Chapter 10
The Political Economy of Trade Policy
◼ Chapter Organization
The Case for Free Trade
Free Trade and Efficiency
Additional Gains from Free Trade
Rent Seeking
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
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
54 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
Box: Free Trade versus Customs Unions
Box: Do Trade Preferences Have Appeal?
Case Study: Trade Diversion in South America
Summary
APPENDIX TO CHAPTER 10: Proving that the Optimum Tariff Is Positive
Demand and Supply
The Tariff and Prices
The Tariff and Domestic Welfare
◼ 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 that 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 such as quotas are involved, rent-seeking behavior—where
companies expend resources 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. The 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 that address these issues directly rather than indirectly through a tariff, which may
have negative side effects. Students may better understand this concept 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 that combines both a subsidy and a tax has other effects that limit social welfare gains.
56 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
◼ Answers to Textbook Problems
1. The arguments for free trade in this quote include:
2. a. This is potentially a valid argument for a tariff because it is based on an assumed ability of the
United States to affect world prices—that is, it is a version of the optimal tariff argument. If the
United States is concerned about higher world prices in the future, it could use policies that
encourage the accumulation of oil inventories and minimize the potential for future adverse
shocks.
3. Without tariffs or subsidies, we compute domestic production as S = 20 + (10 10) = 120 and
domestic consumption as D = 400 − (5 10) = 350, for imports of 230.
Chapter 10 The Political Economy of Trade Policy 57
© 2015 Pearson Education, Inc.
welfare effects of this tariff, consider the diagram below. We know that, because this is a small
country, the tariff will lead to a net welfare loss as the gains in producer surplus and tariff
revenue are smaller than the losses in consumer surplus. The net loss from the tariff is
highlighted by the shaded triangles representing deadweight losses from consumption and
production distortions.
Computing the two deadweight loss triangles yields ½(5 50) + ½(5 25) = 187.5.
Against the losses from the tariff, we must consider the social gain from increased domestic
production. After the tariff, domestic production increased by 50 units. The marginal social
benefit from each unit of production is 10, so the social gain from increased production is 500.
Thus, the net effect of the tariff on total welfare is 500 − 187.5 = 312.5.
b. A production subsidy would cause domestic supply to rise by S = 20 + 10(10 + 5) = 170, an
increase of 50 units as with the tariff. However, the domestic price will not change in this
country, so consumers do not lose any welfare with this subsidy. Rather, the only efficiency loss
comes from production distortion costs, the leftmost triangle in the diagram above. The net loss
of the subsidy is ½(5 50) = 62.5. However, the increase in domestic production caused social
welfare to rise by 50 10 = 500, leading to a net welfare gain of 500 − 62.5 = 437.5.
c. The production subsidy is a better targeted policy than the import tariff because it directly affects
the decisions that reflect a divergence between social and private costs while leaving other
decisions unaffected. The tariff has a double-edged function as both a production subsidy and a
consumption tax.
d. The optimal subsidy would be for producers to fully internalize the externality by raising the subsidy
to 10 per unit. Supply would then rise to S = 20 + 10(10 + 10) = 220. The production distortion
would now be ½(10 100) = 500, but the total social benefit from increasing production by
100 units would be 100 10 = 1000. The net welfare gain would be 1,000 − 500 = 500.
4. Refer back to the diagram in 3a. The gain in producer surplus from the tariff is equal to the area bounded
above by the price of 15, below by the price of 10, and to the right by the supply curve. This area is
