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    Chapter 9Chapter 9

    The Political Economy of Trade PolicyThe Political Economy of Trade Policy

    Udayan Roy

    International Economics: Theory and PolicyInternational Economics: Theory and Policy, Eighth Edition

    by Paul R. Krugman and Maurice Obstfeld

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    Slide 9-2

    Introduction

    The Case for Free Trade

    National Welfare Arguments against Free Trade

    Income Distribution and Trade Policy

    International Negotiations and Trade Policy

    Chapter Organization

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    Slide 9-3

    Introduction

    Some gain and some lose from free trade. But the

    gains exceed the losses; free trade maximizes national

    welfare (i.e., total surplus).

    Yet most governments restrict trade in some way or

    other.

    Why dont governments listen to economists cost-

    benefit calculations? Should they?

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    Slide 9-4

    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

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    Slide 9-5

    In the case of a small country, free trade maximizes

    total surplus.

    A tariff causes a net losscalled the deadweight

    lossto the economy.

    The Case for Free Trade I

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    Slide 9-6

    World price

    plus tariff

    World price

    Price, P

    Quantity, Q

    S

    D

    Consumption

    distortion

    Production

    distortion

    Figure 9-1: The Efficiency Case for Free Trade

    The Case for Free Trade I

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    Slide 9-8

    The Cases for Free Trade I

    However, because tariff rates are already low for most

    countries, estimated benefits of moving to free trade are only a

    small fraction of national income for most countries.

    So, this argument has become less persuasive, now that tariffsare already significantly lower than before.

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    Slide 9-9

    The Cases for Free Trade I

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    9-10

    The Cases for Free Trade (cont.)

    Yet when quotas are used instead of tariffs, costs can

    be magnified through rent seeking.

    To seek quota licenses or the rights to sell a restricted

    number of imports and the profit that they will earn,individuals or institutions need to spend time and other

    resources.

    Thus, another reason why trade allocates resources

    efficiently is that it avoids the loss of resourcesthrough rent seeking.

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    Slide 9-11

    The Cases for Free Trade I

    And for some countries in some time periods, the estimated

    cost of protection was substantial.

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    Slide 9-12

    The Cases for Free Trade I

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    Slide 9-13

    In the case of increasing returns to scale, bulkproduction reduces per unit costs.

    This benefit from bulk production is calledscale

    economies. Protected markets in small countries do not allow firms

    to exploit scale economies.

    Example: In the auto industry, an efficient scale assembly

    should make a minimum of 80,000 cars per year. In Argentina, under a protectionist regime in 1964, 13 firms

    produced a total of 166,000 cars per year.

    In the presence of scale economies, free trade makesmore varieties available and at lower prices.

    The Case for Free Trade II

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    Slide 9-14

    The Case for Free Trade III

    Free trade enables an inventor to sell to a larger

    market. As a result, free trade provides a stronger

    incentive for innovation.

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    Slide 9-15

    A political argument

    Free trade is the best feasiblepolitical policy, even thoughthere may be better policies in principle

    Trade policies that single out certain industries forprotection from imports are in practice dominated by

    special-interest politics rather than consideration of

    nationalcosts and benefits.

    The Case for Free Trade IV

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    Slide 9-16

    There are two theoretical arguments againstthe

    policy of free trade:

    The terms of trade argument for a tariffWe have seen this one before!

    The domestic market failure argument

    National Welfare Arguments

    Against Free Trade

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    Slide 9-17

    The Terms of Trade Argument for a Tariff

    For a large country, a tariff lowers the price ofimports.

    This benefit of a tariff is called a terms oftrade benefit.

    It is possible that the terms of trade benefits of a tariffoutweigh its costs.

    Therefore, free trade might not be the best policy for a

    large country.

    National Welfare Arguments

    Against Free Trade I

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    Slide 9-18

    Terms of Trade Argument for a Tariff

    Weaknesses

    The argument doesnt work for small countries

    Even if a large country benefits from a tariff, thatbenefit will come at the expense of other countries.

    The world as a whole would be worse off

    This would invite retaliatory tariffs, in which case the

    tariff might hurt everybody

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    Slide 9-19

    1

    National welfare

    Tariff rateOptimum

    tariff, to

    Prohibitive

    tariff rate, tp

    Figure 9-2: The Optimum Tariff

    National Welfare Arguments

    Against Free Trade

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    Slide 9-20

    Optimum tariffThe tariff rate that maximizes national welfare

    It is always positive but less than the prohibitive rate

    that would eliminate all imports.It is zero for a small country because it cannot affect its

    terms of trade.

    National Welfare Arguments

    Against Free Trade

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    Slide 9-21

    The Domestic Market Failure Argument Against

    Free Trade

    Consumer and producer surplus ignore the social costs

    and benefits ofdomestic market failures such as:Unemployment or underemployment of labor

    Technological spillovers from industries that are new or

    particularly innovative

    Environmental externalities

    A tariff may raise welfare if there is a marginal socialbenefit to production of a good that is not captured by

    producer surplus measures.

    National Welfare Arguments

    Against Free Trade II

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    Slide 9-22

    National Welfare Arguments

    Against Free Trade II

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    Slide 9-23

    The domestic market failure argument against freetrade is a particular case of the theory of the second

    best.

    The theory of the second best states that a hands-offpolicy is desirable in any one market only if all other

    markets are working properly.

    If one market fails to work properly, a government intervention

    may actually increase welfare.

    National Welfare Arguments

    Against Free Trade

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    Slide 9-24

    How Convincing Is the Market Failure Argument?

    Domestic distortions should be corrected withdomestic (as opposed to international trade) policies.

    Example: A domestic production subsidy is superior toa tariff in dealing with a production-related market

    failure.

    Market failures are hard to diagnose and measure.

    Example: A tariff to protect urban industrial sectors willgenerate social benefits, but it will also encourage

    migration to these sectors that will result in higher

    unemployment.

    National Welfare Arguments

    Against Free Trade II

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    Slide 9-25

    While economists may talk about national welfare or

    total surplus, in a democracy, trade policy is

    influenced by the difference in political power

    between those who lose from free trade and thosewho gain.

    There are two main theories in political science about

    how governments make decisions:

    Median voter theorem Collective action theory

    Real World Trade Policy

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    Slide 9-26

    The Median Voter Theory

    There are two competing political parties.

    Each party has to decide on the level of the tariff

    imposed.Voters differ in the tariff they prefer.

    What policies will the two parties promise to follow?Both parties will support the tariff policy that the

    median voter (the voter who is exactly halfway up thelineup) prefers.

    Real World Trade Policy

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    Slide 9-27

    Median Voter Theorem Fails

    The median voter theorem cannot explain the

    widespread use of tariffs

    Those who benefit from a tariff are usually few in

    number compared to those who are hurt by the tariff.Therefore,

    Had the median voter theorem been correct, tariffs

    would rarely have been enacted

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    Slide 9-28

    Voters

    Preferred tariff rate

    Median

    voter

    tM

    tB

    tA

    Political support

    Income Distribution

    and Trade Policy

    Figure 9-4: Political Competition

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    Slide 9-29

    Collective Action

    This approach views political activity as a publicgood.

    For instance, if one consumers letter to a politicianhelps to stop a tariff, allconsumers would benefit.

    This encouragesfree riding. Consequently,

    Trade policies that impose large total losses that are

    spread among many individual consumers may notface opposition.

    Industries that are well organized (or have a small

    number of firms) will get protection.

    Real World Trade Policy

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    Slide 9-30

    Sugar import quota, 1990

    The U.S. quota on sugar imports

    Limits imports to 2.13 million tons, which is half ofwhat it would be under free trade

    Keeps the U.S. price at $466 per ton, compared to$280 per ton in world markets

    Consumers lose $1.646 billion

    Producers gain $1.066 billion

    Net loss to the U.S. is $580 million per year

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    Slide 9-31

    Sugar import quota, 1990

    The loss per consumer is $6 per year. This is about $25 per

    family.

    As the U.S. sugar industry employs about 12,000 workers, the

    gains per employee is $90,000 per year. No wonder, the producers are politically organized and the

    consumers dont bother!

    The final insult: without the quota, between 2000 and 3000

    workers would have had to look for jobs elsewhere.

    Thus, the cost to the consumer per job saved in the sugar

    industry is more than $500,000 per year.

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    Slide 9-32

    Modeling the Political Process

    Interest groups buy policies by offeringcontributions contingent on the policies followed by

    the government.

    Income Distribution

    and Trade Policy

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    Slide 9-33

    Who Gets Protected?

    Two sectors seem to get protected in advancedcountries:

    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.

    Protection is very likely to diminish in the future inboth sectors (due to international trade negotiations).

    Income Distribution

    and Trade Policy

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    Copyright 2009 Pearson Addison-Wesley. All rights

    reserved.

    9-34

    Table 9-2: Welfare Costs of U.S.

    Protection ($ billion)

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    Slide 9-35

    Effects of trade barriers

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    Slide 9-36

    International Negotiations

    and Trade Policy

    Globalization has increased from the mid-1930s

    partly because the United States and other advanced

    countries gradually removed tariffs and non-tariff

    barriers to trade.

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    Slide 9-37

    International Negotiations

    and Trade Policy

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    Slide 9-38

    GATT and WTO

    The removal of trade barriers was facilitated by

    institutionalized negotiations among countries

    TheGeneral Agreement of Tariffs and Trade was

    begun in 1947 as a provisional international

    agreement

    It was replaced by a more formal international

    institution called the World Trade Organization in1995.

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    Slide 9-39

    International negotiations

    Why was it necessary to engage in international

    negotiations to get trade barriers reduced?

    Why didnt the advanced countries reduce their trade

    barriers unilaterally?

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    Slide 9-40

    The Advantages of International Negotiation

    It is easier to lower tariffs as part of a mutualagreement than to do so as a unilateral policy

    because:It helps mobilize exporters to support freer trade and

    speak up against the import-competing industries

    who oppose imports.

    It can help governments avoid getting caught indestructive trade wars. (Next two slides.)

    It reduces the possibility of an adverse terms-of-trade

    effect from a unilateral reduction of tariffs.

    International Negotiations

    and Trade Policy

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    Slide 9-41

    International Negotiations

    and Trade Policy

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    Slide 9-42

    In Table 9-4, each country would choose protection.

    Even though each country acting individually would

    be better off with protection, they would both be

    better off if both chose free trade. In game theory, this situation is known as a Prisoners

    dilemma.

    Japan and the U.S. can establish a binding agreement

    to maintain free trade and thereby escape the

    prisoners dilemma.

    International Negotiations

    and Trade Policy

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    Bilateral versus Multilateral

    Smoot-Hawley tariffs in 1930

    Widely recognized to be a mistake that worsened the

    Great Depression

    But unilateral tariff reduction was politically difficult

    Initially bilateral tariff-reducing agreements were

    pursued

    Later multilateral agreements became popular

    Why?

    Slide 9-43

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    Slide 9-44

    Bilateral Trade Liberalization

    Suppose the USA and Brazil currently imposetariffs on each others goods and cannotunilaterally remove the tariffs because of thepolitical power of US coffee growers andBrazilian wheat farmers

    When bilateralnegotiations begin, the US coffeegrowers (or, Brazilian wheat farmers) resistanceto free trade would be opposed by US wheatfarmers (or, Brazilian coffee growers) eyeing apossible reduction of Brazils (or, the USs) tariffson US wheat (or, Brazilian coffee).

    In this way, bilateral negotiations to reduce tariffscan succeed even when unilateral efforts fail.

    USA

    Brazil

    Wheat Coffee

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    Slide 9-45

    Multilateral Trade Liberalization

    In this example, bilateralnegotiations between, say, Angolaand Brazil will not succeed inreducing tariffs.

    As Brazil does not export coffee toAngola, there will be no oppositionto Brazilian oil producers demandsfor a tariff on Angolan oil.

    However, a multilateral agreement

    will be successful. In each country,exporters will organize to opposeimporters resistance to themultilateral agreement.

    Angola Brazil

    China

    Oil

    CoffeeWheat

    I i l N i i

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    Slide 9-46

    International Trade Agreements: A Brief History

    Internationally coordinated tariff reduction as a tradepolicy dates back to the 1930s (the Smoot-HawleyAct).

    The multilateral tariff reductions since World War IIhave taken place under the GeneralAgreement onTariffs and Trade (GATT), established in 1947 andlocated in Geneva.

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

    The GATT-WTO system is a legal organization thatembodies a set of rules of conduct for international trade

    policy.

    International Negotiations

    and Trade Policy

    I i l N i i

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    Slide 9-47

    The GATT-WTO system prohibits the imposition of:

    Export Subsidiesexcept for agricultural products

    New Import quotasexcept when imports threaten market disruption

    New or Higher Tariffsany new tariff or increase in a tariff must be offset by

    reductions in other tariffs to compensate the affected

    exporting countries

    This is called binding of tariffs

    International Negotiations

    and Trade Policy

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    9-48

    World Trade Organization

    The WTO negotiations addresses trade restrictions

    in at least 3 ways:

    1. Reduction of tariff rates through multilateralnegotiations.

    2. Binding: a tariff is bound by having the imposingcountry agree not to raise it in the future.

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    9-49

    World Trade Organization (cont.)

    3. Prevention of non-tariff barriers: quotas andexport subsidies are changed to tariffs because the

    costs of tariff protection are more apparent.

    Subsidies for agricultural exports are an exception.

    Exceptions are also allowed for market disruptionscaused by a surge in imports.

    I t ti l N ti ti

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    Slide 9-50

    Trade round

    A large group of countries get together to negotiate a set of tariffreductions and other measures to liberalize trade.

    Eight trade rounds have occurred since 1947:

    The first five of these took the form of parallel bilateralnegotiations (e.g., Germany with France and Italy).

    The sixth multilateral trade agreement, known as the KennedyRound, was completed in 1967:

    This agreement involved an across-the-board 50% reduction intariffs by the major industrial countries, except for specified

    industries whose tariffs were left unchanged.

    Overall, the Kennedy Round reduced average tariffs by about 35%.

    International Negotiations

    and Trade Policy

    I t ti l N ti ti

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    Slide 9-51

    The so-called Tokyo round of trade negotiations

    (completed in 1979) resulted in:

    Reduced tariffs

    New codes for controlling the proliferation of non-tariff barriers, such as VERs (or, voluntary export

    restrictions).

    An eighth round of negotiations, the so-called

    Uruguay Round, was competed in 1994.

    International Negotiations

    and Trade Policy

    I t ti l N ti ti

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    Slide 9-52

    The Uruguay Round

    Its most important results are: Trade liberalization

    Administrative reforms

    Trade Liberalization The average tariff imposed by advanced countries decreased by

    almost 40%.

    More important is the move to liberalize trade in two important

    sectors: agricultural and clothing. From the GATT to the WTO

    Much of the publicity surrounding the Uruguay Round focusedon its creation of the WTO.

    International Negotiations

    and Trade Policy

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    Trade liberalization, Uruguay round

    Advanced country tariffs reduced by 40%

    Agricultural subsidies by exporters reduced by 36%

    Volume of subsidized exports reduced by 21%

    Agricultural import quotas replaced by bound tariffs

    MFA phased out in 2005

    All quantitative restrictions gone

    Some tariffs remain Government procurement brought under fairer rules

    Slide 9-53

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    9-54

    World Trade Organization

    The World Trade Organization was founded in 1995

    on a number of agreements

    General Agreement on Tariffs and Trade: covers trade in

    goods

    General Agreement on Tariffs and Services: covers trade inservices (ex., insurance, consulting, legal services,

    banking).

    Agreement on Trade-Related Aspects of IntellectualProperty: covers international property rights (ex., patents

    and copyrights).

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    9-55

    World Trade Organization

    The dispute settlement procedure: a formal procedurewhere countries in a trade dispute can bring their case to a

    panel of WTO experts to rule upon.

    The cases are settled fairly quickly: even with appeals theprocedure is not supposed to last more than 15 months.

    The panel uses previous agreements by member countriesto decide which ones are breaking their agreements.

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    9-56

    World Trade Organization

    A country that refuses to adhere to the panels decisionmay be punished by allowing other countries to impose

    trade restrictions on its exports.

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    9-57

    World Trade Organization

    The GATT/WTO multilateral negotiations, ratified in

    1994 (called the Uruguay Round),

    agreed that all quantitative restrictions (ex., quotas) on

    trade in textiles and clothing as previously specified in theMulti-Fiber Agreement were to be eliminated by 2005.

    But as the restrictions were eliminated, China had to

    reimpose quotas until 2011 due to political pressure.

    International Negotiations

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    Slide 9-58

    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 theWTO included rules on trade in services (the General

    Agreement on Trade in Services (GATS)) and on

    international application of international property rights.

    The WTO has a new dispute settlement procedure

    which is designed to reach judgments in a much shorter

    time.

    International Negotiations

    and Trade Policy

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    Slide 9-59

    WTO: US v. Venezuela

    US laws allowed domestic oil refineries to sell oil with more

    pollutants than imported oil

    Venezuela, which exports oil to the US, sued the US at the

    WTO

    Venezuela won. The US had to change its laws to make them

    non-discriminatory

    This episode showed that the WTO worked

    Environmentalists complained that the WTO made it harder

    for the US to reduce pollution

    Actually, the fault lies with the US law. The WTO should not

    be blamed

    International Negotiations

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    Slide 9-60

    Benefits and Costs

    The economic impact of the Uruguay Round isdifficult to estimate.

    However, estimates of the GATT and of theOrganization for Economic Cooperation andDevelopment suggest a gain to the world economy as awhole of more than $200 billion annually once theagreement is fully in force.

    Most economists believe that these estimates are too low.

    The costs of the Uruguay Round will be felt by well-organized groups, while much of the benefit will accrueto diffuse populations.

    International Negotiations

    and Trade Policy

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    9-61

    WTO Doha Round

    In 2001, a new round of negotiations was started in

    Doha, Qatar, but these negotiations have failed to

    produce an agreement.

    Most of the remaining forms of protection are inagriculture, textiles and clothingindustries that are

    politically active (see Collective Action above).

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    9-62

    Table 9-4: Percentage Distribution of

    Potential Gains from Free Trade

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    9-63

    Do Agricultural Subsidies in Rich Countries

    Hurt Poor Countries?

    We learned in chapter 8 that subsidies lower the worldprice ofproducts because domestic producers are enticed to producemore. So why should poor countries want rich countries to remove their

    agricultural subsidies? The likely answer has to do with the desires of farmers in poorcountries who compete with farmers in rich countries.

    Yet, urban residents and farmers who do not compete (ex., coffeefarmers) actually benefit from the lower prices of subsidized food onworld markets.

    For example, because China imports a lot of food, it would be hurt by theremoval of agricultural subsidies in rich countries (ex., the U.S. andEurope) according to the Doha negotiations.

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    9-64

    Table 9-5: Percentage Gains in

    Income under Two Doha Scenarios

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    Slide 9-65

    WTO Doha Round

    Main sticking point: agriculture subsidies

    Rich countries want to protect their farmers

    Poor countries want free market access for their

    farmers

    Countries seem to have given up on WTO

    negotiations

    Preferential trade agreements seem popular

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    Slide 9-66

    Nations establish preferential trading

    agreements under which they lower tariffs with

    respect to each other but not the rest of the world.

    The GATT-WTO, through the principle of non-discrimination called the most favored nation

    (MFN) principle, prohibits such agreements.

    The formation of preferential trading agreements isallowed if they lead to free trade between theagreeing countries.

    Preferential Trading Agreements

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    Slide 9-67

    Free trade can be established among several WTOmembers as follows:

    A free trade area allows free-trade among members,but each member can have its own trade policy

    towards non-member countries. Example: The North American Free Trade Agreement

    (NAFTA) creates a free trade area.

    A customs union allows free trade among membersand requires a common external trade policy towards

    non-member countries. Example: The European Union (EU) is a full customs

    union.

    A common market is a customs union with freefactor movements (especially labor) among members.

    Preferential Trading Agreements

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    Slide 9-68

    Are preferential trading agreements good?

    It depends on whether it leads to trade creation ortrade diversion.

    Trade creation Occurs when the formation of a preferential trading

    agreement leads to replacement of high-cost domestic

    production by low-cost imports from other members.

    Trade diversion

    Occurs when the formation of a preferential trading

    agreement leads to the replacement of low-cost imports

    from non members with higher-cost imports from member

    nations.

    Preferential Trading Agreements

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    Slide 9-69

    Summary

    There are three arguments in favor of free trade:

    The efficiency gains from free trade

    The additional gains from economies of scale

    The political argument There are two arguments for deviating from free

    trade:

    The terms of trade argument for a tariff

    The domestic market failures

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    Slide 9-70

    Summary

    In practice, trade policy is dominated by considerations

    of income distribution.

    Political parties adopt policies that serve the interests of

    the median voter. Groups that are well organized (or small groups) are often

    able to get policies that serve their interests at the expense

    of the majority.

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    Slide 9-71

    Summary

    International negotiation helps reduce tariffs inindustrial countries and avoid trade wars.

    The GATT is the central institution of the international

    trading system. The most recent worldwide GATT agreement also setsup a new organization, the WTO.

    Three kinds of preferential trading agreements areallowed under the WTO: free trade areas, customsunions, and common markets.

    Preferential trading agreements can be good or baddepending on the magnitude of trade creation and tradediversion effects.

    Appendix: Proving that the

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    Slide 9-72

    Home import demand

    Foreign export supply

    PF

    Price, P

    Quantity, Q

    P

    ~

    PW

    t

    Appendix: Proving that the

    Optimum Tariff is Positive

    Figure 9A-1: Effects of a Tariff on Prices

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