ECON 1535 Final Exam PART TWO

efficiency loss

The triangles represent the efficiency loss that arises because a tariff distorts incentives to consume and produce, tariff distorts production and consumption decisions (too much production, too little consumption)

marginal social benefit, p. 280

Then there is a marginal social benefit to additional production that is not captured by the producer surplus measure. This marginal social benefit can serve as a justification for tariffs or other trade policies.

the import demand function is

downward sloping

Tariff

a tax on imports Although tariffs can sometimes be welfare enhancing, they are often raised for idiosyncratic reasons, and not with social welfare in mind Once in place, tariffs are often hard to remove, even when they no longer serve the role that motivated them We have seen this as well with the US-China trade war Tariffs often generate negative impact on domestic firms, even when they are meant to protect these firms

Foreign direct investment (FDI) flows

are made up of equity capital, reinvested earnings, and other capital associated with an intercompany debt transaction (10% equity stake requirement)

Smarzynska (2004)

argues that spillovers from FDI are more likely to be vertical than horizontal in nature she finds that the positive effects of FDI take place mostly through backward linkages, with a negligible effect of FDI through either horizontal or forward linkages So local suppliers become more productive when MNEs enter a country Recent work (Manelici and Alfaro-Ureña, 2019) finds similar results with firm-level data from Costa Rica

Chicken Tax

"Chicken Tax" originally a retaliation by Lyndon Johnson's administration to tariffs imposed on U.S. exports of chicken to Europe (early 1960s) Tariff protected European chicken producers, but it was defended by arguing that hormone use affected male virility U.S. retaliated with a 25% tariff on imports of light commercial trucks (still in place 50 years later!) Retaliation was focused on Germany (one of the main political proponents of the original tariff) and Volkswagen in particular

Feldstein (1995) Desai, Foley and Hines (2005)

"How much does the U.S. domestic capital stock decline per dollar of additional capital in foreign affiliates of U.S. multinationals?" Key issues: Do portfolio investment inflows compensate for part of these outflows? How much financing of affiliates comes from U.S.? Answers are: "No" and "Little". Overall, only about 20-40 cents are "lost" Desai, Foley and Hines (2005) find a complementarity at the firm level (more investment abroad → more investment at Home)

'America First' Trade Policy:

1. Defending Our National Sovereignty Over Trade Policy No love for the DSP 2. Strictly Enforcing U.S. Trade Laws 3. Using Leverage to Open Foreign Markets 4. Negotiating New and Better Trade Deals Renegotiation of NAFTA

USMCA

Acronym for U.S.-Mexico-Canada Agreement Agreement signed in 2018 and came into effect in 2020 Regional content goes up to 75% Mexico required to pass legislation that improves the collective bargaining capabilities of labor unions 40-45% of automobiles manufactured in North America must be made in a factory that pays a minimum of $16/h Stipulation that the agreement itself must be reviewed by the three nations every six years, with a 16-year sunset clause Some clauses on dairy productions & IPR (Canada)

Section 301 tariffs:

Authorizes the President to take all appropriate action, including tariff-based and non-tariff-based retaliation, to obtain the removal of any act, policy, or practice of a foreign government that violates an international trade agreement or is unjustified, unreasonable, or discriminatory, and that burdens or restricts U.S. commerce Various phases of section 301 on increasing amount of U.S. imports from China (invoked violation of IPR) Followed by Chinese retaliation Eventually will be reviewed by WTO

TTIP (Transatlantic Trade and Investment Partnership)

Estimated to produce small benefits in the U.S. and EU Not so much about tariffs IPR protection, harmonization of standards, ISDS

The Doha Round

In March 2002, the U.S. government imposed a 30% tariff on a range of imported steel products (key for swing states) Europe, Japan, China and Korea filed suit against U.S. In July of 2003, the WTO ruled against the U.S. and the U.S. complied with the ruling Was it because of the ruling, or due to a fear of retaliation (e.g., oranges in Florida)? More recently, U.S. allowed to retaliate against European subsidies to Airbus In 2001, a new round of negotiations was started in Doha, Qatar, but these negotiations have not yet produced an agreement Part of the reason for this is that the potential gains from further liberalization are modest The sectors that are left to liberalize (agriculture, textiles, clothing) are particularly politically sensitive It was harder to generate Pareto improvements for all countries involved (Brazil and India complained)

Trade Diversion may dominate Trade Creation

J. Viner

NAFTA

NAFTA is widely condemned: claims it cost millions of jobs, suppressed wages, deepened inequality, contributed to trade deficit NAFTA has become a proxy for fear of job loss and bad trade agreements This story line hardly challenged, but has no basis in economic research Not much evidence for job losses Quantitative models indicate modest effects on real income: Mexico +1.31%; US +0.08%; Canada -0.06% Negotiations began in August 2017 Greatest concern: Automobile industry NAFTA trade in cars/trucks/parts accounts for 25% of US trade with Canada and Mexico (all US firms!) 700,000 jobs in industry in US, equal number in Mexico Jobs disproportionately in swing voter states! Initial US demand: tighten and tilt rules of origin Current NAFTA rules: 62.5% regional content US proposed increasing this to 85% (with 50% US) Laxer ROOs if workers paid more than $15 per hour

Section 201 Tariffs

Permits the President to grant temporary import relief to injured domestic industries Analog of Article XIX of GATT, which allows contracting parties to provide relief from injurious competition if temporary protection will enable the domestic industry to make adjustments to meet the competition. Solar panels and washing machines (Feb 2018) Eventually will be reviewed by WTO

Agricultural subsidies and LDCs

Rich countries protect textiles and agriculture, where LDCs might have comparative advantage This lowers world prices and can be quite harmful for LDCs that are large exporters of these goods For example, the US and EU heavily subsidize domestic cotton growers In 2001-2 US government subsidies to America's 25,000 cotton farmers amounted to $160,000 per farmer ($4 billion total) Since the mid-1990s cotton prices have fallen by half This has had a big impact on some of the world's other cotton producers US subsidies cost some countries more than 1% of their GDP per year But other countries benefit (cotton-importing countries)

TPP (Trans-Pacific Partnership)

Similar in many respects to TTIP, but involves relatively some relatively less developed economies Looks pretty dead right now...

National Security Tariffs

So called section 232 tariffs Not used by any President since WTO created in 1995 DOC claims U.S. steel producers must run plants at 80% of capacity to sustain adequate domestic steel supply But Def. Sec. Mattis: "The U.S. military requirements for steel and aluminum each represent only about 3% of U.S. production" Aluminum and steel tariffs critical for U.S. national security, but somehow OK to exempt "our friends" Surely will be found a violation of WTO obligations Surely will generate retaliation

Boeing vs. Airbus Prisonner's Dilemma Subsidy example

The predicted outcome depends on which firms invests/produces first If Boeing decides first, then Airbus will exit If Airbus decides first, then Boeing will exit But a subsidy of 5+ε by the European Union can alter the outcome by making it profitable for Airbus to produce regardless of Boeing's action Subsidy will generate a large profit gain for Airbus (105) But conclusion sensitive to details

Zollverein

a customs union between German states signed in 1834

specific tariff

levied as a fixed charge for each unit of goods imported (for example, $3 per barrel of oil).

the export supply function is

upward sloping

terms of trade gain

while the rectangle represents the terms of trade gain that arise because a tariff lowers foreign export prices. for a large enough country, the tariff will reduce the (untaxed) export price cashed by foreigners

A multinational firm is (define + 4 characteristics)

"an enterprise that controls and manages production establishments (plants) located in at least two countries" Firm and Industry Characteristics Common to MNEs 1. High levels of R&D expenditures over sales 2. Employment of a large number of nonproduction (skilled) workers 3. Production of new and/or complex goods 4. High levels of product differentiation and advertising Examples: - Nestlé's decision to "go multinational" was motivated by export barriers, which forced Nestlé to set up factories throughout Europe. By 1996, the Swiss-based company had factories in 74 of the 193 countries in the world - Toyota --> Expansion explained by high weight-to-price ratio of motor vehicles and strict government policies that protect domestic markets and support local production More recently, some location decisions (Mexico, Turkey and Eastern Europe) seem to be based on cost considerations As Nestlé's, Toyota's production system relies on fully-owned assembly plants, which obtain components and parts largely from external suppliers - Intel --> It kept the skill-intensive parts of the production process (wafer production and fabrication) in the United States (later extending them in Israel and Ireland) It shifted the labor-intensive parts (assembly and testing) to low-wage countries, such as Malaysia, the Philippines, Barbados, and more recently China and Costa Rica. Intel exerts substantial control over the different parts of the production process All production facilities (including those in LDCs) are fully-owned by Intel - Nike --> none of the Nike's pairs of athletic shoes sold in the U.S. were produced there\ And none of these pairs of shoes were produced in Nike-owned production facility Nike subcontracts 100% of its footwear production to independently owned and operated factories Nike's strategy is based on the attraction of low-wage labour and only marginally on the market potential of these locations Nike's reliance on subcontracting is not a quirk (general in apparel industry)

There are several reasons for why FDI should affect productivity of local firms in host countries

1. Domestic firms may benefit from increased technological diffusion if foreign affiliates located in that country introduce new products or processes 2. Productivity may increase simply from host-country firms observing how production takes place in local affiliates of foreign firms 3. FDI may toughen the competition faced by domestic firms, thereby forcing them to "trim their fat" and become more competitive 4. Productivity spillovers via labor turnover former employees of multinational firms set up their own businesses and adopt some of the techniques they were using in the foreign firm 5. FDI can generate positive spillovers by increasing local demand for intermediate inputs, hence allowing suppliers to move down along their average curve 6. By the same argument, FDI can decrease the productivity of domestic firms operating in the same sector because the "business-stealing" effect may increase average costs

The WTO differs from GATT in several ways

1. It applies not just to trade in goods but also to trade in services (though this has not yet had much impact) 2. It has taken up the issue of intellectual property rights through an agreement on the Trade-Related Aspects of Intellectual Property (TRIPS) 3. It has a formal dispute settlement procedure

Why do MNEs exist?

1. Location: why is a good produced in at least two countries rather than in just one country? 2. Internalization: why is production in different locations done by one firm rather that by separate firms?

WTO negotiations address trade restrictions in at least 3 ways:

1. Reducing tariff rates through multilateral negotiations 2. Binding tariff rates: a tariff is "bound" by having the imposing country agree not to raise it in the future 3. Eliminating nontariff barriers: quotas and export subsidies are changed to tariffs because the costs of tariff protection are more apparent and easier to negotiate Subsidies for agricultural exports are an exception Exceptions are also allowed for "market disruptions" caused by a surge in imports

international negotiation, p. 289

At least part of the answer is that the great postwar liberalization of trade was achieved through international negotiation. That is, governments agreed to engage in mutual tariff reduction. These agreements linked reduced protection for each coun- try's import-competing industries to reduced protection by other countries against that country's export industries. Such a linkage, as we will now argue, helps to offset some of the political difficulties that would otherwise prevent countries from adopting good trade policies.

theories of internalization

Costly technology transfer: transfer of knowledge or technology may be easier within a single organization than through a market transaction (e.g., licensing) Patent or property rights may be weak or non-existent Knowledge may not be easily packaged and sold Non-excludability Helps explain decision of Intel to own all its plants Vertical integration: consolidation of different stages of a production process Intrafirm purchases may avoid or attenuate contractual difficulties Integration may affect the relative bargaining power and incentives of producers and suppliers in a profit-enhancing way May explain why Toyota internalizes certain upstream production stages, while Nike doesn't

local content requirement

A local content requirement is a regulation that requires some specified fraction of a final good to be produced domestically. In some cases, this fraction is specified in physical units, like the U.S. oil import quota in the 1960s. In other cases, the require- ment is stated in value terms by requiring that some minimum share of the price of a good represent domestic value added. Local content laws have been widely used by developing countries trying to shift their manufacturing base from assembly back into intermediate goods. In the United States, a local content bill for automobiles was pro- posed in 1982 but was never acted on. From the point of view of the domestic producers of parts, a local content regulation provides protection in the same way an import quota does. From the point of view of the firms that must buy locally, however, the effects are somewhat different. Local content does not place a strict limit on imports. Instead, it allows firms to import more, provided that they also buy more domestically. This means that the effective price of inputs to the firm is an average of the price of imported and domestically produced inputs. The important point is that a local content requirement does not produce either government revenue or quota rents. Instead, the difference between the prices of imports and domestic goods in effect gets averaged in the final price and is passed on to consumers. A local content requirement is a regulation that requires that some specified fraction of a final good be produced domestically Provides protection for domestic producers of inputs (similar to import quota) From the viewpoint of firms that must buy domestic inputs, it is a bit more flexible than an import quota (can expand domestic input purchases) Local content requirement provides neither government revenue (as a tariff would) nor quota rents

political argument for free trade, p. 277

A political argument for free trade reflects the fact that a political commitment to free trade may be a good idea in practice even though there may be better policies in prin- ciple. Economists often argue that trade policies in practice are dominated by special- interest politics rather than by consideration of national costs and benefits. Economists can sometimes show that in theory, a selective set of tariffs and export subsidies could increase national welfare, but that in reality, any government agency attempting to pursue a sophisticated program of intervention in trade would probably be captured by interest groups and converted into a device for redistributing income to politically influential sectors. If this argument is correct, it may be better to advocate free trade without exceptions even though on purely economic grounds, free trade may not always be the best conceivable policy.

voluntary export restraint (VER)

A variant on the import quota is the voluntary export restraint (VER), also known as a voluntary restraint agreement (VRA). (Welcome to the bureaucratic world of trade policy, where everything has a three-letter symbol!) A VER is a quota on trade imposed from the exporting country's side instead of the importer's. The most famous example is the limitation on auto exports to the United States enforced by Japan after 1981. Voluntary export restraints are generally imposed at the request of the importer and are agreed to by the exporter to forestall other trade restrictions. As we will see in Chapter 10, certain political and legal advantages have made VERs preferred instru- ments of trade policy in some cases. From an economic point of view, however, a vol- untary export restraint is exactly like an import quota where the licenses are assigned to foreign governments and is therefore very costly to the importing country. A VER is always more costly to the importing country than a tariff that limits imports by the same amount. The difference is that what would have been revenue under a tariff becomes rents earned by foreigners under the VER, so that the VER clearly produces a loss for the importing country. A voluntary export restraint is analogous to an import quota, except that the quota is imposed by the exporting country These restraints are however usually requested by the importing country Example: limitation on Japanese exports of autos in 1981 The profits or rents from this policy are earned by foreign governments or foreign producers Sometimes VERs are multilateral in nature (ex: MFA)

export subsidy

An export subsidy is a payment to a firm or individual that ships a good abroad. Like a tariff, an export subsidy can be either specific (a fixed sum per unit) or ad valorem (a proportion of the value exported). When the government offers an export subsidy, shippers will export the good up to the point at which the domestic price exceeds the foreign price by the amount of the subsidy. The effects of an export subsidy on prices are exactly the reverse of those of a tariff (Figure 9-11). The price in the exporting country rises from PW to PS, but because the price in the importing country falls from PW to P*S, the price increase is less than the subsidy. In the exporting country, consumers are hurt, producers gain, and the govern- ment loses because it must expend money on the subsidy. The consumer loss is the area a + b; the producer gain is the area a + b + c; the government subsidy (the amount of exports times the amount of the subsidy) is the area b + c + d + e + f + g. Thenetwelfarelossisthereforethesumof theareasb + d + e + f + g.Of these, b and d represent consumption and production distortion losses of the same kind that a tariff produces. In addition, and in contrast to a tariff, the export subsidy worsens the terms of trade because it lowers the price of the export in the foreign market from PW to P*S. This leads to the additional terms of trade loss e + f + g, which is equal to PW - P*S times the quantity exported with the subsidy. So an export subsidy unam- biguously leads to costs that exceed its benefits. Export subsidies were used very widely (now somewhat less so) by the EU under its Common Agricultural Policy An export subsidy raises the price of a good in the exporting country, while lowering it in foreign countries Consumers are worse off, producers are better off, and government revenue is negative The welfare effects are unambiguously negative overall slide 27, lecture 18 --> graphical analysis The European Union's Common Agricultural Policy sets high prices for agricultural products and subsidizes exports to dispose of excess production In fact, without these subsidies, Europe would be a net importer of most of these agricultural goods The direct cost of this policy for European taxpayers was almost $76 billion in 2009 There are proposals to make these subsidies independent of production (preferred policy)

optimum tariff, p. 278

At point 1 on the curve in Figure 10-2, corresponding to the tariff rate to, national welfare is maximized. The tariff rate to that maximizes national welfare is the optimum tariff. (By convention, the phrase optimum tariff is usually used to refer to the tariff justified by a terms of trade argument rather than to the best tariff given all possible considerations.) The optimum tariff rate is always positive but less than the prohibitive rate (tp) that would eliminate all imports. What policy would the terms of trade argument dictate for export sectors? Since an export subsidy worsens the terms of trade, and therefore unambiguously reduces national welfare, the optimal policy in export sectors must be a negative subsidy, that is, a tax on exports that raises the price of exports to foreigners. Like the optimum tariff, the optimum export tax is always positive but less than the prohibitive tax that would eliminate exports completely. The policy of Saudi Arabia and other oil exporters has been to tax their exports of oil, raising the price to the rest of the world. Although oil prices have fluctuated up and down over the years, it is hard to argue that Saudi Arabia would have been better off under free trade.

partial equilibrium analysis

By that we mean that we focus on the effects of a tariff on an industry that is "small" relative to the size of the economy By "small" we mean that: No income effects of trade policy feeding back into demand No effect on wages (or exchange rates) which might feed back into the supply side Do not worry about the trade balance being equal to zero Then we can use standard supply and demand analysis

Fajgelbaum, Goldberg, Kennedy, Khandelwal, 2019

Empirical evidence on the recent increase in tariffs ρ ≈ 1

what would happen if workers in LDCs could only be employed by domestic firms? what is the effect of MNEs on average host-country wages?

Evidence suggests that workers employed in MNEs in LDCs are paid wages that are on average higher than those paid by domestic firms Particular studies include Glewwe (2000) for Vietnam, Aitken et al. (1996) for Mexico, Lipsey and Sjoholm for Indonesia (GLEWWE) Average wages appear to be significantly higher in foreign-owned businesses (FOB) Type of workers that MNEs hire may be different from type of workers that domestic firms hire MNEs hire higher skilled workers This is problematic because the relevant "alternative wage" for MNE- employed workers might be higher than that of the average domestic worker Sjoholm and Lipsey (2004) --> Control for average worker characteristics and firm characteristics Foreign-Owned wage premium remains but appears smaller Sjoholm and Lipsey (2006) --> Use within-establishment comparison (i.e., takeovers). Again premium survives Heyman et al. (2007) --> Use individual worker data rather than firm averages (Swedish data), Again look at the effects of takeovers. Premium close to gone! But was the takeover random? MNEs could lead to a large fall in average wages, with a disproportionate negative effect on workers employed in domestic firms Theoretically, the effect is unclear: If MNE implies capital or technology inflow, or increased trade integration (fragmentation), then one would expect positive effect on wages (rule out factor price insensitivity) If MNEs are monopsonists in labor markets, then there could be perverse effects Aitken et al. (1996) find that MNEs have a positive impact on host- country wages... ...but that this positive effect tends to be concentrated among the set of workers that are employed by these MNEs Their results indicate that skilled workers tend to benefit more than unskilled workers from FDI result confirmed by a variety of studies problematic for standard models of vertical fragmentation (remember our discussion of wage inequality in Lec. 11)

The capital flight problem

Most countries use a source-based corporation tax A source-based tax system is vulnerable to tax competition (through profit shifting)

export supply curve

Foreign export supply is the excess of what Foreign producers supply over what Foreign consumers demand.

We have shown that in the majority of cases, welfare is higher under free trade than under autarky But what are optimal trade policies? Is it free trade?

Free trade may not always be superior to some combination of tariffs and/or subsidies Remember from the last lecture that the welfare effect of a tariff is ambiguous In fact, for a "large" open economy, welfare is maximized via a small import tariff or export tax Key: Terms-of-trade manipulation Caveat: assumes no retaliation! Another common argument for restricting trade is based on the theory of the second best This is the idea that a laissez-faire policy in one area of the economy is clearly superior only if there are no distortions in any other area of the economy Example: the case of external economies of scale Example: labor market failures which make it difficult for workers who lose jobs in one sector to find jobs in another There are at least two important caveats with the second-best argument for protection Caveat #1: it is often hard to identify the sources of market failures that trade protection will attempt to correct Caveat #2: domestic market failures should (when possible) be corrected by a "first-best" policy − a domestic policy aimed directly at the source of the problem

import demand curve

Home import demand is the excess of what Home consumers demand over what Home producers supply

Two main reasons for MNE activity to be profit-maximizing

Horizontal FDI Vertical FDI

collective action, p. 284

In Olson's phrase, there is a problem of collective action: While it is in the interests of the group as a whole to press for favorable policies, it is not in any individual's interest to do so.

internalization

In developing their global sourcing strategies, firms not only decide on where to locate the different stages of the value chain, but also on the extent of control to exert over them The issue of internalization or control is crucial for the existence of MNEs But theories of location shed little light on the issue of internalization why will fragmentation occur within firm boundaries?

free trade area, p. 299

In general, two or more countries agreeing to establish free trade can do so in one of two ways. They can establish a free trade area in which each country's goods can be shipped to the other without tariffs, but in which the countries set tariffs against the outside world independently.

General Agreement on Tariffs and Trade (GATT), p. 291

Multilateral negotiations began soon after the end of World War II. Originally, dip- lomats from the victorious Allies imagined such negotiations would take place under the auspices of a proposed body called the International Trade Organization, paral- leling the International Monetary Fund and the World Bank (described in the second half of this book). In 1947, unwilling to wait until the ITO was in place, a group of 23 countries began trade negotiations under a provisional set of rules that became known as the General Agreement on Tariffs and Trade, or GATT. As it turned out, the ITO was never established because it ran into severe political opposition, especially in the United States. So the provisional agreement ended up governing world trade for the next 48 years.

Vertical FDI

In the presence of factor price (cost) differences across countries, a producer may find it optimal to fragment production and undertake different parts/processes in different countries The production process entails a skill-intensive process (R&D, product development...) and an unskilled-intensive process (assembly) One option is to concentrate both processes in the same plant or location An alternative is to set up an affiliate in a foreign market that focuses on the production of a given process What are the costs of FDI? Transportation costs involved in the cross- border exchange of inputs; coordination costs; communication costs; fixed costs What are the benefits of FDI? Exploitation of cross-country differences in factor prices by shifting production processes (with different input requirements) to locations where they can be carried out more cheaply This is very much related to the concept of comparative advantage in Heckscher-Ohlin Model The model predicts that the prevalence of MNEs and FDI should be: Decreasing in transportation costs (as well as coordination costs) Increasing in relative factor endowment differences across countries (which generate factor price differences) Increasing in relative factor intensity differences across processes Notice also that while in Horizontal FDI models, trade and FDI are substitutes... ... here, Vertical FDI and trade are complements Yeaple (2003) shows that U.S. MNEs favor skilled-abundant countries over unskilled- abundant countries in skill intensive sectors But instead favor unskilled-abundant countries in unskilled- intensive industries

trade war, p. 289

International negotiation can also help to avoid a trade war. The concept of a trade war can best be illustrated with a stylized example.

effects of tariff on supply and demand (SOE vs. LOE)

Now suppose that the Home country levies a specific tariff t on imports from Foreign - perfect substitutes Foreign producers will not be able to sell at Home unless the price difference between the domestic and foreign markets is at least as large as the tariff At the original price, there is excess demand in the domestic market and excess supply in the foreign market The price will tend to rise in the domestic market (by less than the tariff), while it will tend to fall in the foreign market An import tariff raises the domestic price so we expect that the tariff will hurt consumers, but benefit producers In addition, the government obtains some tariff revenue, which may be rebated back to consumers (directly or more realistically indirectly) SOE --> no effect on world price, domestic consumers pay full price of tariffs

World Trade Organization (WTO), p. 291

Officially, the GATT was an agreement, not an organization—the countries partici- pating in the agreement were officially designated as "contracting parties," not mem- bers. In practice, the GATT did maintain a permanent "secretariat" in Geneva, which everyone referred to as "the GATT." In 1995, the World Trade Organization, or WTO, was established, finally creating the formal organization envisaged 50 years earlier. However, the GATT rules remain in force, and the basic logic of the system remains the same.

terms of trade argument for a tariff, p. 278

One argument for deviating from free trade comes directly out of cost-benefit analysis: For a large country that is able to affect the prices of foreign exporters, a tariff lowers the price of imports and thus generates a terms of trade benefit. This benefit must be set against the costs of the tariff, which arise because the tariff distorts production and consumption incentives. It is possible, however, that in some cases the terms of trade benefits of a tariff outweigh its costs, so there is a terms of trade argument for a tariff.

customs union, p. 299

Or they can establish a customs union in which the coun- tries must agree on tariff rates. The North American Free Trade Agreement—which establishes free trade among Canada, the United States, and Mexico—creates a free trade area: There is no requirement in the agreement that, for example, Canada and Mexico have the same tariff rate on textiles from China. The European Union, on the other hand, is a full customs union. All of the countries must agree to charge the same tariff rate on each imported good. Each system has both advantages and disadvan- tages; these are discussed in the accompanying box.

producer surplus

Producer surplus is an analogous concept. A producer willing to sell a good for $2 but receiving a price of $5 gains a producer surplus of $3. The same procedure used to derive consumer surplus from the demand curve can be used to derive producer surplus from the supply curve. If P is the price and Q the quantity supplied at that price, then producer surplus is P times Q minus the area under the supply curve up to Q (Figure 9-8). If the price is P1, the quantity supplied will be S1, and producer surplus is measured by area c. If the price rises to P2, the quantity supplied rises to S2, and producer surplus rises to equal c plus the additional area d. measures the amount that producers gain from sales by computing the diffe- rence between the price received and the minimum price at which they would be willing to sell

National procurement

Purchases by the government or strongly regulated firms can be directed toward domestically produced goods even when these goods are more expensive than imports. The classic example is the European telecommunications industry. The nations of the European Union in principle have free trade with each other. The main purchasers of telecommunications equipment, however, are phone companies—and in Europe, these companies have until recently all been government-owned. These government-owned telephone companies buy from domestic suppliers even when the suppliers charge higher prices than suppliers in other countries. The result is that there is very little trade in telecommunications equipment within Europe. Government agencies are sometimes obligated to purchase from domestic suppliers (even when they charge higher prices than foreigners)

trade creation, p. 302

Returning to our two cases, notice that Britain gains if the formation of a customs union leads to new trade—French wheat replacing domestic production—while it loses if the trade within the customs union simply replaces trade with countries outside the union. In the analysis of preferential trading arrangements, the first case is referred to as trade creation,

trade diversion, p. 302

Returning to our two cases, notice that Britain gains if the formation of a customs union leads to new trade—French wheat replacing domestic production—while it loses if the trade within the customs union simply replaces trade with countries outside the union. In the analysis of preferential trading arrangements, the first case is referred to as trade creation, while the second is trade diversion. Whether a customs union is desirable or undesirable depends on whether it mainly leads to trade creation or trade diversion.

Bureaucratic regulations

Safety, health, quality or customs regulations can act as a form of protection and trade restriction (Ex: Poitiers 1982)

Red-tape barriers

Sometimes a government wants to restrict imports without doing so formally. Fortunately or unfortunately, it is easy to twist normal health, safety, and customs procedures in order to place substantial obstacles in the way of trade. The classic example is the French decree in 1982 that all Japanese videocassette recorders had to pass through the tiny customs house at Poitiers (an inland city nowhere near a major port)—effectively limiting the actual imports to a handful.

All four trade policies benefit producers and hurt consumers. (T/F)?

TRUE (see (9-1 table) summarizing effects)

Smoot-Hawley Act

Tensions among countries rose after WWI and with the advent of the great depression many countries turned to protectionism In 1930, the U.S. passed a very stringent tariff law, the Smoot-Hawley Act (tariffs rose and US trade fell) Very soon, the government decided these tariffs were a bad idea However, special interests protected by the tariff made it very difficult to repeal

The three arguments outlined in the previous section probably represent the stan- dard view of most international economists, at least those in the United States:

The conventionally measured costs of deviating from free trade are large. There are other benefits from free trade that add to the costs of protectionist policies. Any attempt to pursue sophisticated deviations from free trade will be subverted by the political process. Nonetheless, there are intellectually respectable arguments for deviating from free trade, and these arguments deserve a fair hearing.

quota rent

The difference between a quota and a tariff is that with a quota, the government receives no revenue. When a quota instead of a tariff is used to restrict imports, the sum of money that would have appeared with a tariff as government revenue is collected by whoever receives the import licenses. License holders are thus able to buy imports and resell them at a higher price in the domestic market. The profits received by the hold- ers of import licenses are known as quota rents. In assessing the costs and benefits of an import quota, it is crucial to determine who gets the rents. When the rights to sell in the domestic market are assigned to governments of exporting countries, as is often the case, the transfer of rents abroad makes the costs of a quota substantially higher than the equivalent tariff.

theory of the second best, p. 280

The domestic market failure argument against free trade is a particular case of a more general concept known in economics as the theory of the second best. This theory states that a hands-off policy is desirable in any one market only if all other markets are working properly. If they are not, a government intervention that appears to distort incentives in one market may actually increase welfare by offsetting the consequences of market failures elsewhere. For example, if the labor market is malfunctioning and fails to deliver full employment, a policy of subsidizing labor-intensive industries, which would be undesirable in a full-employment economy, might turn out to be a good idea. It would be better to fix the labor market by, for example, making wages more flex- ible, but if for some reason this cannot be done, intervening in other markets may be a "second-best" way of alleviating the problem. When economists apply the theory of the second best to trade policy, they argue that imperfections in the internal functioning of an economy may justify interfering in its external economic relations. This argument accepts that international trade is not the source of the problem but suggests nonetheless that trade policy can provide at least a partial solution.

efficiency case for free trade, p. 275

The efficiency case for free trade is simply the reverse of the cost-benefit analysis of a tariff. Figure 10-1 shows the basic point once again for the case of a small country that cannot influence foreign export prices. A tariff causes a net loss to the economy mea- sured by the area of the two triangles; it does so by distorting the economic incentives of both producers and consumers. Conversely, a move to free trade eliminates these distortions and increases national welfare.

nontariff barriers

The importance of tariffs has declined in modern times because modern governments usually prefer to protect domestic industries through a variety of nontariff barriers, such as import quotas (limitations on the quantity of imports) and export restraints (limitations on the quantity of exports—usually imposed by the exporting country at the importing country's request).

trade round, p. 291

The lever used to make forward progress is the somewhat stylized process known as a trade round, in which a large group of countries get together to negotiate a set of tariff reductions and other measures to liberalize trade. Eight trade rounds have been completed since 1947, the last of which—the Uruguay Round, completed in 1994— established the WTO. In 2001, a meeting in the Persian Gulf city of Doha inaugurated a ninth round, but despite many years of negotiations this never led to an agreement. We'll discuss the reasons for this failure later in this chapter.

binding, p. 291

The principal ratchet in the system is the process of binding. When a tariff rate is "bound," the country imposing the tariff agrees not to raise the rate in the future. At present, almost all tariff rates in developed countries are bound, as are about three- quarters of the rates in developing countries. There is, however, some wiggle room in bound tariffs: A country can raise a tariff if it gets the agreement of other countries, which usually means providing compensation by reducing other tariffs. In practice, binding has been highly effective, with very little backsliding in tariffs over the past half-century. In addition to binding tariffs, the GATT-WTO system generally tries to prevent non- tariff interventions in trade. Export subsidies are not allowed, with one big exception: Back at the GATT's inception, the United States insisted on a loophole for agricultural exports, which has since been exploited on a large scale by the European Union. As we pointed out earlier in this chapter, most of the actual cost of protection in the United States comes from import quotas. The GATT-WTO system in effect "grandfathers" existing import quotas, though there has been an ongoing and often successful effort to remove such quotas or convert them to tariffs. New import quotas are generally forbidden except as temporary measures to deal with "market disruption," an undefined phrase usually interpreted to mean surges of imports that threaten to put a domestic sector suddenly out of business.

preferential trading agreement, p. 299

There are some important cases, however, in which nations establish preferential trading agreements under which the tariffs they apply to each other's products are lower than the rates on the same goods coming from other countries. The GATT in general prohibits such agreements but makes a rather strange exception: It is against the rules for country A to have lower tariffs on imports from country B than on those from country C, but it is acceptable if countries B and C agree to have zero tariffs on each other's products. That is, the GATT forbids preferential trading agreements in general, as a violation of the MFN principle, but allows them if they lead to free trade between the agreeing countries.9 Under the GATT and WTO, reductions in tariff rates are nondiscriminatory (they must apply to all members) "Most Favored Nation" status implies that a country receives the minimum tariff applied to all potential importers The rules allow for one and only one exception to this rule, when two countries wish to abolish tariffs altogether Under a free trade area, countries abolish all tariffs on trade with each other, but do not require a common external tariff (e.g. NAFTA) Under a customs union, countries additionally agree to a common external tariff (e.g. European Union) Customs unions are more difficult to negotiate, but reduce trade barriers more, as the origin of goods does not have to be documented at the border

Export credit subsidies

This is like an export subsidy except that it takes the form of a subsidized loan to the buyer. The United States, like most other countries, has a government institution, the Export-Import Bank, devoted to providing at least slightly subsidized loans to aid exports. A subsidized loan to exporters (Ex: US Export-Import Bank)

effective rate of protection

To encourage a domestic auto industry, the first country places a 25 percent tariff on imported autos, allowing domestic assemblers to charge $10,000 instead of $8,000. In this case, it would be wrong to say that the assemblers receive only 25 percent pro- tection. Before the tariff, domestic assembly would take place only if it could be done for $2,000 (the difference between the $8,000 price of a completed automobile and the $6,000 cost of parts) or less; now it will take place even if it costs as much as $4,000 (the difference between the $10,000 price and the cost of parts). That is, the 25 percent tariff rate provides assemblers with an effective rate of protection of 100 percent.

Prisoner's dilemma, p. 290

To those who have studied game theory, this situation is known as a Prisoner's dilemma. Each government, making the best decision for itself, will choose to protect. These choices lead to the outcome in the lower right box of the table. Yet both govern- ments are better off if neither protects: The upper left box of the table yields a payoff that is higher for both countries. By acting unilaterally in what appear to be their best interests, the governments fail to achieve the best outcome possible. If the countries act unilaterally to protect, there is a trade war that leaves both worse off. Trade wars are not as serious as shooting wars, but avoiding them is similar to the problem of avoiding armed conflict or arms races.

Terms-of-Trade manipulation

Trade policy to affect foreign prices (e.g., decrease the price of the importing good) The government internalizes that by restricting its demand it can affect the price of the importing good

Transfer Pricing

Traditionally, mispricing of trade in goods, overinvoicing where tax rates are low Modern times, develop property in foreign subsidiary, which then leases it at high price to domestic parent Domestic parent enjoys cost deductions while foreign subsidiary pays little tax on lease earnings Earnings stripping Domestic parent borrows heavily from foreign subsidiary in Cayman Islands Domestic parent enjoys interest deductions while foreign subsidiary pays little tax on interest earnings shifting to tax havens solutions --> International coordination (floor on profit tax rates) But requires coordination among "all" countries Shift to revenue- or cash-flow- based taxation But it is not obvious this is desirable or easy to implement

U.S. Sugar Quota

U.S. guarantees sugar producers a "break even" price on sugar production The USDA will buy any amount of sugar at this price Even at this relatively high price, domestic demand exceeds domestic supply of sugar, so the US imports sugar In order to maintain this higher price, the US imposes a sugar quota and lets foreign governments administer the quota and retain the quota rents Over the past 25 years, this higher price has been on average twice the world market price of sugar The quota does increase employment in the sugar industry: employment would be 32% lower without quota The US sugar industry is very concentrated geographically (in Florida) and very well organized US sugar sales represent 1% of US farm receipts and 0.5% of US farm employment US sugar lobby contributions represent 17% of campaign contributions from agricultural sector The Fanjul brothers who own Flo-Sun (the biggest US sugar cane growing and refining company) gave $1M in political contributions in each of the 2000 and 2004 election cycles In 1996, a congressional amendment was introduced to phase out the US sugar quota (and price support program) The amendment was defeated by 217-209 in the house of representatives Five co-sponsors of the bill switched their support against their own amendment in the final vote Within days of the vote, each received an average of $11,000 from the US sugar lobby

export tax

Using an analogous analysis, one can show that export taxes may be welfare-enhancing Oil-producing countries sometimes use export taxes Or China more recently in the case of rare earth metals (tungsten)

Volkswagen

Volkswagen stopped producing light trucks, but by then the "big three" auto and truck producers were concerned about competition from Japan Chrysler, Ford, GM successfully lobbied to keep a 25% tariff For a while, Subaru's response to the tariff was to introduce a "passenger" vehicle (subject to the substantially lower 2.5% tariff) Latest firm to be hit by the tariff is Ford − one of the initial proponents of the tariff! Ford produces and sells the Ford Transit as a commercial truck in Europe ... but the "truck" looks quite different when it is shipped to the U.S., before being reconverted into a truck

median voter, p. 283

What policies will the two parties then promise to follow? The answer is that they will try to find the middle ground—specifically, both will tend to converge on the tariff rate preferred by the median voter, the voter who is exactly halfway up the lineup. To see why, consider Figure 10-4. In the figure, voters are lined up by their preferred tariff rate, which is shown by the hypothetical upward-sloping curve; tM is the median voter's preferred rate. Now suppose one of the parties has proposed the tariff rate tA, which is considerably above that preferred by the median voter. Then the other party could propose the slightly lower rate, tB, and its program would be preferred by almost all voters who want a lower tariff, that is, by a majority. In other words, it would always be in the political interest of a party to undercut any tariff proposal that is higher than what the median voter wants.

Horizontal FDI

When exporting is costly, replication of the production process in a foreign market may be profit-maximizing (Nestlé, Toyota) What is the cost of FDI? Suppose it entails additional fixed costs associated with creating a new plant Exporting will also be costly, but most of the costs will be variable in nature Horizontal FDI will tend to dominate exporting in industries in which: costs of transporting the goods internationally are high plant-level fixed costs are low relative to firm-level fixed costs Furthermore, a larger demand or productivity level (i.e., larger sales) will make horizontal FDI more attractive relative to exporting Easier to amortize the fixed cost of the new plant Firms facing low demand or featuring low productivity will opt out of becoming multinationals Why positive effect of firm-level fixed costs? Entry entails a fixed cost FE plus an additional fixed cost FD per plant operating Suppose exporting entails a cost equal to t per unit So exporting is less profitable (and MNE + profitable) whenever FD is low, S is high or n is low (i.e., FE is high) Brainard (1997) found strong supportive evidence for the model Helpman, Melitz and Yeaple (2004) confirmed the results and also showed a negative effect of productivity on the ratio EXP/FDI

rent seeking, p. 277

When imports are restricted with a quota rather than a tariff, the cost is sometimes magnified by a process known as rent seeking. Recall from Chapter 9 that to enforce an import quota, a government has to issue import licenses and economic rents accrue to whoever receives these licenses. In some cases, individuals and companies incur substantial costs—in effect, wasting some of the economy's productive resources—in an effort to get import licenses.

domestic market failures, p. 279

Why might producer surplus not properly measure the benefits of producing a good? We consider a variety of reasons in Chapters 11 and 12: These include the possibility that the labor used in a sector would otherwise be unemployed or underemployed, the existence of defects in the capital or labor markets that prevent resources from being transferred as rapidly as they should be to sectors that yield high returns, and the pos- sibility of technological spillovers from industries that are new or particularly innovative. These can all be classified under the general heading of domestic market failures. That is, in each of these examples, some market in the country is not doing its job right—the labor market is not clearing, the capital market is not allocating resources efficiently, and so on.

Trump Tariffs

china did not really pay tariffs tariffs increase most in areas where GOP vote was high

Aitken and Harrison (1999)

estimate the productivity effects of inward FDI on a sample of Venezuelan manufacturing plants in the period 1976- 1989 Although the average effect of FDI on plant productivity is positive, domestic firms in sectors with larger foreign presence record lower productivity So average effect is purely coming from foreign firms being more productive Other authors have found positive (but small) horizontal spillover effects in other countries (i.e., UK)

export restraint

limitations on the quantity of exports—usually imposed by the exporting country at the importing country's request

import quota

limitations on the quantity of imports It is important to avoid having the misconception that import quotas somehow limit imports without raising domestic prices. The truth is that an import quota always raises the domestic price of the imported good. When imports are limited, the immediate result is that at the initial price, the demand for the good exceeds domestic supply plus imports. This causes the price to be bid up until the market clears. In the end, an import quota will raise domestic prices by the same amount as a tariff that limits imports to the same level (except in the case of domestic monopoly, in which the quota raises prices more than this; see the appendix to this chapter). A more straightforward way to achieve the same goal is by directly restricting the volume of imports: an import quota This quota is usually enforced by issuing licenses to domestic importing firms or to foreign exporting countries' governments If the quota is binding, the domestic price will rise because of the associated excess demand The analysis is essentially identical to that of import tariffs For each tariff there is a quota that implements the same change in import volumes and prices But notice that the government is not collecting any tariff revenues in the quota case Is a quota always worse? Only when all quota rents are collected by domestic agents will the two instruments be equally effective Example: U.S. Sugar quota rents go to foreign gov's Sugar quotas save jobs, but they cost $826,000 per job

consumer surplus

measures the amount a consumer gains from a purchase by comput- ing the difference between the price he actually pays and the price he would have been willing to pay. If, for example, a consumer would have been willing to pay $8 for a bushel of wheat but the price is only $3, the consumer surplus gained by the purchase is $5. measures the sum of the differences in the prices actually paid by consumers from the maximum prices they would be willing to pay for each unit consumed

ad valorem tariff

taxes that are levied as a fraction of the value of the imported goods (for example, a 25 percent U.S. tariff on imported trucks

consumption distortion loss

resulting from the fact that a tariff leads consumers to consume too little of the good

production distortion loss

resulting from the fact that the tariff leads domestic producers to produce too much of this good

Two theories of the determination of policy are:

theory of the median voter: What policy will political parties advocate? Result: In order to maximize their support, they will advocate policies close to the tariff preferred by the median voter (majority rule) This implies that policies should be chosen on the basis of how many voters they please Neat theory, but in the real world a lot of trade policies provide a large benefit to few voters, and small costs to many voters (example: sugar quota) problem of collective action: Political activity on the part of a group is a public good Activity undertaken by one member of the group benefits all the members equally The free-rider problem means that a policy that has large costs in total but small costs for each individual may not be effectively opposed On the other hand, a policy that has small benefits in total but large benefits for a very small number of individuals may be effectively proposed and supported Protection for Sale In the U.S. political system, considerable sums of money are needed in order to get elected