University:
California State University, Northridge
Course:
ECON 405 | International Trade
Academic year:

2024
Views:

171

Pages:

20
Author:

Podkulr7i

Topic 5 The Political Economy of Trade Policy Part 2 Counter-Argument • For some countries, like the U.S., an import tariff or an export tax could improve national welfare at the expense of other countries. • But this argument ignores the likelihood that other countries may retaliate against large countries by enacting their own trade restrictions. The Cases Against Free Trade (cont.) • A second argument against free trade is that domestic market failures may exist that cause free trade to be a suboptimal policy. ♦ The efficiency loss calculations using CS and PS assume that markets function well. The Cases Against Free Trade (cont.) • Types of market failures include: ♦ Labor used to produce the import-competing good would be unemployed otherwise. • Production in labor-intensive (import-competing) industries helps the economy reach full employment. ♦ There are technological spillovers from the importcompeting industry to other industries. • Production of the import-competing good will improve technology in the country, but firms in the industry can’t earn revenues from this; and therefore, don’t take this into consideration when deciding output. The Cases Against Free Trade (cont.) • Economists calculate the marginal social benefit to represent the additional benefit to society from private production. ♦ With a market failure, MSB is not accurately measured by PS of private firms, so that efficiency loss calculations are misleading. Fig. 3: The Domestic Market Failure Argument for a Tariff Fig. 3(a) Fig. 3(a) shows the conventional cost-benefit analysis of a tariff in a small country. Fig. 3(b) shows the MSB from production not taken into account by PS. Tariff ↑P → ↓D and ↑S → distortions labeled a and b. But this ignores the possibility that ↑S → social benefit labeled c. If the tariff is small enough, c > a + b and welfare rises. Fig. 3(b) The Cases Against Free Trade (cont.) • The domestic market failure argument against free trade is an example of a more general argument called the theory of the second best. • This theory states that government intervention which distorts market incentives in one market may increase national welfare by offsetting the consequences of market failures elsewhere. ♦ The best policy would be to fix the market failures themselves, but if this is not feasible, then government intervention in another market may be the “second-best” way of fixing the problem. The Cases Against Free Trade (cont.) • E.g., If the labor market is not at full employment, then a policy of subsidizing L-intensive industries, which is undesirable in full employment, may be a good idea with high unemployment. ♦ Better to fix the labor market by making wages more flexible! But if this can’t be done, then intervening in other markets may be the “second-best” way to alleviate unemployment. Counter-Arguments • Economists supporting free trade counterargue that domestic market failures should be corrected by a “first-best” policy: a domestic policy aimed directly at the source of the problem. ♦ If national welfare increases with a tariff because it ↑Q which has social benefits, then ↑Q with a production subsidy. ♦ A production subsidy does not ↑P to consumers, so the under-consumption efficiency loss (due to the tariff) disappears. Counter-Arguments (cont.) • E.g., In U.S., VER on autos was supported to save jobs of autoworkers. • Advocates argue that labor markets are too inflexible for autoworkers to remain employed by cutting wages or finding jobs elsewhere. • Purely domestic policy: subsidize firms that hire autoworkers. ♦ Political opposition: require large payments → ↑federal budget deficit or ↑income taxes. ♦ Autoworkers are among the highest paid manufacturing workers, so public would object to this. Counter-Arguments (cont.) • VER is even more expensive: while bringing about the same level of employment, it also distorts consumer choice. • Difference in two policies: costs are less visible with VER → ↑Pautos vs. direct G outlays. • Critics of domestic market failure argument for protection argue that this case is typical. ♦ Most deviations from free trade are adopted because the public does not understand the true costs and not because benefits of protection > costs. Counter-Arguments (cont.) • In the real world, market failures are hard to identify, so it’s difficult to be certain about the appropriate policy response. ♦ E.g., Urban UE in developing countries. What is the best policy? Tariff to protect urban industrial sector will draw UE into work. Or might this policy encourage more rural-urban migration that will raise urban UE? • Economic theory explains properly functioning markets but provides little guidance for market failure. Political Models of Trade Policy • How is trade policy determined? • Models that address this question: 1. Median voter theorem 2. Collective action 3. And a model of trade policy that combines aspects of both Median Voter Theorem • The median voter theorem predicts that democratic political parties may change their policies to court the voter in the middle of the ideological spectrum (i.e., the median voter). • Suppose that this ideological spectrum is defined only by a tariff rate policy. ♦ And suppose that voters can be ranked according to whether they desire high or low tariff rates. Median Voter Theorem (cont.) • Assumptions of the model: 1. There are two competing political parties. 2. The objective of each party is to get elected by majority vote (not to maintain ideological purity). • What policies will the parties promise to follow? ♦ Both parties will offer the same tariff policy to court the median voter (the voter in the middle of the spectrum) in order to capture the most votes on either side of the median voter. Fig. 4: Political Competition Voters are lined up in order of the tariff they prefer. If one party proposes a high tariff tA, the other party can win over the most voters by offering a somewhat lower tariff, tB. This political competition drives both parties to propose tariffs close to tM, the tariff preferred by the median voter. Median Voter Theorem (cont.) • Thus, the median voter theorem implies that a two-party democracy should enact trade policy based on how many voters it pleases. ♦ A policy that inflicts large losses on a few people (import-competing producers) but benefits a large number of people (consumers) should be enacted into law. • But trade policy doesn’t seem to follow this prediction! Collective Action • Political activity is often described as a collective action problem: ♦ While consumers as a group have an incentive to advocate free trade, each individual consumer has no incentive because his benefit is not large compared to the cost and time required to advocate free trade. ♦ Policies that impose large losses for society as a whole but small losses on each individual may therefore not face strong opposition. Collective Action (cont.) • However, for those groups who may suffer large losses from free trade (e.g., UE), each individual in that group has a strong incentive to advocate the policy he desires. ♦ In this case, the cost and time required to advocate restricted trade is small compared to the cost of unemployment. Collective Action (cont.) • E.g., sugar quota costs the typical U.S. family $30/yr. Loss is small and most voters are unaware of the quota. One individual’s letter of protest won’t change policy and the small annual loss doesn’t justify the effort. • By contrast, the sugar producers are well organized and they are aware that the quota is worth thousands of dollars to an individual producer. They lobby Congress and make political contributions, so we end up with a trade policy whose costs > benefits.

The Political Economy of Trade Policy, Part 2

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