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
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 Metal
The End of Trade Agreements
Box: Do Agricultural Subsidies Hurt the Third World?
Chapter 10 The Political Economy of Trade Policy 61
Box: Free Trade versus Customs Unions
Box: Brexit
The Trans-Pacific Partnership
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
62 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
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.
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” that 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 industries may be protected solely 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, harder to organize 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 that 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 because
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.
Chapter 10 The Political Economy of Trade Policy 63
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. Of note from this round was the phase–out of the Multi-Fiber
Agreement, a set of tariffs and quotas on trade in textiles. Table 10–2 estimates that the phase–out of trade
barriers in textiles has saved the United States roughly $11 billion since 2002.
The chapter also notes that more recent multilateral negotiations (the Doha Round) have failed, 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 percent of global income.
The sources of failure of the Doha Round are echoed in the apparent failure to enact the Trans-Pacific
Partnership (TPP). Previous trade agreements had largely eliminated many traditional trade barriers like
quotas and tariffs. The TPP focused on less concrete trade barriers like intellectual property rights and
investor-state dispute settlement. As such, the simple logic of free trade was less resounding in advocating
for this deal when balanced against its criticisms. Similarly, the case of the UK’s impending departure
from the European Union (Brexit) had less to do with concerns over free trade and more to do with another
nontariff trade barrier: labor mobility. The cases of Doha, TPP, and Brexit suggest that the remaining
barriers to completely free trade and full economic integration will be increasingly difficult to remove.
◼ Answers to Summary Questions (5, 6, 9)
5. If the main effect of DR-CAFTA was to increase clothing exports from the signatory nations to the
United States, then the overall economic impact on the U.S. economy would be rather modest. Prior
© 2018 Pearson Education, Inc.
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
d. There may be external economies associated with the domestic production of semiconductors.
This is potentially a valid argument. But the gains to producers of protecting the semiconductor
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.
a. To analyze the welfare effects of the tariff, it is helpful to draw a diagram for this small country.
Note that since this is a small country, the tariff will not affect the world price, and the domestic
price will rise by the full amount of the tariff, rising from 10 to 15.
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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
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
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
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
Chapter 10 The Political Economy of Trade Policy 67
© 2018 Pearson Education, Inc.
of 10, and to the right by the demand curve. This area is 1,687.5. Total welfare from the tariff is
725 + 775 − 1,687.5 = 187.5.
However, if the government values every dollar of producer gain as worth $3 of consumer surplus,
then from the government’s perspective, the net gain from the tariff is equal to:
Gain in Producer Surplus = 725
Political Gain in Producer Surplus = 725 3 = 2,175
Tariff Revenue = 775
Loss in Consumer Surplus = −1,687.5
Net Welfare Gain = 1,987.5
5.
a. This would lead to trade diversion because the lower-cost Japanese cars with an import
b. Before the addition of Poland to the EU, Japanese cars were not imported because their
import price was €36,000. Thus, Poland’s addition to the EU would lead to trade creation
because German cars that cost €30,000 to produce would be replaced by Polish cars that cost
only €20,000.
c. This would lead to trade diversion because the lower-cost Japanese cars with an import
6. The United States has a legitimate interest in the trade policies of other countries, just as other countries
have a legitimate interest in U.S. activities. The reason is that uncoordinated trade policies are likely
7. The optimal tariff argument rests on the idea that in a large country, tariff (or quota) protection in a
particular market can lower the world price of that good. Therefore, it is possible that with a (small)
8. The game is no longer a Prisoners’ Dilemma. As the chapter discusses, protectionist measures are
welfare reducing in their own right. Each country would have an incentive to engage in free trade no
68 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
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matter what the strategy of the other country. Only in a more complex dynamic game in which a trade
partner will only open its markets if the home country threatens sanctions (and the threats are only
credible if occasionally carried out) would we find any welfare-enhancing reason to use a tariff.
9. The argument is probably not valid for a number of reasons. One reason is the domestic market failure
argument. There is a lack of information regarding safety standards that leads a government to simply
ban unsafe products, as opposed to letting consumers choose which risks they would like to take. Thus,