Free Trade

Chapter Organization
 Introduction
 The Case for Free Trade
 National Welfare Arguments against Free Trade
 Income Distribution and Trade Policy
 International Negotiations and Trade Policy
 Summary
 Appendix: Proving that the Optimum Tariff is
Positive
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Introduction
 Free trade maximizes national welfare, but it is
associated with income distributional effects.
• Most governments maintain some form of restrictive
trade policies.
• This chapter examines some of the reasons
governments either should not or do not base their
policy on economists’ cost-benefit calculations.

Introduction
 What reasons are there for governments not to
interfere with trade?
• There are three arguments in favor of free trade:
– Free trade and efficiency
– Economies of scale in production
– Political argument

The Case for Free Trade
 Free Trade and Efficiency
• The efficiency argument for free trade is based on the
result that in the case of a small country, free trade is
the best policy.
– A tariff causes a net loss to the economy.
– A move from a tariff equilibrium to free trade
eliminates the efficiency loss and increases national
welfare.

Figure 9-1: The Efficiency Case for Free Trade
Price, P S
Production Consumption
distortion distortion
World price
plus tariff
World price
D
Quantity, Q

Table 9-1: Estimated Cost of Protection,
as a Percentage of National Income

 Additional Gains from Free Trade
• Protected markets in small countries do not allow firms
to exploit scale economies.
– Example: In the auto industry, an efficient scale assembly
should make a minimum of 80,000 cars per year.
– In Argentina, 13 firms produced a total of 166,000 cars per year.
• The presence of scale economies favors free trade that
generates more varieties and results in lower prices.
• Free trade, as opposed to “managed” trade, provides a
wider range of opportunities and thus a wider scope for
innovation.
 Political Argument for Free Trade
• A political commitment to free trade may be a good
idea in practice.
• Trade policies in practice are dominated by special-
interest politics rather than consideration of national
costs and benefits.

National Welfare Arguments
Against Free Trade
 Activist trade policies can sometimes increase the
welfare of the nation as a whole.
 There are two theoretical arguments against the
policy of free trade:
• The terms of trade argument for a tariff
• The domestic market failure

Against Free Trade
 The Terms of Trade Argument for a Tariff
• For a large country (that is, a country that can affect
the world price through trading), a tariff lowers the
price of imports and generates a terms of trade benefit.
– This benefit must be compared to the costs of the tariff
(production and consumption distortions).
• It is possible that the terms of trade benefits of a tariff
outweigh its costs.
– Therefore, free trade might not be the best policy for a
large country.

Against Free Trade
Figure 9-2: The Optimum Tariff
National welfare
Optimum Prohibitive Tariff rate

tariff, to tariff rate, tp
Against Free Trade
• Optimum tariff
– The tariff rate that maximizes national welfare
– It is always positive but less than the prohibitive rate
that would eliminate all imports.
– It is zero for a small country because it cannot affect its
terms of trade.

Against Free Trade
• What policy would the terms of trade argument dictate
for export sectors?
– An export subsidy worsens the terms of trade, and
therefore unambiguously reduces national welfare.
– Therefore, the optimal policy in export sectors must be a
negative subsidy, that is, a tax on exports.
– Like the optimum tariff, the optimum export tax is
always positive but less than the prohibitive tax that
would eliminate exports completely.

Against Free Trade
 The Domestic Market Failure Argument Against
Free Trade
• Producer and consumer surplus do not properly
measure social costs and benefits.
– Consumer and producer surplus ignore domestic
market failures such as:
– Unemployment or underemployment of labor
– Technological spillovers from industries that are new or
particularly innovative
– Environmental externalities
• A tariff may raise welfare if there is a marginal social
benefit to production of a good that is not captured by
producer surplus measures.
Against Free Trade
Figure 9-3: The Domestic Market Failure Argument for a Tariff
Price, P
S
(a) PW + t
PW a b
D
S1 S2 D2 D1 Quantity, Q
Dollars
(b) Marginal
social
c benefit
S1 S2 Quantity, Q
Against Free Trade
• The domestic market failure argument against free
trade is a particular case of the theory of the second
best.
– The theory of the second best states that a hands-off
policy is desirable in any one market only if all other
markets are working properly.
– If one market fails to work properly, a government
intervention may actually increase welfare.

Against Free Trade
 How Convincing Is the Market Failure Argument?
• The are two basic arguments in defense of free trade in
the presence of domestic distortions:
– Domestic distortions should be corrected with domestic
(as opposed to international trade) policies.
– Example: A domestic production subsidy is superior to a tariff
in dealing with a production-related market failure.
– Market failures are hard to diagnose and measure.
– Example: A tariff to protect urban industrial sectors will
generate social benefits, but it will also encourage migration to
these sectors that will result in higher unemployment.

Income Distribution
and Trade Policy
 In practice, trade policy is dominated by income
distribution considerations.
• The desires of individuals get more or less imperfectly
reflected in the objectives of government.
– There exist models in which governments try to
maximize political success.
 Electoral Competition
• Political scientists argue that policies are determined
by competition among political parties that try to
attract as many votes as possible.

Income Distribution
and Trade Policy
• Assumptions of the model:
– There are two competing political parties.
– The objective of each party is to get elected.
– Each party has to decide on the level of the tariff
imposed (this is the only policy available).
– Voters differ in the tariff they prefer.
• What policies will the two parties promise to follow?
– Both parties will offer the same policy consisting of the
tariff that the median voter (the voter who is exactly
halfway up the lineup) prefers.

Income Distribution
and Trade Policy
Figure 9-4: Political Competition
Preferred tariff rate

Political support
tA
tB
tM
Median
Voters
voter
Income Distribution
and Trade Policy
 Collective Action
• This approach views political activity as a public
good.
– For instance, the imposition of a tariff protects all
firms in an industry, but the lobbying costs for
imposing the tariff are covered by only a few firms.
• Trade policies that impose total large losses that are
spread among many individual firms or consumers
may not face opposition.
– Industries that are well organized (or have a small
number of firms) get protection.
Income Distribution
and Trade Policy
 Modeling the Political Process
• Interest groups “buy” policies by offering
contributions contingent on the policies followed by
the government.

Income Distribution
and Trade Policy
 Who Gets Protected?
• Two sectors seem to get protected in advanced
countries:
– Agriculture
– Farmers are well organized and the structure of the U.S.
government enhances their political power.
– Clothing
– Both textiles and apparel have enjoyed substantial protection.
This sector employs less skilled workers and it is unionized as
well.
• Protection is very likely to diminish in the future in
both sectors (due to international trade negotiations).
Income Distribution
and Trade Policy
Table 9-2: Effects of Protection in the United States ($ billion)

International Negotiations
and Trade Policy
 International integration has increased from the mid-
1930s until about 1980 because the United States and
other advanced countries gradually removed tariffs
and nontariff barriers to trade.

and Trade Policy
Figure 9-5: The U.S. Tariff Rate

and Trade Policy
 How was the removal of tariffs politically possible?
• The postwar liberalization of trade was achieved
through international negotiation.
– Governments agreed to engage in mutual tariff
reduction.
 The Advantages of Negotiation
• It is easier to lower tariffs as part of a mutual
agreement than to do so as a unilateral policy
because:
– It helps mobilize exporters to support freer trade.
– It can help governments avoid getting caught in
destructive trade wars.
and Trade Policy
Table 9-3: The Problem of Trade Warfare
Japan
U.S. Free trade Protection
10 20
Free trade
10 -10
-10 -5
Protection
20 -5

and Trade Policy
 In Table 9-3, each country has a dominant strategy:
Protection.
 Even though each country acting individually would
be better off with protection, they would both be
better off if both chose free trade.
• In game theory, this situation is known as a Prisoner’s
dilemma.
• Japan and the U.S. can establish a binding agreement
to maintain free trade.

and Trade Policy
 International Trade Agreements: A Brief History
• Internationally coordinated tariff reduction as a trade
policy dates back to the 1930s (the Smoot-Hawley
Act).
• The multilateral tariff reductions since World War II
have taken place under the General Agreement on
Tariffs and Trade (GATT), established in 1947 and
located in Geneva.
– It is now called the World Trade Organization
(WTO).
– The GATT-WTO system is a legal organization that
embodies a set of rules of conduct for international
trade policy.
and Trade Policy
• The GATT-WTO system prohibits the imposition of:
– Export Subsidies (except for agricultural products)
– Import quotas (except when imports threaten “market
disruption”)
– Tariffs (any new tariff or increase in a tariff must be
offset by reductions in other tariffs to compensate the
affected exporting countries)
• Trade round
– A large group of countries get together to negotiate a set
of tariff reductions and other measures to liberalize
trade.
and Trade Policy
• Eight trade rounds have occurred since 1947:
– The first five of these took the form of “parallel”
bilateral negotiations (e.g., Germany with France and
Italy).
– The sixth multilateral trade agreement, known as the
Kennedy Round, was completed in 1967:
– This agreement involved an across-the-board 50% reduction in
tariffs by the major industrial countries, except for specified
industries whose tariffs were left unchanged.
– Overall, the Kennedy Round reduced average tariffs by about
35%.

and Trade Policy
– The so-called Tokyo round of trade negotiations
(completed in 1979) resulted in:
– Reduced tariffs
– New codes for controlling the proliferation of nontariff
barriers, such as VER’s.
– An eighth round of negotiations, the so-called Uruguay
Round, was competed in 1994.

and Trade Policy
 The Uruguay Round
• Its most important results are:
– Trade liberalization
– Administrative reforms
 Trade Liberalization
• The average tariff imposed by advanced countries decreased by
almost 40%.
– More important is the move to liberalize trade in two important
sectors: agricultural and clothing.
 From the GATT to the WTO
• Much of the publicity surrounding the Uruguay Round focused
on its creation of the WTO.

and Trade Policy
• How different is the WTO from the GATT?
– The GATT was a provisional agreement, while the WTO
is a full-fledged international organization.
– The GATT applied only to trade in goods, while the
WTO included rules on trade in services (the General
Agreement on Trade in Services (GATS)) and on
international application of international property rights.
– The WTO has a new “dispute settlement” procedure
which is designed to reach judgments in a much shorter
time.

and Trade Policy
 Benefits and Costs
• The economic impact of the Uruguay Round is
difficult to estimate.
– However, estimates of the GATT and of the
Organization for Economic Cooperation and
Development suggest a gain to the world economy as a
whole of more than $200 billion annually once the
agreement is fully in force.
– Most economists believe that these estimates are too low.
– The costs of the Uruguay Round will be felt by well-
organized groups, while much of the benefit will accrue
to diffuse populations.

and Trade Policy
 Preferential Trading Agreements
• Nations establish preferential trading agreements
under which they lower tariffs with respect to each
other but not the rest of the world.
• The GATT-WTO, through the principle of non-
discrimination called the “most favored nation”
(MFN) principle, prohibits such agreements.
– The formation of preferential trading agreements is
allowed if they lead to free trade between the
agreeing countries.

and Trade Policy
• Free trade can be established among several WTO
members as follows:
– A free trade area allows free-trade among members,
but each member can have its own trade policy
towards non-member countries.
– Example: The North American Free Trade Agreement
(NAFTA) creates a free trade area.
– A customs union allows free trade among members
and requires a common external trade policy towards
non-member countries.
– Example: The European Union (EU) is a full customs
union.
– A common market is a customs union with free
factor movements (especially labor) among members.
and Trade Policy
 Are preferential trading agreements good?
• It depends on whether it leads to trade creation or
trade diversion.
– Trade creation
– Occurs when the formation of a preferential trading
agreement leads to replacement of high-cost domestic
production by low-cost imports from other members.
– Trade diversion
– Occurs when the formation of a preferential trading
agreement leads to the replacement of low-cost imports
from non members with higher-cost imports from member
nations.

Summary
 There are three arguments in favor of free trade:
• The efficiency gains from free trade
• The additional gains from economies of scale
• The political argument
 There are two arguments for deviating from free
trade:
• The terms of trade argument for a tariff
• The domestic market failures

Summary
 In practice, trade policy is dominated by considerations
of income distribution.
• Political parties adopt policies that serve the interests of
the median voter.
• Groups that are well organized (or small groups) are often
able to get policies that serve their interests at the expense
of the majority.

Summary
 International negotiation helps reduce tariffs in industrial
countries and avoid trade wars.
 The GATT is the central institution of the international
trading system.
• The most recent worldwide GATT agreement also sets up
a new organization, the WTO.
 Three kinds of preferential trading agreements are
allowed under the WTO: free trade areas, customs unions,
and common markets.
 Preferential trading agreements can be good or bad
depending on the magnitude of trade creation and trade
diversion effects.
Appendix: Proving that the
Optimum Tariff is Positive
Figure 9A-1: Effects of a Tariff on Prices
Price, P
~ Foreign export supply

P
t
PF
PW
Home import demand
Quantity, Q

Appendix: Proving that the
Optimum Tariff is Positive
Figure 9A-2: Welfare Effects of a Tariff
Price, P S
~
P
Loss
PF
Gain
PW
Q 1 Q2 D2 D1 Quantity, Q

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Chapter Organization

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Optimum Prohibitive Tariff rate

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Preferred tariff rate

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U.S. Free trade Protection

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~ Foreign export supply

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