The Political Economy of Trade Policy

The following sections are included:

• About the Author
• Contents
• Preface
• Political Economy of Trade Policy: An Introduction

This paper provides a theory of lobby formation within a framework in which trade policy is determined through political contributions. Under certain conditions, free trade turns out to be an equilibrium outcome either when the government has a high affinity for political contributions or when it cares a great deal about social welfare. Moreover, greater inequality in asset distribution results in a greater number of lobbies and, in most cases, more protection for each of these lobbies. Furthermore, industries with higher levels of capital stock, fewer capitalists, more inelastic demand, and smaller geographical dispersion are the ones that get organized.

In a bargaining model of endogenous protection, I introduce fixed costs of political-organization that need to be incurred by capitalists prior to actual lobbying. Unlike Maggi and Rodriguez-Clare [J. Pol. Econ. 106(3) (1998) 575] intersectoral capital mobility is disallowed. Nevertheless, I am still able to obtain their main result that a government with low bargaining power vis-à-vis the import-competing lobby precommits to a free-trade agreement. Further, with high fixed organizational costs, the government prefers to stay out of such agreements. Its maximum bargaining power consistent with signing a trade agreement has an inverse-V-shaped relationship with respect to the size of fixed costs.

Using the menu-auction approach to endogenous determination of tariffs and allowing additionally for lobby formation itself to be endogenous, this paper analyzes the impact of unilateral trade liberalization by one country on its partner's trade policies. We find that such unilateral liberalization may induce reciprocal tariff reductions by the partner country. Intuitively, unilateral liberalization by one country has the effect of increasing the incentives for the export lobby in the partner country to form and to lobby effectively against the import-competing lobby there for lower protection.

The median-voter approach to trade policy determination (within a Heckscher-Ohlin framework) as in Mayer [Am. Econ. Rev. 74(5) (1984) 970] predicts that an increase in inequality, holding constant the economy's overall relative endowments, raises trade barriers in capital-abundant economies and lowers them in capital-scarce economies. We find support for this prediction using cross-country data on inequality, capital-abundance and diverse measures of protection. We perform certain robustness checks that include controlling for the effects of political rights and schooling as well as using alternative datasets on factor endowments.

In this paper, we investigate empirically how government ideology affects trade policy. The prediction of a partisan, ideology-based model (within a two-sector, two-factor Heckscher-Ohlin framework) is that left-wing governments will adopt more protectionist trade policies in capital-rich countries, but adopt more pro-trade policies in labor-rich countries, than right-wing ones. The data strongly support this prediction in a very robust fashion. There is some evidence that this relationship may hold better in democracies than in dictatorships, though the magnitude of the partisan effect seems stronger in dictatorships.

Trade policy depends on the extent to which the government wants to redistribute income as well as on a country's overall factor endowments and their distribution. While the government's desire to redistribute income itself is dependent on asset distribution, it is to a large extent also driven by the partisan nature of the government, i.e., whether it is pro-labor or pro-capital. Using cross-country data on factor endowments, inequality and government orientation, we find that, conditional on inequality, left-wing (pro-labor) governments will adopt more protectionist trade policies in capital-rich countries, but adopt more pro-trade policies in labor-rich economies than right-wing (pro-capital) ones. Also, holding government orientation constant, higher inequality is associated with higher protection in capital-abundant countries while it is associated with lower protection in labor-abundant countries. These results are consistent with the simultaneous presence of both inequality as well as ideology as determinants of protection within a two-factor, two-sector Heckscher–Ohlin framework. Overall, various statistical tests support an umbrella model (that combines both the ideology and inequality models) over each of the individual models.

Barring very few exceptions, international trade has never and nowhere been free, even though only under extraordinary circumstances are deviations from free trade optimal. To explain this puzzle, an entire literature on the political economy of trade policy has emerged over the last three decades. In this literature, one common feature is that trade policies are chosen not with the aim of maximizing national economic efficiency and aggregate welfare, but set by politicians and policy makers whose objective functions diverge from aggregate welfare. Trade policies, in this view, are often used as indirect tools to redistribute income to certain targeted groups. The identity of these groups depends on (a) the type of political economy framework (lobbying or majority voting) assumed, (b) the actual economic, political, and geographic characteristics of the various sectors in the economy that determine which of them are politically organized, and (c) the political and economic ideology of the government…

This paper shows how unilateral liberalization in one country can increase the voting support for reciprocal reduction in trade barriers in a partner country. When trade policies are determined simultaneously in the two countries, we show the possibility of multiple political equilibria — one in which the countries are both protectionist and another in which they trade freely with each other. Starting with trade protection in both countries, a unilateral reform in one country is shown to bring about a free trade equilibrium that obtains majority support in both countries.

For a “genuine” small open economy that has experienced both dictatorship and democracy, we find support for the predictions of the Grossman-Helpman (1994) “Protection for Sale” model. In contrast to previous studies, we use various protection measures (including tariffs, the direct measure of the theoretical model) and perform both single-year and panel regressions. Using Turkish industry-level data, the government's weight on welfare is estimated to be much larger than that on contributions. More importantly, we find that this weight is generally higher for the democratic regime than for dictatorship.

In the Grossman and Helpman (1994) model of endogenous trade protection, sectoral lobbies try to influence an incumbent government that maximizes a weighted sum of political contributions and aggregate welfare. We empirically investigate this model using U.S. and Turkish data. Our specification is more tightly tied to theory than those in existing studies. Additionally, we assume all specific-factor owners to be organized into different lobbies. These changes, validated by hypothesis tests, yield more realistic parameter estimates of the government's concern for aggregate welfare and of the fraction of population organized into lobbies…

In a model of strategic interaction between firms in lobbying activity, I show that capitalists might prefer tariffs (protection) to production subsidies (promotion). This is due to the congestion problem arising from the government's convex welfare costs of providing subsidies as opposed to both the free-rider problem and the congestion problem acting in opposite directions in the case of tariffs. If an industry association exists, coordination can be achieved when lobbying for tariffs, but not in the case of production subsidies.

Using Turkish industry-level data from 1983 to 1990, we find that politically organized industries receive both higher protection and promotion than unorganized ones. Tariff rates are decreasing (increasing) in the import-penetration ratio and the absolute value of the import-demand elasticity for organized (unorganized) industries. Subsidy rates are decreasing (increasing) in the output-supply elasticity for organized (unorganized) industries. The results are consistent with the predictions of the Grossman–Helpman model and its extension in this paper. The mix of protection and promotion is inversely related to the ratio of their respective marginal deadweight cost measures.

This area of research tries, through the introduction of politics in economic models, to explain the existence and the extent of anti-trade bias in trade policy. The two main approaches, namely, the median-voter approach and the special-interest approach are surveyed. Certain applications of these approaches to policy issues, such as trade agreements, the issue of reciprocity versus unilateralism in trade policy, regionalism versus multilateralism, hysteresis in trade policy and the choice of policy instruments, are discussed. Finally, the empirical literature on the political economy of trade policy is surveyed. The new literature that employs a more ‘structural’ approach is emphasized.

While much of the literature has considered the merits of the two policy stances of unilateralism and reciprocity independently of each other, we focus on the possible causal connection between the two. Can unilateral trade liberalization by one country lead to reciprocal liberalization by its partner in the absence of negotiations between the two countries? In this survey paper, we consider this issue analytically in the context of different political economy approaches to trade policy determination.

The following sections is included:

• Index