INTERNATIONAL ECONOMICS

LECTURE 7: 9 APRIL 2017

Chapter 9The Political Economy of Trade Policy

To Accompany International Economics: Theory and Policy, Sixth Edition

by Paul R. Krugman and Maurice Obstfeld

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Introduction The Case for Free Trade National Welfare Arguments against Free Trade Income Distribution and Trade Policy International Negotiations and Trade Policy Summary Appendix: Proving that the Optimum Tariff is

Positive

Chapter Organization

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Introduction

In 1981 the United States asked Japan to limit its exports of autos to the United States. This raised the prices of imported cars and forced U.S. consumers to buy domestic autos they clearly did not like as much.

While Japan was willing to accommodate the U.S. government on this point, it was unwilling to do so on another—a request that Japan eliminate import quotas on beef and citrus products—quotas that forced Japanese consumers to buy incredibly expensive domestic products instead of cheap imports from the United States.

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Introduction

Free trade maximizes national welfare, but it is associated with income distributional effects.• Most governments maintain some form of restrictive

trade policies.• This chapter examines some of the reasons

governments either should not or do not base their policy on economists’ cost-benefit calculations.

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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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Few countries have anything approaching completely free trade. The city of Hong Kong, which is legally part of China but maintains a separate economic policy, may be the only modern economy with no tariffs or import quotas.

Nonetheless, since the time of Adam Smith economists have advocated free trade as an ideal toward which trade policy should strive.

At one level, theoretical models suggest that free trade will avoid the efficiency losses associated with protection. Many economists believe that free trade produces additional gains beyond the elimination of production and consumption distortions.

The Case for Free Trade

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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.– A move from a tariff equilibrium to free trade eliminates the efficiency loss

and increases national welfare.

The Case for Free Trade

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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

Free Trade and Efficiency

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It is noteworthy that the costs of protection to the United States are measured as quite small relative to national income. This situation reflects two facts: (1) the United States is relatively less dependent on trade than other countries, and (2) with some. Major exceptions, U.S. trade is fairly free. By contrast, some smaller countries that impose very restrictive tariffs and quotas are estimated to lose as much as 10 percent of their potential national income to distortions caused by their trade policies.

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The Case for Free TradeTable 9-1: Estimated Cost of Protection,

as a Percentage of National Income

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Additional Gains from Free Trade• 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, 13 firms produced 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

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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

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The three arguments outlined in the previous section probably represent the standard view of most international economists, at least in the United States:1. The conventionally measured costs of deviating from free trade are large.2. There are other benefits from free trade that add to the costs of protectionist policies.3. Any attempt to pursue sophisticated deviations from free trade will be subverted by the political process

The Case for Free Trade

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The case of Unified European Market 1987 Negotiations Towards 1992 Types of Protections that exist in the EU Main aim of 1992 Gains from 1992 What eventually happened after 1992?

Case StudyThe Gains from 1992