Narrative Report

NARRATIVE REPORT
Chapter 10: The Political Economy of Trade Policy
I. Introduction
In understanding actual trade policies, we must learn about the reasons
for government not to interfere with trade. There are several cases for free trade which
will be discussed in this chapter. As well as the National Welfare Arguments against
Free Trade, Income Distribution and International Negotiations and Trade Policy.
II. Objectives
This chapter aims to articulate arguments for free trade that go beyond the
conventional gains from trade and evaluate national welfare arguments against free
trade. It also aims to relate the theory and evidence behind “political economy” views of
trade policy, explain how international negotiations and agreements have promoted
world trade and discuss the special issues raised by preferential trade agreements.
III. Discussion
The Cases for Free Trade

Producers and consumers allocate resources most efficiently when market prices
are not distorted through trade policy. National welfare of a small country is highest with
free trade. With restricted trade, consumers pay higher prices and consume too little
while firms produce too much. Also, with restricted trade, distorted prices cause
overproduction either by existing firms producing more or by too many firms in the
industry. A trade restriction, such as a tariff, leads to production and consumption
distortions. This means a move to free trade eliminates these distortions and increase
national welfare.
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.
Free trade allows firms or industries to take advantage of economies of scale.
Protected markets limit gains from external economies of scale by inhibiting the
concentration of industries such as many firms to enter the protected industry and the
scale of production of each firm becomes inefficient. In economies of scale, the higher
the size of firm/industry, means more or higher efficiency.
Free trade provides competition and opportunities for innovation (dynamic
benefits). By providing entrepreneurs with an incentive to seek new ways to export or
compete with imports, free trade offers more opportunities for learning and innovation.
Free trade also avoids the loss of resources through rent seeking. Rent seeking is a
process when imports are restricted with a quota rather than a tariff.
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 political groups, leading to
decreased national welfare.
National Welfare Arguments Against Free Trade

For a large country, a tariff lowers the price of imports in world markets and
generates a terms of trade benefit. This benefit must be set against the cost of the tariff
which arise because the tariff distorts production and consumption incentives. A small
tariff will lead to an increase in national welfare for a large country. But at some tariff
rate, the national welfare will begin to decrease as the economic efficiency loss exceeds
the terms of trade gain.
A second argument against free trade is that domestic market failures may exist
that cause free trade to be a suboptimal policy. The economic efficiency loss
calculations using consumer and producer surplus assume that markets function well.
Economists calculate the marginal social benefit to represent the additional
benefit to society from private production. With a market failure, marginal social benefit
is not accurately measured by the producer surplus of private firms, so that economic
efficiency loss calculations are misleading. It’s possible that when a tariff increases
domestic production, the benefit to domestic society will increase due to a market
failure.
Income Distribution and Trade Policy

The Median Voter Theorem predicts that democratic political parties pick their
policies to court the voter in the middle of the ideological spectrum (i.e., the median
voter). Thus, the median voter theorem implies that a two-party democracy should enact
trade policy based on how many voters it pleases.
Political activity is often described as a collective action problem. While
consumers as a group have an incentive to advocate free trade, each individual
consumer has no incentive because his benefit is not large compared to the cost and
time required to advocate free trade.
International Negotiations and Trade Policy
After rising sharply at the beginning of the 1930s, the average U.S. tariff rate has
decreased substantially from the mid-1930s to 1998. Since 1944, much of the reduction
in tariffs and other trade restrictions has come 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.
World Trade Organization
In 1947, a group of 23 countries began trade negotiations under a provisional set
of rules that became known as the General Agreement on Tariffs and Trade, or GATT.
In 1995, the World Trade Organization, or WTO, was established as a formal
organization for implementing multilateral trade negotiations (and policing them).
WTO negotiations address trade restrictions in at least 3 ways. First, by reducing
tariff rates through multilateral negotiations. Second, by binding tariff rates and finally,
eliminating nontariff barriers: quotas and export subsidies are changed to tariffs
because the costs of tariff protection are more apparent and easier to negotiate.
Preferential Trading Agreements

Preferential trading agreements are trade agreements between countries in which
they lower tariffs for each other but not for the rest of the world. There are two types of
preferential trading agreements in which tariff rates are set at or near zero, a free trade
area and a customs union. A free trade area is an agreement that allows free trade
among members, but each member can have its own trade policy towards nonmember
countries. While, a customs union is an agreement that allows free trade among
members and requires a common external trade policy towards nonmember countries.
Reference: Krugman Paul R,O.M. (2012). International Economics: Theory and Policy:
USA: Pearson Education, Inc.

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Chapter 10: The Political Economy of Trade Policy

The Cases for Free Trade

National Welfare Arguments Against Free Trade

Income Distribution and Trade Policy

Preferential Trading Agreements

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