Chapter 10Chapter 10The Political EconomyThe Political Economy

of Trade Policyof Trade Policy

Prepared by Iordanis Petsas

To Accompany International Economics: Theory and PolicyInternational Economics: Theory and Policy, Sixth Edition

by Paul R. Krugman and Maurice Obstfeld

Slide 9-2Copyright © 2003 Pearson Education, Inc.

Introduction The Case for Free Trade Income Distribution and Trade Policy International Negotiations and Trade Policy

Chapter Organization

Slide 9-3Copyright © 2003 Pearson Education, Inc.

Introduction What reasons are there for governments not

to interfere with trade?

• There are three arguments in favor of free trade:

–Free trade and efficiency

–Economies of scale in production

–Political argument

Slide 9-4Copyright © 2003 Pearson Education, Inc.

1) Free Trade and Efficiency

• The efficiency argument for free trade is based on the result that in the case of a small country, free trade is the best policy.

–A tariff causes a net loss to the economy (i.e. deadweight loss).

–A move from a tariff equilibrium to free trade eliminates the efficiency loss and increases national welfare.

The Case for Free Trade

Slide 9-5Copyright © 2003 Pearson Education, Inc.

World priceplus tariffWorld price

Price, P

Quantity, Q

S

D

Consumptiondistortion

Productiondistortion

Figure 9-1: The Efficiency Case for Free Trade

The Case for Free Trade

Slide 9-6Copyright © 2003 Pearson Education, Inc.

2) Economies of scale in production• Protected markets in small countries do not allow

firms to exploit economies of scale.Example: In the auto industry, an efficient scale assembly

should make a minimum of 80,000 cars per year. o In Argentina, 13 firms produce a total of 166,000 cars per

year.

• The presence of scale economies favors free trade that generates more varieties and results in lower prices.

• Free trade, as opposed to “managed” trade, provides a wider range of opportunities and thus a wider scope for innovation.

The Case for Free Trade

Slide 9-7Copyright © 2003 Pearson Education, Inc.

3) Political Argument for Free Trade

• A political commitment to free trade may be a good idea in practice.

• Trade policies in practice are dominated by special-interest politics rather than consideration of national costs and benefits.

The Case for Free Trade

Slide 9-8Copyright © 2003 Pearson Education, Inc.

Who Gets Protected?

Two sectors get protected in advanced countries:

Agriculture

Farmers are well organized and the structure of the U.S.

government enhances their political power.

Clothing

Both textiles and apparel have enjoyed substantial

protection. This sector employs less skilled workers and

it is unionized as well.

Income Distribution and Trade Policy

Slide 9-9Copyright © 2003 Pearson Education, Inc.

How was the removal of tariffs politically possible?• The postwar liberalization of trade was achieved

through international negotiation.• Governments agreed to engage in mutual tariff

reduction. The Advantages of Negotiation

• It is easier to lower tariffs as part of a mutual agreement than to do so as a unilateral policy because:– It helps mobilize exporters to support freer trade.– It can help governments avoid getting caught in

destructive trade wars.

International Negotiations and Trade Policy

Slide 9-10Copyright © 2003 Pearson Education, Inc.

JapanJapan

U.S.U.S.

1010

1010

-5-5

-5-5

2020

-10-10

2020

-10-10

Free tradeFree trade

Free tradeFree trade

ProtectionProtection

ProtectionProtection

Table 9-3: The Problem of Trade Warfare

International Negotiations and Trade Policy

Slide 9-11Copyright © 2003 Pearson Education, Inc.

In Table 9-3, each country has a dominant strategy: Protection.

Even though each country acting individually would be better off with protection, they would both be better off if both chose free trade.

• Japan and the U.S. can establish a binding agreement to maintain free trade.

International Negotiations and Trade Policy

Slide 9-12Copyright © 2003 Pearson Education, Inc.

International Trade Agreements: A Brief History The multilateral tariff reductions since World War II

have taken place under the General Agreement on Tariffs and Trade (GATT), established in 1947 and located in Geneva.

It is now called the World Trade Organization (WTO).

The WTO system is a legal organization that embodies a set of rules of conduct for international trade policy.

International Negotiations and Trade Policy

Slide 9-13Copyright © 2003 Pearson Education, Inc.

Year Place/name Subjects covered Countries

1947 Geneva Tariffs 231949 Annecy Tariffs 131951 Torquay Tariffs 381956 Geneva Tariffs 26

1960-1961 Dillon Round

Tariffs 26

1964-1967 Kennedy Round

Tariffs and anti-dumping measures 62

1973-1979 Tokyo Round

Tariffs, non-tariff measures, “framework”agreements

102

1986-1994 Uruguay Round

Tariffs, non-tariff measures, rules, services, intellectual property, dispute settlement,

textiles, agriculture, creation of WTO, etc

103

GATT Eight Rounds of Trade Negotiations

Slide 9-14Copyright © 2003 Pearson Education, Inc.

How different is the WTO from the GATT? The GATT was a provisional agreement, while the

WTO is a full-fledged international organization.

The GATT applied only to trade in goods, while the WTO included rules on trade in services (the General Agreement on Trade in Services (GATS)) and Trade Related Aspect of Intellectual Property Rights (TRIPs).

The WTO has a new “dispute settlement” procedure which is designed to reach judgments in a much shorter time.

International Negotiations and Trade Policy

Slide 9-15Copyright © 2003 Pearson Education, Inc.

1) Trade without discriminationA. Most-favored-nation:

    Under the WTO agreements, countries cannot normally discriminate between their trading partners. Cannot grant someone a special favor.

B. National treatment:

    Imported and locally-produced goods should be treated equally at domestic market. The same should apply to foreign and domestic services, and to foreign and local trademarks, copyrights and patents.

Principles of the WTO Trading System

2) Freer trade: gradually, through negotiation

Lowering trade barriers is one of the most obvious means of encouraging trade. The barriers concerned include tariffs and measures such as import quotas.

3) Predictability: through binding and transparency

Sometimes, promising not to raise a trade barrier can be as important as lowering one, because the promise gives businesses a clearer view of their future opportunities. With stability and predictability, investment is encouraged, jobs are created and consumers can fully enjoy the benefits of competition choice and lower prices.

Slide 9-16Copyright © 2003 Pearson Education, Inc.

Slide 9-17Copyright © 2003 Pearson Education, Inc.

A free trade area allows free-trade among members (no tariffs), but each member can have its own trade policy towards non-member countries.

A customs union allows free-trade among members and requires a common external trade policy (common tariff) towards non-member countries.

A common market is a customs union with free mobility of factors of production (capital and labor) among members.

A monetary union is a common market with common currency and common monetary policy.

Economic Integration

18

Stages of Economic IntegrationCommon

Currency and Monetary Policy

Free Movement of

Factors

Unified External Tariff

Elimination of Tariffs

Preferential Agreement

√ Free Trade Area

√ √ Customs Union

√ √ √ Common Market

√ √ √ √ Monetary Union

19

EUEFTANAFTANAFTA

ASEAN

Mercosur

Main Regional Agreements

GAFTAGAFTAGCCGCC APEC

CAFTACAFTA

COMESACOMESAWAEMUWAEMU SAFTASAFTA