Vine Essay Trade Liberalisation Unilateral vs Multilateral

8
1Tushar Kelkar – David Vines ‘What matters most for developing countries is that they liberalise their own trade, not that they wait for trade liberalisation by others. Holding back from liberalisation is undesirable for such countries.’ Discuss. This essay will consider the case of liberalisation for developing countries within the context of unilateral as well as multilateral trade deals. By starting from analysing the welfare gains from free trade within the Ricardian and Heckscher-Ohlin (HO) model we see that perfect markets would imply there is a strong case for liberalising unilaterally –the only problem left would be one of compensating the ‘losers’ from liberalisation in order to achieve a Pareto optimal outcome. However, if we drop the assumption of perfect markets in order to model a developing country we begin to build an argument against unilateral liberalisation, developed by Stiglitz within the framework of the second-best policy of dealing with market failures. Here capital market failures, information asymmetries, increasing returns to scale, externalities and complementarities all serve to create market failures that the government may not be able to solve my addressing the fundamental problem thereby creating the need for trade policy to correct for market failure Moreover, we can also consider the argument for an optimal tariff if we assume that the country is large enough to influence the world price of internationally traded goods, however this leads us to a situation where we must now consider a model where the trade policies of one country influence the trade policies of another. We consider how the situation of coordinated liberalisation that one hopes to achieve can be modelled as a Prisoner’s dilemma, and therefore unilateral liberalisation, even within a hypothetical scenario of perfect markets -- with countries large enough to influence the price of internationally traded goods and services - may be a suboptimal Nash equilibrium to the coordination problem of international trade: the country would also stand to gain from dropping out of the ‘liberalisation agreement’. Ultimately developing countries can be described as small, open economies that do not influence the price of internationally traded goods on the whole, and therefore what matters is the strength of the second best policy argument when it comes to deciding to unilaterally liberalising. If we consider a small, open economy with perfect markets with the Ricardian model it is easy to see how the country stands to gain from international trade: if we consider one country, North, and

description

essa liberalisation

Transcript of Vine Essay Trade Liberalisation Unilateral vs Multilateral

6Tushar Kelkar David Vines

What matters most for developing countries is that they liberalise their own trade, not that they wait for trade liberalisation by others. Holding back from liberalisation is undesirable for such countries. Discuss.

This essay will consider the case of liberalisation for developing countries within the context of unilateral as well as multilateral trade deals. By starting from analysing the welfare gains from free trade within the Ricardian and Heckscher-Ohlin (HO) model we see that perfect markets would imply there is a strong case for liberalising unilaterally the only problem left would be one of compensating the losers from liberalisation in order to achieve a Pareto optimal outcome. However, if we drop the assumption of perfect markets in order to model a developing country we begin to build an argument against unilateral liberalisation, developed by Stiglitz within the framework of the second-best policy of dealing with market failures. Here capital market failures, information asymmetries, increasing returns to scale, externalities and complementarities all serve to create market failures that the government may not be able to solve my addressing the fundamental problem thereby creating the need for trade policy to correct for market failure Moreover, we can also consider the argument for an optimal tariff if we assume that the country is large enough to influence the world price of internationally traded goods, however this leads us to a situation where we must now consider a model where the trade policies of one country influence the trade policies of another. We consider how the situation of coordinated liberalisation that one hopes to achieve can be modelled as a Prisoners dilemma, and therefore unilateral liberalisation, even within a hypothetical scenario of perfect markets -- with countries large enough to influence the price of internationally traded goods and services - may be a suboptimal Nash equilibrium to the coordination problem of international trade: the country would also stand to gain from dropping out of the liberalisation agreement. Ultimately developing countries can be described as small, open economies that do not influence the price of internationally traded goods on the whole, and therefore what matters is the strength of the second best policy argument when it comes to deciding to unilaterally liberalising.If we consider a small, open economy with perfect markets with the Ricardian model it is easy to see how the country stands to gain from international trade: if we consider one country, North, and another country, South, that are greater endowed with respect to capital and labour respectively, we will see that North is comparatively more efficient at producing a less labour-intensive product, say computers. Therefore, the country would be better off specialising at producing computers, whilst South specialises in producing a more labour-intensive good, say textiles. North can trade computers for textiles at the international price, thus allowing them to achieve a higher consumption mix than allowed under the production possibility frontier under autarky. Resources can be either combined domestically, described by the slope of the domestic production frontier to show how effectively they can be combined to produce the combination of goods being described, or exports can be exchanged for imports if there is a divergence between the domestic price (the relative cost of production) and the international price (to include the exchange rate) then we can argue that there are gains to be made from trade regardless of the trade policy of the other country. Unilateral trade liberalisation, under the assumption of perfect markets, is beneficial for the economy.However, it should be noted that the benefits of trade may not be dispersed uniformly throughout the economy. Under the H-O model, owners of the resources that are scare under autarky will lose out from trade liberalisation as their resource is no longer scare: the price they receive for production of the good intensive in the use of their particular scare resource decreases relative to the other resources (say price of labour relative to capital) and therefore, say, owners of labour will lose out, with the gains to the owners of other resources being greater than the loss in purely income terms whether international trade is beneficial here depends on how we weight the incomes for the different groups in terms of social welfare.We can easily see the welfare gains from unilateral liberalisation through a tariff diagram:

We can see a partial equilibrium analysis with the small countrys downward sloping demand curve DD, supply curve SS, the world trade price equal to the free trade equilibrium domestic price Pw. The horizontal dotted line here indicates that an unlimited amount of goods can be supplied at this price. The distance KL represents the initial level of imports, with L being quantity domestically demanded, and K being quantity domestically produced. A tariff of size Pt minus Pw would not, by assumption, affect the world price, but would simply increase the tariff-trade equilibrium domestic price level. This would then lead to imports being equal to distance MN, with N representing domestic demand and M representing domestic production. Areas 1+2+3+4 would be the loss of consumer surplus, area 1 being the increase in producer surplus, area 3 being the increase in government revenue from the tariff, and therefore areas 2 and 4 would represent the welfare loss/ deadweight loss to society from the tariff. We can see this effect in more detail by considering the following diagrams representing the effect of a tariff on production and the effect of a tariff on demand:

The price of food increases shifting the price ratio from 1 to 2, domestically. The value of domestic output has fallen because, when price domestically ignoring the effects of the tax, the price ratio parallel to line 1 intersects the food axis at a point lower than before: therefore a lower food value of output is being produced, decreasing from 0F to 0D. The effect on demand involves the effect of income from the tariff, and so is harder to model, but shows that we are on a consumption bundle on a lower indifference curve compared to before the tariff, with a similar effect being seen in the effect of tariffs on imports. This analysis allows us to highlight how protection of the export industry does not guarantee higher exports, due to the income effect leading to potentially lower exports [depending on whether exports are normal/ inferior goods David?] Therefore it appears conclusive that there are significant welfare gains from reducing the level of tariffs in an economy. One caveat to this argument is that we have assumed that the economy cannot alter the world price of the good being exported. However, it may well be the case that this is not true, even for a developing country take China and rare earth minerals, for example. Protection in this scenario may well be justified within the context of a terms of trade argument. We can model a tariff that improves the terms of trade by drawing a home net import demand curve, and a foreign export supply curve

If the vertical axis is the world relative price of food then a tariff would lead to a decrease in the net demand for imports from Q to A. The shift of the net domestic demand schedule from M to M would lead to the terms of trade ratio of food decreasing. The economy has acted like a monopoly, and decreased the supply of its exports, thereby increasing the price of its exports (clothing). At some point, however, the tariff would be so extortionate that it would lead to no trade at all, which going by the analysis of the Ricardian/H-O mode is less optimal than with free trade. Therefore there is some optimal tariff rate between these two points that maximises welfare. However, we now have to relax the assumption that the trade policy of other countries is independent of this countrys: tariffs frequently lead to retaliation. We will model this later in the essay.A more general problem facing the analysis of removal of trade barriers is the assumption of free markets. When we relax this assumption, and consider the economy through a dynamic analysis rather than the static analysis seen above in the tariff diagram, we can easily see how tariffs are justifiable. Firstly it might be the case that a country that has a comparative advantage in one good may be able to develop a comparative advantage in another industry in the long run through investment or similar activities, private or public sector. One problem facing developing countries is the fall in the price of exported primary products; indeed, South Korea was able to diversify away from export of primary products in order to industrialise through the export of manufactured goods. Whether this example shows us the relevancy of free trade is of vital importance to the debate over unilateral liberalisation: if we believe South Korea, and other similar East Asian countries that achieved miraculous economic growth through export-led industrialisation, can be achieved through no government intervention perhaps if the private sector took into account the future effects of industrialisation on future income, then government intervention through export subsidies are unnecessary. However, households dont account for future income due to a mixture of myopia, uncertainty and discounting, thereby necessitating government intervention (or non-private sector involvement at the least).Moreover, we can consider the problem of infant industries and the development of these future comparative advantages. Infant industries will enjoy lower average costs, and therefore more competitive production, through a dynamic analysis over time, perhaps involving both economies of scale as well as increasing returns to scale. In addition, the economy may suffer from positive externalities with complementary inputs in the economys production function (leading to increasing returns to scale at an economy-wide scale). Lastly, there may be informational failures in the capital markets. All of these effects will serve to make it less likely that infant industries will be allowed to develop without protection from more efficient imports, even if in the long run the domestic production will be more efficient, and thus exported. Capital markets will not know whether the enterprise will be a success, and will not be willing to risk loans that cover the loss period of a start-up in a developing country; unbalanced growth may be required to make it easy for key, forwardly and backwardly linked industries to generate growth in other industries, not possible within the free market, thereby calling for protection or intervention of some kind, with a similar effect being attributed to economies of and increasing returns to scale. Ultimately, what is crucial to this analysis is the point over whether protection from imports is really the best policy to pursue to correct these market failures surely we would be better off trying to address the capital market failures by intervening in the capital market itself, rather than through tariffs? If developed countries are seemingly fine with covering the losses of start-ups without having to resort to import protection/substitution, can developing countries not achieve the same? This is a debateable point, and I cannot conclude whether tariffs are necessary as a second-best-policy response to the market failures afflicting developing countries. This result is crucial to my overall conclusion for this essay. The example of the East Asian countries subsidising exports, with these countries achieving the highest level of economic growth ever recorded for any developing country, suggests that evidence is not stacked against the pro-intervention argument. However, some would argue that the Asian growth miracle is an exceptional case. Owens and Woods argue that it is still possible for some countries to achieve industrialisation through specialisation in semi-skilled industries such as processing primary goods, in which Latin American countries are abundant, but not possible for countries like the sub-Saharan African ones as they do not have a high enough skill to labour ratio (they lack human capital at the moment perhaps government intervention in education would solve this?) Therefore there might be a case for a second-best policy designed to achieve export-led growth. Moreover, I would argue that achieving export-led growth is not a second best policy in the example of the problem of demand indivisibilities: if we require access to the world market in order for investment to be profitable in certain industries, then ensuring that they are capable of achieving growth as soon as possible (if market failures prevent them from being able to export initially) seems more optimal than trying to correct the market failure of demand indivisibilities that leads to a lack of investment, vis--vis the Big Push model.Nonetheless, we should consider the viewpoint that trade liberalisation is positive for growth. One paper by Frankel suggests that we can argue in favour of this from the empirical evidence, and therefore it seems reasonable to continue as if trade does improve growth/ income per person (and thus delivers welfare gains depending on some social welfare assumptions). Thus holding back from liberalisation appears to be undesirable for developing countries. We now must consider whether it matters if liberalisation is unilateral or multilateral. Clearly the main impact on this debate will be if developing countries can affect the world price of their exported and imported goods. I would argue that this is not the case by and large, and therefore unilateral liberalisation, especially in the agricultural and textile industry (as well as other low-skilled, labour-intensive industries in which developing countries enjoy comparative advantages). However, some could argue that unilaterally liberalising gives up a bargaining chip in trying to negotiate with other countries for them to decrease their trade barriers. We can see the box diagram of the world economy in the 2x2x2 framework to see how the other countrys trade barriers are instrumental in utility for the domestic economy.

Here both countries produce at level Q, however a tariff (in either the home economy or the other economy) leads to the different slopes for the price ratios 1 and 2. Without the tariff, the countries could be producing at A and B, thereby leading to a higher welfare level as a Pareto optimal outcome is achieved. Moreover, if we do assume that countries simply want protection unilaterally we can model protection as a Prisoners Dilemma. If both countries though that they could increase their welfare (either falsely or correctly) by unilaterally protecting their economy then they would always have the incentive to drop out of an agreement to have free trade. However, both countries would think this, thereby leading to a Nash equilibrium that is globally sub-optimal as the best solution to the problem would be if both countries freely traded, as seen in the Box Diagram. This is where multilateral trade agreements come into their own, enforcing a solution to the Prisoners dilemma. However, we have argued that in the case of developing countries, if we assume that protection IS bad for the economy, then this should never even be a problem: they will simply unilaterally liberalise their economy, thereby improving welfare, regardless of what other economies are doing with their trade policy.