1. society
2. work
3. unemployment

1
1.NEW TRADE THEORY
2. POLITICAL ECONOMY OF TRADE
POLICY
Lecture 14: AHEED Course “International Agricultural
Trade and Policy”
Taught by , Alex F. McCalla, Professor Emeritus, UC
Davis.
April 7, 2010 University of Tirana, Albania
Lecture courtesy of Professor Colin A. Carter, UC Davis
“New Trade Theory”
2




In late 1980s, Helpman/Krugman coined the imperfectly competitive
framework as the “new trade theory”
Theorists noted that much trade is dominated by a small number of
large firms & this raised the following question: could increasing
returns cause trade? (as opposed to exogenous differences in
technology or factor endowments)
They also noted that trade in differentiated products is more
important than homogeneous goods trade. Theorists argued that
increasing returns (which typically leads to imperfect competition)
could be as fundamental a cause of international trade as
comparative advantage.
Intra-industry trade cannot be explained by Ricardian or H-O
models.
Important to Agriculture?
3

Relevance to Agric? Intra-industry trade > 50% @ 4 digit
level for processed foods. For example, US imports & exports
tomatoes. At 6 digit level Harmonized System (HS) codes
would show tomato exports to Canada and imports from
Canada & Mexico. 8,000 different products at HS 10 digit
level.
“New Trade Theory”-2
4








New Trade Theory emphasizes:
1) increasing returns, i.e., f (tx1 , tx2) > t f (x1,x2)
2) imperfect competition
3) differentiated products
Economies of scale means average cost of production declines as the # of
units increases.
Internal scale economies (Helpman & Krugman): AC declines with output of
individual firm – may be due to fixed costs associated with starting a firm.
External scale economies (Markusen & Melvin): AC declines as the size of
the industry grows.
This literature shows that increasing returns raises the gains from
international trade.
Presence of economies of scale & imperfect competition raises the
question: are their new arguments against free trade? Could there be new
reasons for government intervention through import restrictions, export
subsidies, etc
Brander/Spencer showed (with a duopoly model) that a gov’t may be able
to shift profits from foreign to domestic exporters through an export subsidy
Intra-Industry Trade & the Krugman
Model (1980)
5
1. Trade models based on comparative advantage focus
on:
Trade between dissimilar countries (different technologies,
factor endowments, etc)
 Inter-industry trade : trade in different commodities

2. Krugman noticed:
Considerable Intra-Industry trade (i.e., trade in similar
goods): Grubel & Lloyd showed this many years ago.
 Large amount of trade among similar economies.

3. Krugman showed that trade is possible & mutually
beneficial in the case of two completely identical
countries
Krugman Model cont
6
4. Krugman assumptions:






2 identical economies (home (H) & foreign (F)) in terms of technology &
preferences
One nontraded factor of production (labor) & equal endowment across
countries LH = LF
Large number of competitors but many varieties of goods (i.e,
differentiation). Each firm produces its own variety. Each firm acts as a
monopolist (monop. competition) – goods are substitutes so price falls as
more firms enter the market. In equib. p = AC.
Consumer preferences: homothetic & identical across countries
Consumer preferences: love of variety & diminishing marginal utility
associated with the consumption of extra units. Consumption of more
varieties yields higher utility – “city lights” effect.
Trade is of the intra-industry type - exchange of varieties of the same
differentiated good.
Krugman cont 2
7
5. In Krugman type model (monopolistic competition &
internal scale economies) the gains from trade arise due
to:
 a) larger number of varieties available to consumers
(i.e., more choice)
 b) larger production of each individual variety, resulting
in a larger real income (lower prices due to increased
market size and increased competition).
 c) No income distribution effects – everybody gains.
Brander/Spencer (1985):
8


Brander/Spencer showed (with a duopoly model) that a
gov’t may be able to shift profits from foreign to
domestic exporters through an export subsidy
Two new arguments:
1)
2)
Strategic Trade Policy : gov’t can tilt the terms of
oligopolistic competiton to shift excess returns from
foreign to domestic
Externalities: gov’t should favor industries that yield
positive externalities
Brander/Spencer (1985): Boeing vs Airbus airplane production.
Assume: 2 countries (1 firm in each country); no domestic demand; market is profitable for 1 firm
but not 2.
Hypothetical payoff matrix:
AIRBUS
Produce
Produce
BOEING
Not Produce
-5
0
-5
Not
Produce
100
100
0
0
0
AIRBUS
Produce
Produce
Not Produce
-5
BOEING
0
5
-5
Not
Produce
100
100
110
0
0
0
New outcome
9

Europe pays Airbus a subsidy of $10 & Game’s outcome is reversed

A subsidy of $10 raises Airbus’ profits from 0 to $100
Without
Intervention,
Boeing has a
head start
Bhagwati Econ Journal March ‘94
10
Conventional challenges to free trade:
 Great depression  unemployment  Keynes’s apostasy on free
trade
 1930s. Edward Chamberlin & Joan Robinson developed theory of
imperfect competition, undermining the notion that market prices
reflect social costs & questioning free trade
 1950s – 1960s heyday of free trade with successive GATT rounds;
trade mostly expanded in developed countries, whereas many
developing countries embraced “infant industry” & “import
substitution” arguments (e.g., Prebisch-Singer)
 “Market failure” argument was used to justify intervention & this led
to theory of optimal policy intervention (Bhagwati, Corden &
Johnson) – which showed trade policy was 2nd best intervention, with
domestic policy 1st best
Bhagwati - cont
11


1980s literature concerned with product market imperfections, whereas previous
literature was concerned with factor market imperfections.
shifted pre-occupation with protectionism in developing countries to pre-occupation with
protectionism in developed countries

new theory immediately moved into center of public policy debate

Theorists who developed “New Trade Theory” have now backed away.



Not empirically important because there are too few rents to shift – “Chicago school
approach” – e.g., Gene Grossman
“Public Choice School” approach says govt’s are predatory & intervention may produce
worse outcomes than the imperfect markets we are trying to fix (Krugman has taken this
approach)
1990s saw proponents of NTT backing off & developments in “political economy”
literature strengthened the case against protectionism.
ADDITIONAL CHALLENGES
12
Two New Challenges have arisen
 “Fair” Trade as a precondition for “free” trade. e.g., demands for harmonization of
domestic environmental/labor standards. But diversity of domestic policies,
institutions, & standards is generally compatible with gainful free trade.


Bhagwati notes that ironically “fair trade” instruments such as Anti-dumping and
Countervail duties have been “captured” by special interests & used “unfairly” to gain
protection.
“Trade & wages” – North is now fearful of the South & low wages.

Bhagwati notes that SS theorem & FPE theorem probably don’t hold in the real world
due to factor intensity reversal. Scale economies can also invalidate the SS theorem.
Additional critiques of NTT
 Empirically difficult to model imperfect markets (as amount of information is
often overwhelming). Eaton/Grossman (QJE May ’86) showed that in a duopoly
model where the optimal strategic policy was an export subsidy with quantity
competition, became an export tax with price competition.
 Gains from intervention will be dissipated by entry of rent-seeking firms.
 General equilibrium considerations increase empirical difficulty of formulating
optimal trade policies & so intervention could do more harm than good.
Monop. Comp & Trade
13
Political Economy of Trade Policy
14




If Imperfect competition and increasing returns still
don’t explain why actual trade patterns don’t match
the predictions of HOS, what does explain it?
Another alternative is that trade outcomes are
explained more by policy than basic economics.
If so, what explains the kind of policies country’s
pursue- politics and the political process in place.
So lets look at literature on “Political Economy of Trade
Policy”.
What Does the P.E. Literature on Trade Policy
(not) tell us? (Rodrik)
15
Three questions lie at the core of Political Economy of
Trade Literature
1.
Why is international trade not free?
2.
Why are trade policies biased against trade?
3.
What determines protection levels across
countries/commodities?
Traditional Views of Gov’t Role in
Agriculture
16




Correct for “market failure” or
externalities
Provide “public goods”
Correct for imperfect competition
Equity – income redistribution
Agric. Protectionism
17


Ag. is typically taxed in developing countries &
subsidized in industrial countries (Little et al., 1970;
Johnson, 1973; Bale and Lutz, 1981; Binswanger and
Scandizzo, 1983; Anderson, Hayami, et al., 1986;
Krueger, Schiff and Valdes, 1988; Tyers and Anderson,
1992).
This remains broadly true when the additional negative
effects of manufacturing protection & overvalued
exchange rates are taken into account (Schiff & Valdes,
‘92; Anderson, ‘95).
18
19
Incumbent Advantage
Source: http://www.opensecrets.org
20
21
22
Public Choice Theory
23



Public Choice literature rejects the view of a
benevolent gov’t
Public Choice theory emphasizes self-interest
motives of politicians, voters, pressure groups &
bureaucrats.
Political markets redistribute wealth.
Political Economy Models
24



Political economy models generally take either a
specific-factors or Heckscher-Ohlin setting & modify
it by:
Assuming policy-makers have preferences for
certain groups, or
Assume lobby groups are able to take action to
shape policy-makers’ preferences.
A Political Economy Model of Trade Policy
Must have 4 elements
25
1.
2.
3.
4.
A description of individual preferences over the
domain of policy choices available.
A description of how these preferences are
aggregated & channeled through pressure
groups etc. into political demands.
Characterize policy-makers preferences.
Specify the institutional setting in which policy
takes place.
Direct Majority Voting Models
26





H-O Model: each agent owns 1 labor & some K
Imports are K intensive, so tariff leads to higher r &
lower w
Economy opts for a + tariff if median voter has a
higher ki than the economy as a whole
Model cannot explain how an industry with a small # of
voters can secure protectionism
R-V Model: Voting costs combined with asymmetry
btwn. gains to a small sector & losses to owners in rest
of economy can lead to a tariff with majority voting
Pressure Group Models
27







Producer groups seeking protection typically involve a
small # of agents, with high per capita benefits & lower
per capita costs
Findlay & Wellisz, Fixed Factor Model:
1 fixed factor & 1 mobile, 2 sectors
Mobile factor (labor) lobbies on behalf of fixed factor
Nash equib. determines tariff
Fixed factor gains; mobile may/may not
Low ed for mobile factor leads to less lobbying
Pressure Group Models
28





Young & Magee, H-O model:
Both factors mobile
Each factor lobbies on own behalf
Intensive factor gains, other loses
Low ed for factor leads to more lobbying & more
protection
Modeling Gov’t Behavior
29


Bhagwati categorized Clearinghouse Gov’t (CHG)
versus Social Welfare Function (SWG) models
“The commonly held belief that the government is a
ship of fools might be replaced with the government
as an island covered with pirates” Magee, Brock &
Young, Black Hole Tariffs
Explanation of Agricultural Policy
30

Olson: policy of switching from taxation to subsidization is
caused primarily by the decrease in the free-rider
problem; as # of firms decline, the political organization
of farmers becomes more efficient.

Gardner (’87) found variables associated with the cost of
redistribution & cost of generating political power explain
intervention in U.S. agriculture.
Protection across countries/time
31

Anderson (’93) analyzed asymmetry of agric.
protection in rich vs. poor countries

Main argument is that a tax on agric. in a poor
country results in a relatively small cost for
farmers but a big gain for industrialists;
whereas an agric. subsidy in a rich country
entails big gains for farmers but small costs for
industrialists