Richard E. Baldwin

1

• Richard E. Baldwin

• Read Chapter 9 only up to (but not including)
  section Income Distribution Trade Policy WHAT
  IS LEFT OUT?
• Political economy models (median voter, etc.)
  interesting but will be covered more in depth in
  the trade policy formation week. (might want to
  read it out of personal interest)
• Discussion of trade negotiations is quite shallow
  compared to what you have and will learn.
• Preferential trading agreements is likewise too
  light youll have a whole week on regionalism.

2
Arguments for Free Trade

• Economic Perspective
• Political Perspective

3
Pro-FT Efficiency Perspective

• Reverse of cost/benefit analysis of a tariff.
• Free trade eliminates deadweight losses
  associated with tariff reverses any ToT effects.

4
The naïve case for free trade

• FT efficiency
• Small nations unambiguously gain from removing
  tariffs
• e.g. Hong Kong Singapore have basically zero
  tariffs.
• Basis of naïve statement by some Unilateral
  liberalisation is always good
• Econ professors love this example since it is
  unambiguous and requires no sophisticated
  reasoning.

5
Less naïve case for free trade via MTNs

• The ToT gain for Home is matched exactly by the
  ToT loss for Foreign.
• But both Home and Foreign experience DWL.
• THUS, matching tariffs is lose-lose situation
• Suppose another market where Home exports and
  Foreign imposes T.
• If Home and Foreign impose tariffs on each others
  exports (then ToT gains/losses cancel out), then
  both removing them at same time will make both
  nations better off by the amt of the DWL.

6
MTNs passing parade parable

• Coordination failures Nash eqa (Econ View)
• Each nation might lose if unilateral
  liberalisation, but team-work liberalisation
  avoids ToT losses.
• Juggernaut theory of trade liberalisation
  (Pol.Econ.View)
• MTNs solve the internal political dilemma of
  liberalisation.
• Reciprocity gt Exporters become free-traders in
  pursuit of better foreign mkt access.
• MTN liberalisation changes economic landscape and
  thus relative political power of pro-trade
  anti-trade grps.

7
Econ Arg (contd) Dynamic GFT

• The so-called static efficiency gains (the
  triangles and rectangles) are multiplied by other
  gains such as increased economies of scale, and
  pro-investment effects these knock-on effects
  often called dynamic GFT.
• Main examples
• Scale Pro-Competitive Effects
• By creating large markets, FT allows better
  exploitation of IRS while simultaneously boosting
  competition.
• CC-PP diagram analysis fundamental
  scale-vs-competition trade off.
• Pro-investment effects
• Working these out can be complex, but basic idea
  is simple.
• Requires consideration of economics of growth
  (not hard but )
• Improved static efficiency improves a nations
  investment climate, so more investment gets done.
• The initial static GFT is multiplied by
  trade-induced investment-led growth
• Liberalisation improves economic efficiency since
  market forces allowed to work more freely. This
  extra efficiency makes the nation a more
  attractive place to invest. Extra human, physical
  and knowledge capital formation gets done.
• Main idea is to improve investment climate FT
  may help.
• These are usually included in the CGE analyses of
  trade liberalisation.

8
Pro-FT Political Perspective

• Perspective Protection is a way of allocating
  resources in the economy, i.e. influencing
  production and distn of welfare.
• Markets are imperfect so there may be an economic
  argument for protection, but politicians are also
  imperfect, so the question is
• Which is more imperfect? Politically/bureaucratica
  lly chosen import prices, or market chosen?
• Corruption and import protection.
• Internal/world price wedge invites smuggling,
  fraud, etc.
• Protection allows govt officials to allocate
  quota rents /or prodr surp. gains.
• Overt corruption (some nations) or legitimate
  corruption that is

9
Pro-FT Political Perspective (contd)

• Even without overt corruption, political system
  chooses trade policy via legitimate corruption
• Lobbying Campaign contributions perspective
• One vote one person (democracy), meets one dollar
  on vote (the market).
• Powerful special interest groups often manage to
  get govts to adopt policies that help the few and
  the harm the many.
• Trade policy often has regressive impact on
  income distn.
• Poor people spend higher fraction of income on
  consumption.
• e.g. in rich nations, imports goods include food
  clothing.
• Many recipients of US EU farm aid are rich
• Clothing workers are poor in rich nations, but
  firm owners are rich and take most of benefit
  from protection since wages set by external
  factors, e.g. mkt forces (US UK), or labour mkt
  institutions (EU)
• Interest grps often use populist arguments play
  on voter ignorance.

10
Pro-FT Political Perspective (contd)

• Perspective Market as a good governance tool.
• Market-based prices in a reasonable competitive
  setting reflect costs of production and
  benefits of consumption.
• Many, many people involved no one dominates
• 1 dollar 1 vote
• Relying on market prices is a way of gathering
  vast quantities of information without temptation
  to distort it
• To make pet projects look good.
• To make favoured ideology or politician look
  good, etc.
• Example Export-oriented development strategy
  might work by reducing the worst abuses export
  success provides measure of performance that
  cannot be fully controlled by the firms being
  evaluated.

11
Pro-FT Political Perspective (contd)

• Interesting Perspective Free Market as a good
  governance tool.
• If govt does intervene in the market, do so in as
  broad a fashion as possible.
• Support ALL industry, or all firms in a sector
  picking choosing opens door to manipulation,
  corruption, etc.
• If support cluster, do so for any/all entrants
  dont pick winners losers.
• In trade, suggests a uniform tariff
• e.g. 0 on all capital goods, 20 on all
  industrial goods, 30 on all consumer goods.
• Trade-off restrain political/bureaucratic
  abuse/mistakes, but doesnt optimise on economic
  grounds.
• May lead to a less imperfect outcome than picking
  choosing.

12
Anti-FT

• Naïve ToT argument. optimal tariff argument
• A country can improve welfare if foreign nations
  do not retaliate.
• Recall PE analysis.
• A nation always gains if tariff is sufficiently
  small.
• Argument almost never used on import side
• Exception US oil import fee argument (not
  accepted).
• Often used on export side (commodity cartels,
  OPEC, etc.)
• Justifies Govt marketing boards
• Essentially a form a govt sanctioned collusion to
  raise price of exports.

13
Arguments against FT

• Domestic market failures
• Since mkts are imperfect, mkt production level
  may not be socially optimal.
• D-curve gives the margl priv. benefit of
  production.
• Social benefit may be higher than this
  externalities
• Logic in words should be clear
• If public vs private benefit diverge, the free
  market wont allocate resources in an efficient
  manner.
• This opens the door to a logically valid reason
  for govt intervention on efficiency grounds
• Must carefully evaluate particular situation to
  know if intervention is warranted.

14
Arguments against FT

• Domestic market failures
• Same point with a diagram.
• Bottom panel shows the private-public marginal
  benefit gap.
• Protection that raises output to S2 will have
  extra gains for area C.
• In this case, tariff may raise welfare, despite
  the DWL.

15
Arguments against FT

• This is one aspect of infant industry argument
• External economies spillovers mean worth to
  nation of extra production exceeds private worth,
  so should encourage it.
• Many industries claim positive spillovers
  externalities.
• Figures never lie, but liars always figure.
• Even with a valid spillovers argument, protection
  may not be the best response. That is

16
Counter-arguments Dom.Distortions

• Theory of the second best
• Protection is almost never the best govt
  intervention
• it is too blunt.
• Tariff taxes consumption and subsidies
  production, but usually govts goal is only to do
  one
• Usually promote production is the goal.
• Counter example Anti-consumption import policy,
  e.g. luxury items.
• First-best response is to directly subsidise the
  activity where the externality occurs, or tax
  consumption govt wants to discourage.
• In words
• A tariff equal to T euro per unit is exactly the
  same as a consumption tax of T euro per unit AND
  a production subsidy of T euro per unit.
• But usually govt only want to promote production,
  so why also tax consumers?
• To see this in the PE diagram see slides at end
  of lecture.

17
Counter-arguments Pigouvian taxes subsidies

• The full, ideal govt answer is
• Pigouvian taxes subsidies scheme
• In words Remove the wedge between
  private-vs-social benefit of consumption
  production with taxes or subsidies.
• The market price reflects the private marginal
  benefit (pMargl Utility)
• If we add a subsidy that reflects the social
  margianal benefit, then the with-subsidy price
  reflects full benefit to society.
• Private, competitive firms will produce the right
  amt.

18
Pigouvian taxes subsidies

• In diagram
• S is the standard supply curve, i.e. the MC
  curve.
• The social S-cur includes the spillover
  (assumed here to be positive, so social is below
  private).
• If govt gives production subsidy to firms to
  bring private S-curve down to social m.c. curve,
  then private firms produce the socially optimal
  amount.

Producer price
Home demand curve
Social S-curve
S
True marginal Social cost to Nation private MC
Soc. Marg Benefit (spillover)
Pw
quantity
Q2
Q3
Q5
19
Pigouvian taxes subsidies

• Problems and practice
• In real world, govt has hard time finding
  information on exact size of all the spillovers,
  so very few set industry or sector specific
  subsidies, however
• Many govt take rough-and-ready approach e.g.
  give all manufactures a tax break, subsidize all
  RD, make all public education free, provide free
  govt services to help firms, etc.
• General policies allow some intervention while
  reducing info costs opportunities for
  corruption/special interest influence.
• NB this approach explains why govt have a
  perfectly legitimate reason for some subsidies.
• Justifies the WTOs boxes approach.
• Youll learn much, much more about boxes next
  semester.

20
Counter-arguments

• A nice way to summarize the point
• Specificity Principle
• Put the bandage where the cut is
• Protection tends to be adopted over domestic
  policies simply because public fails to
  understand the true costs of protection.
• Industry likes protection Production subsidy
  with auto-financing tax perfect for industry a
  2 for 1 package!

21
National Defense Argument

• Argues that a particular industry is vital to a
  nations security because of its products or the
  skills it develops.
• Extreme form of the domestic distortion
  argument.
• 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. (Food in Switzerland?)
• 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.

22
Market Failure Arguments for Protection
23
Infant Industry Argument

• May be a valid argument for enhancing total world
  welfare.
• Relies on Economies of Scale (IRS) in particular
  industry.
• Must evaluate each case carefully.
• Argument 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.
• Recall the Thai-v-Swiss watch example.
• Import Tariff means consumers finance the
  expansion of the industry but they also reap LR
  benefits of lower price.
• Theoretically valid if there are capital market
  imperfections, or external economies but
• difficult to identify industries in practice.
• Many such industries are set up by private firms
  in rich-nations (no borrowing constraint), e.g.
  micro-machine technologies, bio-tech, GMOs, etc.
• Empirical evidence does not find many instances
  of success.
• Alternative Policies to achieve Goal?
• Specificity Principle Subsidy to domestic
  industry by govt has lower welfare cost.

24
Save jobs in specific industries

• Special interests often argue for protection to
  save jobs in a particular industry.
• US steel sector, EU footwear sector, Japanese
  rice sector.
• The cost per job saved (i.e. avoiding the
  worker having to switch industries) can be high
  

25
Costs of Protecting U.S. Jobs, 1990
Source Hufbauer Elliot, Measuring Costs of
Protection in the U.S., 1994
26

• END

27
Tariffconsn tax prodn subsidy

• Optional diagram
• Spose no tariff, but subsidy tax T.
• Border price Pw.
• Tax shifts down D-curve for any given conss
  level.
• Subsidy shifts down the S-curve for any given
  prodn level.

Producer price
Home supply curve
Home demand curve
S w/Subsidy
PwT
Pw
quantity
Q2
Q3
Q4
Q5
28
Tariffconsn tax prodn subsidy

• Positive effects exactly like a tariff.
• Same consn
• Same prodn

Producer price
Home supply curve
Home demand curve
S w/Subsidy
PwT
Pw
quantity
Q2
Q3
Q4
Q5
29
Tariffconsn tax prodn subsidy

• Welfare effects exactly like a tariff.
• ?CS (use old D-cur since this shows M.U.)
• ? by ABCD
• ?PS (use old S-cur since this shows M.C.)
• ? by A
• Tax revenue ABC
• Subsidy cost AB
• Net gain in revenue C.
• Net loss DWL triangles BD.

Producer price
Home supply curve
Home demand curve
S w/Subsidy
PwT
A
C
B
D
Pw
quantity
Q2
Q3
Q4
Q5
30
prodn subsidy alone

• ?CS 0. Consn at Q5.
• ?PS ? by A.
• Subsidy cost AB
• Net welfare effect -B, i.e. only the production
  distn.
• Cd add in the externality as before with a
  diagram below.

Producer price
Home supply curve
Home demand curve
S w/Subsidy
PwT
A
C
B
D
Pw
quantity
Q2
Q3
Q4
Q5