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

2024
Views:

424

Pages:

19
Author:

Adeline Ryan

Topic 5 The Political Economy of Trade Policy Preview • The cases for free trade • The cases against free trade • Political models of trade policy • International negotiations of trade policy and the WTO • Preferential trading agreements The Cases for Free Trade • Few countries have anything like free trade. ♦ Hong Kong is the only modern city with no quotas or tariffs. • Yet, economists have argued since Adam Smith that governments should pursue free trade. • Why? We will discuss three reasons. The Cases for Free Trade • First case for free trade: producers and consumers allocate resources most efficiently when governments do not distort market prices through trade policy. ♦ National welfare of a small country is highest with free trade. ♦ With restricted trade, consumers pay higher prices. ♦ With restricted trade, higher prices cause overproduction either by existing firms producing more or by more firms entering the industry. Fig. 1: The Efficiency Case for Free Trade A small country cannot influence foreign export prices. The tariff only distorts consumer and producer decisions. A move toward free trade eliminates these distortions and raises national welfare. Table 1: Benefits of a Move to Worldwide Free Trade (percent of GDP) Because tariff rates are already low for most countries, the estimated benefits of moving to free trade are only a small fraction of national income for most countries. The Cases for Free Trade (cont.) • 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 quantity 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. The Cases for Free Trade (cont.) • E.g., U.S. imports of canned tuna are protected by a “tariff-rate quota:” a small Q of tuna (4.8% of C) can be imported at a tariff of 6%; but any imports beyond that face a tariff of 12.5%. • There are no import licenses and the right to M tuna at the low tariff rate is given on a first come, first served basis. • This results in a costly race to get tuna into U.S. as fast as possible. • Importers stockpile large Q of canned tuna in warehouses in late Dec. and release the product as soon as the calendar year begins. The Cases for Free Trade (cont.) • Second case for free trade: it produces benefits beyond the elimination of production and consumption distortions. a) Allows firms or industry to take advantage of economies of scale. ♦ Need to deter massive entry into industries with falling AC and the resulting inefficient scale of production. The Cases for Free Trade (cont.) • Protection ↓competition and ↑profits domestically → encourages too many firms to enter the industry → each firm produces on a small scale where AC is higher. ♦ E.g., An efficient scale auto assembly plant should produce 80,000 to 200,000 autos/year. Yet, in 1964, Argentina protected its auto industry and produced 166,000 cars with 13 firms! The Cases for Free Trade (cont.) b) Free trade provides competition and opportunities for innovation. • Free trade gives entrepreneurs an incentive to export or compete with imports → giving more opportunities for learning and innovation than a system of “managed trade” where government dictates imports and exports. The Cases for Free Trade (cont.) • E.g., Until 1990s, India pursued an extreme form of ISI. This forced resources into the production of goods that were far more expensive and of lower quality than what could be bought abroad. • India was a very “closed” economy with X = 5% of GDP, which was among the lowest of any major nation. GDP per capita growth rate = 1.3%. • In 1990s, India liberalized trade and encouraged foreign I. By 2005, X = 20.3% of GDP and GDP per capita growth rate = 7.7%. The Cases for Free Trade (cont.) • These additional gains from trade (i.e., economies of scale and opportunities for innovation) are dynamic benefits, unlike the static benefits of eliminating the efficiency losses from over-production and underconsumption. The Cases for Free Trade (cont.) • Third case is called the political argument for free trade, says that free trade is the best feasible political policy, even though there may be better policies in principle. ♦ Economists might be able to show in theory that a set of tariffs and export subsidies could lead to higher national income. The Cases for Free Trade (cont.) • However, a government that tries to follow such a sophisticated trade policy would probably be captured by interest groups and converted into a program that redistributes income to politically powerful industries. The Cases Against Free Trade • First argument against free trade: for a “large” country, a tariff or quota lowers the price of imports in world markets and generates a terms of trade gain. ♦ This benefit may exceed the losses caused by distortions in production and consumption. • In fact, a small tariff will increase national welfare for a large country. ♦ But at some tariff rate, the national welfare will begin to decrease as the efficiency losses exceed the tot gain. Fig. 2: The Optimum Tariff Prohibitive tariff leaves the country worse off than free trade where tariff = 0. ↑tariff rate beyond tP has no impact on national welfare. Optimal tariff is greater than zero, but less than a rate that would prohibit all imports. Free trade The Cases Against Free Trade (cont.) • A tariff rate that completely prohibits imports leaves a country worse off, but tariff rate t0 may exist that maximizes national welfare: an optimum tariff. The Cases Against Free Trade (cont.) • An export tax that completely prohibits exports leaves a country worse off, but an export tax rate may exist that maximizes national welfare through the terms of trade gain. ♦ An export subsidy lowers the tot for a large country; but an export tax raises the tot. ♦ An export tax may raise the price of exports in the world market, increasing the tot. ♦ E.g., Saudi Arabia and other oil exporters tax oil exports, raising oil prices on world markets.

The Political Economy of Trade Policy, Part 1

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