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

1. 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

2. “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.

3. Important to Agriculture? • Relevance to Agric? Intra-industry trade > 50% @ 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.

4. “New Trade Theory”-2 • New Trade Theory emphasizes: • 1) increasing returns, i.e., f (tx1 , tx2) > 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 gov’t may be able to shift profits from foreign to domestic exporters through an export subsidy

5. 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

6. 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.

7. 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.

8. Brander/Spencer (1985): • Brander/Spencer showed (with a duopoly model) that a gov’t may be able to shift profits from foreign to domestic exporters through an export subsidy • Two new arguments: • Strategic Trade Policy : gov’t can tilt the terms of oligopolistic competiton to shift excess returns from foreign to domestic • Externalities: gov’t should favor industries that yield positive externalities

10. BhagwatiEcon Journal March ‘94 Conventional challenges to free trade: • Great depression  unemployment  Keynes’s 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

11. 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 govt’s 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.

12. 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 don’t hold in the real world due to factor intensity reversal. Scale economies can also invalidate the SS theorem. 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.

13. Monop. Comp & Trade

14. Political Economy of Trade Policy • If Imperfect competition and increasing returns still don’t explain why actual trade patterns don’t 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 country’s pursue- politics and the political process in place. • So lets look at literature on “Political Economy of Trade Policy”.

15. 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?

16. Traditional Views of Gov’t Role in Agriculture • Correct for “market failure” or externalities • Provide “public goods” • Correct for imperfect competition • Equity – income redistribution

17. 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).

19. Incumbent Advantage Source: http://www.opensecrets.org

23. Public Choice Theory • Public Choice literature rejects the view of a benevolent gov’t • Public Choice theory emphasizes self-interest motives of politicians, voters, pressure groups & bureaucrats. • Political markets redistribute wealth.

24. 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.

25. A Political Economy Model of Trade Policy Must have 4 elements • A description of individual preferences over the domain of policy choices available. • A description of how these preferences are aggregated & channeled through pressure groups etc. into political demands. • Characterize policy-makers preferences. • Specify the institutional setting in which policy takes place.

26. 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

27. 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

28. 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

29. Modeling Gov’t Behavior • Bhagwati categorized Clearinghouse Gov’t (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

30. 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.

31. 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