BA 187

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BA 187 International Trade

• Krugman Obstfeld, Chapter 9
• Political Economy of Trade Policy

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The Arguments for Free Trade
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Arguments for Free Trade

• Efficiency Perspective
• Reverse of cost/benefit analysis of a tariff.
• Free trade eliminates deadweight losses
  associated with tariff.
• Additional gain to world through economies of
  scale since protected markets fragment
  production, raise costs of production.
• Competition with rest-of-world induces innovation
  by domestic producers that would not occur in
  protected market.
• Political Perspective
• Free trade, and its implied philosophy towards
  economic issues, is a good idea in practice even
  if there are better policies in theory.
• In practice, trade policies are dominated by
  special interest groups who gain at expense of
  national welfare.
• Summary
• Costs of deviating from free trade are large.
• Free trade provides additional benefits that
  increase protection costs.
• Optimal deviations from free trade will be
  subverted politically.

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Fallacious Arguments for Protection
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Fallacious Arguments for Protection

• Protection Against Cheap Foreign Labor
• Even if domestic wages are higher than foreign,
  domestic labor costs can be lower if domestic
  labor productivity is sufficiently higher.
• If not the case, then foreign has comparative
  advantage and both nations gain from trade.
• Scientific Tariff
• Tariff rate that makes price of imports equal to
  domestic price. Argue this allows domestic
  producers to compete with foreign producers.
• Distorts comparative advantage, eliminates
  rationale for trade entirely.

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Traditional Arguments for Protection
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Traditional Arguments for Protection

• Evaluate traditional arguments for protection
• Present reasons given for why protection
  necessary.
• Evaluate the validity of the reasons given.
• Ask if other instruments better suited to goals.
• Focus on perspective from which argument made.
• National Perspective
• Nation as a whole will benefit from protection.
• Individual Industry Perspective
• Individual industry benefits, regardless of
  national benefit.
• Particular Factor of Production Perspective
• Particular factor of production benefits,
  regardless of other effects.
• World as a Whole Perspective
• Welfare in World as a whole will increase as
  result.

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Terms-of-Trade Argument

• Argues national welfare can be enhanced by
  tariff.
• Gain comes through favorable change in nations
  terms of trade.
• Gain at expense of trading partners, termed
  Beggar-thy-neighbor
• Restrictive trade policy may raise ratio PExports
  /Pimports and improve nations welfare.
• Occurs because tariff reduces world demand for
  import good.
• Only a large country can make this argument
  successfully.
• Two effects to imposing a tariff on nations
  welfare.
• Increase in terms of trade means nation receives
  more imports for each unit of exports, enhances
  welfare.
• But quantity of imports falls with tariff,
  reduces welfare.
• Optimum tariff Rate that maximizes nations
  welfare.
• Potential problem is retaliatory protection by
  injured partners, reducing both nations welfare
  relative to free trade.

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U.S. Japanese Tariff Effects
Billions of 1980 Effect on U.S. Real Income Effect of Japans Real Income
10 Increase in Tariffs
Bilaterally by U.S. 2.5 (0.10) -4.5 (-0.43)
Multilaterally by U.S. 15.7 (0.60) 0.7 (0.07)
Bilaterally by Japan -1.1 (-0.04) 1.0 (0.10)
Multilaterally by Japan 0.5 (0.02) 8.7 (0.84)
Bilateral increase tariffs on only other
nations goods.
Multilateral increase tariffs on goods of all
trading partners.
Source P. Petri, Modeling Japanese-American
Trade, 1984
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Tariff to Reduce Total Unemployment

• Argues tariff can enhance nations welfare if
  during slack times have unemployment.
• Imposing a tariff shifts demand from imports to
  domestic goods.
• Home industry expands output jobs, reduces
  aggregate unemployment.
• Problems
• Tariff may create few jobs in Home industries.
  Possible retaliatory tariffs by trading partners
  may reduce jobs in export sector, offsets tariff
  gains .
• Exports of Home may decline due to lower incomes
  in trading partners due to fall in their exports
  to Home.
• Tariff may lead to appreciation of Home currency,
  effect will be to reduce jobs in Home export and
  import-substitute industries.
• No certainty tariff will work. Better to use
  monetary or fiscal policies to directly affect
  unemployment
• Known as Specificity Principle in setting policy.

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To Improve the Balance of Trade

• Common argument claims that tariffs will improve
  the balance of trade by reducing imports without
  affecting level of exports.
• Problems
• Possible retaliation by trading partners to these
  tariffs.
• Tariffs reduce foreign exports, and income,
  lowering Home exports.
• If imports were inputs to Home export goods, then
  Home exports fall.
• Even if successful, result will be appreciation
  of Home currency which offsets effect by reducing
  Home exports, increasing Home imports.
• May produce inflationary pressures in Home
  country, as tariff increases demand for
  home-produced import substitutes.
• Macroeconomic interpretation of trade deficit
• Y C I G X Im means Y (C I G)
  X Im
• Trade deficit results if Domestic Demand (C I
  G) exceeds domestic production Y. Better to
  reduce demand by fiscal/monetary policies.

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National Defense Argument

• Argues that a particular industry is vital to a
  nations security because of its products or the
  skills it develops.
• If trade permitted in industry, foreign imports
  will dominate, driving Home producers out or
  reduce size of Home industry.
• During war, normal trade may be disrupted,
  cutting off imports.
• Without adequate supplies, Home country national
  security threatened.
• With tariff protection, industry will remain
  large enough to avoid threat in event of
  emergency or war.
• Problems
• Not easy to identify industries vital to
  security. (U.S. watch industry?)
• Other policies may have lower welfare costs for
  nation as a whole such as stockpiling goods or
  production subsidy to domestic firms.
• Costs then borne by all consumers rather than
  consumers of single good.

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Market Failure Arguments for Protection
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Domestic Market Failure Arguments

• Market Failure Argument
• Situation occurs when additional social benefit
  to production differs from producer surplus
  measure.
• Typical Reasons
• Labor used in the sector is under-employed or
  unemployed.
• Defects in capital or labor markets prevent
  resources from moving between sectors rapidly.
• Possibility of technological spillovers.
• Theory of the Second Best
• A Hands-off Govt policy is desirable in any
  market only if all other markets are working
  properly.
• If all markets are not working properly, then a
  govt policy that seems to distort incentives in
  one market, may actually increase welfare by
  offsetting consequences of market failure
  elsewhere.

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Evaluating Market Failure Arguments

• Does the market failure argument convincingly
  undermine the case for free trade? Probably not.
• Specificity Principle
• Domestic market failures are often best corrected
  by appropriate domestic policies rather than by
  trade policies.
• Compare cost-benefit analysis of a domestic
  production subsidy with that of an import tariff.
  Domestic subsidy more efficient.
• Generally this tends to be true, whether the
  argument be about labor markets, capital markets,
  or environmental questions.
• Protection tends to be adopted over domestic
  policies simply because public fails to
  understand the true costs of protection.
• Identifying Market Failures
• Market failures are difficult to identify
  precisely, hence difficult to decide on the
  appropriate policy response.
• If uncertainty and disagreement among trade
  experts, then may have trade policy captured by
  special interest groups.

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Infant Industry Argument

• Valid argument for enhancing total world welfare.
• Relies on Economies of Scale (IRS) in particular
  industry.
• Assume growth of new industry inhibited by
  low-cost imports from foreign country.
• Temporary protection to domestic industry would
  allow it to realize IRS, become low cost producer
  to world.
• Import Tariff means consumers finance the
  expansion of the industry but they also reap LR
  benefits of lower price.
• Generally argued more by developing countries
  than developed.
• Theoretically valid but difficult to identify
  industries in practice.
• Empirical evidence does not find many instances
  of success.
• Alternative Policies to achieve Goal?
• Subsidy to domestic industry by govt has lower
  welfare cost.
• Efficient capital markets should overcome problem.

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Tariff to Reduce Unemployment in a Specific
Industry

• Tariff to increase a particular factor of
  productions welfare.
• Tariff in specific industry increases price and
  quantity of import-competing Home good.
• Result is increase in employment in specific
  industry, even though total employment in Home
  may fall or rise.
• While argument is true, question is whether
  tariff is most effective way to achieve goal.
• Subsidy to production or employment likely to be
  welfare-superior way to achieve goal.
• Next table shows high cost of using tariffs to
  protect jobs in specific industries.

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Costs of Protecting U.S. Jobs, 1990
Industry with Import Restraint Jobs Saved Consumer Cost per Job Saved Annual Welfare Cost to U.S.
Ball Bearings 146 438,356 1,000,000
Benzoid Chemicals 216 gt 1,000,000 10,000,000
Costume Jewelry 1,067 96,532 5,000,000
Dairy products 2,378 497,897 104,000,000
Frozen Concentrated OJ 609 461,412 35,000,000
Glassware 1,477 180,095 9,000,000
Luggage 226 933,628 26,000,000
Machine Tools 1,556 348,329 35,000,000
Polyethylene resins 298 590,604 20,000,000
Rubber Footwear 1,701 122,281 12,000,000
Softwood lumber 605 758,678 12,000,000
Womens footwear 3,702 101,567 11,000,000
Source Hufbauer Elliot, Measuring Costs of
Protection in the U.S., 1994
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Offsetting Effects of Dumping

• Antidumping argument for tariff asserts that
  dumping by foreign firms is unfair threat to
  Home producers.
• Imposing a tariff to offset price differential,
  an antidumping duty, offsets foreign firms
  unfair price advantage.
• Three Types of Dumping
• Persistent Dumping Good continually sold in Home
  for more than sold in Foreigns own market.
  Tariff lowers welfare in Home.
• Predatory Dumping Foreign sells at low price to
  drive out Home producers, then raises price to
  monopoly level. Valid argument for tariff to
  prevent this type of pricing which leads to
  inefficiency.
• Sporadic Dumping Foreign producers have
  temporary surplus that they export at whatever
  price can get. Short-term, no tariff justified.
• U.S. has specific procedures for identifying and
  responding to dumping by foreign firms.

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Offsetting a Foreign Export Subsidy

• Tariff to offset foreign export subsidy argues
  that this is unfair to Home producers of good.
• Impose tariff to offset advantage foreign
  receives from subsidy.
• Argument valid at the level of world welfare if
  subsidy lets foreign firm export good in which
  foreign does not have a comparative advantage.
• True even though result is higher domestic price
  to Home consumers.
• Export subsidy distorts free trade allocation of
  resources. Offsetting tariff simply restores more
  efficient outcome.
• Note the argument is likely to be invalid at the
  level of national welfare, due to higher price
  paid by consumers.
• U.S. has a procedure to determine if foreign
  export subsidy and what countervailing duty (CVD)
  should be imposed.

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To Benefit a Scarce Factor of Production

• More sophisticated argument for tariff to benefit
  individual factor of production based on H-O
  model of trade.
• Tariff on imported good increases returns to
  scarce factor of production in Home country.
• Political decision to redistribute income to
  scarce factor.
• Country as a whole suffers but individual scarce
  factor gains.
• More efficient way to achieve goal would be to
  directly tax the abundant factor and allocate
  revenues to scarce factor.
• Avoids welfare loss at national level associated
  with tariff.
• Also if factors not completely mobile, i.e.
  Specific Factor model is relevant, then this
  argument does not hold.
• Tariff increases returns to import-specific
  factor alone.

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Who Gets Protected?
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Models of the Political Process

• Electoral Competition.
• Assume political parties compete for votes to win
  elections.
• Each promises whatever it takes to win election.
  Assume policy characterized by single dimension,
  say the tariff rate.
• Both parties try to find the median voters
  preference for the tariff rate, the voter who is
  exactly halfway along tariff preferences.
• Does not work for trade policy, since predicts
  that policy that hurts majority (as a tariff
  does) should be rejected by both parties.
• Collective Action.
• Political activity is a public good, activity by
  an individual shared by all members of the same
  group. Incentive to free ride.
• Policies that result in large total losses, but
  small losses for any individual, are unlikely to
  result in political activity.
• When group is small, well-organized, and benefits
  to actions larger, easier to get collective
  action.
• Seems to explain why protectionist policies
  successful politically.

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Who Gets Protected?

• Pressure Group or Interest Group.
• Industries or factors of production that are
  highly organized are more likely to receive trade
  protection than less organized groups.
• Market Failure.
• In industrial countries, protection is more
  likely to go to labor-intensive industries with
  unskilled, low wage workers who might have great
  difficulty finding alternative employment.
• Countervailing Power.
• Industries producing final consumer goods, as
  opposed to intermediate inputs, obtain more
  protection.
• Geographic Decentralization.
• Industries with large number of workers that are
  geographically decentralized receive more
  protection. Voting power across regions.
• Status Quo.
• Industry is more likely to be protected now if
  protected in past.