Chapter 10 - The Political Economy of Trade Policy

Question 1

What is a Multilateral Trade Agreement? Give two examples.

Answer 1

By ‘multilateral’ trade agreement we mean that many countries are involved. 1) Formed in 1947, The General Agreement on Tariffs and Trade (GATT) was multilateral trade agreement aimed at liberalising trade after WW2. 2) The World Trade Organisation (WTO) was formed in 1944 to try to strengthen the mechanisms by which trade liberalisation is achieved. The WTO has at its core the rules of the GATT.

Question 2

Why has the GATT attracted criticism? What is the idea behind the GATT?

Answer 2

The GATT has attracted a huge amount of negative publicity throughout its history. It is portrayed as a faceless, undemocratic organisation. But the basic idea behind the GATT seems quite benign. It is to provide a framework within which countries’ government can agree to make tariff reductions.

Question 3

How can we model the GATT? (4)

Answer 3

1) We model the GATT as a forum in which countries can ‘communicate’ and interact repeatedly over trade policy. 2) Through repeated interaction countries can support free trade as a ‘subgame perfect Nash Equilibrium’. 3) We are therefore thinking of the international negotiations that take place in the ‘negotiating rounds’ of the GATT as repeated interactions in a game. 4) We can equivalently think of the GATT as providing a ‘focal point’ for interest groups such as exporters.

Question 4

How different is the WTO from the GATT? (3)

Answer 4

1) The GATT was a provisional agreement, while the WTO is a fully-fledged international organisation. 2) The GATT applied only to trade in goods, while the WTO introduces rules on trade in services (the General Agreement on Trade and Services (GATS)) and on international application of international property rights. 3) The WTO has a new “dispute settlement” procedure which it’s designed to reach judgements in a much shorter time.

Question 5

What are the implications of trade policy for Brexit? (5)

Answer 5

1) Since the EU is a CU, we can think of it as a single country from the standpoint of trade policy. 2) Focusing just on trade policy, we can think of the Brexit negotiations as forming a trade agreement between the EU-27 and the UK. 3) First, unilateral liberalisation is a mistake. 4) Since the UK is significantly smaller than the EU-27, there may be areas where the UK wants an agreement while the EU-27 does not. 5) Then, UK must make ‘side payments’ - e.g. the so-called ‘divorce settlement’ to get a trade agreement.

Question 6

Give two different types of Bilateral Trade Agreements and examples of each.

Answer 6

1) A customs union (CU) is where members agree to remove tariffs and other trade barriers between each other and they coordinate on the setting of ‘common external tariff policy.’ That is, they agree on the tariffs set against non-members. The European Union (EU) is an example of a CU. 2) A Free Trade Area (FTA) is where members agree to remove tariffs and other trade barriers between each other but continue to set trade policy independently against non-member nations. The North American Free Trade Agreement (NAFTA) is an example of a Free Trade Area.

Question 7

What is the difference between trade creation and trade diversion?

Answer 7

Trade creation - occurs when the formation of a preferential trading agreement leads to replacement of high-cost domestic production by low-costs imports from other members. Trade diversion - occurs when the formation of a preferential trading agreement leads to the replacement of low-cost imports from non-members with higher-cost imports from member nations.

Question 8

What is the only modern economy without any tariffs or import quotas?

Answer 8

Hong Kong

Question 9

What can be said about free trade for different countries across the world?

Answer 9

For the world as a whole, according to these estimates, protection costs less than 1% of GDP. The gains from free trade are somewhat smaller for advanced economies such as the United States and Europe and somewhat larger for poorer “developing countries”.

Question 10

Give an example of how protection leads to inefficient scale.

Answer 10

Argentine Automobile Industry

Question 11

Give examples of rent seeking (2)

Answer 11

1) Indian Steel industry - Indian companies allocated the rights to buy imported inputs in proportion to their installed capacity. Thus the companies would build more blast furnaces than they needed, simply to get more import licenses. 2) American Tuna Industry

Question 12

Political arguments for free trade. (3)

Answer 12

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 protection. 3) Any attempt to pursue sophisticated deviations from free trade will be subverted by the political process.

Question 13

What is the best form of tariff for a large country?

Answer 13

At small tariff rates, a large country’s welfare is higher than with free trade. The optimum tariff rate is always positive but less than the prohibitive tariff rate that would eliminate all imports.

Question 14

What are the two lines of defence for free trade, against the market failure argument?

Answer 14

1) Domestic market failures should be corrected by domestic policies aimed directly at the problems sources. 2) Economists cannot diagnose market failure well enough to prescribe policy.

Question 15

What was one of the most important provisions of the Uruguay round?

Answer 15

Signed in 1994, was the phaseout of the Multi-Fiber Agreement, which took place at the end of 2004.

Question 16

Give two reasons why it is easier to lower tariffs as part of a multilateral agreement.

Answer 16

1) A mutual agreement helps mobilise support for freer trade. 2) Negotiated agreements on trade can help governments avoid getting caught in destructive wars.

Question 17

What was the format of the first five trade rounds?

Answer 17

The first five trade rounds that took place under the GATT took the form of parallel bilateral negotiations, where each country negotiates pairwise with number of countries at once.

Question 18

What was the Kennedy Round? (3)

Answer 18

1) The sixth round of negotiations, complete in 1967. 2) Multilateral negotiations led to an agreement of a 50% reduction in tariffs by the major industrial industries. 3) Reduced average tariffs by around 35%

Question 19

What does TRIPS stand for?

Answer 19

The Trade-Related Aspects of Intellectual Property.

Question 20

What factors explain why the Doha Round failed?

Answer 20

1) Poor countries saw little in the proposals for them, they pressed for much higher concessions from rich countries. 2) The governments of rich countries, in turn, refused to take the political risk of crossing powerful interest groups especially farmers, without something in return. 3) Poor countries were unwilling to offer the deep cuts in their remaining tariffs that would have been sufficient.

Question 21

What are the national welfare argument against free trade? (3)

Answer 21

1) Activist trade policies can sometimes increase the welfare of the nation as a whole. 2) The terms of trade argument for a tariff. 3) Domestic market failure: The ‘infant-industry’ argument is the most theoretically compelling, but open to capture in practice.

Question 22

Graphically show the efficiency case for free trade.

Answer 22

For the case of a small country that cannot influence foreign export prices. A tariff causes a net loss to society measured by the area of the two triangles; it does so by distorting the incentives to producers and consumers. Conversely a move to free trade eliminates these distortions.

Question 23

What additional gains are there from free trade?

Answer 23

1) Protected markets limit gains from external economies of scale. When the economies of scale are internal, they not only fragment production internationally, but by reducing competition and raising prices, they also lead too many firms to enter the market. 2) 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. 3) More productive firms engage in exports while less productive firms stay with the domestic market. Suggesting, a move to free trade makes the economy as a whole more efficient.

Question 24

What is the stance of the GATT on preferential trading agreements?

Answer 24

The GATT forbids preferential trading agreements in general, as a violation of the MFN principle, but allows them if they lead to free trade between the agreeing countries.

Question 25

Graphically depict the efficiency case for free trade.

Answer 25

Question 26

Show graphically the optimum tariff.

Answer 26

Question 27

Show graphically, the domestic market failure argument for a tariff.

Answer 27