Oatley, Chapters 2 and 3

The World Trade Organization and the World Trade System – Chapter 2Growth in world tradeWorld merchandise trade; 1953: $84 billion2007: $14 trillionInternationalization of production and

consumptionThis is based on political structures: the WTO

(and its predecessor, GATT)

WTOWTO – commonly negotiated and enforced

rules to govern world tradeIn 1995 GATT became what is now WTOWTO

is a forum for trade negotiationsadministers trade agreementsprovides mechanisms to resolve trade disputes

WTOAs a political system, WTO can be broken

down into 3 parts:A set of principles and rulesAn intergovernmental bargaining processA dispute settlement mechanism

I. WTO principlesWTO is based on 2 core principles:

Market liberalismNon-discrimination

Market liberalismAssertion: Open/liberal trade system raises

world living standardsThis provides the economic logic for WTOPlease check:

http://news.bbc.co.uk/2/hi/europe/country_profiles/2430089.stm

On Doha Round:http://www.theguardian.com/global-

development/2012/sep/03/doha-round-trade-talks-explainer

Non-discriminationIdentical opportunities to trade:

each WTO member faces identical opportunities to trade with other WTO members. This principle takes two specific forms within the WTO.

Most-Favored Nation (MFN) prohibits governments from using trade policies to provide special advantages to some countries and not to others.

It simply requires each WTO member to treat all WTO members the same way as it treats its favourite trading partner.

Non-discrimination but there are exceptions to MFN, including regional

trade arrangements and customs union… there is another exception: the Generalized System

of Preferences (GSP) enacted in late 1960s. It allows the advanced industrialized countries

to apply lower tariffs to imports from developing countries than they apply to the same goods coming from other advanced industrialized countries.

These exceptions aside, MFN ensures that all countries trade on equal terms.

Non-discriminationNational treatment: is the second form of

nondiscrimination found in the WTO. National treatment prohibits governments from using taxes, regulations and other domestic policies to provide an advantage to domestic firms at the expense of foreign firms.

Article 3 of GATT: National treatment requires governments to treat domestic and foreign versions of the same product similarly once they enter the domestic market.

Non-discriminationBeyond this there are hundreds of rules and

more than 60 agreements since 1947, comprising 30,000 pages of text

II. International bargainingDecision making processNegotiate agreements to liberalize trade

TariffsNon-Tariff Barriers (NTBs)

II. International bargainingNon-Tariff Barriers (NTBs) refer to

restrictions that result from prohibitions, conditions, or specific market requirements that make importation or exportation of products difficult and/or costly.

NTBs arise from different measures taken by governments and authorities that protect the domestic industries from foreign competition.

Examples of NTB: Import bans, general or product-specific quotas, unjustified sanitary conditions, state subsidies, state ownership, “buy national" policy

II. International bargainingRather than bargain continously, governments

organize their negotiations in bargaining rounds each with a start date and a target date for conclusion.

GATT and WTO trade rounds

From the 1980s onwards free trade not only included manufactured products but agriculture and services as well.

For example, the 1995 Agreement on Agriculture advocated universal reductions in trade protection, farm subsidies and government intervention.

II. International bargainingWTO Ministerial Conference (MC) (highest level

of WTO decision making)MC establishes an agenda and target dates for

conclusion of the roundResulting agreement is ratified by WTO membersTo date, 8 rounds have been concludedThe 9th, Doha Round, is the latest round of trade

negotiations among the WTO membership. It is yet to be concluded. Its aim is to achieve major reform of the international trading system through the introduction of lower trade barriers and revised trade rules.

II. International bargainingSee Table 2.1 on page 26 for summary of

trade negotiations and Rounds (notice the expanding range of subjects covered).

Rules provide a framework of law for international trade relations

Rule-based systemMultilateral trade system

III. Dispute Settlement MechanismEnsuring compliance by helping governments

resolve disputesIndependent quasi-judicial tribunal

Investigates facts and the relevant WTO rulesGovernments may be required to alter policy or

compensate other countries

Power and interests in the World Trade SystemDistribution of power in the international systemWorld trade system has shifted between open and

liberal periods to periods in which it is closed and discriminatory

Hegemonic Stability TheoryWTO reflects the interests of those who created itHegemon: country that produces a disproportionately

large share of the world’s total output and leads in the development of new technologies

Hegemon has economic interest in open and liberal international trade system

But, as hegemon declines, it becomes less supportive of liberal trade and the system shifts toward greater protectionism

Hegemonic power and the creation of the postwar trade systemGreat Britain as the hegemonic power in 19th

centuryIndustrial RevolutionTrade flourishedLate 19th century: British hegemony in declineEnd of World War 1, US economy was twice as

large as that of BritainDuring transition, however, international

trade system shifted toward discriminatory and protectionist practices

WWI as low point for liberal tradeUS was not willing (though possibly able) to

promote liberalism1929 Great DepressionUS raised tariffs in 1930Trading blocsImperial Preference SystemOther countries followed suit

In 19th century US was not interested in exporting since it could not compete with British firms in foreign markets

Protectionism as preferred policyBut, US industrialization made trade less

threatening to USExports became more attractiveUS industry became increasingly willing to

accept lower tariffs at home in return for lower tariffs abroad

1934: Reciprocal Trade Agreements Act (RTAA)US negotiated bilateral agreements with

countries to lower tariffs1947: GATT1950s: US moved to strengthen GATTMarshall Plan: import of (critical) American

goods into EuropeAsymmetric trade liberalization: US opened

market to Europeans while Europeans continued to discriminate against American goods

By 1960s Europe was ready for trade liberalization

Hegemonic decline and the world trade system Rise of Japan as an industrial power Rise of Western Europe (European Union and common

market, collectively represented at WTO)

US adopts more aggressive trade policy (bilateralism) The United States has bilateral free trade agreements with

Australia, Bahrain, Canada, Chile, Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, Israel, Jordan, Mexico, Morocco, Nicaragua, Oman, Peru and Singapore

This led to concern that the multilateral trade system was at risk

However, there is also plenty of evidence that multilateral trade flourishes despite apparent US hegemonic decline

Trade rounds continue to be concluded (despite the delay in the Doha round)

WTO was established in 1995, enjoying support of developing countries

How to explain this? Inertia: the US decline is leading to change,

but it is not immediately apparentOR:

Institutions: maybe a hegemon is not required to sustain it!

The Evolving WTO: New Directions, New ChallengesTrends:

Extension of the scope of WTO rulesGrowing difficulty of reaching agreement

within the WTO

Extension of scope of WTO rulesNot just tariffs anymore: early bargaining

rounds focused on tariff reductions, but now average tariff levels is much lower in comparison to 1950s.

Nontariff barriers. WTO rules have begun to regulate areas that traditionally have been the exclusive preserve of national governments.

Nontariff barriersIntellectual property: Governments negotiated

the Agreement on Trade-Related Aspects of Intellectual Property (TRIPs) to protect intellectual property.

Intellectual property: creations of the mind: inventions, literary, and artistic works, symbols, names, images and designs used in commerce.

Nontariff barriersTrade in services: a service is an economic activity

that does not involve manufacturing, farming, or resource extraction.

e.g financial services such as banking and insurance, transportation services such as shipping and tourism, business services such as consulting and accounting etc.

Liberalizing trade in services often requires substantial changes to national policies. The major obstacle to trade in services usually lies in national regulations that prevent foreign service firms from operating in the local market.

Agreement on Trade-Related Aspects of Intellectual Property (TRIPs)

Specifically, TRIPS requires WTO members to provide copyright rights, patents etc.

The key aim is the protection and enforcement of all intellectual property rights.

New rules to govern servicesTrade Related Investment Measures (TRIMs):

limited the ability of governments to regulate certain aspects of MNC activities. (Many governments used regulations to require foreign firms to purchase a certain % of their inputs from domestic producers.

Problems

So, new WTO rules intrude deeply into national policies

Doha Round: Agriculture, subsidies and service sector liberalization

Another problemReaching consensus with so many members is difficultThere were 150 members as of 2007….30 more had

appliedDiverse interests (wealthy, advanced industrialized

countries versus middle-income countries versus developing countries)

Additionally WTO is not popular outside (see the various protest movements mobilizing against the WTO) – problem of legitimacy

Should the decision making mechanism be changed?And shouldn’t civil society be allowed to participate in

the decision-making process?But these are contradictory questions (effectiveness

versus legitimacy) regarding the direction of reform necessary

The Greatest Challenge?: Regional Trade Arrangements and the WTORegional trade arrangement (RTA)

Free trade area (eliminate tariffs on goods, but each member retains independent tariffs on goods entering their market from nonmembers)

Customs union (member governments eliminate all tariffs on goods entering the union from nonmembers)

RTAs are discriminatoryArticle XXIV of the GATT allows for RTAs

(with proviso)But, rapid proliferation of RTAs may threaten

multilateral international trade and WTOBut, do RTAs complement or challenge WTO?

RTAs complement WTO in liberalizing trade, but challenge the WTO through institutionalization of discriminationTrade creation: more trade as a result of RTATrade diversion: more trade between RTA

members at the expense of non-membersCould this all lead to protectionist trade

blocs? Too early to tell where RTAs will take us

The Political Economy of International Trade Cooperation – Chapter 3Why does the WTO exist: interests of the US?Or cooperation between nation states?Cooperation, in turn, requires assurances (trust

and guarantees)Institutions are the usual method to solve this

problemWTOAbstract logic of cooperation:

Trade theory (welfare gains): countries can gain from cooperation with one another.

But governments tend to avoid adopting liberalization (Mercantalist tendencies)

Examine how WTO helps governments cooperate in order to liberalize trade and capture welfare gains

The economic case for tradeWhat are “gains from trade”?Why does trade generate these gains?

(comparative advantage)

The Gains from Trade in Partial EquilibriumTheoretical frameworks:

Partial equilibrium (focus on market for a single commodity – highlights how production and consumption of this commodity change in response to trade)

General equilibrium (focuses on entire economy – change of all goods in response to trade) – concept of comparative advantage (the underlying reason why these gains exist)

The Gains from Trade in Partial EquilibriumFig 3. 1 A. Autarky

D

S

Consumer Surplus

Producer Surplus

Q

P

The Gains from Trade in Partial EquilibriumConsumer surplus: A consumer surplus

occurs when the consumer is willing to pay more for a given product than the current market price.

Producer surplus: the difference between the amount that a producer of a good receives and the minimum amount that he or she would be willing to accept for the good. 

The gains from trade in partial equilibrium Examine what happens when a country shifts from autarky to

trade See figure 3.1 on page 49 ‘Consumer surplus’ increases Horizontal line: quantity Vertical line: price

The Gains from Trade in Partial EquilibriumB. Free Trade

S

Consumer surplus

D

Producer SurpluspW

Q ws

Old price

Q wD

imports

The Gains from Trade in Partial EquilibriumTogether, consumer surplus and producer surplus depict the

amount and the distribution of social welfare generated in the market

We assume here that domestic producers and consumers of shirts are ‘world price takers’ – figure 3.1

At the world price, domestic consumers buy more shirts than domestic producers supply

As a result, trade changes the equilibrium shirt production and consumption: domestic shirt production falls, domestic shirt consumption rises, and imports fill the difference between

The Gains from Trade in Partial EquilibriumAggregate social welfare is higher under this

new equilibriumThe improvement in aggregate welfare is the

gain from tradeTrade has made consumers better offBut trade has made producers worse offGains from trade arise because the amount

by which consumers gain is greater than the amount that producers lose

The Gains from Trade in Partial EquilibriumConsumers have more money in their pockets

with trade than withoutAnd producers can be compensated for their

losses through the gains. This is what is meant by the claim that trade

raises social welfare

The Gains from Trade in Partial Equilibrium

We can also calculate the losses from protectionism, known as efficiency losses caused by tariffsConsumption distortion (consumers buy too

few shirts compared with world price of shirts)

Production distortion loss (producers produce too many shirts)

The Gains from Trade in Partial EquilibriumVoluntary Export Restraints: a protectionist

measure in which exporting countries agree to restrict their shipments of a particular product to a country to deter it from imposing even more onerous import quota.

VERs provide quota rents to foreign producers. Quota rents are above-market returns created by the quota. Rents arise because quotas restrict the number of foreign goods that can be sold in the domestic market below the level that domestic consumers want to buy.

The Gains from Trade in Partial EquilibriumWith supply held below demand, foreign producers

can charge a higher price for each good they sell. E.g during the 80s-Americans wanted to buy 4 million

Japanese cars.VER US negotiated with Japan allowed Japan to

export only 2.3 million cars at the market price.Japanese cars will be sold at a higher price with VER.Quota rent is the difference between the high price

Japanese auto producers received for each car with the VER and lower price without the VER.

The Gains from trade in General EquilibriumThe partial equilibrium framework helps us

understand the gains from trade, but it doesn’t help us understand why these gains exist or why these gains must exist for every country.

Nor does it help us think about the broader economic consequences of international trade.

To grasp these issues we need to examine a general equilibrium model of trade.

The Gains from trade in General EquilibriumExamines how trade alters equilibrium

production and consumption in the economy as a whole.

The standard general equilibrium model of trade is called the 2x2x2 model, as it is based on 2 countries, each of which produces 2 goods using 2 factors of production.

The Gains from trade in General EquilibriumBut first we need to establish a few core concepts:Production possibility frontier (PPF) – factors are

finite, so resource allocation decisions must be made.

Any decision to use factors to produce one good means that these factors are not available to produce other goods.

A decision to allocate capital and labor to the production of computers necessarily requires the country to forgo the production of some number of shirts.

The Gains from trade in General EquilibriumThese forgone shirts are what economists call

opportunity costs and the production possibility frontier allows us to measure these opportunity costs quite precisely.

Let us consider an illustrative production possibility frontier for the United States.

Let’s assume that the US has a fixed stock of labor and capital that it can use in combination to produce two goods: shirts and computers.

Shirts millions

Computers millions

A

B

100 m

300 m

Consumption İndifference curve

E

The Gains from trade in General EquilibriumWhat does point A tell us?If the US allocates all of its labor and capital

to computer production, it could produce 100 million computers.

What does point B tell us?If it allocates all labor and capital to shirts, it

can produce 300 million shirts.If we connect A and B with a line, we have

defined a Production Possibility Frontier for the US.

The Gains from trade in General Equilibrium

The slope of the line, called the marginal rate of transformation tells us how many shirts that country forgoes for each computer it produces.

In this example, every computer the United States produces costs three shirts.

Because an autarkic country cannot consume more than it produces, the PPF also defines the limits of possible consumption.

The Gains from trade in General EquilibriumSecond core concept, consumption

indifference curves, helps us to understand what specific combination of computers and shirts American consumers will purchase.

Key assumption: consumers prefer more to less and therefore consumer utility increases as we move away from the origin.

If we connect every combination of shirts and computers that provides our consumer with the same amount of utility with a curved line, we draw an indifference curve.

The Gains from trade in General Equilibrium

Three additional characteristics of indifference curves are important:

Indifference curves typically slope downwards. This slope, called the marginal rate of substitution tells us how much of one good the consumer is willing to give up to acquire an additional unit of the second good.

The Gains from trade in General EquilibriumIndifference curves typically bend towards

the origin. This reflects the assumption of diminishing marginal utility. (first computer provides a large improvement in utility. Each successive computer provides a smaller increase of utility).

When we focus on production and consumption for an entire country, we construct community indifference curves rather than individual indifference curves.

The Gains from trade in General EquilibriumProduction and consumption will occur

where the Production Possibility Frontier and the indifference curve are tangent.

Point e on Figure 3.2Under autarky, equilibrium production and

consumption in the US equals 60 million computers and 120 million shirts

The Gains from trade in General EquilibriumTo appreciate how trade affects the

equlibrium we need another countryChina (figure 3.3)Possibility frontierMarginal rate of transformation is 20Point of tangencyEquilibrium: 13 million computers and 140

million shirts under autarky

The Gains from trade in General EquilibriumHow trade affects equilibrium production and

consumption in both countries (see Figure 3.4)SpecializationUS: computersChina: shirtsUS acquires more shirts per computer when it

buys them from China than when it produces them at home

A computer buys 20 shirts in China whereas at home a computer buys only 3 shirts

The Gains from trade in General EquilibriumHow does trade effects equilibrium

consumption in both countries?We need to know the price at which the US

and China will exchange shirts for computers.The price need to fall between 3 and 20

shirts per computer.Let’s assume that the two agree to trade at 6

shirts per computer

The Gains from trade in General EquilibriumEquilibrium consumption in both countries has

expanded beyond what was possible under autarky.

American consumption expands from 60 million computers and 120 million shirts under autarky to 75 million computers and 150 million shirts.

Chinese consumption expands from 13 million computers and 140 million shirts under autarky to 25 million computers and 250 million shirts.

The Gains from trade in General EquilibriumThis model shows how every country

gains by specializing in goods it produces relatively well and trading them for the goods it produces relatively less well.

The Gains from trade in General EquilibriumWhat determines which goods a particular

country will produce relatively well and which it will produce relatively less well?

The Hecksher-Ohlin (H-O) modelArgues that comparative advantage arises from

differences in countries’ factor endowments.Labor: workersCapital: the entire pysical plant that is used in

production, including the buildings that house factories and the machines on the assembly lines inside these factories.

The Gains from trade in General Equilibrium

A country’s abundant factor will be cheaper to emply than its scarce factor.

US- abundant factor: capitalUS has a comparative advantage in

computersChina-abundant factor: laborChina has a comparative advantage in t-shirts

The politics of trade cooperationWhereas the trade theory introduced suggests

the logic of unilateral trade liberalization, governments adopt the opposite logic

Analyze the domestic politics of trade policyInterests of domestic firms are heavily

represented in domestic trade politics, but the interests of consumers are often overlooked

As a result, governments care little about consumer gains and care a lot about trade’s impact on domestic industries

Not all domestic industries gain from trade liberalization

Trade liberalization becomes possible only through international agreements that provide reciprocal tariff reductions

But, additionally there is an ‘enforcement problem’: governments cannot be certain that other governments will comply with the trade agreements that they conclude. As a result, gvts will be reluctant to enter into trade agreements, even when they recognize that they would benefit from doing so.

Consider Prisoner’s Dilemma (China: PL>LL> PP>LP)

United StatesChina Liberalize Protect

Liberalize LL LP

Protect PL PP

Considering this we note that China’s most preferred outcome is unreciprocated access to the US market; it’s second best outcome is reciprocal tariff reductions

Prisoner’s Dilemma is a symmetric game: payoff order for US is the same

So, ‘protect’ is a dominant strategyThat is, protect yields more utility for China

than liberalize regardless of the US strategyAnd protect is the US’ dominant strategy, too.

Problem: international system does not provide effective enforcement mechanisms (anarchic)

The WTO and Trade CooperationWTO helps iterate the game by creating expectations

of repeated interactionWTO provides information that governments need to

in order to use reciprocity strategiesTransparency means that it is easier for

governments to determine whether a specific trade measure adopted by a particular government is or is not consistent with WTO rules

WTO’s dispute settlement mechanism helps governments use the WTO to enforce trade agreements

See Figure 3.6 on page 67 (outline of standard procedure)

Dispute Settlement Body (DSB) creates a formal panel to investigate complaint

Three expertsFinal reportAppeal of panel’s decisionDSB creates appellate body composed of three to five

people drawn from a list of 7 permanent membersReportGovernment policy may need to be amended or

compensation may be requiredProcess should take less than 15 months to completeE.g. EU’s banana import regime and the WTOThis case demonstrates that WTO helps governments gain

the assurances they need in order to conclude trade agreements required to capture the gains from trade