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Lecture 13

The Political Economy of Trade Policy


Introduction
Free trade maximizes national income, but it is associated with income distributional
effects.
It seems that there is no strong case for a deviation from free trade in most cases and
not much room for trade policy on national welfare and economic efficiency grounds.
However trade policies are used by practically all countries why?

In practice, trade policy is dominated by income distribution considerations.


The desires of individuals get more or less imperfectly reflected in the
objectives of government.
There exist models in which governments try to maximize political success.

Median Voter Theorem


Political scientists argue that policies are determined by competition among
political parties that try to attract as many votes as possible.
The median voter theorem predicts that democratic political parties may change
their policies to court the voter in the middle of the ideological spectrum (i.e., the
median voter).

Suppose that this ideological spectrum is defined only by a tariff rate policy.
Assumptions of the model:
There are two competing political parties.
The objective of each party is to get elected.
Voters differ in the tariff they prefer.
Each party has to decide on the level of the tariff imposed (this is the only policy
available).
What policies will the two parties promise to follow?
Both parties will offer the same policy consisting of the tariff that the median
voter (the voter who is exactly halfway up the lineup) prefers.
Voters are lined up in the order of the tariff rate they prefer.
If one party proposes a high tariff, the other party can win over most of the
voters by offering a somewhat lower tariff leading to the tariff preferred by the
median voter.

Thus, the median voter theorem implies that a two-party democracy should enact
trade policy based on how many voters it pleases.
A policy that inflicts large losses on a few people (import-competing
producers) but benefits a large number of people (consumers) should be
enacted into law.
But trade policy doesnt seem to follow this prediction.

Collective Action
This approach views political activity as a public good.
For instance, the imposition of a tariff protects all firms in an industry,
but the lobbying costs for imposing the tariff are covered by only a
few firms.
Trade policies that impose total large losses that are spread among many
individual firms or consumers may not face opposition.

This model would predict that the Industries that are well organized (or have a
small number of firms) get protection.
Modeling the Political Process Trade Policy for Sale (Baldwin and Magee)
Interest groups buy policies by offering contributions contingent on the
policies followed by the government.
The size of the gains for the winners from protection and the number of
individuals in that group.
Benefit (or loss) to each producer = PS / (number of produces)
The size of the losses from losers from protection and the number of
individuals in that group
Benefit (or loss) to each consumer = CS / (number of consumers)

When are tariffs likely?


If some groups are more efficient than others in organizing their
political activity
For any individual there is a cost for being involved in any
political activity.
If benefits are less that the costs for each individual then the
individual will not participate (compare the benefit to each
producer (consumer) of the policy to the personal cost of being
involved in its politics).
Free rider problem (let other people bear the cost, if they
succeed I will reap the benefit too)

Who Gets Protected (in developed countries)?


Agriculture: in the US, Europe and Japan farmers make up a small fraction of
the electorate but receive generous subsidies and trade protection
Examples: European Unions Common Agricultural Policy, Japans
1000% tariff on imported rice, Americas sugar quota.
Clothing: textiles (fabrication of cloth) and apparel (assembly of cloth into
clothing).
Both textiles and apparel have enjoyed substantial protection. This
sector employs less skilled workers and it is unionized as well.
Import licenses for textile and apparel exporters are specified in the
Multi-Fiber Agreement between the US and many other nations.
Due to international trade negotiations protection is very likely to diminish in
the future in both sectors.

The Median Voter Model of Mayer (1984)


Consider a two-by-two Heckscher-Ohlin model. In this model the capital abundant
country A imports labor intensive good X and the labor abundant country B imports
capital intensive good Y.
In each country government can impose tariff on imports and redistribute the
revenue back to its citizens.
The question is under what condition the median voter would support tariff.
It turns out the answer depends on the capital/labor distribution in each
country.
When K/L holding of the median voter is equal to that of the whole economy
we have no income inequality. As more concentration of capital in the hand of
a few and the laborer earns only wages (and not rents) then income inequality
is higher.
In the capital abundant country A
An increase in tariff t would increase the price of the labor intensive imports
This leads to an increase in wage rate w and a reduction in rents r.
tPL-int imports w,r
When there no income inequality
=> GDP => everyones income & welfare of the median voter.
The median voter is against tariffs.
But as income inequality rises, the median voters income increasingly
becomes dependent of his wage income.
Then an increase in tariff and hence his wage income would make him support
such policy.

In the labor abundant country B


A reduction in tariff t would decrease the price of the capital intensive
imports.
t PK-int imports r, w

When there no income inequality


=> GDP => everyones income & welfare of the median voter.
The median voter is for the policy.
But as income inequality rises, a reduction in tariff would lead to a raise in the
wage income earned by the median voter which would make him favor the
policy.

This model suggests that:


Less developed countries with higher income inequalities have free trade
policies.
Among the advanced countries, those with higher income inequalities would
practice less free trade policies.

We expect increased inequalities to be associated with more restrictive trade policies


in industrialized countries but more open trade policies in developing countries.

These results have received strong empirical support (from Duttaand Mitra 2002).
The Protection for Sale Model of Grossman and Helpman (1994)
The median voter model assumes that policies are determined by majority vote.
This is an overly simplified description of representative democracies where the
electorate votes for legislators, who then determine the policies. In such settings the
policies chosen will be jointly influenced by votes, voice, and dollars from the
campaign contribution of lobbying groups.

Now we consider a model in which the government simultaneously considers the


contributions of numerous lobbies, as well as consumer welfare, in determining trade
policy. (Grossman and Helpman 1994)

In this model output is produced using mobile labor and a sector specific capital.
Every one owns a unit of labor. But the sector specific capital in each industry i is
owned by Hi members of the society. H people earn return to labor and sector
specific capital.
A subset of these industries are organized into lobbies and the others are unorganized.
The purpose of each lobby is to provide contributions to the government for
influencing the tariff/subsidy schedule.
The government values campaign contributions, but also weighs these against the
consume welfare of all individuals.
The resulting government action hinges on two counter balancing forces: campaign
contributions and welfare of the median voter. In this model it is possible (but not
very likely) that unorganized industries receive import subsidies or export taxes
serves as a way to lower their domestic prices and therefore benefit consumers.
This Model has received strong empirical support for the U.S. from Goldberg and
Maggi (1997 and 1999).
Empirical tests of the model show that the weight of consumer welfare in the
government objective function in the US is between 50 to 100 times higher than the
weight of political contributions. But in China the state-owned enterprises have a
weight that is between 4 and 7 times greater than that given to consumers!