EC 340

Lecture 7 - Political Economy of Trade

from last time
history of trade policy
politics of trade barriers
Japan's development strategy
effects of trade on the environment
pollution-haven hypothesis
external costs dolphin-safe tuna
global environmental issues

From Last time

History of Trade Policy

Tariffs were originally designed for revenue. The U.S. used a tariff of 5% as its earliest source of government revenue. Alexander Hamilton recommended protective tariffs to develop infant industries. The U.S. tariff rate rose to 25% by 1815. The South depended on imported goods and managed to block the really substantial protective tariffs favored by the North until the Civil War. The ascendancy of northern manufacturing interests after the Civil War ushered in a long period of high tariffs. Wi th the Tariff of 1897, tariffs reached an average of 57%. In 1913, the Democrats lowered tariffs to 29% but Republicans returned to power in 1921 and passed high agricultural and manufacturing tariffs.

The Smoot-Hawley tariff (1930) placed an average tariff of 59.1% on 800 items in all sectors. 12 large trading countries retaliated with their own heavy tariffs. Total imports of 75 countries had been $3 billion a month in January 1929 but just $500 million in March 1933. U.S. exports were only 53% of their 1929 volume in 1932.

The Reciprocal Trade Act of 1934 provided for tariff cuts only in return for tariff cuts by our trading partners. It also set up most favored nation status: if the U.S. cut a tariff to one nation it would cut them to all. Reciprocal tariff reductions are available on a non-discriminatory basis. The average tariff level fell from 53% in 1934 to 11% in 1962.

The major force for free trade in the post-WWII era has been GATT, the General Agreement on Tariffs and Trade. Member of GATT agreed to three things: (1) MFN status extended to all members, (2) quotas are prohibited, and (3) members agree to submit trade disputes to non-binding GATT panels. The most important activity has been its sponsorship of conferences of multilateral trade negotiation.

The Uruguay round created the World Trade Organization. The WTO is the successor to GATT and is designed to oversee global trade treaties, to provide a forum in which future trade deals will be discussed, and to resolve disputes. Under GATT, suppose that the U.S. complains that Japan is blocking imports of U.S. widgets and a GATT panel agrees. If Japan dissents from that finding, U.S. cannot legally retaliate with trade sanctions. With WTO, a finding that a country violated a trade accord would stand unless all 132 member nations voted it down.

Politics of Trade Barriers

Trade policy is an outcome of the political process. Any change in policy produces winners and losers who have an incentive to lobby for a legislative outcome in their own favor. On the other side, politicians need votes and money to stay in office. These are the sources of supply and demand for trade policy.

Those who gain from free trade are numerous and gain only a little while those who gain from protection are highly concentrated in well-defined industry groups. It is easier, therefore, for protectionists to organize.

Japan's Development Strategy

Keiretsu (the word means system) are affiliations between firms.
  1. horizontal
  2. vertical
  3. distribution
Keiretsu can create entry barriers for newcomers and engage in anti-competitive practices which reduce imports.

Effects of Trade on the Environment

It is sometimes argued that trade is bad for the environment because trade promotes economic growth and economic growth leads to environmental degradation in the form of pollution, depletion of resources, and degradation of the scenic environment.

In developing countries, rural areas have seen large-scale soil erosion and water quality deterioration, deforestation, and declining soil productivity. Urban areas have experienced seriously diminished air and water quality.

But, growth enables governments to tax and raise resources to reduce pollution and protect the environment. We see more environmental protection in rich countries.

Pollution-Haven Hypothesis

Another environmental objection to trade claims that since environmental standards are less strict in developing countries, these LDC's will become pollution havens: places where firms can move and operate without the strict environmental controls of the developed countries.

testing the hypothesis:

External Costs

Economic efficiency occurs at the level of output at which the marginal social benefits (MSB) equal the marginal social costs (MSC). Demand and supply determine equilibrium prices and quantities in a free market. A free market will result in efficiency when (1) the demand curve is the same as the MSB curve and (2) the supply curve is the same as the MSC curve. MSC=MSB
Economists make a distinction between private costs and external costs. Private costs are borne by someone involved in the transaction that created the externality. External costs are borne by someone not involved in the transaction. The same distinction is made between private and external benefits.

Social costs = private costs + external costs

Social benefits = private benefits + external benefits

When there are external costs or benefits, a free market produces too much or too little of the good.

external costs
When there is a harmful production externality, the production of a good imposes external costs. The marginal social costs exceed marginal private costs by the amount of the external costs. When choosing how much to produce, firms are only concerned with their own costs, the marginal private costs (MPC). The market supply curve is the MPC curve. Although the firm is unconcerned with the external costs, society counts these costs as part of the cost of producing the good. So the free market results in too much of the good being produced.

policies for externalities

  1. regulation: allow the externality to the point where MSC = MSB
  2. taxes or subsidies: levied on polluting activities to make MPC = MSC
  3. pollution permits: firms are required to possess permits for each unit of pollution emitted and these permits can be bought and sold
  4. assign property rights: the Coase theorem says that costless bargaining leads to the efficient level of the externality

Dolphin-Safe Tuna

Mexican fishermen use nets that snare lots of dolphins along with the tuna. The United States attempted to ban imports of Mexican tuna because the dolphins have mouths that are contorted into nice smiles, making them look cute. A GATT panel ruled against the U.S. ban. Let's analyze this case as an externality.

The problem is that foreign production of tuna is imposing an external cost on us. The best response to an external cost is a tax on the producer, but the U.S. lacks the ability to tax Mexican fishermen. The next best response would be to tax the consumers of Mexican tuna with a tariff on tuna imports.

Global Environmental Issues

David A. Latzko
318 COB
Department of Business and Economics
Wilkes University
Wilkes-Barre, PA 18766
phone: (717) 408-4718
fax: (717) 408-4917