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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: The Salmon War
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.
Chapter 10 The Political Economy of Trade Policy 55
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.
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.
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 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 percent of global income.
56 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
◼ Answers to Textbook Problems
1. There are four typologies of regional trade integration: (1) Preferential Trade Agreement (PTA)/FTA
(Free Trade Area); (2) Custom Unions; (3) Common Markets; (4) Economic and Monetary Unions.
They are characterized by a growing level of integration.
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
b. Sharply falling prices benefit U.S. consumers, and because these are off-season grapes and do not
compete with the supplies from U.S. producers, the domestic producers are not hurt. There is no
reason to keep a luxury good expensive.
c. The higher income of farmers, due to export subsidies and the potentially higher income to those
who sell goods and services to the farmers, comes at the expense of consumers and taxpayers.
Unless there is some domestic market failure (such as the subsidized good generating a positive
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
industry must as always be weighed against the higher costs to consumers and other industries
e. Thousands of home buyers as consumers (as well as workers who build the homes for which the
timber was bought) have benefited from the cheaper imported timber. If the goal of policy is to
soften the blow to timber workers, a more efficient policy would be direct payments to timber
workers in order to aid their transitions to different industries.
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.
After the tariff is imposed, domestic production will rise to S = 20 + (10 15) = 170 and
domestic consumption falls to D = 400 − (5 15) = 325, for imports of 155. To analyze the
welfare effects of this tariff, consider the diagram below. We know that, because this is a small
Chapter 10 The Political Economy of Trade Policy 57
© 2015 Pearson Education Limited
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
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
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
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
equal to 725. Government tariff revenue is given by 5 times the quantity of imports = 5 155 = 775.
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
Net Welfare Gain = 1,987.5
58 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
5. a. This would lead to trade diversion because the lower-cost Japanese cars with an import value
b. Before the addition of Poland to the EU, Japanese cars were not imported because their import
c. This would lead to trade diversion because the lower-cost Japanese cars with an import value
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
to be inferior to those based on negotiations. By negotiating with each other, governments are better
7. Rent-seeking policy is a common strategy and it is obtained by imposing taxes and other duties that
benefit only a section of the economy.
8. While it is true that free trade, by providing incentives companies to internationalize their approach
and export to new countries, fosters learning and innovation, which eventually benefit the whole
9. It is easy to see how this works for a commodity–rich country. An export subsidy worsens the terms
of trade, reducing national welfare; thus, the optimal policy in export sectors must be a negative
subsidy, that is, a tax on exports that raises the price of exports to foreign markets. Like the optimum
