Controversies in Trade Policy
Controversies in Trade Policy
Controversies in Trade Policy
Abstract
Controversies over international trade have arisen over the past 35 years, each raising issues that
previously has not been seriously analysed by international economists.
Economists have identified two kinds of market failure that seem to be present and relevant to
trade policies of advanced countries:
(1) externality, appropriability problem: the inability of firms in high-tech industries to capture
the benefits of that part of their contribution to knowledge that spills over to other firms, and
(2) imperfect competition that results in revenues that exceed all costs, excess profits: the presence
of monopoly profits in highly concentrated oligopolistic industries.
Externalities are those benefits (or costs) that accrue to parties other than the firms that produced
them. A case of externality implies that the marginal social benefit of investment in new
technologies pioneered, is not represented by producer surplus. When such externalities can be
proven to exist, there is a good case for subsidizing export industries (activist trade policy).
The point for activist trade policy is that while firms can appropriate some of the benefits of their
own investment in knowledge, they usually cannot appropriate them fully.
The problem of externality and appropriability of knowledge disincentivize innovation,
particularly in high-tech industries.
Should the government support high-tech industries through subsidy in case of externalities?
Should the US government subsidize high technology industries?
When considering whether a government should subsidize high-technology industries, consider:
Arguments that US in particular should have a deliberate policy of promoting high-tech industries
and helping them compete against foreign rivals have curious history. This question raised in 1980-
1980, when Japanese firms started dominating some high-tech sector, previously dominated by US.
Between 1978 and 1986, the US share world production of memory chip fell from 70% to 20%,
while Japanese raised from 30% to 75%. There was a widespread concern that other high-tech
products produced in the US would suffer the same fate.
However, the Japanese dominance in microchips have not been translated in computer production,
perhaps. Furthermore, by 1990, US surged into a renewed period of technological dominance
related to Internet application (Japanese did not).
- A potential idea for US could be, instead of subsidizing specific industries, it should
subsidize R&D through the tax code – R&D expenses can be deducted from corporate
taxable income
3. Externalities may occur across countries as well: if this is the case, no individual country has an
incentive to subsidize industries if all countries could take advantage of the externalities generated
in another.
(2) Imperfect competition and strategic trade policy – Barbara Spencer and James Brander
This argument identifies the market failure that justifies government intervention as the presence of
imperfect competition in international markets.
Imperfectly competitive industries are typically dominated by a few firms that generate monopoly
profits or excess profits. Imperfectly competitive industries at international level are the concern. In
these industries, there is excess returns, meaning that firms will make profits above what equally
risky investments elsewhere in the economy can earn. There is thus an international competition
over who gets these profits. According to Spencer and Brander, this case may justify in principle
government to alter the rules of the game to shift these excess profits from foreign to domestic
firms – through subsidy of domestic firms.
Example – the Brander-Spencer analysis
The Brande-Spencer analysis can be illustrated with a simple example in which only two firms
(Boeing and Airbus) compete in the international market, but they are located in two different
countries (U.S. and Europe).
Both firms manufacture airplanes (the same product), but each firm’s profit depends on the actions
of the other. Each firm decides to produce or not depending on profit levels.
The table reflects the following assumption: either firm alone could earn profits by making the
product – if Boeing produces (and Airbus does not) it earns 100, and vice versa. But if both firms
try to produce them both will incur in losses.
Which firm actually gets the profits? This depends on who gets to produce first:
The predicted outcome depends on which firms invest/produce first:
- If Boeing produces first, the Airbus will not find it profitable to produce
- If Airbus produces first, then Boeing will not find it profitable to produce
Suppose Boeing is able to produce first. Airbus is constrained to choose only in the between -5 and
0 since it is sure that Boeing produce. Airbus would choose not to produce because 0 is better than a
loss of -5.
But a subsidy by EU, for example, can alter the outcome by making it profitable for Airbus to
produce regardless of Boeing’s actions.
Suppose that EU government gives a 25 subsidy if Airbus choose to produce. This will increase the
profits in the first quadrant from -5 to 20. In this case, Airbus would produce regardless the other
firm’s actions.
If Boeing expects that the European Union will subsidize Airbus, Boeing will be deterred from
producing. Boeing knows that whatever it does, it will have to compete with Airbus and will
therefore lose money if it chooses to produce (0 of not producing is better than -5) – after the 25
subsidies.
As direct consequence, the EU subsidy would cause Boeing to choose not to produce. Therefore,
the 25 subsidies will generate 125 profits for Airbus.
The subsidy raises profits more than the amount of the subsidy itself due to its deterrent effect on
foreign competition
Such government policy aimed at giving domestic firm a strategic advantage in production, is also
called strategic trade policy.
3. Strategic trade policy, like any other trade policy, could be manipulated by politically powerful
groups.
The above claim can be true, but we cannot claim that trade hurts workers for sure. In fact, a
Ricardian model predicts that while wages in Mexico should remain lower than those in the U.S.
due to low productivity in Mexico, Mexico wages will actually rise relative to their pre-trade level.
Similarly, HO model predicts that unskilled workers in the U.S. (developed) will lose from
NAFTA, but it also predicts that unskilled workers in Mexico (developing) will gain.
Despite the overall lower wages of Mexico compared to US after trade, both theories predict that
those workers in Mexico are better off with trade than they would be in absence of trade.
Rationale: the comparison between working conditions and wages before and after trade, should be
between different sectors within Mexico (sectors internationally involved vs. sectors not) instead
between Mexico and U.S.
- Evidence shows that wages in maquiladoras have risen relative to wages in other Mexican
sectors. Therefore, one should compare working conditions and wages in maquiladoras with
those in other Mexican sectors, rather than comparing maquiladoras conditions with the U.S.
The standard argument is that despite low wages in developing countries, those workers are better
off than they would have been with no trade
But we cannot conclude that trade hurts the environment. There are at least as many cases of
environmental damage that has occurred in the name of “inward-looking” policies of countries
reluctant to integrate with the global economy. A notable example is the destruction of many square
miles of rain forest in brazil, the consequence of a domestic policy that subsidizes development in
the interior.
Many environmental activists want to include environmental standard in trade negotiation, but
to this end there is an open debate.
Still, the developing countries’ governments seems to be the ones opposed to such environmental
standards. This on the basis that it may be difficult for poorer countries to satisfy such requirements.
- Environmental standards could be used as a protectionist tool whenever developing
countries cannot satisfy such standards imposed by advanced countries.
- Environmental standard could be used as basis to start a lawsuit.
- Environmental standards satisfaction is expensive for poorer producers
Economic growth and environmental damage – Kuznets theory
Both production and consumption often lead to environmental damage. Since production and
consumption lead to economic growth, it may be claimed that economic growth can lead to
environmental damage.
To this regard, as poor countries grow richer by (increasing production and consumption), they
cause also more environmental degradation.
However, as they grow richer, to some extent they can devote more money to environmental
protection, thus diminishing the damage to the environment.
Both the ideas that economic growth leads to environmental damage and that economic growth
leads to more intense environmental protection, are represented in the environmental Kuznets
curve.
The idea is that as countries’ economies grow (as income per capita grow), the initial effect is
growing damage to the environment. For example, China whose economy has surged in recent
decades, is in effect moving from A to B.
But when a country gets sufficiently rich, it can afford to take action to protect the environment.
Growing richer and doing less damage to the environment.
Pollution Havens
Because rich countries usually have strict environmental regulations and poor countries do not,
environmentally hazardous activities (shipbreaking) may be moved to poor countries.
A pollution heaven is a place where an economic activity that is subject to strict environmental
controls in some countries is moved to other countries with less strict regulation (poorer countries).
(1) Are pollution heavens an important factor? (2) Do they deserve to be a subject of international
negotiation?
(1) yet there is evidence that pollution havens are insignificant relative to the pollution that occurs
without international trade. (2) some types of pollution affect the domestic territory, so it may be
not in the interest of other countries to make pollution heavens a subject of trade negotiation.
However, considering the question (2), it depends on the nature of the pollution. Pollution is a valid
reason for government intervention (through standards in trade negotiation) when it extends across
national boundaries – it justifies international concern (i.e. carbon dioxide emissions)
Pollution is a negative externality: a cost that individuals impose on others but do not pay for.
When such negative externality affects individuals internationally, they deserve to be subject of
international negotiations – Carbon dioxide emissions affect the future climate for all countries.
Summary
1. One argument for an activist trade policy is that investment in high-technology industries
produces externalities for the economy.
- But it is hard to identify which activities produce externalities and if so, to what degree they
do.
2. A second argument for an activist trade policy is that governments can give domestic firms a
strategic advantage in industries with excess profits.
- But it is unclear if such a policy would succeed at giving a firm a strategic advantage or if it
would be worthwhile.
3. Some have opposed free trade because of the fact that workers in low- and middle-income
countries earn lower wages and have worse working conditions than workers in high-income
countries.
- But workers in low- and middle-income countries are predicted to have lower wages due to
lower productivity, yet still have higher wages compared to their situation without trade.
4. Some have proposed that trade negotiations should involve labor, environmental, or “cultural”
standards, but these standards are generally opposed by governments of low- and middle- income
countries.