INTERNATIONAL ECONOMICS Chapter 4 FREE TRADE AND

INTERNATIONAL ECONOMICS

Chapter 4: FREE TRADE AND PROTECTIONISM IN INTERNATIONAL TRADE POLICY

Content: • • International Trade Policy Protectionism Trade Policy Free Trade Policy Key principles in International Trade

International Trade Policy • The study of international trade can be divided into three areas: – Trade theory – Empirical studies of trade – Trade Policy

International Trade Policy • Trade policy analysis includes: – Determine the trade effects of domestic policies – Analysis of consumer preferences and social policy – Deals with institutions and questions relating to the efficacy of those institutions

International Trade Policy • Trade policy analysis includes: – Determine the trade effects of domestic policies – Analysis of consumer preferences and social policy – Deals with institutions and questions relating to the efficacy of those institutions

International Trade Policy • The concept of Trade Policy: – A Collection of Rules and Regulations which pertain to trade – The policy is formulated to be most appropriate for their country – To run international trade smoothly, by setting clear standards and goals which can be understood by potential trading partners

International Trade Policy • The use of Trade Policy Instruments:

Protectionist Trade Policy can take numerous forms Are intended to improve the position of domestic relative to foreign producers Can be done through policies that: ◦ increase the home market price of the foreign product ◦ Decrease the production costs of domestic firm ◦ Restrict the access of foreign producers to the domestic market

Protectionist Trade Policy Ø Specific goal of protectionist trade policy is to expand domestic production in the protected industries, benefiting the owners, workers and suppliers of resources to the protected industry. Ø The government also benefits in the form of tax revenue

Protectionist Trade Policy Forms of Protectionism: ◦ Tariff: which are simply taxes imposed on goods entering a country from abroad, result in higher prices Be the most common form of protection for domestic producers ◦ Quotas: Restrict foreign producers access to the domestic market By which, importers typically are limited to a maximum number of products that they can sell in the home market over specific period

Protectionist Trade Policy Forms of Protectionism: ◦ Regulatory Barriers: Product standards: serve the public interest and intentionally protect domestic producers ◦ Subsidies: An alternative to restrict the terms under which foreigners can compete in the home market May focus upon industry in general or upon the export activities of the industry Ø Difference between subsidies and tariffs involves the revenue implications for the government.

Protectionist Trade Policy • Forms of Protectionism: – Exchange controls: • Restricting access to the foreign money required to by foreign goods • Hard to sustain

Protectionist Trade Policy v. The arguments for Protectionism: • National defense: • Import barriers are necessary to ensure the capacity to produce crucial goods in a national emergency v The national defense argument ignores the possibility of purchases from other countries during emergency and possibilities of storage

Protectionist Trade Policy v. The arguments for Protectionism: • Income Redistribution: • Trade restriction might be defended on the grounds that it favors some disadvantaged group • Adverse effects on the efficient allocation of resources • Optimum Tariff Argument: • The optimum tariff argument applies to situations in which a country has the economic power to alter world prices

Protectionist Trade Policy v. The arguments for Protectionism: • Balancing the Balance of Trade: • Eliminating a balance of trade deficit or increasing a balance of trade surplus • Dated from the mercantilist view that larger trade surpluses are beneficial from a national perspective

Protectionist Trade Policy v. The arguments for Protectionism: • Protection of Jobs – Public Choice: • A domestic industry faced with increased imports from its foreign competition is under pressure to reduce production and lower costs. Ø Workers must change jobs and relocate to other cities ØOwners of capital in the affected industry bear similar costs

Protectionist Trade Policy v. The arguments for Protectionism: • Infant industry: • Promoting domestic industry with competitive advantage • In order to assist the entrant of a new industry, tariff protection can be used to shield the firm from foreign competition

Protectionist Trade Policy v. The arguments for Protectionism: • Spillover effects • Strategic Trade Policy • Reciprocity and the “Level Playing Field”

Protectionist Trade Policy v. Which Industries are protected? – Agriculture: in the US, Europe and Japan farmers make up a small fraction of the electorate but receive generous subsidies and trade protection. • Examples: European Union’s Common Agricultural Policy, Japan’s 1000% tariff on imported rice, America’s sugar quota.

Protectionist Trade Policy v. Which Industries are protected? – Clothing: textiles (fabrication of cloth) and apparel (assembly of cloth into clothing). • Import licenses for textile and apparel exporters are specified in the Multi-Fiber Agreement between the US and many other nations.

Protectionist Trade Policy v. Which Industries are protected?

International Negotiations of Trade Policy • The average US tariff rate on dutiable imports has decreased substantially from 1920– 1993. • Since 1944, much of the reduction in tariffs and other trade restrictions came about through international negotiations. – The General Agreement of Tariffs and Trade was begun in 1947 as a provisional international agreement and was replaced by a more formal international institution called the World Trade Organization in 1995.

International Negotiations of Trade Policy

International Negotiations of Trade Policy • Multilateral negotiation mobilize exporters to support free trade if they believe export markets will expand. – This support would be lacking in a unilateral push for free trade. – This support counteracts the support for restricted trade by import-competing groups.

International Negotiations of Trade Policy • Multilateral negotiations also help avoid a trade war between countries, where each country enacts trade restrictions. • If each country has a political interest (due to political pressure) to protect domestic producers, regardless of what other countries do, – then all countries could enact trade restrictions, even if it is in the interest of all countries to have free trade. • Let’s use a simple example to illustrate this point.

International Negotiations of Trade Policy

International Negotiations of Trade Policy • In this simple example, each country acting individually would be better off with protection, but both would be better off if both chose free trade. • If Japan and the US can establish a binding agreement to maintain free trade, both can avoid the temptation of protection and both can be made better off.

Free Trade Policy • The case for globalization: “If a country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage” (Adam Smith)

Free Trade Policy • The case for free trade: – The first case for free trade is the argument that producers and consumers allocate resources most efficiently when governments do not distort market prices through trade policy. • National welfare of a small country is highest with free trade. • With restricted trade, consumers pay higher prices. • With restricted trade, distorted prices cause overproduction either by existing firms producing more or by more firms entering the industry.

Free Trade Policy • The case for free trade:

Free Trade Policy • The case for free trade:

Free Trade Policy • The case for free trade: – A second argument for free trade is that allows firms or industry to take advantage of economies of scale. – A third argument for free trade is that it provides competition and opportunities for innovation. – These dynamic benefits would not be reflected in static estimates of the elimination of efficiency losses of producers, caused by distorted prices and overproduction.

Free Trade Policy • The case for free trade: – A fourth argument, called the political argument for free trade, says that free trade is the best feasible political policy, even though there may be better policies in principle. • Any policy that deviates from free trade would be quickly manipulated by special interests, leading to decreased national welfare.

Free Trade Policy • The case against free trade:

Free Trade Policy • The case against free trade: – A tariff rate that completely prohibits imports leaves a country worse off, but tariff rate t 0 may exist that maximizes national welfare: an optimum tariff.

Free Trade Policy • The case against free trade: – An export tax (a negative export subsidy) that completely prohibits exports leaves a country worse off, but an export tax rate may exist that maximizes national welfare through the terms of trade. • An export subsidy lowers the terms of trade for a large country; an export tax raises the terms of trade for a large country. • An export tax may raise the price of exports in the world market, increasing the terms of trade.

Free Trade Policy • The case against free trade – Counter argument – For some countries like the US an import tariff or and export tax could improve national welfare at the expense of other countries. – But this argument ignores the likelihood that other countries may retaliate against large countries by enacting their own trade restrictions.

Free Trade Policy • The case against free trade: – Economists calculate the marginal social benefit to represent the additional benefit to society from additional production. • In each of the market failure cases, marginal social benefit is not accurately measured by the producer surplus of private firms, so that economic efficiency loss calculations are misleading. – It is possible that a tariff raises domestic production, thereby increasing the benefit to domestic society because a market failure.

Free Trade Policy • The case against free trade: – The domestic market failure argument against free trade is an example of a more general argument called theory of the second best. – This theory states that government intervention which distorts market incentives in one market may increase national welfare by offsetting the consequences of market failures elsewhere. • The best policy would be to fix the market failures themselves, but if this is not feasible, then government intervention in another market may the “second-best” way of fixing the problem.

Free Trade Policy • The case against free trade: – The domestic market failure argument against free trade is an example of a more general argument called theory of the second best. – This theory states that government intervention which distorts market incentives in one market may increase national welfare by offsetting the consequences of market failures elsewhere. • The best policy would be to fix the market failures themselves, but if this is not feasible, then government intervention in another market may the “second-best” way of fixing the problem.

Free Trade Policy • The case against free trade – Counter argument: – Economist supporting free trade counter- argue that domestic market failures should be corrected by a “firstbest” policy: a domestic policy aimed directly at the source of the problem. • If persistently high under-employment of labor is a problem, then the cost of labor or production of labor-intensive products could be subsidized by the government. • These subsidies could avoid the economic efficiency loss for consumers due to a tariff.

Free Trade Policy • The case against free trade – Counter argument: – Economist supporting free trade counter- argue that domestic market failures should be corrected by a “firstbest” policy: a domestic policy aimed directly at the source of the problem. • If persistently high under-employment of labor is a problem, then the cost of labor or production of labor-intensive products could be subsidized by the government. • These subsidies could avoid the economic efficiency loss for consumers due to a tariff.

Free Trade Policy The case against free trade – Counter argument: ◦ Because it is unclear when and to what degree a market failure exists in the real world, it is unclear when and to what degree government policies should respond. ◦ Government policies to address market failures are likely to be manipulated by politically powerful groups. ◦ Because it distorts the incentives of producers and consumers, a trade policy may have unintended consequences that make a situation worse, not better.

Key principles in International Trade • Most Favored Nation Treatment (MFN) • National Treatment (NT) • Other principles

Key principles in International Trade • Most Favored Nation Treatment (MFN): – A cornerstone of the multilateral trading system conceived after World War II – Seeks to replace the frictions and distortions of power-based (bilateral) policies with the guarantees of a rules-based framework where trading rights do not depend on the individual participants’ economic or political clout

Key principles in International Trade • Most Favored Nation Treatment (MFN): – The best access conditions that have been conceded to one country must automatically be extended to all other participants in the system – Allows everybody to benefit, without additional negotiating effort, from concessions that may have been agreed between large trading partners with much negotiating leverage.

Key principles in International Trade • Most Favored Nation Treatment (MFN): – No discrimination between like products / services originating in or destined for other WTO Members. Each trading partner gets immediately and unconditionally the best treatment given to any trading partner even if not a WTO Member

Key principles in International Trade • Most Favored Nation Treatment (MFN): – Under the WTO agreements, countries cannot normally discriminate between their trading partners. Grant someone a special favour (such as a lower customs duty rate for one of their products) and you have to do the same for all other WTO members.

Key principles in International Trade • Most Favored Nation Treatment (MFN): – GATT – GATS – TRIPS

Key principles in International Trade Most Favored Nation Treatment (MFN): ◦ Exceptions: Countries can set up a free trade agreement that applies only to goods traded within the group — discriminating against goods from outside. They can give developing countries special access to their markets. A country can raise barriers against products that are considered to be traded unfairly from specific countries. In services, countries are allowed, in limited circumstances, to discriminate. But the agreements only permit these exceptions under strict conditions. In general, MFN means that every time a country lowers a trade barrier or opens up a market, it has to do so for the same goods or services from all its trading partners — whether rich or poor, weak or strong.

Key principles in International Trade • Most Favored Nation Treatment (MFN): – Exceptions: • • GATS Art. II: 2 (Specific List of MFN Exemptions) GATS Art. II: 3 (Advantages to Adjacent Countries) GATS Art. V (Economic Integration) GATS Art. V bis (Labour Market Integration) GATS Art. XIV (General Exception) GATS Art. XIV bis (Security Exception) Marrakesh Agreement Art. IX: 3 (Waiver)

Key principles in International Trade • National Treatment (NT): – Imported and locally-produced goods should be treated equally — at least after the foreign goods have entered the market. The same should apply to foreign and domestic services, and to foreign and local trademarks, copyrights and patents.

Key principles in International Trade • National Treatment (NT): – This principle of “national treatment” (giving others the same treatment as one’s own nationals) is also found in all the three main WTO agreements (Article 3 of GATT, Article 17 of GATS and Article 3 of TRIPS), although once again the principle is handled slightly differently in each of these.

Key principles in International Trade • National Treatment (NT): – National treatment only applies once a product, service or item of intellectual property has entered the market. Therefore, charging customs duty on an import is not a violation of national treatment even if locally-produced products are not charged an equivalent tax.

Key principles in International Trade National Treatment (NT): ◦ As a general rule, imported products must not be discriminated against vis-à-vis domestic products ◦ Members cannot impose higher internal taxes or more burdensome obligations on imported “like” products ◦ Determinants of likeness - the properties, nature and quality of the products; the end-uses of the products; consumers' tastes and habits and the tariff classification of the products ◦ None of these elements is dispositive

Key principles in International Trade Exceptions to the National Treatment Principle under GATT: ◦ ◦ ◦ ◦ GATT Art. III: 3 (“Grandfathering”) GATT Art. III: 8(a) (Government Procurement) GATT Art. III: 8(b) (Production Subsidies) GATT Art. III: 9 (Prejudicial effect of internal price control measures) GATT Art. III: 10 and Art. IV (Cinematographic films) GATT Art. XX (General Exception) GATT Art. XXI (Security Exception) Marrakesh Agreement Art. IX: 3 (Waiver)

Key principles in International Trade • MFN Treatment v. National Treatment Non- Discrimination Non-Discrimination Equal Treatment between WTO Members’ Products Goods Equal Treatment between Imported and Domestic Article I GATT (Article II GATS Article IV TRIPS) Article III GATT (Article XVII GATS Article III TRIPS) At the Border: Inside Border:

Key principles in International Trade Other principles: ◦ ◦ Transparency Market access Regional Trade Agreements GATT Art. XXIV: Free-Trade Areas and Customs Unions “substantially all trade” among Members; “not on the whole more trade-restrictive” measures against third countries; limited transition period – normally not to exceed 10 years

Key principles in International Trade Other principles: ◦ GATS Art. V: Economic Integration Agreements ◦ “substantial sectoral coverage; absence or elimination of substantially all discrimination Enabling Clause: Regional/Global Trading Arrangements “purpose should be to create trade among participating countries and not raise barriers to the trade of third countries

Key principles in International Trade Other principles: ◦ ◦ ◦ State Trading Enterprises and Monopolies GATT Art. XVII: STEs Allowed to have STEs but they must respect the non -discrimination principles and operate in accordance with commercial considerations GATS Art. V: Monopolies Allowed but should not operate to undermine a Member’s specific commitments