1.NEW TRADE THEORY 2. POLITICAL ECONOMY OF TRADE POLICY

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1.NEW TRADE THEORY2. POLITICAL ECONOMY OF TRADE
POLICY

• Lecture 14 AHEED Course International
  Agricultural Trade and Policy
• Taught by , Alex F. McCalla, Professor Emeritus,
  UC Davis.
• April 7, 2010 University of Tirana, Albania
• Lecture courtesy of
  Professor Colin A. Carter, UC Davis

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New Trade Theory

• In late 1980s, Helpman/Krugman coined the
  imperfectly competitive framework as the new
  trade theory
• Theorists noted that much trade is dominated by a
  small number of large firms this raised the
  following question could increasing returns
  cause trade? (as opposed to exogenous differences
  in technology or factor endowments)
• They also noted that trade in differentiated
  products is more important than homogeneous goods
  trade. Theorists argued that increasing returns
  (which typically leads to imperfect competition)
  could be as fundamental a cause of international
  trade as comparative advantage.
• Intra-industry trade cannot be explained by
  Ricardian or H-O models.

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Important to Agriculture?

• Relevance to Agric? Intra-industry trade gt 50 _at_
  4 digit level for processed foods. For example,
  US imports exports tomatoes. At 6 digit level
  Harmonized System (HS) codes would show tomato
  exports to Canada and imports from Canada
  Mexico. 8,000 different products at HS 10 digit
  level.

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New Trade Theory-2

• New Trade Theory emphasizes
• 1) increasing returns,
  i.e., f (tx1 , tx2) gt t? f (x1,x2)
• 2) imperfect competition
• 3) differentiated products
• Economies of scale means average cost of
  production declines as the of units increases.
• Internal scale economies (Helpman Krugman) AC
  declines with output of individual firm may be
  due to fixed costs associated with starting a
  firm.
• External scale economies (Markusen Melvin) AC
  declines as the size of the industry grows.
• This literature shows that increasing returns
  raises the gains from international trade.
• Presence of economies of scale imperfect
  competition raises the question are their new
  arguments against free trade? Could there be new
  reasons for government intervention through
  import restrictions, export subsidies, etc
• Brander/Spencer showed (with a duopoly model)
  that a govt may be able to shift profits from
  foreign to domestic exporters through an export
  subsidy

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Intra-Industry Trade the Krugman Model (1980)

• 1. Trade models based on comparative advantage
  focus on
• Trade between dissimilar countries (different
  technologies, factor endowments, etc)
• Inter-industry trade trade in different
  commodities
• 2. Krugman noticed
• Considerable Intra-Industry trade (i.e., trade in
  similar goods) Grubel Lloyd showed this many
  years ago.
• Large amount of trade among similar economies.
• 3. Krugman showed that trade is possible
  mutually beneficial in the case of two completely
  identical countries

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Krugman Model cont

• 4. Krugman assumptions
• 2 identical economies (home (H) foreign (F)) in
  terms of technology preferences
• One nontraded factor of production (labor)
  equal endowment across countries LH LF
• Large number of competitors but many varieties of
  goods (i.e, differentiation). Each firm produces
  its own variety. Each firm acts as a monopolist
  (monop. competition) goods are substitutes so
  price falls as more firms enter the market. In
  equib. p AC.
• Consumer preferences homothetic identical
  across countries
• Consumer preferences love of variety
  diminishing marginal utility associated with the
  consumption of extra units. Consumption of more
  varieties yields higher utility city lights
  effect.
• Trade is of the intra-industry type - exchange of
  varieties of the same differentiated good.

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Krugman cont 2

• 5. In Krugman type model (monopolistic
  competition internal scale economies) the gains
  from trade arise due to
• a) larger number of varieties available to
  consumers (i.e., more choice)
• b) larger production of each individual variety,
  resulting in a larger real income (lower prices
  due to increased market size and increased
  competition).
• c) No income distribution effects everybody
  gains.

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Brander/Spencer (1985)

• Brander/Spencer showed (with a duopoly model)
  that a govt may be able to shift profits from
  foreign to domestic exporters through an export
  subsidy
• Two new arguments
• Strategic Trade Policy govt can tilt the terms
  of oligopolistic competiton to shift excess
  returns from foreign to domestic
• Externalities govt should favor industries that
  yield positive externalities
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Bhagwati Econ Journal March 94

• Conventional challenges to free trade
• Great depression ? unemployment ? Keyness
  apostasy on free trade
• 1930s. Edward Chamberlin Joan Robinson
  developed theory of imperfect competition,
  undermining the notion that market prices reflect
  social costs questioning free trade
• 1950s 1960s heyday of free trade with
  successive GATT rounds trade mostly expanded in
  developed countries, whereas many developing
  countries embraced infant industry import
  substitution arguments (e.g., Prebisch-Singer)
• Market failure argument was used to justify
  intervention this led to theory of optimal
  policy intervention (Bhagwati, Corden Johnson)
  which showed trade policy was 2nd best
  intervention, with domestic policy 1st best

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Bhagwati - cont

• 1980s literature concerned with product market
  imperfections, whereas previous literature was
  concerned with factor market imperfections.
• shifted pre-occupation with protectionism in
  developing countries to pre-occupation with
  protectionism in developed countries
• new theory immediately moved into center of
  public policy debate
• Theorists who developed New Trade Theory have
  now backed away.
• Not empirically important because there are too
  few rents to shift Chicago school approach
  e.g., Gene Grossman
• Public Choice School approach says govts are
  predatory intervention may produce worse
  outcomes than the imperfect markets we are trying
  to fix (Krugman has taken this approach)
• 1990s saw proponents of NTT backing off
  developments in political economy literature
  strengthened the case against protectionism.

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ADDITIONAL CHALLENGES

• Two New Challenges have arisen
• Fair Trade as a precondition for free trade.
  e.g., demands for harmonization of domestic
  environmental/labor standards. But diversity of
  domestic policies, institutions, standards is
  generally compatible with gainful free trade.
• Bhagwati notes that ironically fair trade
  instruments such as Anti-dumping and Countervail
  duties have been captured by special interests
  used unfairly to gain protection.
• Trade wages North is now fearful of the
  South low wages.
• Bhagwati notes that SS theorem FPE theorem
  probably dont hold in the real world due to
  factor intensity reversal. Scale economies can
  also invalidate the SS theorem.
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• Additional critiques of NTT
• Empirically difficult to model imperfect markets
  (as amount of information is often overwhelming).
  Eaton/Grossman (QJE May 86) showed that in a
  duopoly model where the optimal strategic policy
  was an export subsidy with quantity competition,
  became an export tax with price competition.
• Gains from intervention will be dissipated by
  entry of rent-seeking firms.
• General equilibrium considerations increase
  empirical difficulty of formulating optimal trade
  policies so intervention could do more harm
  than good.

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Monop. Comp Trade
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Political Economy of Trade Policy

• If Imperfect competition and increasing returns
  still dont explain why actual trade patterns
  dont match the predictions of HOS, what does
  explain it?
• Another alternative is that trade outcomes are
  explained more by policy than basic economics.
• If so, what explains the kind of policies
  countrys pursue- politics and the political
  process in place.
• So lets look at literature on Political Economy
  of Trade Policy.

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What Does the P.E. Literature on Trade Policy
(not) tell us? (Rodrik)

• Three questions lie at the core of Political
  Economy of Trade Literature
• Why is international trade not free?
• Why are trade policies biased against trade?
• What determines protection levels across
  countries/commodities?

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Traditional Views of Govt Role in Agriculture

• Correct for market failure or externalities
• Provide public goods
• Correct for imperfect competition
• Equity income redistribution

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Agric. Protectionism

• Ag. is typically taxed in developing countries
  subsidized in industrial countries (Little et
  al., 1970 Johnson, 1973 Bale and Lutz, 1981
  Binswanger and Scandizzo, 1983 Anderson, Hayami,
  et al., 1986 Krueger, Schiff and Valdes, 1988
  Tyers and Anderson, 1992).
• This remains broadly true when the additional
  negative effects of manufacturing protection
  overvalued exchange rates are taken into account
  (Schiff Valdes, 92 Anderson, 95).

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Incumbent Advantage
Source http//www.opensecrets.org
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Public Choice Theory

• Public Choice literature rejects the view of a
  benevolent govt
• Public Choice theory emphasizes self-interest
  motives of politicians, voters, pressure groups
  bureaucrats.
• Political markets redistribute wealth.

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Political Economy Models

• Political economy models generally take either a
  specific-factors or Heckscher-Ohlin setting
  modify it by
• Assuming policy-makers have preferences for
  certain groups, or
• Assume lobby groups are able to take action to
  shape policy-makers preferences.

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A Political Economy Model of Trade Policy Must
have 4 elements

1. A description of individual preferences over the
   domain of policy choices available.
2. A description of how these preferences are
   aggregated channeled through pressure groups
   etc. into political demands.
3. Characterize policy-makers preferences.
4. Specify the institutional setting in which policy
   takes place.

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Direct Majority Voting Models

• H-O Model each agent owns 1 labor some K
• Imports are K intensive, so tariff leads to
  higher r lower w
• Economy opts for a tariff if median voter has a
  higher ki than the economy as a whole
• Model cannot explain how an industry with a small
  of voters can secure protectionism
• R-V Model Voting costs combined with asymmetry
  btwn. gains to a small sector losses to owners
  in rest of economy can lead to a tariff with
  majority voting

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Pressure Group Models

• Producer groups seeking protection typically
  involve a small of agents, with high per capita
  benefits lower per capita costs
• Findlay Wellisz, Fixed Factor Model
• 1 fixed factor 1 mobile, 2 sectors
• Mobile factor (labor) lobbies on behalf of fixed
  factor
• Nash equib. determines tariff
• Fixed factor gains mobile may/may not
• Low ed for mobile factor leads to less lobbying

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Pressure Group Models

• Young Magee, H-O model
• Both factors mobile
• Each factor lobbies on own behalf
• Intensive factor gains, other loses
• Low ed for factor leads to more lobbying more
  protection

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Modeling Govt Behavior

• Bhagwati categorized Clearinghouse Govt (CHG)
  versus Social Welfare Function (SWG) models
• The commonly held belief that the government is
  a ship of fools might be replaced with the
  government as an island covered with pirates
  Magee, Brock Young, Black Hole Tariffs

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Explanation of Agricultural Policy

• Olson policy of switching from taxation to
  subsidization is caused primarily by the decrease
  in the free-rider problem as of firms decline,
  the political organization of farmers becomes
  more efficient.
• Gardner (87) found variables associated with the
  cost of redistribution cost of generating
  political power explain intervention in U.S.
  agriculture.

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Protection across countries/time

• Anderson (93) analyzed asymmetry of agric.
  protection in rich vs. poor countries
• Main argument is that a tax on agric. in a poor
  country results in a relatively small cost for
  farmers but a big gain for industrialists
  whereas an agric. subsidy in a rich country
  entails big gains for farmers but small costs for
  industrialists