International Trade Agreements and Political Economy

The following sections are included:

• CONTENTS

• Acknowledgements

The first of three sections focuses on the theory of protection and trade agreements. The first paper develops a model to analyze customs unions. "A 3 × 3 Model of Customs Unions," develops a three-country-three good model of customs unions that shows that two countries can always benefit from forming a customs union provided that their initial level of trade is not too large. The intuition for this result is that both countries benefit from improved terms of trade with the nonmember country. However, the intra-customs union terms of trade always moves in favor of one country and against the other. Hence, if the initial level of trade is not too large within the customs union, the country that loses from worse intra-union terms of trade does not lose much and will gain overall. This paper was one of the first papers to use the terms of trade-volume of trade approach to analyze customs unions…

In this paper we develop a three-country-three-good model of customs unions. The main result is that a sufficient condition for two countries to benefit from forming a customs union is that they are similar in the sense that their mutual trade is small. This result is obtained by analyzing the terms of trade effects rather than the more traditional emphasis on trade creation-trade diversion effects.

The following sections are included:

• Introduction

• Tariffs in a Non-Cooperative Framework

• Tariffs in a Cooperative Framework: The Negotiation Set

• Tariffs in a Cooperative Framework: The Solution

• Conclusion

• References

Customs union formation is modeled as a two-stage game. In the first stage countries make coalitional choices according to core theory. In the second stage optimal tariffs are determined. This yields a theory that predicts which customs unions form. An example shows that a customs union can be an equilibrium even when both member countries do better at free trade.

It is well known that large countries can manipulate the terms of trade to their advantage by using tariffs. It is widely believed, however, that this invites retaliation, and that the post-retaliation equilibrium leaves all countries worse off than they would be at free trade. We present a simple pure exchange model and show which endowment patterns are consistent with this belief. In this model, we find that if one country is substantially bigger it can expect to gain from a tariff war, despite retaliation. Thus we suggest that big countries win tariff wars. We believe that this provides a potentially important explanation for the persistence of tariffs, and the difficulty of attaining free trade. Our model can also be extended to show that when more than two countries trade with each other, the advantage obtained by being part of a large trading unit can help explain the formation of customs unions (see Kennan and Riezman 1987)…

We construct a model of customs unions in. which countries charge optimal tariffs. Customs unions internalize the externality that exists whenever two countries import the same good. Also, customs unions make several countries into one large unit with more market power. Big customs unions can improve their members' welfare relative to the free trade. Our model of customs unions separates the effects of tariff reduction from the effects of policy co-ordination. The movement from Nash equilibrium to a Free Trade Association improves global resource allocation. Moving from a Free Trade Association to a full customs union has ambiguous resource allocation effects.

Recent developments in dynamic game theory are applied to determine when two countries can sustain freer trade given that they determine trade policies non-cooperatively. Countries know their own level of protection, but not the other country's level of protection. Using import trigger strategies, cooperation (in the form of low tariffs) can be supported, although there are periodic reversionary (high tariff) episodes. However, if terms of trade trigger strategies are used, cooperation does not occur.

This paper examines various implications of preferential trade agreements, namely customs unions and free trade areas, in the context of a multicountry general equilibrium model. The model is calibrated to represent countries with symmetric endowments, and aggregate and disaggregate welfare change measures are used to quantify the welfare effects of preferential trade agreements. It is found that free trade areas are better than customs unions on welfare grounds for the world as a whole. Welfare decompositions suggest that a significant fraction of the welfare changes is explained by the voiume-of-trade effect for both types of preferential trade agreements.

We construct a three-country model to determine how the formation of free trade areas (FTAs) affects optimal tariffs and welfare. We find that, at constant rest of the world (ROW) tariffs, the adoption of internal free trade induces union members to reduce their external tariffs below the Kemp-Wan [J. Int. Econom. 6 (1976) 95-97] level, and causes ROW's terms of trade to improve and its welfare to rise. When ROW also behaves optimally, its policy response to the formation of the FTA is to raise tariffs. Generally, FTA members prefer to liberalize internal trade partially and find regional integration appealing only if their collective size is sufficiently large. We also demonstrate how FTAs may undermine the attainment of global free trade.

This paper uses computational techniques to assess whether or not various propositions that have been advanced as plausible in the literature on regional trade agreements may actually hold. The idea is to make probabilistic statements as to whether propositions of interest might hold, rather than to restrict assumptions so they unambiguously hold. Our aim is to blend theory and numerical simulation and go beyond the ambiguous analytically derived propositions that dominate the theoretical literature so as to assess the likelihood of propositions holding for particular model specifications.

Changes in trade policy affect a nation's economic welfare through terms-of-trade and volume-of-trade effects. A move to global free trade would imply higher world economic welfare equal to the sum of all nations' volume-of-trade, or efficiency, effects. Since the sum of the terms-of-trade effects across all nations is zero, terms-of-trade effects are contentious. Konishi, Kowalczyk and Sjöström (2003) have shown that if customs unions do not affect trade with non-member countries, immediate global free could be achieved if free trade were proposed together with international sidepayments equal to the terms of trade effects. How large would these terms of trade effects, and hence transfers, be? This paper presents estimates from a simple computable general equilibrium model of a world economy of perfect competition. We show that, in some cases, terms-of-trade effects are small compared to efficiency gains, and transfers are not necessary for free trade. In other cases, terms-of-trade gains may account for more than 50% of a country's gains from free trade and transfers could be large.

In "Voter Preferences for Trade Policy Instruments", we consider the choice of tariffs versus production subsidies as a method for redistributing income in a simple political economy model. We find that voters with high direct tax burdens tend to prefer tariffs to subsidies. This is because tariffs create revenue lessening the burden on high tax bracket people while subsidies use revenue thereby increasing the burden on these same people. So despite the fact that tariffs are less efficient the deadweight loss effect is outweighed by the revenue effect for high tax bracket voters. In an uncertain environment it is shown that if actual tariff and subsidy rates are chosen from the set of individually optimal rates, then tariffs will have a smaller range than subsidies. In this case, tariffs might be preferred to subsidies. Finally, for large countries, voters whose income share declines with more protection actually prefer tariffs to subsidies…

We analyze voter preferences for tariffs and production subsidies. The distribution of tax revenues argument shows that voters with high direct tax burdens prefer tariffs to subsidies. The uncertainty argument demonstrates that if actual tariff and subsidy rates are chosen from the set of individually optimal rates then the range of tariff rates is smaller than the range of subsidy rates. Thus, tariffs might be preferred even though they are less efficient. Finally, the large country argument shows that if a country is large then voters whose income shares decline with more protection prefer tariffs to subsidies.

We construct a stochastic model of a legislature with an endogenously determined seniority system. We model the behavior of the legislators as well as their constituents as an infinitely repeated divide-the-dollar game. The game has a stationary equilibrium with the property that the legislature imposes on itself a non-trivial seniority system, and that incumbent legislators are always reelected.

The welfare effects of partial restrictions on political competition are investigated in a model in which two candidates receive campaign contributions from import-competing industries in return for tariff protection. Ceilings on allowable contributions per industry may be welfare-worsening, particularly if the "contributor elasticity" is high, because they induce candidates to seek additional contributors. Restrictions that reduce the number of industries allowed to contribute may also worsen welfare, because candidates respond by increasing contributions (and tariff protection) for each active contributor. The results suggest that the ability of candidates to circumvent partial restrictions may eliminate any potential benefits.

We analyze a two country-two good model of international trade in which citizens in each country differ by their specific factor endowments. The trade policy in each country is set by the politician who has been elected by the citizens in a previous stage. Due to a delegation effect citizens generally favor candidates who are more protectionist than they are. The one-candidate-per-country equilibria exhibit a "protectionist drift" owing to this delegation effect. In addition, we find an additional source of protectionist drift that we call the "abstention effect". Not only do candidates wish to delegate to more protectionist colleagues, but these more protectionist colleagues who can win election, prefer still more protectionist candidates than themselves. Therefore, they have an incentive to abstain, that is, not run for election. We show that because of this abstention effect there exists a range of electable citizens all of whom are more protectionist than the median voter's most preferred candidate. We extend the analysis allowing two-candidate equilibria and the possibility that there are costs and benefits of holding office.

The paper studies a simple voting system that can increase the power of minorities without sacrificing aggregate efficiency or treating voters asymmetrically. Storable votes grant each voter a stock of votes to spend as desired over a series of binary decisions and thus elicit voters' intensity of preferences. The potential of the mechanism is particularly clear in the presence of systematic minorities: by accumulating votes on issues that it deems most important, the minority can win occasionally. But because the majority typically can outvote it, the minority wins only if its strength of preference is high and the majority's strength of preference is low. The result is that the minority's preferences are represented, while aggregate efficiency either falls little or in fact rises, relative to simple majority voting. The theoretical predictions of our model are confirmed by a series of experiments: the frequency of minority victories, the relative payoff of the minority versus the majority, and the aggregate payoffs all match the theory.

The final section of the book explores a variety of topics: from using laboratory experiments to study whether comparative advantage determines trade patterns, to using real business cycle theory to study how trade shocks are transmitted across countries. The first paper "Uncertainty and the Choice of Trade Policy in Oligopolistic Industries", looks at strategic trade policy when there are oligopolistic industries. We focus on the question of how uncertainty affects the choice of trade policy instruments in an uncertain world. In this paper, governments are trying to shift profits toward their firms by using either export taxes/subsidies or quantitative restrictions. We first show that in a world of perfect certainty, governments would use quantitative restrictions rather than export taxes/subsidies as their preferred policy. We then allow uncertainty; at low levels of uncertainty quantitative restrictions are still preferred, but after the uncertainty reaches a certain level, taxes/subsidies are the preferred instrument…

This paper investigates the design of trade policies in an uncertain world. Governments in each of two countries select between direct quantity controls and subsidies in an attempt to shift profits in favour of domestic, imperfectly competitive firms. The equilibrium of this bilateral policy game depends critically on the variability of the environment. In a world of certainty, both governments would choose to regulate the behaviour of their firms through direct quantity controls. With a sufficient amount of uncertainty, both governments regulate their firms through subsidies. This result reflects an important tradeoff between the strategic advantages of direct quantity controls and flexibility gained by the use of subsidies.

This paper studies a laboratory economy with some of the prominent features of an international economic system. The patterns of trade and output predicted by the law of comparative advantage are observed evolving within the experimental markets. Market prices and quantities move in the direction of the competitive equilibrium, but the quantitative predictions of the (risk-neutral) competitive equilibrium are rejected. Considerable amounts of economic activity occur as disequilibria. Factor-price equalization is observed, but there is a universal tendency for factors of production to trade at prices below their marginal products.

This paper reports the first experiments designed to explore the behavior of economies with prominent features of international finance. Two "countries," each with its own currency, were created. International trade could take place only through the operation of markets for currency. The law of one price and the flow of funds theory of exchange rate determination were used to produce general equilibrium models that captured much of the behavior of the economies. Prices of goods, as well as the exchange rate, evolve over time toward the predictions of the models. However, both the law of one price and purchasing power parity can be rejected for reasons that do not appear in the literature. Pattems of international trade were as predicted by the law of comparative advantage.

This paper examines the role of external shocks in explaining macroeconomic fluctuations in African countries. We construct a quantitative, stochastic, dynamic, multi-sector equilibrium model of a small open economy calibrated to represent a "typical" African country. External shocks consist of trade shocks, modeled as fluctuations in the prices of exported primary commodities, imported capital goods and intermediate inputs, and a financial shock, modeled as fluctuations in the world real interest rate. Trade shocks account for roughly half of economic fluctuations in aggregate output. Moreover, adverse trade shocks cause prolonged recessions since they induce a significant decrease in aggregate investment

We develop a two-country, two-sector model of trade where the only difference between the two countries is their distribution of human capital endowments. We show that even if the two countries have identical aggregate human capital endowments the pattern of trade depends on the properties of the two human capital distributions. We also show that the two distributions of endowments also completely determine the effects of trade on income inequality. We also look at a simple majority voting model. It turns out autarky and free trade with and without compensation may be the voting outcome.