KAP 9

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KAP 9

• - The political economy of trade policy

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Economical and political context

• Economies impose trade restrictions that are
  negative for their overall welfare. Hence, there
  must be another dimension of trade policies
  besides the economical one.
• Trade policies must be placed in an political
  context, where special interests are considered.
• In CH.9 we will study the arguments for and
  against free trade?
• Is free trade preferable to restricted trade?

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Arguments for free trade

• Efficiency losses
• Tariffs, export subsidy and import quotas distort
  the incentives for consumers and producers.
• Hence, free trade gt efficiency gains.

P
S
D
Production distortion loss
Consumption distortion loss
PWM t
PWM
Q
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• In reality import quotas are rather uncommon and
  tariffs are in general rather small gt Efficiency
  losses are relatively small.
• However, the efficiency losses in developing
  economies are larger than in advanced economies.
• Benefits of a move from free trade (in of GDP)
• USA 0,57
• EU 0,61
• Japan 0,85
• Dev.Countries 1,4
• World 0,93

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• Dynamic effects (gains)
• Economies of scale
• Trade restrictions makes it more profitable for
  domestic producers to produce gt Too many firms
  operate in the market gt Inefficient production
  level.
• Free trade will lead to an enlargement of the
  market, because firms are able to freely
  penetrate foreign markets
• gt More firms in the domestic market, but less
  domestic firms.
• gt Specialization on few goods, i.e. more
  efficient use of production factors.
• gt Lower production costs
• gt Lower price

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• EX The European market for refrigerators
• Prior to the formation of the EC the major
  European countries (Germany, Italy and France)
  supported a small number of firms that produced
  primarily for the domestic markets. The
  manufactures produced too small a number of
  refrigerators to permit the adoption of automated
  equipment (Qlt100 000 annually) gt High unit cost.
• The formation of the EC resulted in the opening
  of the European market and paved the way for
  adopting large scale production methods (press
  lines, spot welding). In Italy the typical
  refrigerator plant produced approximately 850 000
  units annually during the 1960s.
• Q? gt AC?.

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• Dynamic effects (gains)
• Stronger competition
• Trade restrictions promote some degree of
  monopoly power, whereby a small number of firms
  dominates a domestic market.
• Easier to arrange agreements not to compete on
  the basis of price.
• Trade Successful collusion less likely when the
  number of competitors increase.
• Only the strong survive gt Investments? gt new
  technology, more efficient production lines,
  inventions etc.
• International spillover of knowledge and
  technology.

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• Political arguments
• Economists argue that trade policies in general
  reflects special interests and not national
  welfare gt Countries should commit themselves to
  a free trade agenda to ensure that special
  interests do not dominate the interest of
  national welfare.

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National welfare arguments against free trade
Welfare

• Improved terms of trade
• If a large economy impose a tariff the PWM on
  their import good will decrease. gt (PEX/PIM)?
• When the tariff is relatively low
• Eff. Loss lt terms of trade benefit
• When the tariff is relatively high
• Eff. Loss gt terms of trade benefit
• Point 1 Optimum tariff

1
?
t
Optimum tariff
Prohibitive tariff rate (no trade).
Notice! Only valid for large Economies
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• Optimum export-subsidy
• Negative Export tax
• gt Improved terms of trade (See CH.5)
• EX. Saudi-Arabia taxed their oil exports during
  the 1980s, which increased the world market price
  of oil.
• Critique The argument above is only valid for
  large economies. When a large economy impose a
  trade restriction of any type it is an hostile
  action
• gt Risk for retaliation

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• Market imperfections
• In CH.8 we used producer- and consumer surplus
  to measure effects on welfare. However, CS and
  PS are not necessarily precise measures of
  welfare.
• Assume that some of the labor force (capital)
  used in a specific sector would be unemployed if
  the production in the sector decreased, i.e. the
  labor mobility between sectors is imperfect
  (slow) gt ?PS does not measure the whole welfare
  effect of Q?.
• Positive externalities from production, e.g.
  technology-spillover gt PS does not capture all
  relevant social benefits from production.

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• Graphical illustration
• Assume a tariff gt efficiency losses (bd).
• However, when the domestic production increases,
  the extra social benefit also increases. If the
  tariff is small Cgt (bd)
• Hence, a tariff may improve the welfare in a
  small economy.

P
S
D
Small economy
PWMt
b
d
PWM
Q
D2
D1

Marginal externality (benefit)
c
Q
S1
S2
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• Critique against the market imperfection
  argument
• Usually it is very difficult to tell the cause
  of any market imperfection gt what are the right
  measures? If the wrong measures are taken gt
  worsened situation!
• gt
• The best way to solve problems on any of the
  domestic markets, is not to apply a restrictive
  trade policy, rather the decision-maker should
  take measures that directly attack the source of
  the problem.

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• Assume that the decision-maker want to keep
  workers in an industry employed. The problem
  could potentially be solved by adopting a
  restrictive trade policy, but is that really the
  best solution?
• Assume that two options are available
• 1. Subsidize production in the vulnerable
  industry
• 2. Use trade policy (to increase domestic price)
  
• Both solutions creates a production distortion
  loss, but only the later creates a consumer
  distortion loss.

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• Income distribution and trade
• National welfare is a theoretical concept.
• Trade gt Winners and Losers gt Special interests.
• Special interests are transformed, within the
  political process, to the trade policy adopted by
  the government. What is meant by political
  process, and what trade policy is adopted?
• There are various answers to these questions.
  Modern explanations argue that policy-makers
  maximizes their political success rather than
  national welfare (which is kind of diffuse).

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• Two modern explanations of how trade policies are
  formed
• 1. Electoral competition (median voter model)
• Two parties compete for the citizens votes.
• Except from having different preferences
  regarding the trade policy adopted, all voters
  have the same political preferences.
• gtBoth parties will choose the trade policy that
  is favored by a majority of the voters.
• (the parties will end up choosing the same trade
  policy)
• Not supported by empirical evidence
• ConsumersgtProducers (interest groups) gt
• No (low) tariffs

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2. Collective action The loss of the individual
consumers, caused by tariffs, is relatively small
(they may even not be aware of the tariffs)gt
Most people do not care enough to take action to
get rid of the tariffs, even though the total
loss of consumers are substantial. The benefit
of trade restrictions is often large for
individual producers within the protected sector
gt Even though the number of producers are
relatively small, they often manage to convince
the policy-maker in a favorable direction. This
is because small groups have strong incentives to
organize and take action for their common
interests. The smaller the group the easier it is
to organize, and the potential benefit for each
member will be larger. gt Hard lobbying!
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International negotiations and trade policy

• In the last 50-60 years tariffs around the world
  has been continuously reduced. One important
  reason is international negotiations. At present
  in EU the average tariff rate on industrial goods
  and agricultural goods is around 10 and 40
  respectively.
• The most protected sectors are the textile
  industry and the agricultural sector. Tariffs are
  the major trade policy instrument used. Import
  quotas are banned by the WTO. An exception are
  import quotas for Chinese products.

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The World trade organization (WTO)

• Founded in 1995 as an extension of earlier
  international trade agreements. 149 member
  countries (2005)
• The main objective of WTP is to promote
  international trade and prevent international
  trade discrimination.
• WTO replaced the previous agreement called GATT
  (general agreement on tariffs and trade), which
  had been continuously improved since 1947, trough
  so called trade rounds (negotiation rounds).
• (The latest is the Doha round that broke down
  recently without any new agreements)

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• The objectives of trade rounds
• Bind the tariff rates, i.e. promise to not raise
  tariff rates in the future.
• If some country need to extend their trade
  restrictions, it should first be negotiated
  within WTO (round).
• One of the most basic WTO rules against
  discrimination is the most-favorable-nation
  principle (MFN). This principle mean that any
  deal given to a member of WTO must be given to
  all members. Hence, WTO members that exports some
  specific good to Sweden must be exposed to the
  same tariff rate, as the member that faces the
  lowest tariff rate.

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• One important exception from this principle
  considers preferential trading agreements (e.g.
  EU and NAFTA)
• Customs union Free trade within the union,
  common tariffs on products produced outside the
  union.
• Free trade area Free trade within an area, but
  all members of the area are allowed to set their
  own tariffs.

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• Assume three countries (ABC) It is against the
  MFN-principle that A has a higher tariff rate on
  imports from B that what is true for imports from
  C, but not if A and C have agreed to have no
  tariffs at all on each others products.
• Within EU there are no tariffs, but EU has
  common tariffs on products from outside the
  union. (Notice! Krugman is not clear about this)
• Hence, it is okay to violate the MFN rule if it
  encourage free trade.

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Famous trade conflict that were solved within the
WTO framework

• Steel conflict 2002-2003
• USA impose 8-30 tariffs on various steel
  products.
• EU is not happy gt WTO.
• While waiting on the WTOS decision, EU prepare a
  retaliation plan including tariffs on U.S goods
  (steel, rise, clothes, shoes, boats)
• EU want compensation if the U.S. does not remove
  the tariffs. The U.S. ignore the wish from EU.

• EU imposes 10 tariffs on seven American
  products. The products are chosen with care, i.e.
  aimed at sectors with strong lobby groups.
• In 2003 WTO announce that the U.S. tariffs on
  steel are illegal. gt EU announce that they will
  impose additional tariffs (this time legally) on
  U.S. exports. gt The steel tariffs in the U.S.
  are removed.
• Conflict solved