theory and policy module

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W T O l e a r n i n g m o d u l e s

The WTO:Economic Underpinnings

Roberta PiermartiniEconomic Research and Statistics DivisionWTO

(Version 1 st March 2007)

Copyright WTO 2005-2006

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Slide 2

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Outline

I. Gains from trade

II. Income distribution effects of tradeliberalization

III. Trade policy and development

IV. Need for a multilateral commitment

The aim of this multimedia presentation is to provide a theoretical background for understanding the effects of trade liberalization and those of protection. We will try tounderstand also why countries pursue polices of trade liberalization within the context of theWTO, that is why countries negotiate with each other and commit to bound tariffs, for example, rather than liberalizing unilaterally. The presentation is divided into four parts. Inthe first part I will be providing some insights on what are the most important results of theoretical literature on international economics on the effects of trade liberalization.

I. Gains from TradeIn particular, initially I will be looking at gains from trade in different setups, ranging fromsituations where countries trade because they are different in their level of technology, tosituations where they are different because of their different endowment factors differentendowments in capital, labour or land. And finally, to situations where countries trade evenwhen they are similar.

II. Income distribution EffectsIn all these cases, I will explain that there are gains from trade, but that trade may, at the sametime, have income distribution effects. So that, within each country, there will be somegroups that make gains and some other groups that may lose. Trade liberalization also entailsadjustment costs. We will explain what does this mean and we will look at what governmentscan do to minimize these adjustment costs.

III. Trade policy and developmentIn the third part, we will look at the evidence on the importance of trade liberalization for development.

IV. Need of a multilateral commitmentIn the last part, we will explain the rationale behind engaging in multilateral negotiations andcommit trade liberalization to international agreement.

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Slide 4

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Where do gains from trade comefrom?

A. Gains from better utilization of resources .. FROM SPECIALIZATION according to comparative advantages .. FROM EXPLOITATION OF ECONOMIES OF SCALE

B. ...access to a broader variety of goods andservices

C. .... faster innovation and technologytransfer

Where do these gains come from?

A. Gains from better utilization of resourcesEconomic theory suggests that gains from trade can come from better utilization of resources.

... from specializationWhat does trade do? Trade allows countries to specialize in the production of the goods thatthey can produce relatively MORE efficiently and import the goods that they producerelatively LESS efficiently. The exchange of these goods benefits both countries.

... from exploitation of economies of scaleGains from better utilization of resources may also come from the fact that trade allows firmsto produce on a larger scale. When barriers to trade are eliminated, firms will face thedemand of a larger market. Therefore, firms will be able to choose to produce at a moreefficient level of production, and save costs. These lower costs will benefit the country as awhole.

B. ... access to a broader variety of goods and servicesBut gains from trade may also arise from the access to a broader variety of goods andservices. Consumers love variety. Since trade allows access to the varieties of goodsproduced abroad, consumers in each country will have available a larger variety of goods toconsume: This is because they will have available not only the varieties of goods produced intheir own country, but also those produced abroad.

C. ... faster innovation and technology transferFinally there might be gains from trade also because of the impact that the opening up to tradehas on the incentive to innovate and on technology transfer. On the one had, the larger sizeof the market and competition from abroad increase the incentive of a firm to invest inresearch and development. On the other hand, trade, by giving access to the productsproduced in another country, may be a channel of the technology transfer.

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Slide 5

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A. Gains from specialization

comparative advantage

opportunity cost

The opportunity cost differs across countries because of different technologies

Theory of Comparative Advantage: When two economiesspecialize in producing the goods in which they have acomparative advantage, both economies gain from trade, evenif one country has an absolute advantage in both goods.

Let's now turn to the analysis of the gains from specialization in a little bit more detail.Everybody probably understands that if a country, which is very efficient in producingcomputers, trades with another country which is very efficient in producing roses, then it isprobably to their benefit that the country more efficient in computers produces and exportscomputers, while the other country produces and export roses.But, what about a country that is more efficient in producing both computers and roses trading with a country that is less efficient in the production of both? Is trade still beneficial? the important result from the theory is that there are GAINS from trade and that BOTH

countries gain from trade. These gains will arise from each country specializing in theproduction of the good for which they have a comparative advantage.

Comparative advantage (CA)What does comparative advantage mean? Economists say that a country has a comparativeadvantage in producing a certain good, if the opportunity costs of producing that good interms of other goods, is lower in that country than it is in the other country. Note that whiledefining comparative advantage, we have introduced a new term: "opportunity cost".

Opportunity costWhat is the opportunity cost? The opportunity cost of a certain good, let's say roses, interms of another good, let's say computers, is the number of roses that could have beenproduced with the resources used to produce a given number of computers. Opportunity costsdiffer across countries because of differences in technologies.

Theory of comparative advantageThe theory of comparative advantage states that when two countries specialize in producingthe good in which they have a comparative advantage, both economies gain from trade, evenif one country has an absolute advantage in both goods. In particular, each country willexport the good for which they have a comparative advantage.

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Slide 6

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One workers output:

1,0008 millionCountry B

2005 millionCountry A

ComputersRoses

1. Specialization from technologicaldifferences: the Ricardian Model

The best way to understand the idea of comparative advantage is through a specific example a model that demonstrates this. A model of comparative advantage that relies on differencesof labour productivity was first introduced in the early nineteenth century by an economistnamed David Ricardo, and therefore it is also referred to as the Ricardian Model. In itssimplest form the Ricardian Model can be shown with the following example: Suppose thatthere are only two countries in the world, Country A and Country B and two sectors rosesand computers. A worker employed in the roses sector would produce five million roses inCountry A, and eight million roses in Country B. Another worker employed in the computer

sector would produce 200 computers in Country A and one thousand computers in Country B.In other words, whatever the sector, one worker would produce more units of each good whenemployed in Country B. In this case, Country B has an absolute advantage in the productionof both goods.What about comparative advantages? let's look at the opportunity costs for each country interms of roses, of giving up the production of a thousand computers. For Country B theopportunity costs, in terms of roses, of producing one thousand computers less, is eightmillion roses. What about Country A? If Country A had to produce one thousand computers,it would have to employ five people in the computer sector, because each employee producesonly two hundred computers in Country A. In terms of roses, this would imply a cost of 25million roses.To sum up, while in Country B the opportunity costs of one thousand computers is eightmillion roses, in Country A the opportunity costs of one thousand computers is 25 millionroses. Since the opportunity costs, in terms of roses, of producing computers are lower inCountry B, Country B has a comparative advantage in computers, while Country A has acomparative advantage in roses. The theory of comparative advantage tells us that if CountryA and B open up to trade, then Country A will specialize in the production of roses andCountry B will specialize in the production of computers.

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Slide 7

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Changes in output from specialization:

Specialization increases global production of both goods.All countries can gain from trade.

+ 600+ 2 millionTotal

+1,000- 8 millionCountry B

- 400+ 10 millionCountry A

ComputersRoses

... the Ricardian Model

What will be the effect of specialization? Suppose now that in Country A two workers aremoved from the production of computers to the production of roses. This implies thatCountry A would produce four hundred computers less, and will produce ten million rosesmore. Suppose also that at the same time, Country B will move one worker from theproduction of roses to the production of computers, therefore Country B would produce eightmillion roses less and one thousand computers more. Overall the global production of roseswill increase by two million units. This is because there will be an increase of ten millionroses in Country A and a reduction of eight million in Country B.

In the computer sector there would be six hundred computers more produced globally. Onethousand computer more produced by Country B and four hundred computers less producedby Country A. Since specialization increases the global production of both goods, allcountries can gain from trade. Trade makes available to each country a higher quantity of each of the goods.

Obviously the Ricardian Model is a very simple simplified model to explain all facts of liberalization of trade. However, it provides two very powerful insights. One is that labour productivity differences are very important in explaining patterns in trade and the other one isthat it is comparative advantage and not absolute advantage that is important for trade. In theRicardian Model there is only one factor of production: labour. Therefore, comparativeadvantages only arise because of differences in labour productivity, which result fromdifferences in technology.

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Slide 8

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2. Specialization from differences in

endowments: Factor ProportionTheory (the Heckscher-Ohlin Model)

comparative advantage depends on countries r elativeendowment of production factors (eg. capital, labour, land)

In a close economy, the good that uses more intensivelythe relative abundant factor will be relatively cheaper

With trade:

the prices of the traded goods will be the same acrosscountries

The labour intensive country will export t he labour intensive good

In reality, in the real world, trade is not just determined by technological differences, but italso reflects differences in resources endowments across countries. Therefore, for example,Canada exports forestry products to the United States not because its workers are moreefficient in forestry, but because Canada is more endowed with forests. To explain theimportance of resources in trade two economists, Heckscher and Ohlin, have developed atheory where trade is determined by the interaction between the relative abundance of factorsof production (such as capital, labour or land) and the relative intensity with which thesefactors of production are used in the production of different goods. Since in this theory,

comparative advantages are determined by the proportion of factors endowments and theproportion in which these factors are used in the production of goods, the theory is known asthe "factor proportion theory".

Comparative advantage depends on countries relative endowment of factors of production

According to the factor proportion theory, the country which is relatively abundant in labour will have a comparative advantage in the production of relatively labour intensive goods. Thenation which is relatively capital abundant will have a comparative advantage in theproduction of the relatively capital intensive goods. In particular, for example, Country A hasa comparative advantage in a capital intensive good relative to Country B, if its capital labour ratio is greater than in Country B.

In a closed economy, the good that uses more intensively the relatively abundantfactor will be cheaper

If a country is capital abundant, then the cost of capital will tend to be relatively low. As aconsequence, the cost of production of the capital intensive product, and its price, will tend tobe relatively low. The opposite will occur in a labour abundant country wages will tend tobe relatively low and the cost of the labour intensive products will be relatively low.Differences in relative prices of the two goods will lead to trade.

With trade:o The prices of the traded goods will be the same across countries

When countries start to trade, the prices of the two goods, the labour intensive good ( say, theagricultural) and the capital intensive good ( say, the manufacturing goods) will tend to be the

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same in the two countries. Therefore, for example, the price of the labour intensive good inthe labour intensive country will tend to rise relative to the price of the capital intensive good.

o The labour intensive country will export the labour intensive goodBoth countries will produce more of the good , they have a comparative advantage for. They

will tend to specialize. The capital abundant country will tend to specialize in the productionof the capital intensive goods and export this product, while the labour abundant country willtend to specialize in the labour intensive good and export that product. Like in the case of theRicardian Model, also in the H-O model, it is possible that the global production of bothgoods may increase with trade. It is therefore possible for both trading economies to consumemore of both goods than in the absence of trade and therefore both countries gain from trade.

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Slide 9

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Trade affects incomeredistribution

Important insight from the theory:Even though each country gains overall, thereare gainers and losers within each country

Who gains and who loses?Stolper-Samuelson Theorem: Factors usedintensively in the exporting sector will gain, thoseemployed in the import-competing sector will lose

There are winners and losers in each countryThere is, however, a very important difference between the results of the Ricardian Model andthe results of Heckscher-Ohlin Model. In the Ricardian Model, labour is the only factor of production in the model, it is assumed that labour within each country can move freelywithout costs from one sector to another one. To the single individual, it does not make adifference whether he is employed in one sector or another one. This implies that a simpleRicardian model not only predicts that ALL countries gain from trade, but also within eachcountry EVERY INDIVIDUAL is better off as a result of international trade.

In the factor proportion theory, industries differ in the mix of the production factors theyrequire. In the simplest case, there are two production factors: capital and labour and twosectors one capital intensive and the other one labour intensive. The specialization in one of these two sectors, say the specialization in the production of the capital intensive good,increases the demand for one factor (capital in our example) while lowering demand for theother factor of production (labour). In the H-O model, it is not necessarily true that eachindividual in each country will gain from trade liberalization. Trade generates income re-distribution effects, so that there will be groups who will gain and groups who will lose.

Who gains and who loses? The Stolper-Samuelson TheoremWho will gain and who will lose? The Stolper-Samuelson Theorem helps us to identifywinners and losers. Two economists, Stolper and Samuelson, showed that free trade raisesthe earnings of the country's relatively abundant factor and lowers the earnings of therelatively scarce factor. Let's consider the example of a capital abundant country: what willhappen in this country after liberalization? In the capital abundant country, trade induces areallocation of resources towards the capital intensive goods therefore more capital will bedemanded and this will increase the domestic price of capital. Owners of the capital willtherefore gain more because returns to capital increase. What will happen to the demand of labour in this country? This is the relatively scarce factor, where the country hasn't got acomparative advantage. The demand for labour will go down and wages will go down. Tosum up, in the capital abundant country, owners of capital will gain and owners of labour willlose.

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A consequence of these redistributive effects is likely to be that: owners of the relativelyabundant factor will support trade, while owners of the relatively scarce factor will opposefree trade.

In practice, there are costs to move from one sector to another one. Therefore, it is likely that

resources employed in the import-competing sector suffer the consequences of a restrictionshrinking of that sector. This explains why in industrialized countries at the moment where alabour intensive sector, like the textiles sector, is liberalized both capital owners and workersin that sector oppose free trade. The important result of the theory to bear in mind, though, isthat despite income distribution effects, the country overall gains that is gains outweighlosses. Costs of adjustment will be discussed in more detail later.

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Slide 10

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A. Trade between similar countries

Similar countries trade similar goods:Intra-industry trade

Intra-industry trade relies on economiesof scale (that is, average costsdecrease with the scale of production)

Similar countries trade similar goods: Intra-industry tradeAn important point to bear in mind is that the Ricardian Model and the Heckscher-OhlinModel explain trade between different countries and different goods. In both modelscountries trade because they are different they are either different in terms of their technological level or in terms of factor endowments. Countries specialize in the productionof the good for which they have a comparative advantage and export that product. However,in reality most of the trade occurs between similar countries. And, between one quarter andone half of world trade is intra-industry trade. That is trade between goods that fall in the

same industrial classification. This is particularly true, if one considers trade amongdeveloped countries and in particular trade in manufacturing. In that case, intra-industry tradeis most of the trade occurring. The Heckscher-Ohlin and the Ricardian Model do not explainintra-industry trade.

Intra-industry trade relies on economies of scaleIn order to explain intra-industry trade, we need to introduce economies of scale. In manyindustries, the larger the scale of production, the more efficient the production. Theseindustries are characterized by increasing returns to scale, or economies of scale. This impliesthat by doubling the input, like, for example, doubling the number of workers in theproduction of a certain good, the output is more than doubled. Consider, for example, acompany that produces bicycles. And, suppose that the production of bicycles ischaracterized by economies of scale. This implies, for example, that if 10 workers, say,produce in a day five bicycles, then twenty workers will produce fifteen bicycles in the sametime period. This is more than twice as much as 10 workers can produce.

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Slide 11

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A. Gains from economies of scale

151501055Bicycles

25025201010Video-cameras

WorldBAWorldBA

With TradeWithout Trade

Now suppose, there are two countries: Country A and Country B, and two goods: videocameras and bicycles, for example. Suppose that both the production of video cameras andthe production of bicycles are subject to economies of scale, so that doubling the number of workers employed in each sector, more than doubles the output of the sector. Suppose alsothat the two countries are identical, that is they have the same technologies and sameendowment of resources. Assume also that labour is the only endowment. Initially CountryA employs 10 workers in the video camera sector, and produces 10 video cameras, andemploys 10 workers in the production of bicycles and produces 5 bicycles. Assume that the

situation is identical in Country B so that overall the world will produce 20 video camerasand 10 bicycles. Suppose now that all production of video cameras gets concentrated inCountry A, while that of bicycles concentrates in Country B. Then, Country A will employ20 workers in the production of video cameras and Country B will employ 20 workers in theproduction of bicycles. Because of economies of scales, the use of twice as many workers asbefore in the production of video cameras will more that double the output of video camerasproduced in Country A. Suppose, for example, that the production of video cameras inCountry A increases to 25. Similarly, suppose that in Country B, the production of bicycleswill rise to 15, say. Of course, given that all workers have been moved to the other sector, nobicycles will be produced in Country A, and no video cameras will be produced in Country B.

What happens to world production? Overall the world will gain. There will be 25 videocameras available and 15 bicycles available. Therefore, the potential exists for both countriesto be better off with trade than without trade.

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Slide 12

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B. Gains from access to greater variety of goods and services

Countries produce different varieties of the samegood. Consumers love variety intra-industry trade

Trade liberalization effects may reduce thenumber of varieties produced by each country,but consumers gain access to an overallgreater variety of goods

No or minimal income distribution effects

Countries produce different varieties of the same good. Consumers love variety,which leads to intra-industry trade

It is possible to generalize this example and assume that each industry is characterized by avariety of goods. For instance, bicycles can be differentiated according to their style, colour,comfortableness of their seats, and so on. Similarly, one can differentiate video cameras interms of their qualities, their memory power and so on.

Trade liberalization may reduce the number of varieties produced by eachcountry, but consumers gain access to a greater variety of goods overall

In these circumstances trade allows each country to specialize in the production of a smaller range of goods than it would produce in the absence of trade. However, overall theconsumers in each country will have available a wider choice of goods. This is because trademakes available to the consumer in each country, not only the varieties of the goods produceddomestically, but also the varieties of goods produced in the other countries. Gains from tradein this case will arise from the access to a greater variety of goods and services producedworldwide. Countries will trade different varieties of the same good, thus leading to intra-industry trade.

No income distribution effectsAn important result of the intra-industry trade theory is that intra-industry trade gives raise tovery small income distribution effects. To the extent that trade is of an intra-industry type,trade will not create social problems of income distribution.

Since intra-industry trade occurs mainly between similar countries, it follows that from asocial point of view, it is easier to liberalize trade among similar countries than amongdifferent countries. This is because trade between different countries is mainly driven bycomparative advantage and generates income distribution effects, thus hurting some groups.These groups may lobby against trade liberalization.

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Slide 13

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C. Gains from faster innovationand technology transfer

Trade enhances the incentive toinnovate through: Competition effect (competitive threat) Scale effect

Trade favours technology transfer through various channels: Reverse engineering Personal contacts Enhanced FDI

So far we have been looking at static gains from trade. There are also, however, dynamicgains from trade.

Trade enhances the incentive to innovate through:o Competitive effect

First of all, trade enhances the incentive to innovate. Innovation is the basis of economicgrowth. Therefore, through fostering innovation, trade may have positive effects on growth.Where does the incentive to innovate come from? The incentive to innovate is determined

by what in economics is called "competitive threat". That is, the difference between theprofits that a firm would make if it innovates and the profits that it would make if another firminnovates first. Trade increases competition between countries, therefore it increases thelosses a firm would face, if it fails to innovate, while a competitive firms does it. This, in turn,increases the competitive threat and the incentive to innovate.

o Scale effectThe second source of incentive to innovate is the scale effect. Trade, by enlarging the size of the market, increases the profits of a firm, if it innovates, thus increasing the incentive toinnovate and invest in research and development.

Trade favours technology transfer through various channels:A higher level of technology and productivity can also be due to the transfer of technologycoming from abroad. Trade is one of the channels through which technology can betransferred across countries.

o Reverse engineeringA simple example is reverse engineering. Trade makes available goods to a country. Themere fact of looking at a good, at its design, at its technology, allows competitors to capture inpart the knowledge embodied in the good. To the extent that this knowledge is transferred tothe importing country, the technology is transferred.

o Personal contactsTechnology is also transferred through personal contacts between importers and exporters.

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o Enhanced foreign direct investment (FDI)Or, technology can potentially be transferred through FDI. Trade also favours the inflow of foreign investments into the domestic country. The presence of a foreign company,technologically more advanced, may not only provide an incentive to existing domesticcompanies to update their technologies to remain competitive, but may also directly

contribute to the transfer of technology through the training provided to local employees, or the quality standards required from local firms that supply inputs to the production process of the foreign firm or distribute its output. All this may trigger growth.

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Slide 14

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Adjustment costs

Reallocation of resources induces costs

Costs depend on: Functioning of credit market Functioning of the labour market Quality of infrastructures and utilities Quality of domestic institutions Credibility of the reforms

We have so far talked about gains from trade, but gains do not come without a cost. We havehighlighted that gains from trade are the consequence of a reallocation of resources towardsthe relatively most efficient sectors. Specialization is the most important source of gains fromtrade. There are costs associated with this reallocation. These costs, generally referred to as"adjustment costs", are the costs incurred by displaced workers, those, for example, in theimport-competing sector, that have to look for another job. Adjustment costs are also thecosts of a firm that needs to invest in order to adjust to the new market conditions.

Although these costs are unavoidable, as they are a direct consequence of the reallocationeffect of trade liberalization, the size of these costs depends on a number of characteristics of the domestic market.

Costs depend on:o Functioning of credit market

The functioning of the credit markets and that of the labour market, for example, haveimportant implications for the size of the adjustment costs. Clearly, if the credit marketsworks properly, displaced workers will find less difficulties in funding their periods of lowincome, or zero income. At the same time, firms would find more easily money for newinvestments.

o Functioning of the labour marketSimilarly, the functioning of the labour market will determine the duration of unemploymentfor a worker who is moving to a different sector and looking for another job the moreefficient the labour market the more efficient will be the supply of information aboutvacancies, and more easily wages will adapt to the labour markets' conditions and more easilymarkets will tend to full employment.

o Quality of infrastructures and utilitiesThe quality of infrastructure and utilities is extremely important in some of the sectors wherefor example the cost of telecommunications has an important role.

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o Credibility of the reform and quality of institutionsImportant, is also the credibility of the firms and the quality of institutions: the more crediblethe reforms are, the more likely is that the market will react and respond quickly to thevariations and a new equilibrium is reached faster.

Since for developing countries credit markets, labour markets, quality of infrastructure areworse than for developed countries, the size of the adjustment costs may be more relevant for developing countries than developed countries. It is on the grounds of these higher adjustment costs that developing countries benefit from longer implementation periods in thearrangements for multilateral liberalization.

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Slide 15

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The role of national governments

Implement policies to minimize the size of the costs

Facilitating the adjustment process Defining an appropriate pace for the reforms Underpinning trade reforms by international commitments to

increase credibility of the reforms Use export promotion schemes

Implement policies to compensate those who lose

Supplying social safety nets (buffer during the transitionperiod)

Appropriate redistributive tax system (for long-term losses)

In general there are a number of policies the national government can put in place in order tominimize the size of these adjustment costs.

Implement policies to minimize the size of the costsFirst of all, they can introduce policies to FACILITATE the adjustment. For example, they

could supply information on the availability of jobs and allow more flexible wage settingregimes, or can provide credit guarantees during the adjustment phase. In addition, they candefine an appropriate pace for the reform, they can underpin trade reforms by international

commitments to increase the credibility of the reforms.

o Use export promotion schemesGovernments can also use export promotion schemes. The use of active export promotion bygovernments can be economically justified because of market failures. The adjustmentprocess, in general, involves moving workers and capital from the shrinking import sector tothe expanding export sector. The expansion of a new export activity, however, may requireinvestments and investors may run into risks that are unknown or difficult to measure. If financial markets are not sufficiently developed or if they are inefficient, it may prove to bedifficult for the exporter to get a loan, or hedge for these risks. Under these circumstances,the inefficiency of the credit market would be an obstacle to the expansion of the exportingsector, and an obstacle to the process of adjustment. Therefore, there is a rationale for thegovernment to put in place export promotion policies to facilitate the adjustment process.

Implement policies to compensate those who loseo Supplying social safety nets

The second set of policies that the government could put in place to favour theadjustments process and, in so doing, lower the adjustment costs, is compensation policies for those groups that lose out as a consequence of liberalization. For example, the governmentscould identify those individuals or those groups that face adjustment costs and, for example,supply social safety nets during the transition period to alleviate their suffering.

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Appropriate redistributive tax system

For long term losses, national governments can develop an appropriate redistributive taxsystem that compensates individuals for their losses.

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Slide 16

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Trade liberalization anddevelopment

Link between trade liberalization and level of income

Protectionist policies have been used as wellto favour development

So far, we have been looking at why countries trade, what determines the patterns of trade,and what are the gains and the costs associated with trade liberalization. These are certainlyinteresting questions, but what is more interesting to understand is what should a trade policyof a country be, in order to foster development.

Link between trade liberalization and level of incomeDevelopment is a complex concept it is a process in which people through their work investing and trading with other countries are able to secure their basic needs education,

health, comfortable living standards and freedom. In order to obtain all this, people needadequate economic forces. Therefore an adequate level of income is a basis for all this. Nowwe have seen that trade liberalization can help countries to better utilize their resourcesthrough specialization and through the exploitation of economies of scale. Trade also fostersthe incentive for innovation and the diffusion of technologies. It is a more efficient use of resources that provides the potential for a higher level of income and therefore a higher levelof development.

There is a generally positive relationship between openness and income and the generalpicture is that open and export oriented countries have succeeded in their development efforts,while heavily protected and inward-looking countries have not.

Protectionists policies have been used as well to favour development

However, often a number of protectionist policies have been used as well to favour development. We will now turn to the analysis of how protectionist policies work what arethe instruments for protection what are their effects and what is the rationale behindprotectionist policies. Moreover we will discuss some of the evidence of the results of thesepolicies.

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Slide 17

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What are theinstruments of trade policy?

Tariffs

Quotas

Export subsidies

Any other policy-induced trade cost(standards, customs clearance, etc.)

TariffsWhat are the instruments of trade policy? The most well known one is clearly the tariffs.Tariffs can be specific tariffs or ad valorem tariffs. A specific tariff is a charge a fixedcharge for each unit of the imported good. While an ad valorem tariff is a percentage tax onthe value of the imported good.

QuotasThe best known form of non-tariff barrier is a quota. This is the maximum quantity of some

good that may be imported.

Export subsidiesExport subsidies also represent an instrument of trade policy, as governments by providingsupport to the export activity distort trade.

Any other policy-induced trade costIn general, any policy-induced trade cost represents a barrier to trade. For example, non-tariff barriers may be a particular type of standard that increases relative costs of production for foreigner producers. Or, particularly time consuming customs clearance procedures thatincrease overall transport costs. High transport costs due to anti-competitive behaviours or the low quality of infrastructure may also be thought of as barriers to trade.

In all these cases the analysis of the impact of trade barriers are quite similar. For simplicity,in the rest of the analysis we will look at the impact of import tariffs. But, please bear in mindthat the same comments are applicable to all other forms of barriers to trade.

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Slide 18

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What is the impact of an importtariff?

Case of a large countryWorld price fall TOT gainsTariff revenue for the governmentConsumer loseProducers gainGains? Ambiguous

Case of a small countryWorld price fix NO TOTgainsTariff revenue for thegovernmentConsumer loseProducers gainNet loss

Tariff domestic price of the imported good increasesdemand for imports fall

Let's focus for simplicity on the impact of an import tariff on a certain economy, and let'sconsider initially the case of a small country, where by small country we mean the case of acountry that cannot affect the world price of the imported good.

Case of a small countrySuppose initially that there are no tariffs. Then, consumers in this country pay the world priceto consume. Suppose that the government decides to levy a tariff on the imports of rice, for example. The imposition of a tariff will, first of all, increase the domestic price of the

imported good. People who want to consume rice will now have to pay the world price plusthe tariff. Domestic consumers of rice will, therefore, be worse off, as they will have to paymore, if they want to consume the same quantity of rice as before.

On the other hand domestic producers of rice will gain, because they will be able to sell rice ata higher price. And the government will also gain, as it will be able to collect tariff revenue.

Overall, in the case of a small country, international trade theory shows that the country as awhole will lose and national welfare will be reduced by the imposition of a tariff.

Case of a large countryDifferent is the case of a large country. Notice that here, by large country we do not mean acountry that is large in terms of its geographical size, but rather a country whose importdemand for a certain good is so large that it can affect the world price of the imported good.

What happens if a large country imposes a tariff on the import of a good, let's say rice? Likein the case of a small country, first of all, the domestic price for rice will increase. This willreduce the demand for imports of rice. But, now, in the case of a large country, the lower demand for imports will lead to a reduction in the world price of rice.

In other words, by imposing a tariff on an imported good, a large country is able to affect theprice of the good to its own advantage! Economists refer to this gain as "terms of trade gain"(TOT gain). This gain stems precisely from the ability of the country to affect the world priceof the imported good. It is because of the possibility of terms-of-trade gain that in the case of

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a large country the impact of the imposition of a tariff on the national welfare of the country isAMBIGUOUS, that is it can be either positive or negative.

What is important to highlight at this stage is that terms-of-trade effects only occur in the caseof a large country. In the case of a small country, the imposition of a tariff is unambiguously

welfare decreasing!

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Slide 19

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So why do governments imposeimport tariffs?

Political economy justification: protectionist policiesare a consequence of lobbying from industries in the importcompeting sectors

Economic arguments for protection:

1. Terms-of-Trade argument2. Infant Industry argument3. Strategic Trade Policy4. Other (Fiscal Revenue, Income Redistribution)

International trade theory clearly asserts the benefits of free trade and highlights theinefficiency losses of imposing a tariff. In reality, very few countries have adopted total freetrade. An exception is probably the one of Hong Kong. There are various reasons for this.

The political economy justificationOften it is a question of political economy. Saying that there is a political economyjustification behind the imposition of a tariff means that protectionist policies are theconsequence of the lobbying activity of industries in the import-competing sectors that wish

to be protected against competition from the rest of the world.

There are also some theoretical arguments that can justify the use of protection from anational welfare point of view.

Economic arguments for protection:

1. Terms-of-Trade argumentThe first argument that we will look at is the terms-of-trade argument, according to which

there is an optimal level of tariff at which national welfare is maximized.

2. Infant industry argumentThe second argument, we will look at, is the infant industry argument for protection.According to this theory, there are circumstances where an industry may need temporaryprotection in order for the country to develop a comparative advantage in that sector.

3. Strategic trade policyThe third argument for protection is the strategic trade theory argument. There might becircumstances where a subsidy to a domestic firm may deter foreign companies from enteringinto the market and competing with the domestic firm. In this case, the domestic firm willbenefit from monopoly profits and the country overall may gain.

4. Other arguments

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The other arguments for protection rely on the fact that import tariffs are a tool to raisegovernment fiscal revenue, or they are a tool to redistribute income from the export-competing sector to the protected sector.

Let's now look at each of these arguments in turn.

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Slide 20

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1. The terms-of-trade argument for protection

Theory: There is an optimal tariff rate(low) for which TOT gains offset losses.

But:Argument valid only for large countriesBeggar-thy-neighbour policy, therefore itis subject to retaliationTrade war would lead to losses for allcountries

TheoryThe terms-of-trade arguments follows directly from the cost and benefit analysis of theimposition of a tariff. We have seen before, that when a large country introduces a tariff,there may be positive terms-of-trade effects. The tariff reduces the demand for imports andthis, in turn, decreases the world price of the imported good. Economic theory shows thatthere is an optimal tariff rate that is positive, for which the terms-of-trade gains must offsetdistortionary effects of the imposition of a tariff.

BUTAlthough theoretically valid, this argument presents very strong limitations, when applied toactual policy making. First of all, the argument is valid only for the case of large countries.Small countries are not able to affect foreign prices, therefore they cannot benefit from terms-of-trade gains.

Second, even in the case of a large country, a trade policy that relies on terms-of-trade gains isa beggar-thy-neighbour policy. This is because the gains to the large country come at thecost of welfare losses in the foreign exporting countries that will receive a lower price for their exports. A retaliation of foreign exporting countries may start a trade war that wouldleave all countries worse off.

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Slide 21

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2. Infant industry argument for protection

TheoryTemporary protection needed to develop CA because of market failures (e.g. inefficient financial market, barriers toentry, existence of positive externalities)

BUT- difficult for government to identify industries of potential CA- Better first-best policies to deal with market failures

EvidenceIn many developing countries, industries that havedeveloped because of protection have continued torequest government intervention to stay in the market.

The infant industry argument for protection relies on the arguments that temporary protectionmight be needed for a country to develop a comparative advantage in a particular sector whenmarkets fail. For example, if there are inefficiencies in the financial market, it may happenthat an entrepreneur that wants to start a new business will not find the appropriate fundingfor his or her activity, even if the activity is profitable. Inefficiencies in financial markets indeveloping countries, for example, may stop resources from moving from the traditionalagricultural sectors to new manufacturing sectors. The simple reason might be that banks aretoo small, their portfolios are not sufficiently diversified, or they lack information, and

consequently they cannot manage the risk connected with an investment in a new sector.

EvidenceHistorically, many developing countries, in the aftermath of the Second World War, haveadopted an import-substitution strategy in the attempt to develop their manufacturing sector.In many developing countries, the evidence has been that although the protected sector diddevelop, the production stagnated for a long time and the sector needed continued governmentintervention to stay in the market. In other words, import-substitution strategies did not leadto the development of a competitive industry that eventually could face its competition in theinternational market. That is to say that import-substitution strategies did not allow thedevelopment of the comparative advantages they were meant to develop. A result thatsupports a very strong argument against infant industry protection is that it is very difficult for governments to identify industries of potential comparative advantage!

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Slide 22

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3. Strategic Trade PolicyArgument

Some markets may be characterized by imperfectcompetition: there are only a few big players andexcess profits are made

A subsidy by government to a domestic firm candeter foreign company and raise the profits of thedomestic company by more than the subsidy

Is this policy desirable?

Let's now turn to the discussion on the strategic trade argument for protection.

Some markets may be characterized by imperfect competition so that there areonly a few big players and excess profits are made

Some markets are characterized by imperfect competition. It may occur that because of highfixed costs, only a few companies can survive in a market and these companies are able torealize above normal profits. Countries may decide to enter in competition to try to capturethese excessive profits. Let's take, for example, the case of the air transport industry. It might

be the case that, on specific routes, only one company can survive: If two companies (adomestic and a foreign company, for example) were in the market, they would both realizelosses; but if one company survives, it will realize monopolistic profits.

A subsidy by government to a domestic firm can deter foreign company and raisethe profits of the domestic company by more than the subsidy

In these circumstances if the government of one country provides its domestic air transportcompany with a sufficiently large subsidy, it may create for the company the incentive toenter in the market independently of whether the foreign company enters or not in the market.On the other hand, the foreign air-transport company, facing the competition of a subsidisedcompany, will decide not to enter in the market, because if it did, it would certainly realizelosses.

In the end, only the subsidized company will stay in the market, and it will realizemonopolistic profits. To the extent that these profits are higher than the subsidy paid by thegovernment, the overall welfare of the country that has subsidized its domestic industry willincrease.

Is this policy desirable?At first sight, it might look quite a good idea, under these circumstances, to protect thedomestic industry and capture foreign profits. However, the desirability of such a policydepends on a number of specific conditions. Firstly, it is necessary that the subsidy issufficiently large to actually deter the foreign firm from entering in the market. If it didn'tand both companies entered in the market, then the profits captured by the domestic firm maynot cover the cost of the subsidy and the country as a whole will be worse off.

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In addition, a strategic trade policy is a beggar-thy-neighbour policy, because it is based onthe assumption of capturing foreign profits. As a consequence, strategic trade policy issubject to retaliation and therefore entails the risk of a trade war that might leave everybodyworse off.

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Slide 23

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4. Other arguments for protection

Fiscal revenue argumentIn some developing countries, the tax collectionsystem is inefficient. Tariff revenue is easy tocollect. However: (i) Tariffs produce undesiredlong-term effects; (ii) Simplification of the taxrevenue system is in many cases a solution

Income distributionSecond-best policy. More appropriate taxes andtransfers.

Fiscal revenue argumentAmong other arguments for protection, there is that of fiscal revenue. In many countries,especially developing countries, income taxes are difficult to collect, while tariffs are easier tocollect: imported goods have to cross a border and therefore it is more difficult to hide them.Countries, especially developing countries, have often used this argument to keep their tariffshigh. There is evidence, however, that in many countries the simplification of the tax andtariff systems has led to an increase in the overall fiscal revenue, even when accompanied bya reduction in the average tariff rate. This is because a simplified system is easier to control,

people understand it better and therefore it is less prone to evasion.

Income distributionFinally, some countries have used protection as an instrument to redistribute income. Wehave said that liberalization redistributes incomes. Trade liberalization increases the returnsof the relatively abundant factor and reduces the returns of the scarce factor. Maintainingprotection is therefore a way to avoid these adjustments. This is obviously true. However,trade policy is not the only instrument to achieve redistributive goals. And economists arguethat it is more efficient to use fiscal policies than trade policy to achieve income redistributiontargets.

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Slide 24

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Is there a reason for committing tomultilateral liberalization?

Trade liberalization leads to gains also when it is unilateral. Yet,historically it has been achieved through international negotiations

Theoretical reasons for coordinating liberalisation with others:

1. Reciprocal exchange of market access allows governments to mobilizeexport lobbies to counter-balance import competing lobbies

2. International commitments avoid tit-for-tat trade restrictions that make allworse off. Without coordination both countries would seek to impose theoptimal tariff and they would lose. Coordination allows both countries towin

3. Enhances credibility of a trade policy and avoid time inconsistencyproblems

Trade liberalization lead to gains also when it is unilateral. Yet, historically it hasbeen achieved through international negotiations

It is interesting to notice that historically tariffs were not reduced through a number of unilateral decisions by individual countries, but rather through a number of rounds of international negotiations.But, if countries can realize gains from trade by liberalizing unilaterally, why do they engagein international negotiations and liberalize trade within a context of multilateral

commitments?

Theoretical reasons for coordinating liberalisation with othersThere are at least three reasons why it is easier to remove tariffs at a multilateral level.

1. Reciprocal exchange of market access allows governments to mobilize exportlobbies to counter-balance import competing lobbies

First of all, we have seen that when a country liberalizes trade, some people gain and otherslose. We have seen, in particular, that the import competing sector is likely to lose fromopening up to trade, while the export sector is likely to gain. If a country liberalizesunilaterally, it is likely to face the pressures of the import-competing sector that will mobilizeand lobby against liberalization. On the contrary, if a country is able to negotiate internationalliberalization, it will be able to counteract the pressure of the lobbies of the import-competingsector by mobilizing the exporters' lobbies to counterbalance the lobbies of the import-competing sector. From a political economy point of view, it is much easier for a country toreduce tariffs if its trading partners are doing the same.

2. International commitments avoid tit-for-tat trade restrictionsAnother important reason why it is easier to reduce tariffs at the multilateral level is that bycoordinating liberalization with other countries, countries are able to avoid trade wars. If eachcountry set its trade policy independently, then the optimal policy for large countries would beto set the "optimal tariff". Since this is beggar-thy-neighbour policy, it is subject toretaliations by other countries. To avoid tit-for-tat trade restrictions, the best option is tocooperate to jointly liberalize trade.

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3. Enhances credibility of a trade policy and avoid time inconsistency problemsThere is also a third important reason for underpinning a trade policy to a multilateralcommitment that is that a multilateral commitment enhances the credibility of a trade policyitself and helps to avoid time inconsistency problems.

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Slide 25

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Time inconsistency

An example: Interaction with the financial sector

Time 1: Because of protection national banks are inefficient and haveaccumulated non-performing credits

Time 2: The government announces that it will open the financial sector toforeign competition

Time 3: Banks do not adjust to the announcementTime 4: If the government liberalizes, there will be a crisis in the financial

sector. So it will decide not to liberalize

Time inconsistency occurs when the announcement at time 2 isno longer an optimal policy at time 4. Awareness of timeinconsistency problems means banks will decide not to adjust

International commitments solve time inconsistency p roblems

Let's explain what time inconsistency means with an example.

Example: Interaction with financial sectorSuppose that a government wants to liberalize its financial sector. Suppose also that nationalbanks are inefficient and have accumulated non-performing credits. So they are in a verycritical situation. Assume that, at a certain point in time, the government announces that oneyear later, it will open up the financial sector to foreign competition. What will banks do?There are two possibilities: If the national banks believe the announcement, they will start to

adjust their bad credits and try somehow to become more efficient. However, if they don'tbelieve the announcement, they will not adjust. In this case, one year later, if the governmentdoes liberalize the financial sector, there will be a financial crisis in the country. Therefore, if banks do not adjust after the announcement, probably the government will not beimplementing the policy one year later.

Time inconsistency occurs when the announcement at time 2 is no longer anoptimal policy at time 4. Aware of time inconsistency problems, banks will decidenot to adjust.

Time inconsistency occurs when the announcement, made at a certain time, is no longer anoptimal policy, at the time when it should be implemented. Aware of time inconsistencyproblems, banks will decide not to adjust after the announcement of the government. As aconsequence, when the time of implementing the policy arrives, the government will beobliged not to liberalize, otherwise it would risk a complete crisis in the financial sector.

International commitments solve the time inconsistency problemsThe time inconsistency problem can be solved through international commitments.

International commitments will give credibility to the government announcement that it willliberalize the financial sector, and banks will adjust.

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Slide 26

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Other reasons for multilateralliberalization

No risk of suffering from trade divertingeffects of regional trade agreements

Transparency and predictability

There are other reasons in favour of multilateral liberalization. One of these is to avoid therisk of trade diversion due to the formation of regional trade agreements.

No risk of suffering from trade diverting effects of regional trade agreementsThe policies we have described so far are non-discriminatory policies. This means that if two

countries decide to reduce their reciprocal tariffs, they will also apply these lower tariffs to therest of the world. It may happen as well that countries reduce their tariffs in a preferentialway. This means that a set of countries liberalize their intra-regional trade, but they keep their

barriers against the rest of the world.At the first sight, this might seem a good policy. We have said that unilateral liberalization isgood. We have said that multilateral liberalization is good, so one may think that preferentialliberalization should also be good. In contrast, when countries liberalize in a preferential way,they may incur the risk of suffering from the consequences of what economists call "tradediversion". Trade diversion occurs when the imports from a trading partner of the regionalagreement replaces imports from the rest of the world, although the trading partner is not theglobally most efficient producer of the good. Trade diversion has clearly negative effects onthe exporting countries outside the preferential area.What are the consequences for the importing country member of the preferential area? On theone hand, consumers gain, because they pay less to import the good from a regional partner,since there are no import tariffs. On the other hand, the government loses tariff revenue.Since the trading partner is not the most efficient producer of the good, this loss may be larger than the gain to consumers. In other words, trade diversion may also have negative effects onthe welfare of the partners to the preferential agreement.

Transparency and predictabilityAnother advantage of committing liberalization to international agreements is that of enhancing the transparency and predictability of conditions for the exchange of goods andservices. For example, this reduces the costs of getting information on the tariff rates appliedon a certain product by a certain country to another one and put countries on a level playingfield.

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Slide 27

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Conclusions

The theory of international trade suggests that the optimal tradepolicy regime is one of free trade or a regime with low and evenprotection

While various reasons have been advanced why countries have todepart from this prescription (infant industry or strategic tradepolicy), there is little evidence that these policies have resulted indemonstrably better economic performance

While unilateral liberalization is good, multilateral liberalizationleads to larger gains

Trade policy is only one part of a much bigger growth/developmentstory

Let's now in our conclusion briefly summarize the results of this presentation. I think that thispresentation provides four main messages.

The theory of international trade suggests that the optimal trade policy regime isone of free trade or a regime with low and even protection

The first one is that the optimal trade policy regime is either one of free trade or a regime withlow and even protection. We have said and shown that the regime of low protection may bejustifiable only in the case of a large country.

While various reasons have been advanced why countries have to depart fromthis prescription (infant industry or strategic trade policy), there is littleevidence that these policies have resulted in demonstrably better economicperformance

The second important lesson is that while various reasons have been advanced, why countrieshave to depart from this prescription (such as the infant industry argument or the strategictrade policy argument), there is little evidence that these policies resulted in demonstrablybetter economic performance. On the contrary what we have seen is that, in general, sectorsthat have been protected in the initial stage of their development, then have continued to beprotected and have never grown into competitive sectors.

While unilateral liberalization is good, multilateral liberalization leads to largergains

A very important lesson is that while unilateral liberalization is good, multilateralliberalization not only leads to larger gains, but it also politically more sustainable and morecredible.

Trade policy is only one part of a much bigger growth/development storyFinally, the fourth lesson is that trade is only one part of the growth and development story.Trade liberalization may not have the desired effect if markets are not functioning well or if institutions are weak.

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FAQs 1

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Frequently asked questions

Why do countries trade ?

Question 1:Why do countries trade?Answer:Countries trade because they are different. They have different technologies or have adifferent amount of capital and labour. Or they trade because they produce different varietiesof the same good. In the first case trade generates gains because it allows countries tospecialize in the production of the good it can produce relatively more efficiently or that ituses intensively the factor that they are more endowed with.

In the second case trade generates gains because people love variety and trade provides accessto different varieties of goods produced all over the world. By increasing the variety of goodsconsumers can access and buy, trade makes consumers better off.

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FAQs 2

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One of the main results of internationaltrade theory is that trade is beneficial for all countries why?

Question 2: One of the main results of international trade theory is that trade is beneficial for all countries why?Answer:Let's consider for simplicity reasons, the case when countries differ in their level of technology. International trade theory tells us that trade allows countries to specialize in theproduction of the good they can produce relatively more efficiently. When countriesconcentrate their resources in the production of this good, overall global production will goup, and consumers will be able to consume an amount of goods greater than they would have

been able to consume without trade.

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FAQs 3

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What determines the pattern of trade?

Question 3: What determines the pattern of trade?Answer:When trading partners are different, each country will export the product in which it has acomparative advantage. So, for example, in a case where countries differ in their level of technology, each country will export the product that it can produce relatively moreefficiently.When trade occurs between similar countries, countries will tend to trade different varieties of the same good. In this case, the theory of international trade cannot tell us anything about the

pattern of trade. The pattern of trade is random. The only thing international trade theory canpredict is the volume of trade between the countries.

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FAQs 4

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Can a country have a comparativeadvantage in all goods?

Question 4: Can a country have a comparative advantage in all goods?Answer:A country can have an absolute advantage in all goods. That is, it can have a better level of technology in the production of each good in the market. But, it cannot have a comparativeadvantage in all goods. There will always be a good in which its trading partner has acomparative disadvantage.

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FAQs 5

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Does the fact that trade is mutually-beneficial imply that all individuals ineach country are better off?

Question 5: Does the fact that trade is mutually-beneficial imply that all individuals in eachcountry are better off?Answer:No. An important insight of international trade theory is that international trade, althoughbenefiting the country as a whole, has income distribution effects. This means that somegroups will gain, while other groups may be hurt from trade liberalization. In particular, thoseindividuals and capital employed in the import-competing sector will suffer losses, whilethose employed in the export- competing sector will realize gains.

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FAQs 6

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What policies can a governmentimplement to face the adjustmentproblems connected with tradeliberalization?

Question 6: What policies can a government implement to face the adjustment problemsconnected with trade liberalization?Answer:The reallocation from the import competing sector to the exporting sector induces costs.These costs are represented, for example, by the cost of workers to look for another job in adifferent sector. There are not only simply searching costs, but there might be costs related tothe fact that workers might need some training to learn to work for another firm or companyin another sector. The government can intervene in this process by facilitating this adjustment

process.The government may, for example, supply information on job vacancies, thus reducing searchcosts. It may provide credits by allowing workers, poor workers who need time to look for another job, to borrow money from a bank while looking for another job. It may providecontributions for training. The government may as well define an appropriate pace for thereform. It may implement reforms slowly, so that a small number of workers that look for adifferent job enter into the market at each phase of the implementation period, thus limitingnegative social consequence. The government may also use export promotion schemes. Thatwould allow a more rapid expansion of the exporting sector and facilitate the adjustment.Alternatively, the government may implement policies to compensate those who lose fromtrade liberalization. This can be done by offering during transition periods, for example,social safety nets to support the workers who have lost their jobs or by implementingappropriate redistributive tax system, that may compensate for long term losses.Finally, underpinning trade reforms to international commitments can also be a way tofacilitate the adjustment process. This is because, by committing internationally, thegovernment increases the credibility of the reforms and this is likely to trigger the adjustmentprocess even before the implementation period of reforms.

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FAQs 7

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What are the effects of a tariff?

Question 7: What are the effects of a tariff?Answer:The imposition of a tariff increases the domestic price of an imported good. As aconsequence, consumers will demand less of that good in the domestic country, and importswill fall. In this case there are two possibilities: One is that the reduction in the demand of imports also decreases the world price of the imported good. This is the case of a largecountry, where the country realizes the so called terms-of-trade gains.The second case is that of a small country, where, despite the reduction of the demand for

imports, the world price remains fix and there are no terms-of-trade gains.The difference between the two cases is very important, because in the case when a countrycan realize terms-of-trade gains, trade theory shows that, for a sufficiently low level of tariffs,the imposition of a tariff may increase the overall welfare of the country. In contrast, in thecase of a SMALL country, that is a country that is not able to affect the world price throughchanges in the demand for imports, there are no chances that the tariffs may increase thewelfare through terms-of- trade gains. In the case of a small country, the imposition of a tariff unambiguously generates a loss. What generates this loss is the fact that the higher domesticprice reduces consumers' welfare, as consumers will have to pay more to consume the sameamount of their preferred good.

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FAQs 8

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What are the risks associated with theadoption of an "optimal tariff"?

Question 8: What are the risks associated with the adoption of an "optimal tariff"?Answer:A country may justify its protectionist policy on the grounds of terms-of-trade gains. Optimaltariff theory says that there is a small tariff at which the welfare of a country can bemaximized. That is to say that there is therefore an optimal tariff for which terms-of-tradegains offset losses. There are, however, a number of problems associated with this policy.First of all, it is important to define exactly what a sufficiently low level of tariff is. And thatfrom an empirical point of view is not very easy to determine.

Second, it is important to realize that the argument is only valid for a large country. And, thisdoes not mean that the country needs to be big, but it means that the country is able to affectthe world price of the commodity on which it imposes the tariff. There is also another problem, more serious, that is that the terms-of-trade argument for protection is a beggar-thy-neighbour policy. By imposing a tariff, a country gains in terms-of-trade, but the rest of theworld loses. Therefore it is likely that this policy will be subject to retaliation. And, this maystart a trade war that makes everybody worse off.

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FAQs 9

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What do we mean by infant industryargument?

Question 9: What do we mean by infant industry argument?Answer:Many governments have used the infant industry argument to protect their manufacturingsector. The argument is that the country may have a potential comparative advantage in themanufacturing sector, say, but that the industry is too young and too little developed tocompete at the international level. For this reason, the industry is given a "temporary"protection: to allow the industry to develop, in a way that, as the technological level of theindustry increases, the comparative advantage builds up, and the country may, eventually,

open up to international competition.The reason why the manufacturing sector does not naturally develop, or better the reason whythe industry is "infant" is a market failure. For example, there is an inefficiency in thefinancial market that impedes the natural forces of the market to operate.Although at first sight reasonable, this theory is not without drawbacks. First of all, it isdifficult for the government to identify which industry has a potential comparative advantage.If inefficiencies in the financial markets do not allow banks, for example, to provide fundingto potentially growing sectors, it is equally difficult for the government to identify whichsector is the one with the highest potential for growth. Over time different sectors haveshown different potential for growth and it is not necessarily true, from a development pointof view, that targeting sectors with higher value added is beneficial. A sector with higher value added may present a very small proportion of the production of a country and growth inthat sector may not mean a lot in terms of the country's development, while a growth (even alow rate of growth) in a sector that represents a larger share of the production of the countrymay have a significant effect on development.Another point to make is that is that import-substitution policies are not the most efficientinstrument to address a market failure. To continue with the same example as before, if thereason why a certain industry does not develop is an inefficiency in the financial market, itwill be more appropriate to address directly this issue rather than using trade policy to protectthe manufacturing sector.

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FAQs 10

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What is the evidence of the effectivenessof infant industry policies?

Question 10: What is the evidence of the effectiveness of infant industry policies?Answer:What happened, in many countries, is that industries that have been protected from importcompetition did develop, but they have never been competitive in the international market.The country has not developed a comparative advantage in the protected sector, and firms inthat sector have continued to request government intervention to stay in the market.

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FAQs 11

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Is it desirable to support an industry tobeat foreign competition?

Question 11: Is it desirable to support an industry to beat foreign competition?Answer:Governments may be pushed to subsidize some industries for strategic considerations. In asector characterized by few big players, it may happen that a subsidy gives a strategiccompetitive advantage to the domestic firm, thus pushing the foreign competitor out of themarket, and increasing the domestic firm's profits above the level of the subsidy. This extraprofits might compensate the country for the cost of the subsidy.However, in the real world, the implementation of such a policy may be quite risky and

difficult. First of all, it is important that the subsidy actually deters the foreign firms fromentering. If this does not happen, the extra profits of the subsidized firm may not be sufficientto compensate the government for the cost of the subsidy.Secondly, even in the case when the foreign firms are actually pushed out of the market fromthe subsidised firm, it is necessary that the extra profits of the domestic firm be greater thanthe subsidy, for the strategic policy to be welfare enhancing. To be able to calculate this inadvance requires a lot of information, difficult to obtain and subject to uncertainty.Finally, strategic trade policies make foreign countries worse off. This implies that thedomestic country may face a retaliation policy on the part of foreign countries, in which caseboth the domestic country and the foreign countries will be worse off.

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FAQs 12

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Why do countries commit their tradepolicy to multilateral liberalization? Or, inother words, why do countries join theWTO?

Question 12: Why do countries commit their trade policy to multilateral liberalization? Or, inother words, why do countries join the WTO?Answer:Tying up a country's trade policy to international commitments has a number of advantages.First of all, international commitments enhance the credibility of the trade policy and thisavoids problems, such as time inconsistency problems, whereby a trade policy announcedtoday does not trigger the necessary adjustments to make it an optimal policy also at the timeof implementation. For example, if a government announces to liberalize the financial sector

in a country where banks are highly indebted and banks do not adjust their bad debts, at thetime of the implementation, if a government did implement the policy, the financial sector would go bust. Therefore, it is very likely that the government will not to implement thepolicy.The second reason for liberalizing at the multilateral level is a political economy reason.When a country liberalizes at the multilateral level, at the same time, it reduces its importtariff and accesses more freely the markets of other countries. In this way, at the domesticlevel, governments can counterbalance the lobbying pressure of the import-competing sector against liberalization, by mobilizing the export lobbies that will benefit from the higher market access in foreign markets.Thirdly, international commitments avoid tit-for-tat trade restrictions that make all countriesworse off. If countries (large countries, say) did not coordinate their liberalization, theywould choose to set the optimal tariff, and by doing so, they will inflict upon each other terms-of-trade losses. This would generate losses worldwide. Coordination among countriespushes them towards free trade and this generates gains for all countries.

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FAQs 13

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We have said that unilateral liberalizationis good. We have also said thatmultilateral liberalization might be better.Does it follow that joining a preferentialtrade agreement will always make acountry better off?

Question 13: We have said that unilateral liberalization is good. We have also said thatmultilateral liberalization might be better. Does it follow that joining a preferential tradeagreement will always make a country better off?Answer:Suppose that there are three countries that make up the world. Countries A, B and C.Suppose as well that Country A signs a free trade agreement with Country B and thereforereduces its import tariff on textiles, let's say, against country B. Suppose as well that CountryB is not the most efficient producer of textiles, while Country C is. Before the formation of

the free trade area, Country A was importing its textiles from Country C. After the FTA,Country B will be able to export to Country A at a cheaper price than Country C despite notbeing the most efficient producer.It is clear that Country C will loose following the formation of a free trade agreement betweenCountry A and Country B because trade will be diverted from Country C to Country B andCountry C will no longer export textile to Country A.Will Country A unambiguously gain from this free trade agreement? The conclusion is notthat obvious. On the one hand, because of the reduction of the import tariffs

theory and policy module

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