BA 187 – International Trade

1. BA 187 – International Trade Krugman & Obstfeld, Chapter 9 Political Economy of Trade Policy

2. The Arguments for Free Trade

3. 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.

4. Fallacious Arguments for Protection

5. 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 nation’s 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.

6. Traditional Arguments for Protection

7. 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.

8. Terms-of-Trade Argument • Argues national welfare can be enhanced by tariff. • Gain comes through favorable change in nation’s terms of trade. • Gain at expense of trading partners, termed “Beggar-thy-neighbor” • Restrictive trade policy may raise ratio PExports /Pimports and improve nation’s 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 nation’s 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 nation’s welfare. • Potential problem is retaliatory protection by injured partners, reducing both nation’s welfare relative to free trade.

9. U.S. & Japanese Tariff Effects Bilateral = increase tariffs on only other nation’s goods. Multilateral = increase tariffs on goods of all trading partners. Source: P. Petri, Modeling Japanese-American Trade, 1984

10. Tariff to Reduce Total Unemployment • Argues tariff can enhance nation’s 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.

11. 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.

12. National Defense Argument • Argues that a particular industry is vital to a nation’s 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.

13. Market Failure Arguments for Protection

14. Domestic Market Failure Arguments • Market Failure Argument: • Situation occurs when additional social benefit to production differs from producer surplus measure. • TypicalReasons: • 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 Gov’t policy is desirable in any market only if all other markets are working properly. • If all markets are not working properly, then a gov’t policy that seems to distort incentives in one market, may actually increase welfare by offsetting consequences of market failure elsewhere.

15. 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.

16. 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 gov’t has lower welfare cost. • Efficient capital markets should overcome problem.

17. Tariff to Reduce Unemployment in a Specific Industry • Tariff to increase a particular factor of production’s 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.

18. Costs of Protecting U.S. Jobs, 1990 Source: Hufbauer & Elliot, Measuring Costs of Protection in the U.S., 1994

19. 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 firm’s “unfair” price advantage. • Three Types of Dumping • Persistent Dumping: Good continually sold in Home for more than sold in Foreign’s 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.

20. 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.

21. 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.

22. Who Gets Protected?

23. 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 voter’s 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.

24. 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.