Part B: 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
Rent seeking behaviour reduced
FT is the best feasible political policy

Question 2

Cases against free trade (3)

Answer 2

Trade policies (tariffs (optimal tariff diag) and export tax in particular) can generate terms of trade gains FOR LARGE COUNTRY

Domestic market failures exist in reality making free trade suboptimal (violates small countries always prefer free trade assumption!)

Political arguments e.g protection

Question 3

1st case for FT: Efficiency

A) when is national welfare of a small country highest?

B) under restricted trade, what do consumers face

C) under restricted trade, what do distorted prices cause

Answer 3

Resource allocation is most efficient under FT

A) small want FT

B) pay higher prices and consume less

C) overproduction either by existing firms produce more or new firms entering (hence why should have FT)

Question 4

Diagram to show restricted trade effects e.g a tariff

Answer 4

A tariff has producer and consumer distortion

Draw a basic tariff diagram showing world price+tariff leads to producer distortion (from overproduction) and CS loss (from paying more)

Question 5

Benefits of a move to worldwide free trade

B) what does this imply for trade restrictions like tariffs

Answer 5

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 6

So gains of moving to free trade pretty small:

Are they larger for advanced economies or developing economies

Answer 6

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

Question 7

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

Answer 7

Brazil 9.5%.

So free trade clearly would benefit these countries

Question 8

2nd case for free trade: EOS

Why?
Example

Answer 8

Protected markets limit gains from external economies of scale i,e too many firms operating means scale of production becomes inefficient

1964 Argentine efficient car firm should make 80-200k, instead 13 firms together produced 166k! (Shows inefficient as too many firms so no EOS)

Question 9

3rd case for free trade: Competition and innovation encouraged (dynamic benefits)

Answer 9

Offers more opportunities for learning and innovation

Question 10

4th case for free trade: reduces rent seeking behaviour

B) diagram

Answer 10

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)

Question 11

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

Why?

Answer 11

Free trade is good because 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 12

1st case against free trade:
Tariffs lower the import prices to generate terms of trade gains

For which country is this talking about

Answer 12

A large country! (If they impose a small tariff it can increase their welfare, since protectionist for their infant industries, eventually compete and lower import prices in world markets!)

Question 13

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

Answer 13

Optimum tariff diagram

Question 14

Optimal tariff diagram

Answer 14

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 15

So tariffs can create terms of trade gains.

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

Why?

Answer 15

Large country have market power:
If exporters being taxed, price of exports in the world market increase. Good for large country since has market power

Question 16

Caveat to export tax on a large country (2)

Answer 16

Retaliation by other countries enacting their own restrictions

Also doesn’t work for small countries

Question 17

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

Firstly: why may efficiency loss calculations be incorrect

B) which country would this impact?

Answer 17

Efficiency loss calculations (from PS and CS) accuracy is 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 18

How should benefits be assessed

Answer 18

Marginal social benefit

Question 19

So how does market failures make free trade suboptimal

Cosndier a tarifff

Answer 19

Tariffs increase domestic production, but the benefit to domestic society may increase due to the market failure

Question 20

Diagram of domestic market failure argument for a tariff

Answer 20

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

2nd diagram - simple = just a marginal social benefit (MSB) downward sloping line. Y axis - dollars X axis price) The extension down the line shows the effect of the tariff. Area C rerpeents gain in MSB from tariff.

If c>a+b = tariff increases welfare for a small country with market failures (SO SMALL COUNTRY IN REALITY DOESNT ALWAYS PREFER FREE TRADE)

Question 21

Domestic market failure argument complies with what theory

Answer 21

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) , but if not, tax imports to make c>a+b)
People say if unemployment of labour is problem, cost of labour should be subsidised by gov (to address market theory) which is better and avoids efficiency losses (a+b) of the tariff)

Question 22

Evaluation of market failure argument (3)

Answer 22

People say if underemployment is the market failure. Gov should stick to 1st best policy by subsidising cost of labour, which would be better than tariffs since avoid efficiency losses (a+b)

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

Gov intervention (1st best policy) can create unintended consquences

Question 23

3rd reason against free trade: Political arguments

Answer 23

Free trade harms domestic industry and causes unemployment (since allows foreign competition, bad for domestic firms that cannnot compete - infant industries)

Question 24

So is trade policy socially optimal

Answer 24

In most cases, trade policy is not socially optimal.

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

Question 25

Why would a government still have socially unoptimal trade policy (3)

Answer 25

Policy can reduce chances of being voted out (e.g protecting industries to win them over)

Corruption e.g favouring producers or motives

Less Transparent: trade policy less transparent than e.g income tax, so good for raising revenue/redistributiong

Question 26

So that was why have trade policy not free trade.

Now how is the actual trade policy determined? Which model

Answer 26

Median voter theorem

Question 27

Median voter theorem

Answer 27

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 28

Assumptions of Median voter theory (2)

Answer 28

2 parties
Objective of party is to get majority vote

Question 29

What policy will parties pursue

Answer 29

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

Question 30

Diagram of MVT

Answer 30

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 31

Thus MVT says a policy inflicting lossess on minority but benefits majority should be chosen (since this would get votes)

Does trade policy align with this idea , and example

Answer 31

No

US dairy industry has tariffs. Which impose losses on domestic households, while only benefits a small amount. (Dairy industry only contributes 0.1% of nations workforce)

Question 32

Drawbacks of MVT (4)

Answer 32

One dimensional - Only considers one policy - in reality parties have to consider many.

Only assumes 2 parties - with 3 voters, no stable qequilibrium since alwyas 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 problelm (Free riders)

Question 33

Collective action problem:
Policies that impose large losses to society as a whole, but small lossess indiviudally may not face opposition. Why? (2)

Answer 33

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 34

How to overcome collective action (free rider) problem

Answer 34

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

Question 35

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

Answer 35

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 36

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 36

Yes - found strong impact of money contributing to voting patterns.

Lobbying and contributions can influence policy makers to pursue these donor interests over policies that improve aggregate welfare!!

Question 37

What industries are most protected

Answer 37

Agriculture and clothing