficiaries for various

reasons. First, government officials can claim that the intent of a non-tariff barrier is not

protectionism, but rather advancing a legitimate public policy goal. For example, a

regulation requiring foreign goods to meet national safety standards could conceivably

address a real public safety concern but have the unintended consequence of reducingimports. Then again, the safety regulation may simply be a ruse to disguise protectionist

intent. Deciding whether the regulation is legitimate is often extremely difficult, as the

science involved may be controversial and countries may have widely different public

safety standards. For instance, in 1989, the European Union began prohibiting the import

of US beef products from cattle treated with hormones, claiming that the long-term health

consequences of consuming such beef products were unknown. The United States,

however, contended that no scientific evidence supported these claims and that the real

motivation of this safety regulation was to keep out US meat that is cheaper and of higher

quality than European beef.19


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(p.241) Second, since the effects of non-tariff barriers are often difficult to discern, the

government may be able to assist even large, unpopular firms without incurring the same

level of public resentment. Private groups that believe they will encounter opposition in

obtaining relief from foreign competition through tariffs may be able to obtain protection

through non-tariff barriers.

It seems likely that disputes surrounding the protectionist effects of various domestic

rules, regulations, and practices will remain salient. Since the end of the Uruguay Round,

the trade agenda has expanded from focusing primarily on at the border issues to

encompassing behind the border issues as well. There will be tremendous pressure on

governments, particularly in developing countries where standards often deviate more

from international norms, to harmonize a much broader range of national policies that

affect trade.

IV. International Political Economy of Trade

Policymakers design trade policy based not only on domestic economic and political

factors but also on what other states are doing or are expected to do. For instance, if its

trading partners have protectionist barriers in place, a country may not open its markets

to foreign goods and services even though the intellectual case for unilateral free trade is

very strong. Import-competing industries will point to closed foreign markets as further

justification for imposing barriers to trade at home; exporters may argue that the carrot

of opening domestic markets should be employed as a lever to pry open foreign markets.

Indeed, appeals for a level playing field or fair trade are an almost constant refrain in

discussions of national trade policy.

With the important exception of hegemonic states, to be discussed later, even a cursory

examination of the historical record indicates that states often demand some sort of

reciprocity, whether it be in the form of bilateral, regional, or multilateral agreements

(formal or informal) as a condition for removing their own trade barriers. The world has

only witnessed two sustained periods of open national markets and relatively free trade,

that is, during the late nineteenth century and the post-World War II era. Other historical

periods have been characterized by heavily protected markets and carefully managed

trade.

Why have states found it difficult to achieve free trade despite its demonstrable mutual

benefits? One reason is certainly the domestic politics of trade policy that was analyzed in

the previous section, in which policymakers impose protectionism to garner support from

key societal actors. Even in the absence of these domestic political obstacles, however,

states confront collective action problems as they decide whether to cooperate to achieve

mutually beneficial free trade. In making this choice, states act strategically, attempting to

ascertain how other actors are (p.242) likely to behave if they adopt one course of

action or the other. A powerful heuristic device for understanding situations in which

actors interact strategically is game theory. The prisoners dilemma (PD) game is

particularly useful in identifying the incentives that states face when they decide whether

to remove or maintain trade barriers.20


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Figure 8.5 depicts a simple PD trade game between two countries.21The countries must

decide whether to remove import barriers (e.g., by signing a bilateral treaty), thereby

establishing more open trading relations. Each country can cooperateby lowering

barriers or defectby maintaining them. If both countries defect, the status quo is

sustained and the payoff for each is zero [payoff 0, 0].22If both actors cooperate, they

each achieve gains from greater trade flows [5, 5]. If country A defects but country B

cooperates [8, 2], country A gains due to its greater volume of exports to country B

(plus economies of scale effects from higher levels of production), while still enjoying

protected home markets; on the other hand, country B loses due to higher import

competition from country A plus the costs incurred from shifting resources

Figure 8.5 Prisoners dilemma trade game

(p.243) to its export sector in anticipation of country As opening (but whose markets

actually remain closed). If country B defects while country A cooperates, the outcome is

reversed [2, 8] and country B gains at country As expense. Given this payoff structure,

the only rational course of action for each country is to defect, since no matter what

course of action the other chooses, defecting leaves it better off (if country B defects,

country A is better off defecting [02]; if country B cooperates, country A is again

better off defecting [85]). Thus, the two countries will defect leaving them with the status

quo, even though they would both benefit by cooperating and reaping the gains from

trade.

The PD game shows that it is not sufficient for countries to have an objective interest in

achieving a cooperative outcome, such as the removal of trade barriers; the structure of

their interaction may impede them from realizing a mutually advantageous result. In this

case, countries have both a defensive (avoiding the suckers payoff [2, 8]) and

offensive (exploiting rivals [8, 2]) motive for imposing trade barriers. Achieving more

open trade is even more difficult if the gains from trade are asymmetric. If country A

gains less in relative terms from trade (say the payoff to mutual cooperation is [2, 5]), it

might be reluctant to eliminate protectionism even though it gains absolutely, particularly

if country B is a strategic rival. Some international relations scholars, in fact, contend that


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states with security concerns accord more weight to the relative gains of trade than the

absolute gains (Grieco, 1990); they do not want to provide an economic edge that

another state may transform, through the ability to increase defense spending, for

example, into a military or strategic advantage.

So, how do states overcome the prisoners dilemma in the area of trade, especially in

situations involving many states with multiple issues and asymmetric payoffs? One answer

is that a single powerful state may be able to solve the collective action problem for all.

According to hegemonic stability theory, first advanced by Kindleberger (1973), the

existence of a hegemon (a single dominant state in the international system) is a necessary

condition for establishing a free trade regime; without a hegemon, the international

trading system will witness repeated defections by states that lead to its closure. At first

glance, the theory is consistent with the evidence: the two periods of robust free trade in

the modern era have coincided with the existence of hegemonic states. The United

States, as a hegemon, promoted a free trade order after World War II and Great Britain

did so in the second half of the nineteenth century.23In contrast, the lack of a hegemon

during the interwar period undermined the international trading system. The hegemon

provides an open trading order because it benefits sufficiently that it is willing to bear the

full cost of its provision. Focusing on the post-World War II case, the United States

sought a liberal (p.244) trading order because it had more competitive industries and

expected them to dominate world trade (and initially they did). The United States bore

most of the short-term costs of providing the new trading order. It opened its markets

unilaterally at first, took the lead in establishing international institutions such as the GATT,

and provided ample economic and military assistance to bolster the economies of other

Western countries.24Although other countries had an incentive to free ride on the liberal

order, by keeping their markets protected, they slowly removed barriers to trade as

they developed the capacity to compete effectively in global markets; the United States

also made further trade liberalization contingent upon reciprocity.

Although they recognize that a hegemonic state is helpful for establishing a free trade

regime, other scholars have contended that multilateral institutions, such as the General

Agreement on Tariffs and Trade (GATT) and its successor the World Trade Organization

(WTO), enable states to overcome the collective action problems that they face in

establishing open trade, even in the absence of a hegemon. Although a single-play PD will

lead to mutual defection always, in reality, many games are repeated indefinitely, greatlyincreasing the prospects for cooperation.25Multilateral institutions create a platform for

iterated play and address some of the problems that plague actors in the PD game. First,

they provide a forum for communication, allowing states to exchange information and

engage in consultation and negotiation on trade issues; having an established venue also

reduces the transaction costs that might otherwise make such exchanges too difficult.

Second, they aid states in setting standards for what constitutes cooperation and

defection in the area of trade policy, making it easier for states to monitor trading

partners and determine when cooperation has broken down. Early detection of bad

behavior on the part of other states will give policymakers greater confidence that they

can limit their losses from defection by other states. Third, multilateral institutions


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establish mechanisms for dispute settlement and enforcement. Disputes may be resolved

before they damage trade relations and violators can be sanctioned if they persist in

following proscribed trade policies. Better monitoring and enforcement are especially

important for small states that fear predatory behavior on the part of more powerful

states. Finally, multilateral institutions make it harder for states to backslide during bad

economic times, since rules specify when a country can renegotiate its trade

commitments (Barton, Goldstein, Josling, and Steinberg, 2006).

(p.245) V. Political Economy of Trade ReformOver the course of the last 50 years, starting in the developed world, many countries

have slowly adopted relatively free trade policies. The process of trade reform involves

more than just lowering the degree of protectionism; it also includes making import

barriers more transparent, less complex, and more uniform across sectors.26Eliminating

import barriers would seem to present a serious political challenge. Private groups

favoring protectionism are well organized and politically influential; their stake in

protectionism is high, so that they are likely to devote considerable resources to

maintaining the status quo. In addition, tariffs may generate significant government

revenue, and public officials often use the controls associated with non-tariff barriers or

quantitative restrictions to advance their own political interests. Private groups hurt by

protectionism, on the other hand, are typically poorly informed or organized; they are

likely to incur higher costs in seeking to abolish protectionism than those they suffer

because of protectionist barr iers. Finally, the gains from trade liberalization are typically

much smaller than the amount of redistribution it engenders.27Thus, politicians

embarking on trade reform will have to sell a policy that causes substantial shifts of

income among groups, shifts which are often politically unpopular, to achieve relatively

small improvements in national income. Given these political obstacles, where is the

impetus for reform likely to come from? Societal actors? State officials? External

pressures to liberalize?

If governments implement protectionism in response to societal demands, as

hypothesized above, then the impetus for trade liberalization might stem from protected

industries themselves when they no longer favor barriers to trade. Protected industries,

for instance, may come to view import barriers as detrimental to their interests. Milner

(1988) suggested that the growing interdependence among nations and the

internationalization of production has affected the preferences of firms with extensive

international linkages (especially, multinational firms engaged in significant intra-firm

trade). These firms once embraced protectionism, but now oppose it because it raises

their costs of doing business across national borders. The growing use of outsourcing as

a core business strategy will only add to the incentive for global firms to favor lower

levels of protectionism (at least for all products other than their own).

Private actors hurt by protectionism are another potential force behind trade

liberalization. Among those who are most likely to press for the removal of import

barriers are exporters, industrial import users, businesses providing trade-related

services, and retailers of imported products. Exporters, for instance, would benefit from


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the elimination of the bias that protectionism creates against exportable goods. In

addition, in an effort to gain access to foreign markets, they may press for the lowering of

domestic protectionist barriers since trade opening often occurs through reciprocal

(p.246) concessions. Nevertheless, these groups normally face collective action

problems in organizing to lobby the government to liberalize trade. Although their stake

is moderately high, they tend not to be very concentrated in either business or

geographical terms. Post-World War II multilateralism improved the ability of exporters

to influence trade policy. The nature of multilateral trade negotiations, in which countries

agreed to make tariff concessions on a variety of products in an exchange for better

foreign market access for its key goods, meant that it became harder for import-

competing groups to resist trade opening, as concessions were part of a broader,

multisector deal, and mobilized exporters by providing a greater stake and voice in trade

policy (Gilligan, 1997). For their part, consumers face almost insurmountable collective

action problems in opposing protectionism and are unlikely to be an organized force

behind liberalization.

Politicians will pursue trade liberalization when they determine that the political costs of

protectionism have increased or its benefits have declined. In Figure 8.3, this occurs

when the OL curve shifts up or the OC shifts down, lowering the politically optimal

level of tariffs (that is, T* moves toward the origin). The most likely cause for a decline in

the political utility of protectionism is weakening economic performance, which exposes

the social costs of protectionist policies. In the absence of an economic crisis, leaders

usually avoid major reform because demand for it is low and altering the status quo is

costly.28During a crisis, on the other hand, private groups favoring trade liberalization,

like exporters or heavy users of imported inputs, have a greater incentive to seek the

removal of import barriers. General voters may not express their dissatisfaction with

protectionism directly, but they will withdraw their support for incumbent politicians if

economic conditions deteriorate. Incumbents will worry that political entrepreneurs may

be able to use poor economic conditions as an issue to mobilize dissatisfied voters and

build support for themselves. When faced with political opposition and competition,

government officials will be more motivated to discover ways to improve economic

performance, including lowering inefficient barriers to trade.

In exceptional cases, a change in domestic political institutions can also promote trade

liberalization by altering the cast of trade policymakers or the incentives that they facewhen they design strategy. In the United States, the Reciprocal Trade Agreements Act

(RTAA) of 1934 shifted authority over trade policy from the Congress to the executive

branch. This institutional change occurred in the wake of the infamous SmootHawley Act

of 1930, which dramatically raised tariffs across a wide range of products and

contributed heavily to a sharp drop in the volume of US and global trade as the Great

Depression deepened. US legislators were highly protectionist because their incentive

was to appeal to fairly narrow sectoral interests in their voting districts. The president,

(p.247) on the other hand, was accountable to a broad, heterogeneous national

electorate; therefore, the executive branch had a stronger motivation to design trade

policies that promoted better overall economic performance. Of course, such institutional


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changes are not exogenous; they are endogenously chosen by relevant actors in

response to changes in the economic, political, or social environment. Congress, for

instance, passed the RTAA because it recognized, based on the devastating results of the

SmootHawley Act, that its members were overly vulnerable to the logrolling of sectoral

interests, and that recovery of the US economy and the nations long-term trading

interests lay in increasing global trade and growth.

Finally, the impetus for trade liberalization may stem from external pressure. This

pressure may be direct and specific, in the form of demands from other states or

international economic institutions, like the World Bank or International Monetary Fund,

to open up markets as a condition for receiving a loan or other forms of assistance.

Trading partners sometimes threaten to withhold bilateral aid or close their markets if the

government does not remove import barriers (at least in certain sectors); the United

States, for example, applied such pressure repeatedly on Japan in the 1980s and 1990s,

with mixed results. Trade reform is a central element in structural adjustment programs

funded by the World Bank and International Monetary Fund. In response, government

officials often proclaim, especially to a domestic political audience, that they have no choice

but to initiate trade liberalization or lose badly needed external funds. The evidence

suggests, however, that direct external pressure for trade reform is frequently not very

effective; policymakers, for instance, routinely ignore the demands for structural

adjustment found in conditionality packages. If anything, the causality may be the

reverse: leaders who are committed to trade liberalization seek to enter into agreements

in order to initiate or consolidate reforms that they believe will generate substantial

domestic political opposition.

External pressure may also take a more indirect form. In a globalizing world, government

officials may decide that the costs of remaining protectionist are much higher as they risk

missing out on new opportunities and becoming marginalized. Countries interested in

obtaining the advantages of membership in multilateral trade institutions like the WTO, for

instance, have had to agree to at least some additional trade opening as part of their

accession; of course, once members, countries typically have to continue to accept new

liberalization measures adopted by these institutions. The proliferation of preferential

trade agreements has also been a powerful force: the fear of becoming marginalized is

especially strong if neighboring countries or other traditional trading partners are

entering into such agreements.

Tariff Uniformity

Some scholars and international organizations, like the World Bank, have proposed the

introduction of a uniform tariff as an important step in trade reform. Moreover, the

positive experience of Chile with tariff uniformity since the late 1970s has sparked

interest among several countries, particularly in Latin America. Proponents of uniform

tariffs argue that they promote greater equality in effective rates of protection across

sectors (p.248) and, thus, remove the pernicious consequences that cascading tariff

structures have on resource allocation. In addition, they improve administrative simplicity

and transparency, thereby reducing the opportunity for corruption. The most important


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effect, however, may be their ability to reduce lobbying for tariffs by interest groups. As

Panagariya and Rodrik (1993) show, a uniform tariff increases the severity of collective

action problems among those seeking protection, as the tariff obtained through one

sectors activities becomes available to all sectors; this greatly reduces the incentive for

groups to lobby policymakers.

Complementary Reforms

In order for trade reform to succeed, governments usually must concomitantly

implement other structural reforms. For trade to foster growth, factor markets must

become less rigid and more responsive to price signals, allowing labor and capital to move

freely throughout the economy to where they bring the highest return. In the area of

labor markets, policymakers often will need to reduce controls on the firing and hiring of

workers. In many countries, restrictions on layoffs make it difficult for firms to adjust to

changing market conditions, for instance, by reducing their workforce in the face of

greater import competition.29Similarly, firms whose business is expanding due to trade

opportunities may resist hiring new workers if they will not be able to dismiss them if

market conditions change. In India, for example, firms employing more than 100 people

cannot fire workers without obtaining government permission; most observers feel that

this has proved to be an obstacle to growth in some manufacturing sectors. Governments

can also mitigate the adjustment costs borne by workers who must switch jobs by

providing training that equips them to take advantage of new employment opportunities

and by supplying a safety net (notably, unemployment compensation) for workers in

transition. More generally, the governments ability to compensate or aid the losers from

liberalization may be critically important to diminishing any undesirable distributional

consequences from trade opening (such as harm to low-income groups); this may havethe additional benefit of reducing political resistance to the reform process.

Similarly, policymakers will need to take measures to ensure that financial markets are

better able to finance new business opportunities once they arise. Recall that one of the

primary rationales for infant industry protection is that capital market failures make it

necessary for firms to earn profits immediately because financial entities do not lend to

firms to cover current losses; efficient capital markets should be willing to lend to

promising firms until they develop sufficiently to become profitable. Governments can also

take steps to deepen markets for leasing and used machinery and perhaps modify rules

regarding depreciation of capital stock in order to facilitate the mobility of capital acrosssectors.

(p.249) If tariffs have been an important source of government revenue, trade

liberalization will require policymakers to find alternative sources of revenue to finance

government spending. This usually involves fiscal policy reform, including increasing

income, value added, or sales taxes, a politically unpopular step that also demands

enhancing the governments administrative capacity. More generally, the states

institutional capacity must grow as well, notably by passing more clearly defined property

rights, promoting better rule of law, improving the legal system, and creating a more

impartial judiciary to enforce contracts and adjudicate disputes.


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VI. ConclusionGovernments do not design trade policy solely on the basis of economic rationality;

political considerations are always present and often dominate policymaking, frequently to

the detriment of aggregate national welfare and the distribution of income. This chapter

has explored how domestic politics influence the design and implementation of commercial

policy, including decisions to implement or remove barriers to trade such as tariffs,

quotas, and non-tariff barriers. Politicians usually claim that they are erecting import

barriers in order to promote the national interest when they are actually seeking to

benefit a narrow set of constituents or themselves. Protectionism hurts some groups but

favors others, so that some private actors always have an interest in the implementation

of trade barriers. Nevertheless, the supply side of trade policy, the complex balancing

act among competing interests that politicians undertake when designing strategy, is

equally important. The factors that lead governments to liberalize trade and implement

the complementary reforms needed to achieve success are more difficult to pinpoint. The

most likely domestic causes of trade liberalization are when protected industries

themselves no longer desire trade barriers or politicians determine that the political costs

of protectionism, in the form of votes lost due to lower consumer surplus, have

increased. Deepening globalization has also increased the costs of maintaining highly

protected markets, giving public officials a stronger incentive to undertake trade reform.

The international political and economic context in which trade takes place is also critical

for understanding trade policy. The structure of the trade game generates a powerful

set of constraints and incentives that policymakers must consider when formulating

national strategy. Governments have ample reasons to be cautious in removing trade

barriers, so much so that widespread protectionism has characterized economic

relations among states throughout most of history. Historically, the existence of a

hegemonic state, like the United States, has been required for states to create a liberal

trading order. Nonetheless, multilateral institutions, such as the WTO, once created, can

help states overcome the collective action problems inherent in opening up trade on a

global basis, as they facilitate communication among countries as well as monitoring and

enforcement of trade agreements.

(p.250) Appendix

The Infant Industry Argument In Practice: Import Substitution Industrializationand Export-Led Growth ExperiencesIn the post-World War II era, most developing countries pursued a generalized

application of the infant industry principle by adopting the development strategy called

import substitution industrialization (ISI). The goal of ISI was to increase the percentage

of industrial goods supplied domestically by protecting import-competing industries and

granting them time to develop. Governments used various means to protect industry,

including tariffs, quotas, and non-tariff barriers. Protection was cascading (or escalating),

meaning that tariffs were much higher for goods requiring more advanced levels of

processing so that finished goods (such as consumer products) had higher levels than

inputs (such as raw materials); this led to very high levels of effective protection for


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Political Economcy of Protectionism

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