Controversies in Trade Policy

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CHAPTER 12 – 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.

Four controversies about international trade

Arguments for “activist” trade policy


1. Externality or appropriability problem
2. Strategic trade policy with imperfect competition

Arguments concerning trade and people


3. Trade and low wage labour (opposed to free trade)
4. Trade and the environment
5. Trade and culture

Arguments for “activist” trade policy:


- An activist trade policy usually means government policies that actively support export
industries through subsidies
- It uses the concept of market failure explored in previous chapters.

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.

(1) Technology and externalities

Potential market failure arising from difficulties of appropriating knowledge.


Firms that invest in new technology generally create knowledge that other firms can use without
paying for it: an appropriability problem.

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:

1. The government ability to subsidize the right activity


Many activities in the production process of high-tech firms have nothing to do with generating
knowledge. Perhaps, subsidizing equipment or non-technical workers would make no sense to what
it concerns creating new technology. Rather, it would be better to subsidize R&D activities.
Additional problem is that much of the innovation and knowledge for delivering new technologies,
is not actually occurring in high-tech industries – difficult to tackle the right activity.
A general principle is that trade and industrial policy should be targeted specifically on the activity
in which the market failure occur – in this case market failure is displayed by appropriability
problem.

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

It is a difficult debate to settle whether high-tech industries should be subsidized.

2. The economic importance of externalities to decide whether a government should subsidize:


- it is difficult to determine the quantitative importance that externalities have on the economy
Therefore, it is difficult to say how much to subsidize activities that create externalities.

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.

Criticism of Brander-Spencer Analysis


1. Practical use of strategic trade policy requires more information about firms than is likely
available.
- In fact, the predictions of the previous simple example change if the numbers are slightly
different
- What if government or economists are not exactly right when predicting the profits of firms?
Perhaps, what if Boeing has a better technology that only it can recognize, so that even if
Airbus produces, Boeing still finds it profitable to produce?

2. Foreign retaliation could also result


If European Union subsidizes Airbus, the U.S. could subsidize Boeing which would deter neither
firm from producing, starts a trade war, and waste of taxpayer funds used to subsidize.

3. Strategic trade policy, like any other trade policy, could be manipulated by politically powerful
groups.

Arguments concerning trade and people

3. Trade and low wage labour


The rise of manufactured exports from developing countries have been one of the major shifts in
the world economy over the last generation – manufactured exports from low-middle-income
countries increased, so poor nations rely more on exports of manufactured goods than on exports of
traditional agricultural or mineral products.
However, compared to developed countries, in poorer nations workers in the manufacturing sectors
are paid low wages and may work under bad conditions. For these reasons, in 1990s we observe a
movement of anti-globalization increasing. The concern of the movement is that international trade
between low and high wage countries, may be the cause of harming such low wage countries
producing inequalities on wages and working conditions.
Some more extreme case of anti-globalization argue that international trade hurts both countries’
workers

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

A possible solution: labour standards and trade negotiations


Some labour activists want to include labour standards in trade negotiations and trade agreements
between developed and developing nations.
- A first proposal: a system that monitors wages and working conditions and makes the result
of this monitoring available to consumers in developed countries. So when they buy goods
manufactured by developing countries, they can make sure that those workers were decently
paid, thus feeling better about their purchase – opportunity for mutual gain.
Controversy: this system would have impact only of workers in the export sector of such
developing countries, who represent only a small fraction of overall workforce.
- A second proposal: including formal labour standards as part of trade agreements – that
is, conditions that export industries in developing countries are supposed to meet to be able
to internationally trade (imposed by advanced nations).
Controversy: This proposal has had significant support by advanced nations, but not by
developing countries governments. (1) First, developing countries’ government are
convinced that advanced nations would use such labour standards as protectionist tool –
politicians in advanced countries would set standards that may developing countries are not
able to satisfy. (2) Second, labour standard would be used as basis for lawsuit when
developing countries’ producers are not able to meet standards. (3) standards set by high
income countries would be expensive for low-income producers

4. Trade and the Environment


Many critics argue that globalization is bad for the environment. It is true that environmental
conditions are worse in developing countries.
Some argue that is because environmental standards in developing countries are lower those in
advanced countries. On the other hand, some argue than the main cause of environmental damage in
developing countries is done to provide goods to advanced countries.

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.

A U-shaped relationship between


environmental degradation and income
per person
Empirical evidence suggests that as
economies grow, they initially do
increase environmental damage. Later,
one they become richer, they become
more environmentally friendly through
applicable regulation.

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.

5. Trade and Culture


Some activists believe that trade destroys culture in other countries. It is unmistakably true that the
effect of growing integration is the homogenization of culture around the world.
However, this belief goes against the principle that, in free societies, people must be able to define
themselves are they like, not through standards set by others. In addition, changes in culture is
caused by simple economic changes.

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.

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