Book Title
International Economics: Theory and Policy 9th Edition

978-0132146654 Chapter 10 Lecture Notes

December 18, 2019
48  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
Chapter 10
The Political Economy of Trade Policy
.1 Chapter Organization
The Case for Free Trade
  Free Trade and Efficiency
  Additional Gains from Free Trade
  Political Argument for Free Trade
Case Study: The Gains from 1992
National Welfare Arguments Against Free Trade
  The Terms of Trade Argument for a Tariff
  The Domestic Market Failure Argument Against Free Trade
  How Convincing Is the Market Failure Argument?
Income Distribution and Trade Policy
  Electoral Competition
  Collective Action
Box: Politicians for Sale: Evidence from the 1990s
  Modeling the Political Process
  Who Gets Protected?
International Negotiations and Trade Policy
  The Advantages of Negotiation
  International Trading Agreements: A Brief History
  The Uruguay Round
  Trade Liberalization
  Administrative Reforms: From the GATT to the WTO
Benefits and Costs
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49  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
  Box: Settling a Dispute—and Creating One
Case Study: Testing the WTO’s Mettle
The Doha Disappointment
  Box: Do Agricultural Subsidies Hurt the Third World?
  Preferential Trading Agreements
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
Chapter 10The Political Economy of Trade Policy  50
  Box: Free Trade versus Customs Unions
  Box: Do Trade Preferences Have Appeal?
  Case Study: Trade Diversion in South America
APPENDIX TO CHAPTER 10: Proving That the Optimum Tariff Is Positive
  Demand and Supply
  The Tariff and Prices
  The Tariff and Domestic Welfare
.2 Chapter Overview
The models presented up to this point generally suggest that free trade maximizes national welfare, although
it clearly is associated with income distributional effects. Most governments, however, maintain some
form of restrictive trade practices. This chapter investigates reasons for this. One set of reasons concerns
circumstances under which restrictive trade practices increase national welfare. Another set of reasons
concerns the manner in which the interests of different groups are weighed by governments. The chapter
concludes with a discussion of the motives for international trade negotiations and a brief history of
international trade agreements.
One recurring theme in the arguments in favor of free trade is the emphasis on related efficiency gains.
As illustrated by the consumer/producer surplus analysis presented in the text, nondistortionary production
and consumption choices which occur under free trade provide one set of gains from eliminating protectionism.
Another level of efficiency gains arise because of economies of scale in production.
Two additional arguments for free trade are introduced in this chapter. Free trade, as opposed to “managed
trade,” provides a wider range of opportunities and thus a wider scope for innovation. The use of tariffs
and subsidies to increase national welfare (such as a large country’s use of an optimum tariff), even where
theoretically desirable, in practice may only advance the causes of special interests at the expense of the
general public. When quantity restrictions are involved, rent-seeking behavior—where companies strive
to receive the benefits from quota licenses—can distort behavior and cause waste in the economy.
Next, consider some of the arguments voiced in favor of restrictive trade practices. These arguments that
protectionism increases overall national welfare have their own caveats. The success of an optimum tariff
or an optimum (negative) subsidy by a large country to influence its terms of trade depends upon the
absence of retaliation by foreign countries. Another set of arguments rests upon the existence of market
failure. The distributional effects of trade policies will differ substantially if, for example, labor cannot
be easily reallocated across sectors of the economy as suggested by movements along the production
possibility frontier.
Other proponents of protectionist policies argue that the key tools of welfare analysis, which apply demand
and supply measures to capture social as well as private costs and benefits, are inadequate. They argue that
tariffs may improve welfare when social and private costs or benefits diverge. In general, however, it is
better to design policies which address these issues directly rather than using a tariff which has other effects
as well. Students may find this point transparent by pointing out that a tariff is like a combined tax and
subsidy. A well-targeted subsidy or tax leads to a confluence of social and private cost or benefit. A policy
which combines both a subsidy and a tax has other effects which mitigate social welfare gains.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
51  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
Actual trade policy often cannot be reconciled with the prescriptions of basic welfare analysis. One reason
for this is that the social accounting framework of policy makers does not match that implied by cost-benefit
analysis. For example, policy makers may apply a “weighted social welfare analysis” which weighs gains
or losses differently depending upon which groups are affected. Of course, in this instance there is the issue
of who sets the weights and on the basis of what criteria. Also, trade policy may end up being used as a
tool of income redistribution. Inefficient existing industries may be protected to preserve the status quo.
Indeed, tariffs theoretically can be set at levels high enough to restrict trade in a product.
Divergence between optimal theoretical and actual trade policy may also arise because of the manner in
which policy is made. The benefits of a tariff are concentrated while its costs are diffused. Well-organized
groups whose individuals each stand to gain a lot by trade restrictions have a better opportunity to influence
trade policy than larger, less well-organized groups which have more to lose in the aggregate but whose
members individually have little to lose.
Drawing upon these arguments, one would expect that you could generalize that countries with strong
comparative advantage in manufacturing would tend to protect agriculture, while countries with comparative
advantage in agriculture would tend to protect manufacturing. For the United States, however, this argument
is not validated by the pattern of protection. It is concentrated in four disparate industries: autos, steel, sugar,
and textiles.
International negotiations have led to mutual tariff reductions from the mid-1930s through the present.
Negotiations which link mutually reduced protection have the political advantage of playing well-organized
groups against each other rather than against poorly organized consumers. Trade negotiations also help avoid
trade wars. This is illustrated by an example of the Prisoner’s dilemma as it relates to trade. The pursuit of
self-interest may not lead to the best social outcome when each agent takes into account the other agent’s
decision. Indeed, in the example in the text, uncoordinated policy leads to the worst outcome since
protectionism is the best policy for each country to undertake unilaterally. Negotiations result in the
coordinated policy of free trade and the best outcome for each country.
The chapter concludes with a brief history of international trade agreements. The rules governing GATT are
discussed, as are the real threats to its future performance as an active and effective instrument for moving
toward freer trade. Also, the developments of the Uruguay Round are reviewed, including the creation of the
WTO and the economic impact of the Round. The chapter also notes that more recent multilateral negotiations
(the Doha Round) have stalled, largely over disagreements regarding agricultural subsidies and trade. This
has been a disappointment to free trade proponents as it marks the first time a major multilateral trade round
has failed to produce a substantial agreement. However, the failure of the Doha Round can be partially
attributed to the success of previous rounds of trade negotiations. As the world moves closer and closer to
free trade, the marginal gains from further reductions in trade barriers become smaller. This is highlighted
by Table 10-5 in the text, which shows that even under the most ambitious proposals in the Doha Round,
the gains from freer trade would only be about 0.18% of global income.
There is also a discussion of preferential trading agreements. Free Trade Areas and Customs Unions
are compared, and trade diverting and trade creating effects of customs unions are demonstrated in an
example. Finally, a case study discusses recent evidence on trade diversion in South America. There are
numerous examples of groups of countries moving toward regional economic integration; any of which
can be used as an example to illustrate the ideas of this section. An Appendix proves that there is always
an optimal positive tariff if a country’s protectionist actions affect world prices.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley