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Chapter 12
Controversies in Trade Policy
◼ Chapter Organization
Sophisticated Arguments for Activist Trade Policy
Technology and Externalities
Imperfect Competition and Strategic Trade Policy
Box: A Warning from Intel’s Founder
Case Study: When the Chips Were Up
Globalization and Low-Wage Labor
The Anti-Globalization Movement
Trade and Wages Revisited
Labor Standards and Trade Negotiations
Environmental and Cultural Issues
The WTO and National Independence
Case Study: A Tragedy in Bangladesh
Globalization and the Environment
Globalization, Growth, and Pollution
The Problem of “Pollution Havens”
The Carbon Tariff Dispute
Summary
◼ Chapter Overview
Although the text has shown why, in general, free trade is a good policy, this chapter considers two
controversies in trade policy that challenge free trade. The first regards strategic trade policy. Proponents of
activist government trade intervention argue that certain industries are desirable and may be underfunded by
markets or dominated by imperfect competition and warrant some government intervention. The second
controversy regards the recent debate over the effects of globalization on workers, the environment, and
sovereignty. While the anti-globalization arguments often lack sound structure, their visceral nature
demonstrates that the spread of trade is extremely troubling to some groups.
As seen in the previous chapters, activist trade policy may be justified if there are market failures. One
important type of market failure involves externalities present in high-technology industries due to their
knowledge creation. Existence of externalities associated with research and development and high
64 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
technology make the private return to investing in these activities less than their social return. This means
that the private sector will tend to invest less in high-technology sectors than is socially optimal. Although
there may be some case for intervention, the difficulties in targeting the correct industry and understanding
the quantitative size of the externality make effective intervention complicated. To address this market
failure of insufficient knowledge creation, the first best policy may be to directly support research and
development in all industries. Still, although it is a judgment call, the technology spillover case for
industrial policy probably has better footing in solid economics than any other argument.
Another set of market failures arises when imperfect competition exists. Strategic trade policy by a government
can work to deter investment and production by foreign firms and raise the profits of domestic firms.
An example is provided in the text that illustrates the case where the increase in profits following the
imposition of a subsidy can actually exceed the cost of a subsidy to an imperfectly competitive industry
if domestic firms can capture profits from foreign firms. Although this is a valid theoretical argument for
strategic policy, it is nonetheless open to criticism in choosing the industries that should be subsidized and
the levels of subsidies to these industries. These criticisms are associated with the practical aspects of
insufficient information and the threat of foreign retaliation. The case study on the attempts to promote the
semiconductor chips industry shows that neither excess returns nor knowledge spillovers necessarily
materialize even in industries that seem perfect for activist trade policy.
The next section of the chapter examines the anti-globalization movement. In particular, it examines the
concerns over low wages in poor countries. Standard analysis suggests that trade should help poor
countries and, in particular, help the abundant factor (labor) in those countries. Protests in Seattle, which
shut down WTO negotiations, and subsequent demonstrations at other meetings showed, though, that
protestors either did not understand or did not agree with this analysis.
The concern over low wages in poor countries is a revision of arguments in Chapter 2. Analysis in the
current chapter shows again that trade should help the purchasing power of all workers and that if anyone
is hurt, it is the workers in labor-scarce countries. The low wages in export sectors of poor countries
are higher than they would be without the export-oriented manufacturing, and although the situation of
these workers may be more visible than before, that does not make it worse. Practically, the policy issue is
whether or not labor standards should be part of trade pacts. Although such standards may act in ways
similar to a domestic minimum wage, developing countries fear that such standards would be used as a
protectionist tool. A case study on the 2013 collapse of a garment factory in Bangladesh highlights this
tension. The Bangladeshi garment industry would not be globally competitive if it had to raise labor
standards to rich country standards. Bangladeshi garment workers, though very poorly paid by rich
country standards, earn more than workers in non-export sectors. A potential solution would be for
consumers in rich countries to pay more for goods certified to have been produced under improved labor
standards, thereby giving producers in poor countries both the means and the incentive to improve labor
standards,
Anti-globalization protestors were by no means united in their cause. There were also strong concerns that
export manufacturing in developing countries was bad for the environment. Again, the issue is whether these
concerns should be addressed by tying environmental standards into trade negotiations, and the open
question is whether this can be done without destroying the export industries in developing countries.
Chapter 12 Controversies in Trade Policy 65
The final section of the chapter examines the link between trade and the environment. In general,
production and consumption can cause environmental damage. Yet, as a country’s GDP per capita grows,
the environmental damage done first grows and then eventually declines as the country gets rich enough to
begin to protect the environment. As trade has lifted incomes of some countries, it may have been bad for
the environment—but largely by making poor countries richer, an otherwise good thing. In theory, there
could be a concern about “pollution havens,” that is countries with low environmental standards that
attract “dirty” industries. There is relatively little evidence of this phenomenon thus far. Furthermore, the
pollution in these locations tends to be localized and is therefore better left to national rather than
◼ Answers to Textbook Problems
1. The main disadvantage is that strategic trade policy can lead to both “rent-seeking” and beggar-thy-
neighbor policies, which can increase one country’s welfare at the other country’s expense. Such
policies can lead to a trade war in which every country is worse off, even though one country could
2. Globalization has many pros and cons, well-illustrated in famous controversies—like the one
stimulated by Joseph Stiglitz’s book, Globalization and Its Discontents. Initiatives like the Doha
Development Agenda try to address some of them and find solutions acceptable to every country.
3. The results of basic research may be appropriated by a wider range of firms and industries than
the results of research applied to specific industrial applications. The benefits to the United States
of Japanese basic research would exceed the benefits from Japanese research targeted to specific
4. The reason why strategic trade policies attract retaliation from other countries is because they present
the same problems that are faced when considering the use of a tariff to improve the terms of trade.
Strategic policies are, in essence, a type of beggar-thy-neighbor policies that increase one country’s
welfare at other countries’ expense. A good example is represented by export quotas on scarce
mineral ores—like the one adopted by China for Rare Earth Elements (REE) exports since 2006—
that have already provoked filing a complaint to the WTO by the US, the EU, and Japan.
66 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
5. One argument you could make is the infant industry argument. Because U.S. software firms are already
established, European firms would not be able to compete given the relatively steep learning curve
in this industry. With protection, the European industry could develop into an efficient scale and
be globally competitive. Further, this is likely an industry characterized by external economies of scale,
so once the industry develops, it will generate additional gains by creating a local hub of software firms.
Another line of reasoning in favor of protection is that this industry needs support because of low
appropriability. If the social gains from an investment exceed the private gains, then a firm making
an investment will not be able to capture the full return on its investment and an inefficiently low
level of investment will be made. To get over this market failure, the government could subsidize
innovation. However, can the government accurately identify the right activities to support?
Furthermore, how big will the gains from active targeting be?
can the government correctly identify who and how much to subsidize? What if this policy leads
to retaliation by the American government?
6. The main critique against the WTO with respect to environmental issues is that the WTO refuses to
impose environmental standards on countries, but rather does not allow countries to discriminate
against imported goods that are held to a different standard than domestically produced goods. In
some respects, those opposed to globalization would rather see the WTO have more power than it
7. The French may be following an active nationalist cultural policy as an economic or strategic trade
policy to the extent that cultural activities, such as art, music, fashion, and cuisine, are linked to other
French major industries. Indeed, the fashion industry is tied to the huge textile industry, as well as to
the retail sector and advertising services. One could argue that the promotion of fashion, art, and music
Chapter 12 Controversies in Trade Policy 67
8. The concern is seen clearly in the idea of the environmental Kuznets curve where environmental
damage increases as a country moves from very poor to middle income and declines as the country
gets subsequently richer. The problem comes if the fastest growing countries are the ones moving
from poor to middle income, especially large countries, such as India and China who are almost
certainly on the upslope of the curve. Thus, the countries doing increasing environmental damage
9. Suppose that there were no tariffs on imports in a country that had value-added taxes. This would give
an incentive for domestic firms to locate their production abroad and export their goods to that country
to avoid the value-added tax. Thus, a tariff on imports is necessary to maintain the same relative
price between domestically produced and imported goods. Similarly, the carbon tariff is put into place
