International Trade and Development

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International Trade and Development

• Raul Caruso
• Università Cattolica del Sacro Cuore di Milano
• raul.caruso_at_unicatt.it

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• In the previous classes, we considered only
  competitive scenarios. Ricardian and HO worlds
  were purely competitive. In reality, there is no
  free trade. Different trade policies affect
  patterns and evolution of trade. In particular,
  protectionism seems to be the rule.

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Protection and the Triangle
Trade Protection clealry is closer to the Power
apex.
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Measuring Protection

• The effective rate of protection can be computed
  through

Where V is the value added in a sector. The
subscripts denote the value added in the presence
of trade policies and the value added evaluated
at world prices respectively
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Effect of a Tariff on Prices

• If the Home country imposes a tariff the price
  home at home goes up. Because of the existence of
  a tariff there will be an excess demand which
  leads to a higher world market price
• On the foreign market if the country is
  relatively large there will an excess of supply
  which should lead to a lower price. The latter
  statement canno t hold when the country is small
  and cannot affect world prices.

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Who gains from a tariff?

• 1. Domestic Producers obviously gain from the
  imposition of a tariff.
• 2. The government also gains from a tariff since
  it has higher revenues.

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Who loses from a tariff?

1. consumers lose because they face higher prices.
2. Terms of trade of Small countries worsen. When a
   country is price-taker it cannot influence the
   world price, then the negative impact of foreign
   price does not occur.

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Net gain or loss?

• The net cost of a tariff is
• Consumer loss - producer gain government
  revenue net cost of a tariff

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Quantitative Non-Tariff Barriers

• Quotas, VERs and other quantitative restrictions
  have the same effect of a tariff but they add
  also the emergence of rents through system of
  licenses and administrative tasks to manage them.

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Export Subsidies

• An export subsidy is payment to an exporting
  firm. It can be either specific (a fixed sum per
  unit) or ad valorem ( a proportionof the value
  exported)
• In general, once subsidy is applied the price in
  the exporting country rises and the price in the
  importing country falls.

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Export Subsidies

• What happens to terms of trade?
• Terms of trade of exporting country worsen.
• If the exporting country is relatively large (can
  set prices) the world prices decrease. Terms of
  trade of other exporting countries decrease as
  well. This is the case of competition over a
  third market.
• However, terms of trade of importing country
  would improve.

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Export Subsidies

• The paradox of subsidies is that only producers
  of the exporting country gain.
• Consumer surplus falls
• Government revenue falls, (government spending
  rises)
• Overall National Welfare Falls

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European CAP policy

• It was implemented in order to guarantee high
  prices for agricultural sector by having the
  European Union buy agricultural products whenever
  the prices fell below specific levels.
• Since the 70s the level of protection turned to
  be so high that EU would have been an importer of
  agricultural products in the presence of free
  trade.

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US Policy , (Farm Bill)

• In USA there is a very similar institutional
  architecture to protect farmers in USA.

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IL MERCATO AGRICOLO
UE
USA
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• Commodities and LDCs

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Prices of Commodities and LDCS

• Many LDCs are dependent upon the exports of a
  small number of commodities
• According to FAO(2003), as many as 43 LDCs depend
  upon only one commodity
• More than 50 LDCs depend on exports of three or
  fewer agricultural commodities

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Price of Commodities and LDCs
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Price of Commodities and LDCs

• Over the last twenty years commodity prices
  declined continously
• Cotton (-47), Coffee (-64), Cocoa (-71), sugar
  (-77)

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Price of Commodities and LDCs

• Why?
• Oversupply of commodities which drives the prices
  down. Oversupply is based upon enhancements of
  productivity and emergence of new producers (ex.
  Coffee in Vietnam)
• Shocks in supply determine volatility of prices

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Price of Commodities and LDCs

• The Argument of IMMISERIZING GROWTH is based
  upon the evidence of declining terms of trade for
  developing countries turned largely on
  differences in the degree of competition between
  industries in developed countries, or core, and
  those found on the periphery. Competition among
  producers of raw materials and foodstuffs drive
  prices down to marginal costs in the developing
  economies. The result was that the prices of
  primary goods produced on the periphery declined
  relative to those of manufactures produced in the
  core. For developing countries, free trade
  supposedly resulted in immiserization (or
  immiserizing growth) rather than in increasing
  wealth.
• Hence, according to the terms-of-trade argument,
  developing economies should not favor free trade
  but advocate the protection of domestic
  industrialization instead.

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Price of Commodities and LDCs

• Increased Export volumes until now do not appear
  to compensate the losses in the value of exports.
  
• The decline of prices for some selected
  commodities has been so significant that the
  increase in volume could not compensate for the
  decline of prices.

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Price of Commodities and LDCs
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Price of Commodities and LDCs

• Possible Solutions
• Diversification of Production (long-term
  strategy).However, in the presence of western
  subisidies diversification strategy could fail
  also in the long run
• Cartel of Producers to ensure high prices (the
  demand could decrease dramatically)
• Stabilization Mechanism through international
  agreements on commodities.

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Price of Commodities and LDCs

• Natural evolution?
• An increased demand from newly industrialized
  countries (ex. China, India) and other growing
  economies could stop (or move against) a
  continous decline in commodity prices.

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Future markets

• However, in the latest years (before the subprime
  crises) prices of commodities have been subject
  to high pressure. Such a pressure emerged in the
  presence of a high liquidity in the financial
  markets. This increased dramatically the
  volatility of prices.

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Prices of selected commodities (Oil, Wheat,
Rice, Corn) ( 2003100)
Volatility and pressure on financial markets
for some commodities
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Trade Integration

• However countries also integrate by means of
• Preferential Trade Agreement (PTA)
• Free Trade Areas
• Customs Unions

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Trade Integration

• A PTA occurs when a country (or a group of
  countries) establishes a more favorable duty
  system for goods coming from some selected
  countries. (ex. Tariff are lower)
• Example EEC/Lomè convention

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Trade Integration

• 2. A Free Trade Area (FTA) is an agreement
  between countries allowing for free movement of
  goods. No restriction is allowed. (no tariffs ,
  no quotas)
• Example. USA has a FTA with Israel. NAFTA is also
  a FTA. There is FTA between EU and non-member
  countries in europe.

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Trade Integration

• 3. A costums union (CU) is an agreement between
  countries establishing a common duty against the
  rest of the world. Tariffs and quotas are chosen
  and implemented collectively.
• Example EU is a customs union.

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Trade Integration

• What happens?
• Economists usually distinguish between
• Trade creation
• (2) Trade diversion.
• The ideas of Trade Creation and Trade Diversion
  date back to Viner (1950).

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Trade Integration

• Trade creation is supposed to be beneficial for
  member countries.
• a. Volume of trade increases.
• b. Prices decrease.

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Trade Integration

• By contrast Trade diversion is supposed to have a
  negative impact on trade with third countries.
• Volume of trade with third countries decrease
• The impact on world prices is not precisely
  predictable.

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Trade Integration

• In a FTA the individual member countries agree to
  free trade between themselves but retain their
  individual regime of tariffs and other
  restrictions on imports from third countries. In
  the absence of intra-trade restrictions goods
  exported by third countries cound eneter the
  market of both countries by entering the member
  country with the lowes level of pretection. This
  is called Trade deflection.

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Trade Integration

• Finally
• Trade integration is beneficial for member
  countries and have a negative impact on third
  countries. However, third countries can deflect
  trade. An effective system of rules of origin
  must be implemented.

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Trade Integration

• Given the negativ effects of trade diversions,
  economists usually favoured a spread trade
  integration. That is, there is a strong debate
  between people favouring
• Multilateralism
• Regionalism

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Trade Integration

• Mutilateralism would predict a continous
  liberalization made by all countries made in
  favour of all the other coutries.
• This is the principle of MFN (most favoured
  nation) sorrounding GATT and then WTO

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Trade Integration

• Regionalism is simply a preferentional agreement
  of some countries with othre countries of the
  same region.
• This should create trade diversion against the
  rest of the world.

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Trade Integration

• Finally we can say that
• PTAs are likely to emerge between coutries
  exhibiting a different level of development
• FTAs and CUs emerge between similar countries
• The impact of trade deflection makes preferential
  agreements uneffective.

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Trade Integration

• Translate in language of network theory.
• A PTA is a form of ?
• A hierarchical network (ex. EU/African
  countries.)
• A FTA does fit better with the idea of Random
  Network

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Trade integration

• What is trade deflection
• The emergence of six degrees of separation!!

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Regionalism in a multilateral World

• Wilfred Ethier (1998) presents and proposes a
  tentative explanation of some stylized facts of
  regional intergration which emerged in the last
  years.

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Regionalism in a multilateral World

• Ethier starts considering the historical
  evidence
• In 1950s and 1960s, with the exception of EEC,
  regional agreements failed.
• In 1990s regional agreements exhibit a growing
  success.

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Ethier (1998), New Regionalism

• Ethier then defined this phenomon New
  Regionalism.
• Examples would be The Creation of NAFTA, The
  Mercosur, the further enlargement of European
  Union.

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Ethier (1998), New Regionalism

• Ethier highlights some characteristics
• 1. New regionalism tipically features one or more
  small countries linking up with a big country

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Ethier (1998), New Regionalism

• 2. Very often the small countris have made
  significant unilateral reforms (signalling
  behaviour)

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Ethier (1998), New Regionalism

• 3. New Regional agreements seldom address only
  trade barriers. They usually involve what is
  known as deep integration

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Ethier (1998), New Regionalism

• 4. Integration is due primarily to concessions
  made by small countries.
• Why?
• Because they have a higher evaluation of the
  stake.

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Strategic Trade Policy

• Now it is time to consider how the countries
  behave.
• Hereafter we will assume that countries behave
  strategically.

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Strategic Trade Policy

• The idea of Strategic trade Policy has been
  explained first by James Brander and Barbara
  Spencer.
• It is an application of non-cooperative Game
  Theory to International Trade Theory

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Strategic Trade Policy

• In a strategic relationship agents (firms,
  countries) have a mutually recognized strategic
  interdependence.
• More formally, agents payoffs of one agent must
  be directly affected by the individual strategy
  choices of other agents and this must understood
  by all agents involved.

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Strategic Trade Policy

• Being an application of the concept of Nash
  equilibrium (NE) as the central equilibrium
  concept.
• Nash equilibrium is a rational concept since all
  agents choose strategies such that each players
  strategy maximizes that players payoff given the
  strategy chosen by other players.

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Strategic Trade Policy

• A famous model proposed by Brander and Spencer
  (1985) incorporated a Cournot Model of Duopoly
  into a Third Market to provide an example of
  strategic trade policy.
• In general , models of strategic trade policy
  show that imposing export subsidy can raise
  profits of a home firm at the expense of foreign
  firms.
• These policies where commonly defined
  beggar-thy-neighbor policies. They were quite
  common at the beginning of XX century. Remember
  the period in which Irwin divided the evolution
  of trade.

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Adapting the Brander Spencer Model to include
different distances

• Caruso (2006) present two countries competing as
  in Cournot Duopoly over a third market.
• The two countries face a simple linear world
  demand represented by the inverse form by

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A model of STP to explain subsidy

• Countries choose quantities
• Country 1

Country 2
Max level of production
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A model of STP to explain subsidy

• Payoff Functions
• Country 1

Country 2
Note they are heterogenous in costs. Country 1
faces higher costs (Iceberg Cost)
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A model of STP to explain subsidy

• In the presence of Free Trade Country 1 would
  produce less than country 2 (because of higher
  costs) and would get lower payoffs. Formally we
  have

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A model of STP to explain subsidy

• On the world market the world price will depend
  also on costs of country 1.

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A model of STP to explain subsidy

• In country 1 interest group lobby in order to
  have an export subsidy. The process of Lobby
  (Rent-Seeking)is costly for national welfare. The
  Larger the number of firms the higher the loss
  for national welfare. Lobbying is a competition
  between different interest groups. This cost will
  be indicated by L and a proportional subsidy by
  sx

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A model of STP to explain subsidy

• The Payoff functions become

Country 1
Country 2
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A model of STP to explain subsidy

• In the presence of subsidy the optimal quantities
  chosen will be

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A model of STP to explain subsidy

• In the presence of subsidy the world price will
  be

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A model of STP to explain subsidy

• Does country 1 get a higher welfare with subsidy?
  If and only if

The result depend upon a combination of (1) size
of demand (2) costs (3) level of subsidy (4)
cost of rent-seeking
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Interest Groups and Trade Policies

• Then, governments choose trade policies in order
  to favour some interest group
• We have historical evidence about this. It is not
  a novelty.
• In general an overweight posed on benefits of
  some interest group can lead nations to clash

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When countries clash

• Then, Countries take into account the trade-off
  (1) The potential benefit of imposing some Trade
  policies (2) and the loss due to a clash with
  other trading countries

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When countries clash
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When countries clash

• Then, consider that countries enter negotiations
  under the umbrella of an institution as WTO, They
  could have a payoff function like this

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When countries clash
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When countries clash

• The results of Caruso (2006) show that countries
  joining trade institutions and negotiations can
• Decrease hostility
• Get a higher payoff even in the presence of
  asymmetry
• This holds if and only if the cost of joining is
  relatively low.

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When countries clash

• There are also
• Reputation effect (es. US/UE steel, Banana War)
• Signalling effect
• Insurance effect
• Moral Hazard (hope for unilateral concessions and
  transfers from your rival)

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When countries clash

• The moral of the story is that
• International negotiations on trade, albeit
  unsatisfactory, are better than harsh competition
  policies that lead the prices down affecting
  terms of trade and then welfare
• The Wto dispute resolution mechanism is a very
  good opportunity for all countries.
• Creating costituencies between LDCs could be a
  reasonable path

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The WTO Dispute Resolution System

• A dispute arises when a member government
  believes another member government is violating
  an agreement or a commitment that it has made in
  the WTO. The authors of these agreements are the
  member governments themselves the agreements
  are the outcome of negotiations among members.
  Ultimate responsibility for settling disputes
  also lies with member governments, through the
  Dispute Settlement Body.

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Main Point

• The main point we have to remember is that the
  WTO lacks the direct enforcement capacity.
  Countries must cooperate. Why?
• Information mechanism leading to a reputation
  building
• Higher payoffs which emerge in the long run.

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Number of disputes since 1995
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• When countries invoke the dispute resolution
  system?
• Which countries rely on DSS?
• Which variables can be considered to interpret
  the success of DSS?

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Variable Expected Correlation
Complainants GDP
Defendants GDP
Relative military power of complainant
Threat of retaliation ?
Trade competitiveness
Degree of Openness ?
Trade dependence between countries involved ?
Share of contested sector in total export of complainant
Share of contested sector in total export of respondant ?
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Few reasonable Facts

• The countries that trade more with one another
  tend to have more trade disputes
• Larger economies seem to be more likely to take
  on a trade dispute due to greater ability to
  withstand the effects of (retaliatory) trade
  restrictions
• Differences in power matter

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• LDCs do not invoke the Dispute Settlement Body
  very often. Why?
• Simply, the process is costly
• Reputation (inverse signalling)
• Insurance effect for its exports (threat of
  retaliatory measures adopted by respondant)

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Consider also.

• Consider also that actors ealuate differently the
  stake of a contest. A contest which is vital for
  one country can be negligible for the other
  country.
• In such a case
• (1) the higher-evaluation actor is willing to
  concede more than the opponent.
• (2) When the evalutions converge both actors have
  to concede.

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• An asymmetry in the evaluation of the stake can
  depend upon
• Asymmetric Information
• Different productive systems
• Internal competition between groups

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Summary of the course

• Summary of the whole story about trade and
  development
• Trade can foster growth (we have empirical
  evidence about this)
• Some economic policies are desirable for growth
  and then for trade (resolution of conflicts
  through redistribution of rents, investment in
  education to enhance productivity)
• Joining international trade negotiations is also
  a desirable policy. In particular, cooperation
  among LDCs should be enhanced.