Copyright © 2002 Pearson Education, Inc.Slide 7-1 Chapter 7 Commercial Policy.

Copyright © 2002 Pearson Education, Inc. Slide 7-1

Chapter 7

Commercial Policy


Lecture Objectives Analyze the most common reasons for

countries to protect certain industries Discuss the political economy of protection Discuss the mechanisms used to provide

protection


Introduction: Protection is Costly,So Why is There Protection? Policy makers are ignorant.

Surely true to some extent, but Not very useful.

Economists are ignorant. Surely true to some extent, but Careful analysis of most plausible arguments for

protection suggest that this doesn’t really work. Policy makers are smart, but venal.

This is where political economy analysis starts.


How Ignorant Are Economists? There are a number of situations in which

protection can potentially raise welfare: Recall our discussion of the theory of economic

policy Economic v. Non-Economic Arguments First-best v. 2nd-Best Arguments

Also recall that any of these arguments suggest potential gains, because:

They require explicit value judgments; and They must be implemented properly.


A Typology of Arguments for an Active Trade Policy

Economic Non-Economic

First-best Optimal Tariff

Strategic Trade

CSWF

Second-best Distortions:

External Economies

Infant Industry

Government Revenue

National Defense

Income Distribution

Industrial Policy


First-best, Economic Arguments The Optimal tariff

Theoretically valid, but Of little applicability given the complexity of

actual (many-good many-country) situations. As a result, rarely applied in practice.

Strategic trade policy Theoretically, valid, but Difficult to find actual interventions in which the

assumptions of the argument are satisfied.


Second-best,Economic Arguments, 1 Static Externality Arguments Negative externality : environmental issues

Theoretically legitimate Little practical application to date: note that

practical application means making the second-best argument explicitly.

Some of the trade and environment issues—having to do with cross-border externalities do have an explicitly international component.


Second-best,Economic Arguments, 2 Positive externality

Theoretically legitimate: we examined these in the lecture on imperfect competition.

Empirically identifying such externalities is very difficult. In fact, this argument is rarely used in practice.

Overall: static externality arguments Have weak empirical support Are difficult to implement Are rarely used in practice.

Dynamic externality arguments are much more common: consider the infant industry argument.


Infant Industry Argument: Introduction This is a very popular argument

One of the oldest arguments for protection: Hamilton (1791); List (1841); Mill (1848).

Widely used in developing and industrial countries (the senescent industry argument).

The basic idea is that entrepreneurs will not enter industries in which they could make positive profits because competition from foreign firms render them initially unprofitable.

Proponents suggest that if the government would offer a finite period of protection from international competition, the national industry could become profitable.


Infant Industry Argument:Basic Structure Four key causal claims:

The candidate industry is a positive net present value industry

The normal operation of the market will not support the establishment of the industry (market failure);

A limited period of policy intervention will create conditions conducive to the industry’s establishment.

Trade policy intervention must be either: Optimal; or Constrained optimal (second best).


Infant Industry Argument:Claim 1, Positive NPV, a What is Net Present Value

Suppose that an investment, in every period t, generates some revenues (Rt) and costs (Ct)

The profits, return on investment, in t is Rt – Ct. Since Rt and Ct vary over time and, in particular Rt

< Ct early in a firm’s life, we need to calculate the return, over some reference period, taking into account that future revenues and costs are worth less to us than current revenues and costs.

This process is called discounting


Infant Industry Argument:Claim 1, Positive NPV, b Suppose that our discount rate (the rate at which we

discount future revenues and costs to get their present value) is r. The discount factor is (1 + r), and Letting T be the terminal date for evaluating the

investment, The discounted (or net) present value is:

0

: .1

t Tt t

tt

R CNPV

r


Infant Industry Argument:Claim 1, Positive NPV, c This is more subtle than it seems at first:

The Mill test: requires private positive NPV; and The Bastable test: requires social positive NPV

(i.e. Ct must take into account the costs of protection).

Note that, once we consider social as well as private costs incurred, the industry must be very profitable to pass the positive NPV test. But if this is the case, why isn’t the market

investing in the industry already.


Infant Industry Argument:Claim 2, Market Failure, a Many industries satisfy the positive NPV

criterion. Most industries make losses for some period. This is what capital markets are for.

Why do we expect the government to do a better job than the capital market at identifying positive NPV industries?

The Kemp Test: What is the market failure?


Infant Industry Argument:Claim 2, Market Failure, b Proponents of infant industry protection are rarely

explicit about the source of market failure, but The details of the market failure are essential to:

Identifying the optimal form of intervention, and Identifying the optimal level of intervention.

Without some evidence on this aspect of the argument, the validity of any given instance of infant industry protection is highly doubtful.


Infant Industry Argument:Claim 3, Finite Time, a This is an infant industry argument. Why do we

expect the infant to grow up? The market failure must be correctable with a finite

period of intervention. Recall that all costs of intervention are counted against

NPV in the Bastable test. Recall that static externalities justify permanent

intervention. Capital market failure and dynamic externalities are

the usual claims.


Infant Industry Argument:Claim 3, Finite Time, b In most situations that might support the infant

industry argument, there are incentives against “growing up”. Cost of adopting improved practices may put firms at a

competitive disadvantage; Principal-agent problems.

Once a government has committed to infant industry protection, it will be hard to revoke if the conditions that led to adoption of the policy still obtain.


Infant Industry Argument:Claim 4, Trade Policy is Optimal It should be clear that trade policy intervention is

never first-best in this case. Some form of subsidy will generally dominate trade

intervention. The specific form of subsidy will depend on the specific

form of market failure. Thus, an essential part of the argument is establishing

why the first-best intervention is unavailable. Finally, the constrained optimal level of trade

intervention must be identified.


Infant Industry Argument:The Evidence, 1 Microeconomic evidence

Historical studies by Irwin cast considerable doubt on often mentioned infants in the US case (i.e. steel and tin plate).

Krueger’s study, at the industry level, in Turkey seems broadly inconsistent with infant industry claims, but this has been criticized.

Overall, the microeconomic evidence cannot be said to provide much support.

Note, again, that microeconomic evidence for all four parts of the argument is rarely given when seeking infant industry protection.


Infant Industry Argument:The Evidence, 2 Macroeconomic evidence

There seems to be a loose empirical correlation between protection and growth for the 19th century.

O’Rourke and Williamson have provided some more systematic evidence for this claim, but

work by Irwin casts doubt on the claim. Contemporary evidence is much weaker Some case studies of Taiwan and Korea seem supportive,

but they are controversial Econometric evidence is, at best, inconclusive.


Noneconomic Arguments for Protection, 1 Recall that noneconomic arguments require

the assertion of a legitimate policy goal, in the pursuit of which the government is willing to bear costs.

Note that these goals are rarely independent of costs.

Thus, second-best noneconomic justification for protection bear a particularly strong burden of justification.


Noneconomic Arguments for Protection, 2 There are many noneconomic arguments in

common use: Revenue National defense Job protection Industrial policy

Note that these are all second-best noneconomic arguments for protection


Noneconomic Arguments for Protection, 3: Revenue Revenue arguments for protection

Historically the tariff has been a very important source of government revenue.

It is second best because it is a considerably more distorting way of raising revenue than many alternatives.

As a result, countries with well developed fiscal systems generally eliminate the tariff for fiscal reasons (though it remains for other reasons).

In many developing countries, the tariff continues to be a major source of government revenue.


Noneconomic Arguments for Protection, 4: National defense National defense arguments for protection

National defense is an obviously legitimate goal for any sovereign government.

In many contexts, some industries may be so essential to provision of defense that the government seeks to protect them.

Given the diversity of the world economy, making this argument is harder than it seems.


Noneconomic Arguments for Protection, 4: National defense Burdens of proof in the national defense argument for

protection In time of crisis the commodity in question will be:

Essential to defense, and Unavailable.

For most countries, these are difficult to show for most industries (except military materiel, which are not generally produced under market conditions).

Thus, while often asserted, this argument is rarely applied in any systematic way.


Noneconomic Arguments for Protection, 5: Job Protection, 1 This is a very common argument for

protection. Commonly called the pauper labor argument, the

idea is that, given our high wages, we simply can’t compete against low wage foreign workers.

This argument was very publicly made by Ross Perot in his opposition to NAFTA as “…the giant sucking sound of jobs moving south…”.

Opinion poll evidence shows that many Americans respond strongly to this argument.


Noneconomic Arguments for Protection, 5: Job Protection, 2 First, wage differentials exist, for a variety of

reasons: Endowment differences: capital, infrastructure, etc. affect

the productivity of labor; and Compositional differences: labor is heterogeneous and

training differences may make labor in industrial countries more productive.

This may be why there has been no giant sucking sound—from NAFTA, or to the far longer free trade area with Puerto Rico.


Noneconomic Arguments for Protection, 5: Job Protection, 3 It is important to be clear that changes in trade policy

unquestionably do induce changes in production structure. This is where the gains from trade come from. If the US is unskilled labor scarce, our gains from trade

come from moving out of unskilled labor-intensive industries and expanding output in sectors that use our more abundant factors intensively.

Resisting such changes essentially renders the possession of a comparative advantage an unfair trade practice.


Noneconomic Arguments for Protection, 5: Job Protection, 4 These changes impose genuine adjustment

costs on those that must do the adjusting. People who lose jobs must find new jobs, this

means periods of unemployment. Research by labor economists finds that the

adjustment costs are large. These costs fall unequally. Finally, there are permanent losses—i.e. Stolper-

Samuelson effects.


Adjustment Costs, Empirical Estimates on costs of adjustment vary:

$80,000 average loss in lifetime earning; 12% average lifetime pay cut.

These averages hide very asymmetric effects: Young workers experience relatively small costs;

but Older workers experience large costs.


Noneconomic Arguments for Protection, 5: Job Protection, 5 Thus there certainly are arguments in favor of

adjustment assistance, but this is not an argument for adjustment avoidance.

Trade protection is a very expensive way of providing help to workers affected by trade.


The Costs of Protection per Job Saved


The Costs of Protection per Job Saved 2 Trade policy is a grossly inefficient mechanism to

create jobs It is a non-transparent job-creation program It relies on too many intervening variables, and does not go

directly to the heart of the problem If job creation is the goal better policies exist

sound macroeconomic polices and flexible labor markets

For short term adjustment assistance Direct transfers dominate; and General welfare state policies that don’t distinguish

between trade and other forms of job loss seem better.


Main Noneconomic Arguments for Protection, 6: Retaliation, 1 Retaliation: Another country´s trade barriers

must be countered with trade barriers. Inducing liberal behavior: some argue that

protection in one country focuses the minds of others on the need to pursue liberalization

Bargaining chips: In the context of WTO negotiations, in which “concessions” are exchanged on a reciprocal basis, some protection is necessary


Main Noneconomic Arguments for Protection, 6: Retaliation, 2 These seem like dangerous arguments

Though they have been popular with a number of American presidents.

The notion is that doing something bad, in the interests of the general good, will be generally perceived as good.

At least as likely is that other countries will perceive this as simply selfish protectionism

The result, of course, is a trade war.


Noneconomic Arguments for Protection, 7: Industrial Policy, 1 By definition, a second-best argument for protection

can be launched for virtually any industry by asserting that the government has as a goal support for that industry.

As a result, the public discussion of trade policy is full of such assertions for virtually every industry.

But we cannot subsidize every industry It would obviously be expensive; but, more importantly It is logically impossible—general equilibrium effects.


Noneconomic Arguments for Protection, 7: Industrial Policy, 2 Thus, to effectively make an industrial policy

argument it is essential to argue: Why this industry, instead of others, is particularly

deserving/needful of support; and Why this industry, in particular, needs this support

in the form of trade intervention instead of some more efficient form of support.

These claims are rarely made, so it is very hard to evaluate their significance in explaining actual trade policies.


Summary on arguments for protection Overall: it is very hard to rationalize most existing

protection in terms of any of the well-specified arguments for protection.

Thus, while economists certainly have blind spots in thinking about trade (and other sorts of) policy, economist ignorance, like politician ignorance, doesn’t do much in explaining actually existing trade policy.

This leads us to political economy arguments, i.e.: politicians are smart, but venal.


Why Protect? The Logic of Collective Action, 1 Mancur Olson´s Logic of Collective Action

The costs of tariffs and quotas are borne by a great many people: everyone pays a little for protection

The benefits of protection is concentrated in a few industries: few benefit a lot from protection

Thus, there is an asymmetry in the incentives to oppose the policy: those benefiting from protection have much greater incentives than those hurt by it to lobby for it

This probably explains why final consumers are not very active in trade politics.


Why Protect? The Logic of Collective Action, 2 The collective action approach does a pretty good job

explaining cross-sector variation in protection. Problem: why are intermediate consumers of goods

not more active? Problem: why are exporters not more active? Problem: why so much liberalization?

Recall that the big story of trade policy is a truly massive, and historically unprecedented, liberalization.


Why Protect? The Logic of Collective Action, 3 Dani Rodrik offers a somewhat more formal

version of the argument based on a Political Cost Benefit Ratio:

Net gain” refers to the efficiency gain (i.e. the DWL) and |Δγg| refers to the absolute value of the change in the

income of group g.

net gain1

.2 net gain

g

g GPCBR


Why Protect? The Logic of Collective Action, 4 The numerator is the sum of the absolute value of

income effects of policy across various groups that is, it is a measure of the total redistribution caused by

the policy change. It is divided by two to eliminate the effect of double

counting. This index will take values between zero and infinity

policy that is purely redistributive, with no efficiency change, will produce and index of infinity;

A policy that is Pareto efficient (i.e. increasing some group’s income, with no reduction for any other group) will produce an index equal to zero.


The Interaction of Liberalization and Protection, 1 Protection has fallen to very low levels in all

industrial countries. Note that protection is bounded below by zero. In most industrial countries, protection approaches that

bound. There has always been pressure for marginal changes

in protection. These appear more significant in a low protection era. It is important not to confuse such pressure with a general

increase in protection.


The Interaction of Liberalization and Protection, 2 In the past, this pressure for protection could only be

accommodated by a change in The Tariff. The average level of protection was strongly affected by

Party; but Dispersion was determined by lobbying a la Olson.

Contemporary trade politics are very different. Congress passed its last Tariff in 1930. Since then the pattern has been set by the Reciprocal Trade

Agreements Act of 1934.


The Interaction of Liberalization and Protection, 3 Since the RTAA, major trade legislation

generally contains two parts: Negotiating authority; and Administered protection.

Lobbying on trade legislation is strongly affected by the fact that: Both of these components are public goods; and neither of these components actually implement

protection or liberalization.


The Politics of Protection in the United States, 1 These institutional changes render the modern trade

policy system less prone to protectionist outcomes than the Classic Tariff System that preceded it.

In addition: From the end of WWII until sometime in the 1980s/90s,

trade policy was treated as foreign policy; Very little public interest in trade policy; and As a result, the Executive branch tended to dominate—pushing

liberalization. Liberal trade policy was protected in Congress. Elite attitudes on trade changed to general acceptance of

Liberal trade


The Politics of Protection in the United States, 2 Congressional context has changed dramatically in

recent years: Breakdown of political structure within Congress;

Weakening of Ways & Means Multiple referral of trade legislation

Increased budget constraint: $2 - $4 billion to replace lost tariff revenues (less than 1% of total tax revenue).

Emergence of trade policy as a focus of entrepreneurial politics for congress-people.

This has made Presidential leadership much more important


The Politics of Protection in the United States, 3 Structural changes

Success of the GATT/WTO process has pushed trade politics into more sensitive areas

The end of the Cold War: reduced U.S. willingness to sacrifice domestic political considerations for geopolitical alliances

The rise of the newly industrialized countries (NICs): increased competitive pressures on U.S. industries

The growth of the U.S. trade deficit in the 1980s: spurred fears of the loss of competitiveness

Emergence of systematic anti-Liberal ideologies to organize protests.


The Politics of Protection in the U.S.: Main Mechanisms Section 201 (Trade Act of 1974): Safeguards Section 406 (Trade Act of 1974): Safeguards Against

Communist Countries Title VII (Tariff Act of 1930; Amended Title VII, TA 1979):

Unfair Trade Practices Anti-Subsidy Anti-Dumping

Section 301-303 (TA of 1974): Protection of Rights under International Agreements

Section 337 (Tariff Act of 1930): Violation of Intellectual Property Rights

Section 232-233 (TEA 1962): National Security Import Restrictions


The Politics of Protection in the U.S.: Main Mechanisms (Ag.) Section 22 (Ag. Adjustment Act 1932): Fees and

Quotas Section 204 (Ag. Act 1956): Negotiate International

Market Restraints Sugar Quotas Headnote Authority (1967) Meat Import Act of 1979 International Commodity Agreements

Coffee Sugar Rubber


The Politics of Protection in the U.S.: Main Mechanisms (cont.) The most important of these are:

Less Than Fair Value (Title VII) Countervailing Duty Antidumping

Safeguards (Section 201) Unfair Trade Practices (Section 301)

Let´s analyze each of the procedures in greater detail…


Title VII:Overview The Title VII mechanisms deal with sales at

less than fair market value. Both antidumping and countervailing duty

cases involve two determinations: Are there sales at LTFV? By how much?

International Trade Administration, Department of Commerce, makes this determination.

Is there injury to the domestic industry? International Trade Commission makes this one.


Title VII:Antidumping, 1 Dumping occurs when a firm sells a product in a

foreign market at a price which is less than its fair market value.

Dumping law defines a product as dumped when it is sold in a foreign market as less than the price for which it is sold in its home market. Note that this is not illegal under domestic antitrust law. Note that there is no requirement to show predation, which

is the key to domestic antitrust.


Title VII:Antidumping, 2 The dumping margin plays an important role in this

process: There must be a significant margin; and This margin determines the duty to be applied.

Three methods to determine whether a good is being dumped: 1. Direct price comparison; 2. Comparing the price in third-country markets; or 3. Constructed value: estimating the foreign firm’s

production costs.


Title VII:Antidumping, 3 Problems: Economic theory and legal definitions are

not in agreement If a firm is not earning above average profits somewhere, it

cannot maintain a price somewhere else that is below the cost

Firms often sell below costs May sell at below costs in order to penetrate a market (this is

called a sale). May go for extended periods selling at prices that do not

cover fixed costs as long as the costs of variable inputs (labor and materials) are covered


Title VII:Countervailing Duties Subsidies allow foreign firms to sell their products at

lower prices; countervailing duty seeks to counter the effect of the subsidy Uruguay Round defines three classes of subsidy:

Export-contingent subsidies are outlawed; Domestic policy subsidies are legal; Between the two are domestic subsidies that have systematic trade

effects

From an economic perspective, there is some question as to why we should worry about export subsidies


Title VII:General Concerns Title VII mechanisms seem prone to abuse

Definitions of LTFV and injury are such that they may permit, especially preliminary, affirmative findings.

The costs to respondents may be asymmetrically high. Thus, US firms may file cases even when the legal or

institutional basis is weak. Uruguay Round introduced a sunset clause

(termination after 5 years) Similar mechanisms are spreading to other countries

quite rapidly.


Section 201:The Escape Clause, 1 Article XIX of the GATT permits countries to impose

temporary protection if: Increased imports Cause, or threaten to cause, Serious injury

Note that, unlike Title VII cases, no finding of unfairness is necessary. Only the ITC is petitioned. Because there is no implication of unfairness, the causal

burden of showing injury is heavier.


Section 201:The Escape Clause, 2 After an affirmative finding by the ITC

The petition is forwarded to the President with a recommendation for action; but

The President has considerable discretion in whether or not to act on the recommendation.

Because of the relatively heavy causal burden and Presidential discretion, Section 201 is not used very often.

Some trade lawyers would like to see Title VII eliminated in favor of: National treatment under antitrust; plus An easier to use escape clause.


Section 301:Unfair Trade Practices, 1 Recall that members of the WTO commit to liberalize

access to their own market in exchange for access to other members’ markets.

If, as a result of “unfair trade practices”, this access is “nullified or impaired”, a dispute resolution process is started (Article XXIII).

However, because only countries are members, individual (corporate) citizens have no way of initiating this process.

Section 301 of the US trade is the legal mechanism by which citizens can begin a dispute.


Section 301:Unfair Trade Practices, 2 Because the United States Trade Representative

(USTR) manages US relations with the WTO, Section 301 complaints are handled by the USTR.

This should not be confused with Super 301 This short-lived law required the USTR to identify and act

on: Priority countries; and Priority practices.

Note that these determinations and actions were unilateral This was a very controversial law, but now focuses on

identification, not on unilateral action. All 301 cases have been handled as DSM cases.

Copyright © 2002 Pearson Education, Inc.Slide 7-1 Chapter 7 Commercial Policy.

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