Chapter 9 Notes

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Economics for Management Studies
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Garth Frazer

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Chapter 9 The Political Economy of Trade Policy Notes The Case for Free Trade Political Argument for Free Trade • a political argument for free trade reflects the fact that a political commitment to free trade may be a good idea in practice even though there may be better policies in principle • three arguments probably represent the standard view of most international economists: 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. National Welfare Arguments against Free Trade • most tariffs, import quotas, and other trade policy measures are undertaken primarily to protect income of particular interest groups • politicians often claim, however, that the policies are being undertaken in the interest of the nation as a whole • although economists often argue that deviations from free trade reduce national welfare, there are, in fact, some theoretical grounds for believing that activist trade policies can sometimes increase the welfare of the nation as a whole The Terms of Trade Argument for a Tariff • one argument for deviating from free trade comes directly out of cost-benefit analysis: for a large country that is able to affect the prices of foreign exporters, a tariff lowers the price of imports and thus generates a terms of trade benefit • this benefit must be set against the costs of the tariff, which arise because the tariff distorts production and consumption incentives • however, in some cases the terms of trade benefits of a tariff outweigh its costs, so there is a terms of trade argument for a tariff The Domestic Market Failure Argument against Free Trade • the domestic market failure argument against free trade is a particular case of a more general concept known as theory of second best • this theory states that a hands-off policy is desirable in any one market only if all other markets are working properly • if they are not, a government intervention that appears to distort incentive in one market may actually increase welfare by offsetting the consequences of market failures elsewhere International Negotiations and Trade Policy The Advantages of Negotiation • there are at least 2 reasons why it is easier to lower tariffs as part of a mutual agreement than to do so as a unilateral policy • first, a mutual agreement helps mobilize support for freer trade • second, negotiated agreements on trade can help governments avoid getting caught in destructive trade wars Summary 1. Although few countries practice free trade, most economists continue to hold up free trade as a desirable policy. This advocacy rests on three lines of argument. First is a formal case for the efficiency gains from free trade that is simply the cost-benefit analysis of trade policy read in reverse. Second, many economists believe that free trade produces additional gains that go beyond this formal analysis. Finally, given the difficulty of translating complex economic analysis into real policies, even those who do not see free trade as the best imaginable policy see it as a useful rule of thumb. 2. There is an intellectually respectable case for deviating from free trade. One argument that is clearly valid in principle is that countries can improve their terms of trade through optimal tariffs and export taxes. This argument is not too important in practice, however. Small countries cannot have much influence on their import or export prices, so they cannot use tariffs or other policies to raise their terms of trade. Large countries, on the other hand, can influence their terms of trade, but in imposing tariffs they run the risk of disrupting trade agreements and provoking retaliation. 3. The other argument for deviating from free trade rests on domestic market failures. If some domestic market, such as the labour market, fails to
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