1 International Trade and Development Raul Caruso Università Cattolica del Sacro Cuore di Milano...

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International Trade and Development

Raul Caruso

Università Cattolica del Sacro Cuore di Milano

[email protected]

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In the previous classes, we considered only competitive scenarios. Ricardian and HO worlds were purely competitive. In reality, there is no free trade. Different trade policies affect patterns and evolution of trade. In particular, protectionism seems to be the rule.

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Integration, Exchange

Threat, Power

Trade Protection clealry is closer to the Power apex.

Protection and the Triangle

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Measuring Protection

• The effective rate of protection can be computed through:

T W

W

V VPI

V

Where V is the value added in a sector. The subscripts denote the value added in the presence of trade policies and the value added evaluated at world prices respectively

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Effect of a Tariff on Prices

• If the Home country imposes a tariff the price home at home goes up. Because of the existence of a tariff there will be an excess demand which leads to a higher world market price

• On the foreign market if the country is relatively large there will an excess of supply which should lead to a lower price. The latter statement canno t hold when the country is small and cannot affect world prices.

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Who gains from a tariff?

• 1. Domestic Producers obviously gain from the imposition of a tariff.

• 2. The government also gains from a tariff since it has higher revenues.

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Who loses from a tariff?

1. consumers lose because they face higher prices.

2. Terms of trade of Small countries worsen. When a country is price-taker it cannot influence the world price, then the negative impact of foreign price does not occur.

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Net gain or loss?

• The net cost of a tariff is:

• Consumer loss - producer gain – government revenue = net cost of a tariff

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Quantitative Non-Tariff Barriers

• Quotas, VERs and other quantitative restrictions have the same effect of a tariff but they add also the emergence of rents through system of licenses and administrative tasks to manage them.

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Export Subsidies

An export subsidy is payment to an exporting firm. It can be either specific (a fixed sum per unit) or ad valorem ( a proportionof the value exported)

In general, once subsidy is applied the price in the exporting country rises and the price in the importing country falls.

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Export Subsidies

What happens to terms of trade?

Terms of trade of exporting country worsen.

If the exporting country is relatively large (can set prices) the world prices decrease. Terms of trade of other exporting countries decrease as well. This is the case of competition over a third market.

However, terms of trade of importing country would improve.

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Export Subsidies

The paradox of subsidies is that only producers of the exporting country gain.

Consumer surplus falls

Government revenue falls, (government spending rises)

Overall National Welfare Falls

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European CAP policy

It was implemented in order to guarantee high prices for agricultural sector by having the European Union buy agricultural products whenever the prices fell below specific levels.

Since the 70s the level of protection turned to be so high that EU would have been an importer of agricultural products in the presence of free trade.

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US Policy , (Farm Bill)

In USA there is a very similar institutional architecture to protect farmers in USA.

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IL MERCATO AGRICOLO

UE

USA

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Commodities and LDCs

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Prices of Commodities and LDCS

Many LDCs are dependent upon the exports of a small number of commodities

According to FAO(2003), as many as 43 LDCs depend upon only one commodity

More than 50 LDCs depend on exports of three or fewer agricultural commodities

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Price of Commodities and LDCs

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Over the last twenty years commodity prices declined continously

Cotton (-47%), Coffee (-64%), Cocoa (-71%), sugar (-77%)

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Why?

Oversupply of commodities which drives the prices down. Oversupply is based upon enhancements of productivity and emergence of new producers (ex. Coffee in Vietnam)

Shocks in supply determine volatility of prices

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Price of Commodities and LDCs• The Argument of ‘IMMISERIZING GROWTH’ is based upon

the evidence of declining terms of trade for developing countries turned largely on differences in the degree of competition between industries in developed countries, or core, and those found on the periphery. Competition among producers of raw materials and foodstuffs drive prices down to marginal costs in the developing economies. The result was that the prices of primary goods produced on the periphery declined relative to those of manufactures produced in the core. For developing countries, free trade supposedly resulted in “immiserization” (or “immiserizing growth”) rather than in increasing wealth.

Hence, according to the terms-of-trade argument, developing economies should not favor free trade but advocate the protection of domestic industrialization instead.

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Increased Export volumes until now do not appear to compensate the losses in the value of exports.

The decline of prices for some selected commodities has been so significant that the increase in volume could not compensate for the decline of prices.

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Possible Solutions

1. Diversification of Production (long-term strategy).However, in the presence of western subisidies diversification strategy could fail also in the long run

2. Cartel of Producers to ensure high prices (the demand could decrease dramatically)

3. Stabilization Mechanism through international agreements on commodities.

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Natural evolution?

An increased demand from newly industrialized countries (ex. China, India) and other growing economies could stop (or move against) a continous decline in commodity prices.

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Future markets

However, in the latest years (before the subprime crises) prices of commodities have been subject to high pressure. Such a pressure emerged in the presence of a high liquidity in the financial markets. This increased dramatically the volatility of prices.

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Prices of selected commodities (Oil, Wheat, Rice, Corn) ( 2003=100)

Volatility and pressure on financial markets

for some commodities

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Trade Integration

However countries also integrate by means of:

(1) Preferential Trade Agreement (PTA)

(2) Free Trade Areas

(3) Customs Unions

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Trade Integration

1. A PTA occurs when a country (or a group of countries) establishes a more favorable duty system for goods coming from some selected countries. (ex. Tariff are lower)

Example: EEC/Lomè convention

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Trade Integration

2. A Free Trade Area (FTA) is an agreement between countries allowing for free movement of goods. No restriction is allowed. (no tariffs , no quotas)

Example. USA has a FTA with Israel. NAFTA is also a FTA. There is FTA between EU and non-member countries in europe.

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Trade Integration

3. A costums union (CU) is an agreement between countries establishing a common duty against the rest of the world. Tariffs and quotas are chosen and implemented collectively.

Example: EU is a customs union.

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Trade Integration

What happens?

Economists usually distinguish between:

(1) Trade creation;

(2) Trade diversion.

The ideas of Trade Creation and Trade Diversion date back to Viner (1950).

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Trade Integration

Trade creation is supposed to be beneficial for member countries.

a. Volume of trade increases.

b. Prices decrease.

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Trade Integration

By contrast Trade diversion is supposed to have a negative impact on trade with third countries.

a. Volume of trade with third countries decrease

b. The impact on world prices is not precisely predictable.

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Trade Integration

In a FTA the individual member countries agree to free trade between themselves but retain their individual regime of tariffs and other restrictions on imports from third countries. In the absence of intra-trade restrictions goods exported by third countries cound eneter the market of both countries by entering the member country with the lowes level of pretection. This is called Trade deflection.

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Trade Integration

Finally:

Trade integration is beneficial for member countries and have a negative impact on third countries. However, third countries can deflect trade. An effective system of rules of origin must be implemented.

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Trade Integration

Given the negativ effects of trade diversions, economists usually favoured a spread trade integration. That is, there is a strong debate between people favouring:

(1) Multilateralism

(2) Regionalism

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Trade Integration

Mutilateralism would predict a continous liberalization made by all countries made in favour of all the other coutries.

This is the principle of MFN (most favoured nation) sorrounding GATT and then WTO

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Trade Integration

Regionalism is simply a preferentional agreement of some countries with othre countries of the same region.

This should create trade diversion against the rest of the world.

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Trade Integration

Finally we can say that:

PTAs are likely to emerge between coutries exhibiting a different level of development

FTAs and CUs emerge between similar countries

The impact of trade deflection makes preferential agreements uneffective.

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Trade Integration

Translate in language of network theory.

A PTA is a form of ?

A hierarchical network (ex. EU/African countries.)

A FTA does fit better with the idea of Random Network

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Trade integration

What is trade deflection:

The emergence of six degrees of separation!!

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Regionalism in a multilateral World

Wilfred Ethier (1998) presents and proposes a tentative explanation of some stylized facts of regional intergration which emerged in the last years.

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Regionalism in a multilateral World

Ethier starts considering the historical evidence:

In 1950s and 1960s, with the exception of EEC, regional agreements failed.

In 1990s regional agreements exhibit a growing success.

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Ethier (1998), New Regionalism

Ethier then defined this phenomon ‘New Regionalism’.

Examples would be: The Creation of NAFTA, The Mercosur, the further enlargement of European Union.

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Ethier highlights some characteristics:

1. New regionalism tipically features one or more small countries linking up with a big country

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2. Very often the small countris have made significant unilateral reforms (signalling behaviour)

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3. New Regional agreements seldom address only trade barriers. They usually involve what is known as deep integration

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4. Integration is due primarily to concessions made by small countries.

Why?

Because they have a higher evaluation of the stake.

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Strategic Trade Policy

Now it is time to consider how the countries behave.

Hereafter we will assume that countries behave strategically.

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The idea of Strategic trade Policy has been explained first by James Brander and Barbara Spencer.

It is an application of non-cooperative Game Theory to International Trade Theory

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In a strategic relationship agents (firms, countries) have a mutually recognized strategic interdependence.

More formally, agents’ payoffs of one agent must be directly affected by the individual strategy choices of other agents and this must understood by all agents involved.

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Being an application of the concept of Nash equilibrium (NE) as the central equilibrium concept.

Nash equilibrium is a rational concept since all agents choose strategies such that each player’s strategy maximizes that player’s payoff given the strategy chosen by other players.

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A famous model proposed by Brander and Spencer (1985) incorporated a Cournot Model of Duopoly into a Third Market to provide an example of strategic trade policy.

In general , models of strategic trade policy show that imposing export subsidy can raise profits of a home firm at the expense of foreign firms.

These policies where commonly defined ‘beggar-thy-neighbor policies’. They were quite common at the beginning of XX century. Remember the period in which Irwin divided the evolution of trade.

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Adapting the Brander Spencer Model to include different distancesCaruso (2006) present two countries

competing as in Cournot Duopoly over a third market.

The two countries face a simple linear world demand represented by the inverse form by

Yap

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A model of STP to explain subsidy

Countries choose quantities:

Country 1 ax ,0

Country 2 ay ,0

Max level of production

yxY

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Payoff Functions:

Country 1 xc

xyxxaacyx

)(,,,,1

Country 2 cyyyxyaacxy )(,,,2

Note they are heterogenous in costs. Country 1 faces higher costs (Iceberg Cost)

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In the presence of Free Trade Country 1 would produce less than country 2 (because of higher costs) and would get lower payoffs. Formally we have:

cac 2

10

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**

** yx

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On the world market the world price will depend also on costs of country 1.

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*cca

p

0/* p

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In country 1 interest group lobby in order to have an export subsidy. The process of Lobby (Rent-Seeking)is costly for national welfare. The Larger the number of firms the higher the loss for national welfare. Lobbying is a competition between different interest groups. This cost will be indicated by L and a proportional subsidy by sx

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The Payoff functions become:

sxLxc

xyxxaLsacyx

)(,,,,,,1

cyyyxyaacxy )(,,,,2

Country 1

Country 2

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In the presence of subsidy the optimal quantities chosen will be:

1**

csyx ss

,, 0kkcs

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In the presence of subsidy the world price will be:

** pps

3

cscaps

*

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Does country 1 get a higher welfare with subsidy? If and only if:

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24 cscasL

The result depend upon a combination of (1) size of demand; (2) costs; (3) level of subsidy; (4) cost of rent-seeking

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Interest Groups and Trade Policies

Then, governments choose trade policies in order to favour some interest group

We have historical evidence about this. It is not a novelty.

In general an overweight posed on benefits of some interest group can lead nations to clash

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When countries clash

Then, Countries take into account the trade-off (1) The potential benefit of imposing some Trade policies (2) and the loss due to a clash with other trading countries

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Then, consider that countries enter negotiations under the umbrella of an institution as WTO, They could have a payoff function like this:

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The results of Caruso (2006) show that countries joining trade institutions and negotiations can

(1) Decrease hostility;

(2) Get a higher payoff even in the presence of asymmetry

This holds if and only if the cost of joining is relatively low.

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There are also:

(1) Reputation effect (es. US/UE steel, Banana War)

(2) Signalling effect(3) Insurance effect(4) Moral Hazard (hope for unilateral

concessions and transfers from your rival)

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The moral of the story is that:

International negotiations on trade, albeit unsatisfactory, are better than harsh competition policies that lead the prices down affecting terms of trade and then welfare

The Wto dispute resolution mechanism is a very good opportunity for all countries.

Creating costituencies between LDCs could be a reasonable path

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The WTO Dispute Resolution System

A dispute arises when a member government believes another member government is violating an agreement or a commitment that it has made in the WTO. The authors of these agreements are the member governments themselves — the agreements are the outcome of negotiations among members. Ultimate responsibility for settling disputes also lies with member governments, through the Dispute Settlement Body.

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Main Point

The main point we have to remember is that the WTO lacks the direct enforcement capacity. Countries must cooperate. Why?

1) Information mechanism leading to a reputation building;

2) Higher payoffs which emerge in the long run.

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Number of disputes since 1995

Number of disputes 1995-2007

0

10

20

30

40

50

60

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Numerodispute

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USA 91EU 76Canada 29Brazil 22Mexico 16Argentina 15India 15South Korea 13Japan 12Chile 10Australia 7

Number of disputes as complainant

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USA 96EC 69India 21Canada 15Brazil 15Argentina 15Japan 15Mexico 14Korea 13Chile 12Australia 10China 8Turkey 8

Number of disputes as defendant

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When countries invoke the dispute resolution system?

Which countries rely on DSS?

Which variables can be considered to interpret the ‘success’ of DSS?

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Variable Expected Correlation

Complainant’s GDP +

Defendant’s GDP +

Relative military power of complainant

+

Threat of retaliation ?

Trade competitiveness +

Degree of Openness ?

Trade dependence between countries involved

?

Share of contested sector in total export of complainant

+

Share of contested sector in total export of respondant

?

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Few reasonable Facts

The countries that trade more with one another tend to have more trade disputes

Larger economies seem to be more likely to take on a trade dispute due to greater ability to withstand the effects of (retaliatory) trade restrictions

Differences in ‘power’ matter

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LDCs do not invoke the Dispute Settlement Body very often. Why?

(1) Simply, the process is costly;

(2) Reputation (inverse signalling)

(3) Insurance effect for its exports (threat of retaliatory measures adopted by respondant)

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Consider also….

Consider also that actors ealuate differently the stake of a contest. A contest which is vital for one country can be negligible for the other country.

In such a case: (1) the higher-evaluation actor is willing

to concede more than the opponent.(2) When the evalutions converge both

actors have to concede.

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An asymmetry in the evaluation of the stake can depend upon:

(1) Asymmetric Information;

(2) Different productive systems;

(3) Internal competition between groups

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Summary of the course

• Summary of the whole story about trade and development:

(1) Trade can foster growth (we have empirical evidence about this);

(2) Some economic policies are desirable for growth and then for trade (resolution of conflicts through redistribution of rents, investment in education to enhance productivity)

(3) Joining international trade negotiations is also a desirable policy. In particular, cooperation among LDCs should be enhanced.

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1 International Trade and Development Raul Caruso Università Cattolica del Sacro Cuore di Milano...

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