Part B: 2 Political Economy Of Trade Policy (Arguments For/Against FT +Median Voter)

Question 1

Case for free trade (5)

Answer 1

Improved efficiency
E.o.S
Competition creates more innovation
Rent seeking behaviour reduced
FT is the best feasible political policy

Question 2

Cases against free trade (3)

Answer 2

Trade policy can create ToT gains for large economy (if optimal tariff set right, domestic price rises, world price falls, export price rises creating ToT gains so can consume on a higher IC!)

Under market failure trade policy can increase welfare (breaking small countries always prefer free trade assumption!)

Political arguments e.g protection may be better

Question 3

1st case for FT: Efficiency

Why do we not want restricted trade
B) how can we demonstrate flaws of restricted trade

Answer 3

Resource allocation is most efficient under FT. Under restricted trade, pay higher prices and consume less.
With distorted prices, overproduction caused.

B) tariff diagram can show higher prices, and overproduction by domestic firms.

Question 4

Benefits of a move to worldwide free trade

B) what does this imply for trade restrictions like tariffs

Answer 4

A move to worldwide free trade would only increase world GDP by 0.93%

B) it implies tariff rates are already low (not too restrictive and far from free trade)

Question 5

So gains of moving to free trade pretty small:

Are they larger for advanced economies or developing economies

Answer 5

Larger gains (more beneficial) for developing countries (since more likely smaller which prefer free trade!)

Question 6

Cost of protection as a % of GDP : name a country with high cost of protection

Answer 6

Brazil’s protection costs 9.5% of GDP. Large… so

So free trade clearly would benefit these countries

Question 7

2nd case for free trade: EOS

Protected markets can limit external EOS. How?

B) Example

Answer 7

too many firms operating means scale of production becomes inefficient

B) 1964 Argentine efficient car firm should make 80-200k each, instead 13 firms together produced 166k!

Question 8

4th case for free trade: reduces rent seeking behaviour

B) diagram
What is the maximum loss from lobbying for a quota

Answer 8

Quotas result in economic waste as firms spend time and resources seeking quota rights and the profit they will earn

B) diagram pg 13
Higher price Pq, a is domestic producer gain from imposing quota (higher price and can supply more since import quota)
a+c is maximum loss from lobbying for a quota

Question 9

5th case for free trade: free trade is the best feasible political policy

Why?

Answer 9

Trade policy can be pressured and manipulated by political groups, leading to decreased national welfare

E.g a tariff on an import may be desirable, but government have to resist pressure from other industries to grant them too

Question 10

So how can we demonstrate how large economies benefit from tariffs.

Answer 10

Optimum tariff diagram

Question 11

Optimal tariff diagram

Answer 11

Y axis - National welfare
X axis - tariff rate

Optimum tariff rate is at t₀ and NWopt.

From then, national welfare falls as tariffs continue to rise. NW falls till a minimum, at the prohibitive tariff rate tp.

(Prohibitive tariff is where tariff is so high trade is elimiiated)

Question 12

So tariffs can create terms of trade gains.

Export tax can also create terms of trade gains for a large country

Why?

Answer 12

Large country have market power: if they tax their exports, export supply may fall esp if they instead cater for domestic market, increasing price of exports. (Of course don’t want tax too high to prohibit exports completely otherwise worse off)

Export price/import price creating ToT improvement

Remember export tax has same welfare effects as import tariff

Question 13

Caveat to export tax on a large country (2)

Answer 13

Retaliation by other countries enacting their own restrictions

Also doesn’t work for small countries (can’t influence world prices)

Question 14

2nd case against free trade:
Domestic market failures happen in reality making free trade suboptimal.

Firstly: why may PS/CS (efficiency loss) calculations be incorrect?

B) which country would this impact?

Answer 14

Calculations based upon efficient markets. If market failures, PS & CS do not measure welfare properly

B) small country - the assumption of always preferring free trade may not hold

Question 15

How should benefits be assessed

Answer 15

Marginal social benefit i.e benefit to society from domestic production e.g jobs etc

Question 16

Diagrams of domestic market failure argument for a tariff

(Tariff diagram and MSB diagram)

Answer 16

1st diagram - tariff showing producer (production diverted to less efficient domestic producers) and consumer distortions (lower quantity higher price)

2nd diagram - Y axis - dollars X axis price
Downward sloping aligning with producer distortion in top diagram.
Area C rerpeents gain in MSB

If c>a+b = tariff increases welfare for a small country!

Question 17

Domestic market failure argument complies with what theory

Answer 17

Theory of second best: trade policies are 2nd best options with market failures existing

(First best option is to correct market failure themselves e.g try to fix unemployment (sticky-wage induced) since avoid having to use trade and suffer efficiency losses b+d, but if not, tax imports to make c>a+b)

Question 18

Evaluation of market failure argument (2)

Answer 18

Hard to identify market failures and to what extent in real world

Even gov intervention to address market failures (1st best policy) can be manipulated by political groups

Question 19

3rd reason against free trade: Political reasons e.g protectionism

Answer 19

Free trade harms domestic industry and causes unemployment

Question 20

So is trade policy socially optimal

Answer 20

In most cases, trade policy is not socially optimal. (a+b>c)

So why have protection and trade policy rather than free trade?

Question 21

Why would a government still have socially unoptimal trade policy (3) (where a+b>c)

Answer 21

Political reasons - reduce chances of being voted out

Corruption e.g favouring producers or motives

Trade policy is less transparent than e.g income tax, so good for raising revenue/redistribution

Question 22

So that was why have trade policy not free trade.

Now how is the actual trade policy determined? Which model

Answer 22

Median voter theorem

Question 23

Median voter theorem

Answer 23

Parties change policies to cater for the median voter

E.g if trying to win over deciding the tariff rate.
Line up voters in preferred rate, and choose median

Question 24

Assumptions of Median voter theory (2)

Answer 24

2 parties
Objective of party is to get majority vote

Question 25

What will parties pursue

Answer 25

POLICY CONVERGENCE - Offer the same policy to court the median voter, to capture the most votes on either side

Question 26

Diagram of MVT

Answer 26

Y axis - preferred tariff rate X axis - voters Upward sloping line - political support Tm is the preferred tariff rate of the median voter. Here Tb is closer to Tm than Ta so party B can win over voters by offering the lower tariff. Thus, both parties converge to close to Tm. POLICY CONVERGENCE

Question 27

MVT says a policy inflicting losses on minority but benefits majority should be chosen (since this would get votes) Does trade policy align with this idea , and example

Answer 27

No US dairy industry has tariffs. Which impose losses on domestic households, only benefits dairy industry which is small (0.1% of nations workforce)

Question 28

Drawbacks of MVT (4)

Answer 28

In reality parties have to consider many (not just tariff) Only assumes 2 parties - with 3 voters, no stable equilibrium since always incentive to move in response to opponents Assumes they only care about winning - in reality, they may not adjust their policy close to Tm if they believe differently and care about thier policy. Collective action problem (incentive to advocate as group but not individually)

Question 29

Collective action problem: Group have an incentive to advocate for free trade, but individually no incentive. Why?

Answer 29

Individual consumers benefit is small compared to the cost & time they would need to devote so do not advocate for free trade. Also a Public good - people may let others advocate. In the end noone advocates so no opposition and accept policies that impose large losses to society.

Question 30

Thus policies that impose large losses to society as a whole, but small lossess indiviudally may not face opposition How to overcome collective action (free rider) problem

Answer 30

Make groups small so individuals benefit bigger so more incentive to advocate and lobby for free trade

Question 31

So MTV ignores collective action problem. Whats a more realistic view of how policy is determined

Answer 31

Combine MVT and collective action I.e advocate theories as implied by MVT but also consider advocate groups (with no collective action problem i.e indiviudal benefit is larger) in order to secure funding to run their campaign

Question 32

So as parties need funds to run the campaigns, they may consider interests of lobbyists in order to secure funds. Does evidence show trade policy is for sale then?

Answer 32

Yes - found strong impact of money contributing to voting patterns, can influence policy makers to pursue these donor interests over policies that improve aggregate welfare!!