The Political Economy of Trade Policy

The Political Economy of Trade Policy

1) Survey of early literature The Political Economy of Trade Policy Rodrik, D. (1995). Political Economy of Trade Policy, in Grossman, G. and K. Rogoff (eds.), Handbook of International Economics, Volume 3, Chapter 28, North-Holland. 2) The political contributions approach Grossman, G. M. and E. Helpman (1994). Protection for Sale, American Economic Review 84, 851-874. Grossman, G. M. and E. Helpman (1995). Trade Wars and Trade Talks, Journal of Political Economy 103, 675-708. Goldberg, P.K. and G. Maggi (1999). Protection for Sale: An Empirical Investigation, American Economic Review 89, 1135-1155. 3) Two recent contributions Conconi, P., G. Facchini, and M. Zanardi (2012), Fast Track Authority and International Trade Negotiations, American Economic Journal: Economic Policy 4, 146-89. Conconi, P., G. Facchini, and M. Zanardi (2011), Policymakers Horizon and Trade Reforms: the Protectionist Effect of Elections, CEPR Discussion Paper 8561.

In no other area of economics displays such a gap between what policymakers practice and what economists preach as does international trade. The superiority of free trade is one of the profession's most cherished beliefs, yet international trade is rarely free (Rodrik, 1995) Core question of the literature on the political economy of trade: why do policymakers often fail to support free trade, favoring protectionist policies?

Average MFN Tariffs, 2000

Two possible explanations Economic explanations: welfare maximizing policymakers depart from free trade due to the existence of distortions, e.g. monopoly power in trade imperfect competition dynamic economies of scale revenue constraints Political economy explanations: policymakers are politically motivated and grant protection in response to demands by certain groups in society (e.g., lobbies).

Individual preferences (A) Interest groups (B) trade policy outcomes Policymakers preferences (C) Institutional structure of the government (D)

Standard trade model Small open economy All goods (but no factors) are tradable Consumer preferences are identical and homothetic Perfect competition in product and factor markets Alternative assumptions about the supply side: - Specific-factors (S-F) model - Hecksher-Ohlin (H-O) model

International trade generates winners and losers H-O model: an import tariff raises the real return to the economy s scarce factor and reduces the real return to the abundant factor (Stolper-Samuelson theorem) the distributional effects work along factor lines S-F model: an import tariff in sector i increases the return to the specific factor in that sector, lowering the returns to other specific factors through the induced increase in wages the distributional effects work along industry lines

Typology of political economy models (Rodrik, 1995) A) Median voter model (Mayer, 1984) B) Interest groups models: Tariff formation function (Findlay and Wellisz, 1982) Campaign contributions approach (Magee, Brock and Young, 1989) Political support function (Hillman, 1989) Political contributions approach (Grossman and Helpman, 1994, 1995)

Median voter model (Mayer, 1984) Tariffs determined by majority voting among the population Provided that preferences are single picked (i.e., each person has a unique maximum), the trade policy chosen maximizes the utility of the median voter. In a H-O model, if voters differ in their relative factor endowments and the median voter owns a lower capital-labor ratio than the one for the overall economy, we should observe Import tariffs, if imports are labor intensive Import subsidies, if imports are capital intensive

Lack of realism of the median voter model: - Trade policy not determined by majority voting - Import subsidies not observed - Tariffs observed even in small industries that do not have support from majority of voters

Protection for sale model (Grossman-Helpman, 1994) Small open economy S-F model: numeraire good 0 produced via CRS, using labor alone and freely traded à the price of the numeraire good and wages and can be normalized to 1. n goods produced via CRS, using labor and a specific factor N citizens with identical preferences: u = x n + u i ( x 0 i i= 1 ) (1)

In L of the economic sectors, specific-factor owners overcome free-riding problems (Olson, 1965) and form industry lobbies. Lobby offer political contributions to the incumbent government to influence its trade policy choices. The gross-of-contributions aggregate utility of lobby i is W ( p) = l + π ( p ) + α N[ r( p) s( p)] i i i i i + (2)

Trade policies (ad valorem tariff taxes or subsidies) drive a wedge between domestic (p) and world prices (p * ). Semi-benevolent politicians, setting trade policy to maximize a weighted sum of political contributions and aggregate welfare: G = Ci ( p) + aw ( p) i= L (3) n W (p) l + π i (p i )+ N[r(p)+ s(p)] (4) i=1

The interaction between lobbies an policymakers takes the form of a common-agency game (Bernheim and Whinston, 1986): 1) Each lobby simultaneously and non-cooperatively presents the incumbent with a contribution function, giving a binding promise of payment conditional on the chosen policy. 2) Given lobbies contributions functions, the government sets trade policy and collects the corresponding contributions.

Characteristics of lobbies contribution functions At least around the equilibrium price p 0, lobbies contribution functions are Differentiable Truthful: for any lobby i, the marginal change in the contribution for a small change in the policy matches the effect of the policy change on its welfare: C i 0 ( p 0 )= W i ( p 0 ) This implies that the shapes of the contribution schedules reveal the lobbies true preferences in the neighborhood of the equilibrium.

In a political equilibrium neither the government nor any lobby has an incentive to alter its behavior. First-order condition for trade policy choices of incumbent politicians: W i ( p)+ a W ( p) = 0 (5) i=l

Plugging (2) and (4) into (5) and differentiating (5) with respect to p we can derive optimal ad valorem tariffs or subsidies in each sector: ti Ii α z L i = for i = 1 ti a L e + + α i 1,2,..., n (6) I i : indicator variable equal to 1 if sector i organized into a lobby, 0 otherwise α L 1: fraction of the population organized into lobbies z i = X i /M i : equilibrium ratio of domestic output to imports e i : elasticity of import demand (positive) or export supply (negative)

Predictions An organized import-competing industry (organized export o industry) is able to buy an import tax (export subsidy). A non-organized import-competing industry (non-organized export industry) receives a penalizing import subsidy (export tax). If all industries are organized, the outcome is free trade.

The extent of protection Falls with import elasticity (e i ) Intuition: taxing goods with higher import elasticity generates larger welfare losses. Falls with import penetration (M i /X i ) in organized industries Intuition: if domestic output is large relative to imports, specific-factor owners have more to gain and the economy has less to lose from protection (for a given elasticity).

Strengths of the G-H (1994) model Strong micro-foundations for government-lobby interactions Applicability to other economic problems (e.g. environmental taxation) Directly testable (e.g. Goldberg and Maggi, 1999) Weaknesses of the G-H (1994) model No role for strategic interaction across countries and trade negotiations No analysis of lobby formation and electoral competition

Trade Wars and Trade Talks (Grossman-Helpman, 1995) Two large open economies, home (no *) and foreign (*) Production and demand side of each economy as in G-H (1994) π i : international price p i = π I τ i : domestic price in Home Product markets clear when M i (π i, τ i ) + M i * (π i, τ i* ) = 0, i =1, 2,, n. (7) M i (p i ) =D i (p i ) - X i (p i ) are net domestic imports M i* (p i* ) = D i * (p i* ) - X i* (p i* ) are net foreign imports

Two forms of strategic interaction Non-cooperative (trade wars) Cooperative (trade talks)

Trade wars Stage 1: in each country, lobbies simultaneously and noncooperatively offer contribution functions relating their binding promise of political support to the selected policies. Stage 2: given lobbies contribution functions and the other country s policy, each government sets its trade policy and collects the corresponding contributions.

Home equilibrium response to an arbitrary trade policy by Foreign: τ W i (τ 0,τ * )+ a τ W (τ 0,τ * )= 0 (8) i=l Foreign equilibrium response to an arbitrary trade policy by Home: τ *W i (τ,τ *0 )+ a * τ *W (τ,τ *0 )= 0 (8 * ) i=l * Non-cooperative equilibrium trade policies: t I α X i 1 + for i 1,2,..., n * π M e il L i 1 = = * a + α L i i i (9) First term of (9): political support motives for trade intervention (G-H, 1994) The second term of (9): terms-of-trade motives for trade intervention, the optimal tariff (or export tax) adopted by a large country (Johnson, 1954).

In the case of an import competing lobby, terms-of-trade considerations reinforce the industry s lobbying efforts An organized import-competing industry emerges from a trade war with an higher tariff than in the Johnson equilibrium

Trade talks Stage 1: in each country, lobbies present policymakers with contributions schedules tying their promised political support to the policies that emerge from international talks. Stage 2: given lobbies contribution schedules, governments set cooperative trade taxes and collect corresponding contributions.

Objective functions of the two governments: G = i L C i (τ, τ * ) + a [W (τ, τ * )] (10) G * = i L* C i* (τ *, τ) + a * [W (τ *, τ)] (11) Efficient cooperative policies must be such that G cannot be raised without lowering G *. Objective of a mediator or supra-national government: a * G(τ *, τ) + a G * (τ *, τ) (12)

Equilibrium conditions for cooperative trade policies a * τ W i (τ 0,τ *0 )+ a τ W * i (τ *0,τ * ) +a a * [ τ W (τ 0,τ *0 )+ τ W * (τ *0,τ 0 )] = 0 (13) i L i L * a * τ *W i (τ 0,τ *0 )+ a τ *W * i (τ *0,τ * ) +aa * [ τ *W (τ 0,τ *0 )+ *W * (τ *0,τ 0 )] = 0 (14) τ i L i L *

From (13) and (14), we can derive cooperative trade policies: " τ 0 i τ 0* i = I α il L $ # a +α L X i π i M i ' % " ' I * * α il L $ & a * * # +α L X i * π i M i *' % ' for i =1, 2,..., n (15) & Foreign elasticities do not enter into (15) because terms-of trade motives for trade intervention are internalized by an hypothetical mediator. Protection rates reflect domestic and foreign lobbying.

Higher domestic tariffs if home lobby is stronger than the foreign. The domestic lobby has more political power if foreign industry not organized (I il =1, I il* =0) greater stake in the negotiations (X i >X i* ) smaller government s weight on welfare (a i < a i* ) smaller proportion of population organized (α L < α L* ) If lobbies are equally strong, their political influences cancel out and international prices are the same as in free trade.

Goldberg and Maggi (1999) Predictions of G-H (1994) in empirically testable form: t i 1+ t i = α L a + α L $ & % X i / M i e i ' ) + ( 1 a + α L $ & % I X i / M i e i ' ) i =1,2,...,n (16) ( Empirical model estimated by Goldberg and Maggi: y i = t ie i # = γ X & # i % ( +δ I X & i % ( +ε 1+ t i i =1,2,...,n (17) i $ ' $ ' M i M i γ indicates how trade policy varies with output/import ratio in any industry δ reflects the additional impact of having the industry organized as a lobby Predictions: γ <0, δ >0, γ + δ >0

Main variables Protection measure (t i ): US NTB coverage ratio (1983) Import demand elasticities (e i ): estimates by Shiells et al. (1986) Political organization dummy (I i ): various thresholds of corporate contributions to determine whether I i should be given a value of 1 Import penetration ratio (X i /M i )

Variable Estimation results X i /M i -0.009 ** I i X i /M i 0.01 ** N 107 Coefficients γ and δ have predicted signs and are statistically significant Estimates of γ and δ used to compute the implied structural parameters - government s weight on social welfare (β) as opposed to contributions (1-β) - proportion of the population organized in a lobby (α L )

Main problems Non-tariff barriers inaccurate measure of the level of protection (e.g. non-binding quotas) Overall corporate contributions inaccurate measure of contributions (e.g. not trade related) exclusion of important sources of contributions (e.g. labor unions) Government s weight on welfare (β =0.98): do lobbies really matter? The G-H (1995) model might be the appropriate model to test since US is not a small country (but lack of data on foreign elasticities) Tariffs are often determined cooperatively (but lack of data on foreign political contributions)