Chapter 10

The Political Economy of Trade Policy

 Chapter Organization
The Case for Free Trade
Free Trade and Efficiency
Additional Gains from Free Trade
Rent Seeking
Political Argument for Free Trade
National Welfare Arguments against Free Trade
The Terms of Trade Argument for a Tariff
The Domestic Market Failure Argument against Free Trade
How Convincing Is the Market Failure Argument?
Income Distribution and Trade Policy
Electoral Competition
Collective Action
Box: Politicians for Sale: Evidence from the 1990s
Modeling the Political Process
Who Gets Protected?
International Negotiations and Trade Policy
The Advantages of Negotiation
International Trading Agreements: A Brief History
The Uruguay Round
Trade Liberalization
Administrative Reforms: From the GATT to the WTO
Benefits and Costs
Box: Settling a Dispute—and Creating One
Case Study: Testing the WTO’s Metal
The End of Trade Agreements
Box: Do Agricultural Subsidies Hurt the Third World?
Preferential Trading Agreements
Box: Free Trade versus Customs Unions

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Box: Brexit
The Trans-Pacific Partnership
Case Study: Trade Diversion in South America
Summary
APPENDIX TO CHAPTER 10: Proving that the Optimum Tariff Is Positive
Demand and Supply
The Tariff and Prices
The Tariff and Domestic Welfare

 Chapter Overview
The models presented up to this point generally suggest that free trade maximizes national welfare, although
it clearly is associated with income distributional effects. Most governments, however, maintain some
form of restrictive trade practices. This chapter investigates reasons for this. One set of reasons concerns
circumstances under which restrictive trade practices increase national welfare. Another set of reasons
concerns the manner in which the interests of different groups are weighed by governments. The chapter
concludes with a discussion of the motives for international trade negotiations and a brief history of
international trade agreements.
One recurring theme in the arguments in favor of free trade is the emphasis on related efficiency gains.
As illustrated by the consumer/producer surplus analysis presented in the text, nondistortionary production
and consumption choices that occur under free trade provide one set of gains from eliminating protectionism.
Another level of efficiency gains arise because of economies of scale in production.
Two additional arguments for free trade are introduced in this chapter. Free trade, as opposed to “managed
trade,” provides a wider range of opportunities and thus a wider scope for innovation. The use of tariffs
and subsidies to increase national welfare (such as a large country’s use of an optimum tariff), even where
theoretically desirable, in practice may only advance the causes of special interests at the expense of the
general public. When quantity restrictions such as quotas are involved, rent-seeking behavior—where
companies expend resources to receive the benefits from quota licenses—can distort behavior and cause
waste in the economy.
Next, consider some of the arguments voiced in favor of restrictive trade practices. The arguments that
protectionism increases overall national welfare have their own caveats. The success of an optimum tariff
or an optimum (negative) subsidy by a large country to influence its terms of trade depends upon the
absence of retaliation by foreign countries. Another set of arguments rests upon the existence of market
failure. The distributional effects of trade policies will differ substantially if, for example, labor cannot
be easily reallocated across sectors of the economy as suggested by movements along the production

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possibility frontier.
Other proponents of protectionist policies argue that the key tools of welfare analysis, which apply demand
and supply measures to capture social as well as private costs and benefits, are inadequate. They argue that
tariffs may improve welfare when social and private costs or benefits diverge. In general, however, it is
better to design policies that address these issues directly rather than indirectly through a tariff, which may
have negative side effects. Students may better understand this concept by pointing out that a tariff is like a
combined tax and subsidy. A well-targeted subsidy or tax leads to a confluence of social and private cost
or benefit. A policy that combines both a subsidy and a tax has other effects that limit social welfare gains.
Actual trade policy often cannot be reconciled with the prescriptions of basic welfare analysis. One reason
for this is that the social accounting framework of policy makers does not match that implied by cost-benefit
analysis. For example, policy makers may apply a “weighted social welfare analysis” that weighs gains or
losses differently depending upon which groups are affected. Of course, in this instance there is the issue of
who sets the weights and on the basis of what criteria. Also, trade policy may end up being used as a tool
of income redistribution. Inefficient industries may be protected solely to preserve the status quo. Indeed,
tariffs theoretically can be set at levels high enough to restrict trade in a product.
Divergence between optimal theoretical and actual trade policy may also arise because of the manner in
which policy is made. The benefits of a tariff are concentrated, while its costs are diffused. Well-organized
groups whose individuals each stand to gain a lot by trade restrictions have a better opportunity to influence
trade policy than larger, harder to organize groups, which have more to lose in the aggregate, but whose
members individually have little to lose.
Drawing upon these arguments, one would expect that you could generalize that countries with strong
comparative advantage in manufacturing would tend to protect agriculture, while countries with comparative
advantage in agriculture would tend to protect manufacturing. For the United States, however, this argument
is not validated by the pattern of protection. It is concentrated in four disparate industries: autos, steel, sugar,
and textiles.
International negotiations have led to mutual tariff reductions from the mid-1930s through the present.
Negotiations that link mutually reduced protection have the political advantage of playing well-organized
groups against each other rather than against poorly organized consumers. Trade negotiations also help avoid
trade wars. This is illustrated by an example of the Prisoner’s dilemma as it relates to trade. The pursuit of
self-interest may not lead to the best social outcome when each agent takes into account the other agent’s
decision. Indeed, in the example in the text, uncoordinated policy leads to the worst outcome because
protectionism is the best policy for each country to undertake unilaterally. Negotiations result in the
coordinated policy of free trade and the best outcome for each country.
The chapter concludes with a brief history of international trade agreements. The rules governing GATT are

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discussed, as are the real threats to its future performance as an active and effective instrument for moving
toward freer trade. Also, the developments of the Uruguay Round are reviewed, including the creation of the
WTO and the economic impact of the Round. Of note from this round was the phase-out of the Multi-Fiber
Agreement, a set of tariffs and quotas on trade in textiles. Table 10-2 estimates that the phase-out of trade
barriers in textiles has saved the United States roughly $11 billion since 2002.
The chapter also notes that more recent multilateral negotiations (the Doha Round) have failed, largely over
disagreements regarding agricultural subsidies and trade. This has been a disappointment to free trade
proponents as it marks the first time a major multilateral trade round has failed to produce a substantial
agreement. However, the failure of the Doha Round can be partially attributed to the success of previous
rounds of trade negotiations. As the world moves closer and closer to free trade, the marginal gains from
further reductions in trade barriers become smaller. This is highlighted by Table 10-5 in the text, which
shows that even under the most ambitious proposals in the Doha Round, the gains from freer trade would
only be about 0.18 percent of global income.
The sources of failure of the Doha Round are echoed in the apparent failure to enact the Trans-Pacific
Partnership (TPP). Previous trade agreements had largely eliminated many traditional trade barriers like
quotas and tariffs. The TPP focused on less concrete trade barriers like intellectual property rights and
investor-state dispute settlement. As such, the simple logic of free trade was less resounding in advocating
for this deal when balanced against its criticisms. Similarly, the case of the UK’s impending departure
from the European Union (Brexit) had less to do with concerns over free trade and more to do with another
nontariff trade barrier: labor mobility. The cases of Doha, TPP, and Brexit suggest that the remaining
barriers to completely free trade and full economic integration will be increasingly difficult to remove.

 Answers to Summary Questions (5, 6, 9)

5. If the main effect of DR-CAFTA was to increase clothing exports from the signatory nations to the
United States, then the overall economic impact on the U.S. economy would be rather modest. Prior
to 2004, the Multi-Fiber Arrangement (MFA) imposed quotas on textiles and apparel. As a result,
these industries accounted for over 80 percent of the welfare costs of U.S. protectionism. However,
the MFA was phased out in 2004 and the most recent estimate (see Table 10-2) puts the welfare costs
of protection in these industries at only half a billion dollars. Thus, reducing trade barriers in clothing
through the DR-CAFTA will only have a modest impact since trade in clothing has been pretty free
since the end of the MFA.
6. The main problem with this view is that it assumes that the United States can pursue its own trade
policies in a vacuum. Policies enacted in other countries will have effects in the United States just as

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U.S. trade policy will affect foreign countries. Thus, the United States has a legitimate interest in the
trade policies of other countries, just as other countries have a legitimate interest in U.S. activities.
Uncoordinated trade policies are likely to be inferior to those based on negotiations. By negotiating
with each other, governments are better able both to resist pressure from domestic interest groups and
to avoid trade wars of the kind illustrated by the Prisoners’ Dilemma example in the text.
9. One possible justification for subsidizing the domestic production of rare earth metals is the terms of
trade argument for protection. Because China dominates the production of these metals, it has enough
market power to impose an export tax on these metals and raise the world price (much as Saudi
Arabia does with oil exports). This exercise of power could lead to a welfare gain for China at the
expense of the rest of the world. By subsidizing domestic production, the United States could dilute
China’s market power and reduce the threat of higher prices on rare earth metals. However, the
assumption that China could benefit from an export tax assumes that there would be no retaliation in
other industries. If China were to impose an export tax on rare earth metals, what’s to stop the United
States from imposing an import tariff on electronics from China? Thus, the threat of China imposing
an export tax is perhaps not as large as one might suspect given its market power in this industry.
Another potential justification for subsidizing domestic production would be if doing so would
generate some social benefit in excess of the private benefit to producers. Perhaps there would be
technological spillovers from mining these metals that would exceed any social costs of subsidizing
domestic production. Of course, the opposite could well be true and the social cost of domestic
production may be quite a bit higher than the social benefit given the large environmental impact of
mining these metals. It is often difficult to pinpoint ex-ante which industries are subject to this kind of
market failure and indirect intervention through trade policy may not be the best way to address these
market failures.
 Answers to Textbook Problems
1. The arguments for free trade in this quote include:
• Free trade allows consumers and producers to make decisions based upon the marginal cost and
benefits associated with a good when costs and prices are undistorted by government policy.
• The Philippines is “small,” so it will have little scope for influencing world prices and capturing
welfare gains through an improvement of its terms of trade.
• “Escaping the confines of a narrow domestic market” allows possible gains through economies of
scale in production.
• Free trade “opens new horizons for entrepreneurship,” creating opportunities for Filipino
exporters to reach markets inaccessible without trade.
• Special interests may dictate trade policy for their own ends rather than for the general welfare.
Free trade policies may aid in halting corruption where these special interests exert undue or
disproportionate influence on public policy.

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2. a. The lower income of dairy farmers comes to the expense of consumers and taxpayers. This is
potentially a valid argument for an export subsidy because we have a possible case of market
failure. In this case, an export subsidy always produces more costs than benefits. Indeed, if the
goal of policy is to stimulate the demand for the associated goods and services, the policies
should be targeted directly at these goals.

b. This is potentially a valid argument for a tariff, because it is based on the assumed ability of the
EU to affect world prices on economically certified foods. If the EU is concerned about higher
prices in the future, it could use policies to minimize the potential future adverse shocks.

c. The increased wealth of farmers, due to the export subsidies and the potentially higher income to
those who sell goods and services to the farmers, comes at the expense of consumers and
taxpayers. Unless there is a domestic market failure, an export subsidy always produces more
costs than benefits.

d. There might be external economies of scale associated with the domestic recycling programs.
This is potentially a valid argument. But the gains to recycling companied must always be
weighed against the higher costs to consumers and other industries that need to adopt a recycling
program. A subsidy policy could be of help, because it might bring the advantage of directly
dealing with the externalities associated with domestic recycling programs.

e. Consumers (which are also workers) have benefited from the stable price of coal. It the goal of
policy is to soften the blow to coal workers, a more efficient policy would be direct payments to
coal workers in order to aid their transition to other industries.

3. Without tariffs or subsidies, we compute domestic production as S = 10 + (10 × 5) = 60 and domestic

consumption as D = 600 − (10 × 5) = 550, for imports of 490.
a. To analyze the welfare effects of the tariff, it is helpful to draw a diagram for this small country.
Note that since it is a small country, the tariff will not affect the world price, and the domestic
price will rise by the full amount of the tariff, rising from 5 to 15.
After the tariff is imposed, domestic production will rise to S = 10 + (10 × 15) = 160 and
domestic consumption will fall to D = 600 − (10 × 15) = 450, for imports of 290. To analyze the
welfare effect, we know that the tariff will lead to a net welfare loss as the gains in producer
surplus and tariff revenue are smaller than the losses in consumer surplus. The net loss from the
tariff is obtained by computing the two deadweight loss triangle yields: ½ × (10 × 100) + ½ × (10
× 100) = 1000.

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Against the losses from tariff, we must consider the social gain from increased domestic
production. After the tariff, domestic production increased by 100 units. The marginal social
benefit from each unit of production is 15, so the social gain from increased production is 1500.
Thus, the net effect of the tariff on total welfare is 1500 – 1000 = 500.
b. A production subsidy will cause domestic supply to rise by S = 10 + 10(5 + 10) = 160, an
increase of 100 units as with the tariff. However, the domestic price will not change in this
country, so consumers do not lose any welfare with this subsidy. Rather, the only efficiency loss
comes from the production distortion costs, the leftmost triangle in the diagram. The net loss of
the subsidy of 1/2(10 × 100) = 500. However, the increase in domestic production caused social
welfare to rise by 500 × 5 = 2500, leading to a net welfare gain of 2000.
c. The production subsidy is a better targeted policy than the import tariff because it directly affects
the decisions that reflect a divergence between social and private costs while leaving other
decisions unaffected. The tariff has a double-edged function as both a production subsidy and a
consumption tax.
d. The optimal subsidy would be for producers to fully internalize the externality by raising the subsidy
to 20 per unit. Supply would then rise to S = 10 + 10(10 + 20) = 310. The production distortion
would now be 1/2(20 × 100) = 1000, but the total social benefit from increasing production by 100
units would be 100 × 20 = 2000. The net welfare gain would be 1000.

4. Based on the diagram, the gain in producer surplus from the tariff is equal to the area bounded above by
the price of 15, below by the price of 5 and to the right by the supply curve. This area is equal to 1000.
Government tariff revenue is 948.43. The loss in consumer surplus is the area bounded above by the
price of 15, below the price of 5 and to the right by the demand curve. This area is 1085.6. Total welfare
from the tariff is 1000 + 948.43 − 1085.6 = 862.83.

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However, if the government values every dollar of producer gain as worth of $5 of consumer surplus,
then from the government’s perspective, the net gain from the tariff is equal to:

Gain in Producer Surplus = 1,000

Political Gain in Producer Surplus = 1,000 × 5 = 5,000
Tariff Revenue = 948.43
Loss in Consumer Surplus = −1,718.375
Net Welfare Gain = 5,230.055
5. a. This would lead to trade diversion because the lower-cost Japanese cars with an import value of
€27,000 (but real costs of €18,000) would be replaced by Polish cars with a real cost of
production equal to €20,000.
b. Before the addition of Poland to the EU, Japanese cars were not imported because their import
price was €36,000. Thus, Poland’s addition to the EU would lead to trade creation because
German cars that cost €30,000 to produce would be replaced by Polish cars that cost only
€20,000.
c. This would lead to trade diversion because the lower-cost Japanese cars with an import value of
€24,000 (but real costs of €12,000) would be replaced by Polish cars with a real cost of
production equal to €20,000.
6. The subsidized production in China through unfair and illegal trade practices represent a threat to the
U.S. industry activity. The Chinese aluminum overproduction, along with the export tax policies, drives
an increase of imports into the U.S., which means that the U.S. producers might go out of their
businesses because of a downward effect on prices, market share and employment losses. Thus, the
American manufacturers filled a WTO complaint against the Chinese producers of aluminum foil,
calling for a negotiated agreement to address the overcapacity issue and the unfair trade practices,
which distort the market and violates the U.S. law. The American manufacturers also ask for transparent
procedures and focus on the unique characteristics of the aluminum industry, which has generally
benefited from fair international trade in comparison to the steel industry. That would address the global
industry as a whole on a course of expansion, creating more jobs, and opportunities.
7. The optimal tariff argument rests on the idea that in a large country, tariff (or quota) protection in a
particular market can lower the world price of that good. Therefore, it is possible that with a (small)
tariff, the tariff revenue accruing to the importing country may more than offset the smaller welfare
losses to consumers, smaller because prices have fallen somewhat due to the tariff itself. Basically, a
large country is able to get foreign producers to pay for part of the tariff in the form of a reduced
world price.

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8. The game is no longer a Prisoners’ Dilemma. As the chapter discusses, protectionist measures are
welfare reducing in their own right. Each country would have an incentive to engage in free trade no
matter what the strategy of the other country. Only in a more complex dynamic game in which a trade
partner will only open its markets if the home country threatens sanctions (and the threats are only
credible if occasionally carried out) would we find any welfare-enhancing reason to use a tariff.
9. The possibility that the labor used in the agricultural sector would be unemployed in case of a free
market is explained by the domestic market failure argument. If the labor market cannot deliver full
employment for a free trade case, then a policy of subsidizing labor-intensive industries, like
agriculture, is the best approach. These imperfections in the internal functioning of an economy might
interfere in its external economic relations. But any proposed trade policy should always be compared
with a purely domestic policy aimed at correcting the same problem. If the domestic policy appears to
be costly or has undesirable side effects, the trade policy is even less desirable, even though the costs
are less apparent. The critics of this argument say that this trade policy is adopted not because its
benefits exceed its costs, but because the public fails to understand its true costs. It is always preferable
to deal with market failures as directly as possible, because effects can lead to unintended distortions of
incentives elsewhere in the economy.

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