Chapter 9

The Political Economy of Trade Policy

Udayan Roy
International Economics: Theory and Policy,
Policy Eighth Edition
by Paul R. Krugman and Maurice Obstfeld
 Introduction
 Some gain and some lose from free trade. But the
gains exceed the losses; free trade maximizes national
welfare (i.e., total surplus).
 Yet most governments restrict trade in some way or
other.
 Why don’t governments listen to economists’ cost-
benefit calculations?
 Should they?

Slide 9-3
The Cases for Free Trade I

Slide 9-7
 The Cases for Free Trade I
 However, because tariff rates are already low for most
countries, estimated benefits of moving to free trade are only a
small fraction of national income for most countries.
 So, this argument has become less persuasive, now that tariffs
are already significantly lower than before.

Slide 9-8
The Cases for Free Trade I

Slide 9-9
The Cases for Free Trade (cont.)
 Yet when quotas are used instead of tariffs, costs can
be magnified through rent seeking.
• To seek quota licenses or the rights to sell a restricted
number of imports and the profit that they will earn,
individuals or institutions need to spend time and other
resources.
 Thus, another reason why trade allocates resources
efficiently is that it avoids the loss of resources
through rent seeking.

9-10
 The Cases for Free Trade I
 And for some countries in some time periods, the estimated
cost of protection was substantial.

Slide 9-11
The Cases for Free Trade I

Slide 9-12
 The Case for Free Trade II
• In the case of increasing returns to scale, bulk
production reduces per unit costs.
– This benefit from bulk production is called scale
economies.
• 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, under a protectionist regime in 1964, 13 firms
produced a total of 166,000 cars per year.
• In the presence of scale economies, free trade makes
more varieties available and at lower prices.
Slide 9-13
 The Case for Free Trade III
 Free trade enables an inventor to sell to a larger
market. As a result, free trade provides a stronger
incentive for innovation.

Slide 9-14
 The Case for Free Trade IV
 A political argument
• Free trade is the best feasible political policy, even though
there may be better policies in principle
• Trade policies that single out certain industries for
protection from imports are in practice dominated by
special-interest politics rather than consideration of
national costs and benefits.

Slide 9-15
 National Welfare Arguments
Against Free Trade
 There are two theoretical arguments against the
policy of free trade:
• The terms of trade argument for a tariff
– We have seen this one before!
• The domestic market failure argument

Slide 9-16
 National Welfare Arguments
Against Free Trade I
 The Terms of Trade Argument for a Tariff
• For a “large” country, a tariff lowers the price of
imports.
– This benefit of a tariff is called a terms of trade benefit.
• 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.

Slide 9-17
Terms of Trade Argument for a Tariff

 Weaknesses
• The argument doesn’t work for small countries
• Even if a large country benefits from a tariff, that
benefit will come at the expense of other countries.
– The world as a whole would be worse off
– This would invite retaliatory tariffs, in which case the
tariff might hurt everybody

Slide 9-18
 National Welfare Arguments
Against Free Trade II
 The Domestic Market Failure Argument Against Free
Trade
• Consumer and producer surplus ignore the social costs
and benefits of 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.
Slide 9-21
National Welfare Arguments
Against Free Trade II

Slide 9-22
 National Welfare Arguments
Against Free Trade II
 How Convincing Is the Market Failure Argument?
• 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.
Slide 9-24
 Real World Trade Policy

 While economists may talk about national welfare or

total surplus, in a democracy, trade policy is
influenced by the difference in political power
between those who lose from free trade and those
who gain.
 There are two main theories in political science about
how governments make decisions:
• Median voter theorem
• Collective action theory

Slide 9-25
 Real World Trade Policy

 The Median Voter Theory

– There are two competing political parties.
– Each party has to decide on the level of the tariff
imposed.
– Voters differ in the tariff they prefer.
• What policies will the two parties promise to follow?
– Both parties will support the tariff policy that the
median voter (the voter who is exactly halfway up the
lineup) prefers.

Slide 9-26
 Median Voter Theorem Fails
 The median voter theorem cannot explain the
widespread use of tariffs
 Those who benefit from a tariff are usually few in
number compared to those who are hurt by the tariff.
Therefore,
 Had the median voter theorem been correct, tariffs
would rarely have been enacted

Slide 9-27
 Real World Trade Policy

 Collective Action
• This approach views political activity as a public
good.
– For instance, if one consumer’s letter to a politician
helps to stop a tariff, all consumers would benefit.
– This encourages free riding. Consequently,
• Trade policies that impose large total losses that are
spread among many individual consumers may not
face opposition.
– Industries that are well organized (or have a small
number of firms) will get protection.
Slide 9-29
 Sugar import quota, 1990
 The U.S. quota on sugar imports
• Limits imports to 2.13 million tons, which is half of
what it would be under free trade
• Keeps the U.S. price at $466 per ton, compared to
$280 per ton in world markets
• Consumers lose $1.646 billion
• Producers gain $1.066 billion
• Net loss to the U.S. is $580 million per year

Slide 9-30
 Sugar import quota, 1990
 The loss per consumer is $6 per year. This is about $25 per
family.
 As the U.S. sugar industry employs about 12,000 workers, the
gains per employee is $90,000 per year.
 No wonder, the producers are politically organized and the
consumers don’t bother!
 The final insult: without the quota, between 2000 and 3000
workers would have had to look for jobs elsewhere.
 Thus, the cost to the consumer per job saved in the sugar
industry is more than $500,000 per year.

Slide 9-31
 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).
Slide 9-33
Table 9-2: Welfare Costs of U.S.
Protection ($ billion)

Copyright © 2009 Pearson Addison-Wesley. All rights 9-34

reserved.
 International Negotiations
and Trade Policy
 Globalization has increased from the mid-1930s
partly because the United States and other advanced
countries gradually removed tariffs and non-tariff
barriers to trade.

Slide 9-36
International Negotiations
and Trade Policy

Slide 9-37
 GATT and WTO
 The removal of trade barriers was facilitated by
institutionalized negotiations among countries
 The General Agreement of Tariffs and Trade was
begun in 1947 as a provisional international
agreement
 It was replaced by a more formal international
institution called the World Trade Organization in
1995.

Slide 9-38
 International negotiations
 Why was it necessary to engage in international
negotiations to get trade barriers reduced?
 Why didn’t the advanced countries reduce their trade
barriers unilaterally?

Slide 9-39
 International Negotiations
and Trade Policy
 The Advantages of International 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 and
speak up against the import-competing industries
who oppose imports.
– It can help governments avoid getting caught in
destructive trade wars. (Next two slides.)
– It reduces the possibility of an adverse terms-of-trade
effect from a unilateral reduction of tariffs.
Slide 9-40
International Negotiations
and Trade Policy

Slide 9-41
 International Negotiations
and Trade Policy
 In Table 9-4, each country would choose 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 thereby escape the
prisoner’s dilemma.

Slide 9-42
 Bilateral versus Multilateral
 Smoot-Hawley tariffs in 1930
 Widely recognized to be a mistake that worsened the
Great Depression
 But unilateral tariff reduction was politically difficult
 Initially bilateral tariff-reducing agreements were
pursued
 Later multilateral agreements became popular
 Why?

Slide 9-43
 Bilateral Trade Liberalization
 Suppose the USA and Brazil currently impose
tariffs on each other’s goods and cannot
unilaterally remove the tariffs because of the
political power of US coffee growers and USA
Brazilian wheat farmers
 When bilateral negotiations begin, the US coffee
growers’ (or, Brazilian wheat farmers’) resistance
to free trade would be opposed by US wheat Wheat Coffee
farmers (or, Brazilian coffee growers) eyeing a
possible reduction of Brazil’s (or, the US’s) tariffs
on US wheat (or, Brazilian coffee).
 In this way, bilateral negotiations to reduce tariffs Brazil
can succeed even when unilateral efforts fail.

Slide 9-44
Multilateral Trade Liberalization
 In this example, bilateral
negotiations between, say, Angola
and Brazil will not succeed in China
reducing tariffs.
• As Brazil does not export coffee to
Angola, there will be no opposition Wheat Coffee
to Brazilian oil producers’ demands
for a tariff on Angolan oil.
 However, a multilateral agreement Angola
Oil
Brazil
will be successful. In each country,
exporters will organize to oppose
importers’ resistance to the
multilateral agreement.

Slide 9-45
 International Negotiations
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.
Slide 9-46
 International Negotiations
and Trade Policy
 The GATT-WTO system prohibits the imposition of:
• Export Subsidies
– except for agricultural products
• New Import quotas
– except when imports threaten “market disruption”
• New or Higher Tariffs
– any new tariff or increase in a tariff must be offset by
reductions in other tariffs to compensate the affected
exporting countries
– This is called “binding” of tariffs

Slide 9-47
 International Negotiations
and Trade Policy
 Trade round
• A large group of countries get together to negotiate a set of tariff
reductions and other measures to liberalize trade.
 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%.

Slide 9-50
 International Negotiations
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 non-
tariff barriers, such as VER’s (or, voluntary export
restrictions).
 An eighth round of
negotiations, the so-called
Uruguay Round, was competed in 1994.

Slide 9-51
 International Negotiations
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.

Slide 9-52
Trade liberalization, Uruguay round
 Advanced country tariffs reduced by 40%
 Agricultural subsidies by exporters reduced by 36%
• Volume of subsidized exports reduced by 21%
• Agricultural import quotas replaced by bound tariffs
 MFA phased out in 2005
• All quantitative restrictions gone
• Some tariffs remain
 Government procurement brought under fairer rules

Slide 9-53
 World Trade Organization
 The World Trade Organization was founded in 1995 on
a number of agreements
• General Agreement on Tariffs and Trade: covers trade in
goods
• General Agreement on Tariffs and Services: covers trade in
services (ex., insurance, consulting, legal services, banking).
• Agreement on Trade-Related Aspects of Intellectual
Property: covers international property rights (ex., patents
and copyrights).

9-54
 World Trade Organization
• The dispute settlement procedure: a formal procedure
where countries in a trade dispute can bring their case to a
panel of WTO experts to rule upon.
• The cases are settled fairly quickly: even with appeals the
procedure is not supposed to last more than 15 months.
• The panel uses previous agreements by member countries
to decide which ones are breaking their agreements.

9-55
 World Trade Organization
• A country that refuses to adhere to the panel’s decision may
be punished by allowing other countries to impose trade
restrictions on its exports.

9-56
 World Trade Organization
 The GATT/WTO multilateral negotiations, ratified in
1994 (called the Uruguay Round),
• agreed that all quantitative restrictions (ex., quotas) on
trade in textiles and clothing as previously specified in the
Multi-Fiber Agreement were to be eliminated by 2005.

 But as the restrictions were eliminated, China had to

reimpose quotas until 2011 due to political pressure.

9-57
 International Negotiations
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.

Slide 9-58
 WTO: US v. Venezuela
 US laws allowed domestic oil refineries to sell oil with more
pollutants than imported oil
 Venezuela, which exports oil to the US, sued the US at the
WTO
 Venezuela won. The US had to change its laws to make them
non-discriminatory
 This episode showed that the WTO worked
 Environmentalists complained that the WTO made it harder
for the US to reduce pollution
 Actually, the fault lies with the US law. The WTO should not
be blamed

Slide 9-59
 International Negotiations
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.

Slide 9-60
 WTO Doha Round
 In 2001, a new round of negotiations was started in
Doha, Qatar, but these negotiations have failed to
produce an agreement.
• Most of the remaining forms of protection are in
agriculture, textiles and clothing—industries that are
politically active (see “Collective Action” above).

9-61
Table 9-4: Percentage Distribution of
Potential Gains from Free Trade

9-62
Do Agricultural Subsidies in Rich Countries
Hurt Poor Countries?
 We learned in chapter 8 that subsidies lower the world price of
products because domestic producers are enticed to produce
more.
• So why should poor countries want rich countries to remove their
agricultural subsidies?
• The likely answer has to do with the desires of farmers in poor
countries who compete with farmers in rich countries.
• Yet, urban residents and farmers who do not compete (ex., coffee
farmers) actually benefit from the lower prices of subsidized food on
world markets.
– For example, because China imports a lot of food, it would be hurt by the
removal of agricultural subsidies in rich countries (ex., the U.S. and
Europe) according to the Doha negotiations.

9-63
 Table 9-5: Percentage Gains in
Income under Two Doha Scenarios

9-64
 WTO Doha Round
 Main sticking point: agriculture subsidies
• Rich countries want to protect their farmers
• Poor countries want free market access for their
farmers
 Countries seem to have given up on WTO
negotiations
 Preferential trade agreements seem popular

Slide 9-65
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.

Slide 9-66
Preferential Trading Agreements

• 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.
Slide 9-67
Preferential Trading Agreements

 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.

Slide 9-68
 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

Slide 9-69
 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.

Slide 9-70
 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.
Slide 9-71
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

Slide 9-72
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

Slide 9-73