Many economists encourage governments to abolish import taxes and have complete

6 The Effects of Trade Policy on Aggregate Growth and Poverty

Much of the literature on the effects of trade policy on the outcomes discussed in Sections 3 and 4 focuses on its short-run and static effects. The distinction between short- and long-run effects is not unique to trade policy. But in the case of trade policy, there are good reasons to believe that the long-run effects are orders of magnitude larger than the short-run effects. While the latter can be potentially identified through careful empirical work, the long-run effects are substantially harder to pin down empirically. As a result, arguments about dynamic long-run effects are often made based solely on principles and theoretical models, with little formal empirical support. In this section, we consider the (scant) evidence on long-run effects of trade policy on aggregate growth and poverty.

The relationship between a country's trade policy and aggregate economic growth is of key policy interest, and the empirical literature on the topic is one of the oldest areas of empirical inquiry in international economics. Although many economists believe, based on economic theory, that reductions in trade barriers promote economic growth, robust evidence on this relationship at the aggregate level has been elusive. Rodrik and Rodriguez (2001) and Hanson and Harrison (1999) review the issues that affect the estimation of the effect of trade policy on aggregate growth and conclude that the estimates of the effect are not robust. Most of the literature on the topic has examined the relationship between trade policy and growth in a cross section of countries. The issues that influence the inference include weak links between the empirical work to the underlying predictions from the theoretical literature, selective samples of countries with available data, measurement of trade policy at the aggregate level, consistency of measurement of key variables across countries and time, and endogeneity of trade liberalizations. To the extent that there is a positive relationship between trade policy and economic growth, it is not clear whether trade policy leads or lags. Does trade policy lead to higher economic growth or do countries at a certain level of development choose to implement more liberalized trade policy? Alternatively, do countries with less restrictive trade policy in general have economic institutions in these economies that are associated with higher growth?

While the robustness of findings in this area of research continues to be debated, researchers have recently used microlevel data on trade policy from trade liberalizations during the 1980s and 1990s and empirical frameworks guided by economic theory to make progress on the effects of trade policy on aggregate growth. Estevadeordal and Taylor (2013) find that countries that liberalized trade policy during the 1980s and 1990s (in part driven by the Uruguay round of the WTO negotiations) observed higher growth rates in GDP per capita over this period relative to countries that did not liberalize. According to a version of Solow model they develop, decline in import tariffs on capital goods increases incentives for firms to invest, which in turn increases steady state growth. Lower tariffs on intermediate inputs increase productivity, and subsequently steady state growth. Further analysis, which distinguishes between liberalized trade in production inputs and final consumption goods, finds that the positive relationship between trade liberalization and economic growth is driven by declines in tariffs on intermediate inputs and capital goods. Consistent with these channels, they show that countries that lowered tariffs on intermediate inputs and capital goods observed increased imports of intermediate and capital goods. On the other hand, there is no relationship between lower tariffs on consumer goods and economic growth. These findings provide country-level support for the effects of liberalized trade on improved efficiency of production through imported inputs and technology, channels that have been emphasized in studies of firm performance (Amiti and Konings, 2007; Goldberg et al., 2010; Khandelwal and Topalova, 2011).

The effects of trade policy (via economic growth) on poverty are even more difficult to quantify empirically than the relationship between trade policy and growth. In addition to establishing that trade policy affects growth, one needs to determine both whether and how trade policy-induced growth affects the poor. This is a challenging task to accomplish with aggregate data. Lack of availability of household survey data with information on consumption and income from many low-income countries affects measurement of poverty and average incomes of the poor (Deaton, 2005; Ravallion, 2001). In the absence of reliable survey data, average incomes of the poor, which are often measured by the average income of the households in the bottom fifth of income distribution, are imputed from very noisy measures of income distribution within a country. With noisy measures of income inequality, this imputation makes is likely that measures of income of the poor simply follow changes in average incomes (Banerjee et al., 2006). This biases the results in favor of pro-poor effects of growth.x In recent years, household surveys are increasingly available and the World Bank Research Department has made substantial progress on measurement of poverty across time and space. Nonetheless, the poverty measures do not span periods of trade liberalization for a large share of countries, so the relationship between trade policy and poverty across countries remains empirically elusive.

In summary, the literature on the effects of trade policy on aggregate growth does not provide much robust evidence that trade policy affects growth. This is a very different conclusion from the message in the studies of the effects of trade on firm performance. This leaves one wondering whether the lack of robust aggregate evidence in part reflects the methodological challenges highlighted in Section 2, which are amplified in aggregate studies. Recent work by Estevadeordal and Taylor (2013) makes headway on overcoming some of these issues, while focusing on one particular channel of the link between trade policy and growth. Its findings are consistent with the evidence from firm-level studies that emphasize the role of trade policy in promoting efficiency and innovation through access to imported inputs and capital goods in less developed countries. However, more work is needed is this area.

2.3.2 Prisoners’ Dilemma

We now briefly consider the basic Prisoners’ Dilemma that arises in the monopolistic competition model. As with the models above, we characterize the Nash, efficient and politically optimal tariffs.

To characterize Nash trade policies, we begin by representing the best-response or optimal trade policies for the home and foreign governments. We assume in this discussion that the relevant second-order conditions hold. The home-country best-response import and export policies are then determined by the following two first-order conditions:

(36)Vpfdpfdι=0Vph*dph*dι*+Vp*wdp*wdτh*=0,

where the home-country import tariff τh affects pf via ι, the home-country export tariff affects ph*via ι*, and the indirect utility function V is given in (35). Similarly, the foreign-country best-response import and export policies satisfy the first-order conditions

(37)Vph**dph*dι*=0Vpf*dpfdι+Vpw*dpwdτf=0.

We may now define the Nash trade policies, (τhN,τh*N,τf*N,τfN), as the tariffs that simultaneously satisfy (36) and (37).

Consistent with our discussion earlier, we note that terms-of-trade effects are absent from the conditions that determine the best-response import policies (the top expressions in (36) and (37)) but present in the conditions that determine the best-response export policies (the bottom expressions in (36) and (37)). As Bagwell and Staiger (2015) discuss further, the optimal export policy for a given country thus represents a balance between the terms-of-trade gain that is associated with an export tariff and the firm-delocation benefit that is associated with an export subsidy.

Our next goal is to characterize efficient trade policies. Since this model also has sufficient trade-policy instruments with which to effect lump-sum transfers, efficient trade policies are those which maximize V + V*. Using (34), we observe that total income can be written as

(38)I(⋅)+I*(⋅)=L+L*+[pf−ϕpˆ−pˆ]M(pf,ph*)+[ph*−ϕpˆ−pˆ]E(pf,ph*)≡T(pf,ph*).

Notice in particular that world prices do not affect total income, which is to say that we can express total income as the function T(pf,ph*). Using (35) and (38), we can now also represent joint welfare as a function J(pf,ph*)where

(39)V(⋅)+V*(⋅)=P(pf,ph*)−ϵθ(1ϵθ)+P*(pf,ph*)−ϵθ(1ϵθ)+T(pf,ph*)≡J(pf,ph*).

As this expression confirms, any trade-policy induced change in world prices corresponds simply to pure international rent shifting and does not affect efficiency.

Efficient trade policies thus maximize the joint welfare function J(pf,ph*)given in (39). By (25) and (27), respectively, we also know that ph*=ph*(ι*)and pf = pf(ι); thus, joint welfare is a function of the four tariffs only through ι and ι*. Assuming that the joint welfare function is strictly concave when treated as a function of ι and ι*, the set of efficient tariffs is thus characterized by the following two first-order conditions:

(40)[Vph*+Vph**]dph*dι*=0[Vpf+Vpf*]dpfdι=0.

Bagwell and Staiger (2015) further explore the two conditions in (40) and show that efficiency requires a net subsidy to trade along each trade channel (ie, τf*+τh*<0and τh + τf < 0).ab The intuition is that a net subsidy is desirable due to the positive markup in the differentiated sector.

We now turn again to the three questions raised at the start of the section. First, we consider the efficiency of Nash trade policies. Once again, we expect that Nash trade policies are inefficient, since governments are motivated by world-price considerations when setting Nash policies but not when maximizing joint welfare. More formally, after adding the bottom Nash condition in (36) to the top Nash condition in (37), and likewise adding the top Nash condition in (36) to the bottom Nash condition in (37), we arrive at the following:

(41)[Vph*+Vph**]dph*dι*=−Edp*wdτh*<0[Vpf+Vpf*]dpfdι=−Mdpwdτf<0

where we use (34) and (35) to obtain that Vp*w=Eand Vpw*=M. Comparing (40) and (41), it is now immediate that Nash trade policies are inefficient.

Given the assumed second-order conditions and the symmetry of the model, we know that Nash and efficient tariffs are each such that the total tariffs satisfy ι = ι*. Starting at the Nash equilibrium, if we were to undertake any change in underlying tariffs that delivered a symmetric increase in ι = ι*, then the change in joint welfare would be given by the sum of the terms on the LHS of the equalities in (41), when evaluated at ιN≡1+ϕ+τhN+τfN=1+ϕ+τf*N+τh*N≡ι*N. As is evident from (41), starting at the Nash equilibrium, a symmetric change in ι = ι* increases joint welfare if and only if ι = ι* is decreased. It thus follows that the total trade cost, ι = ι*, is strictly higher at Nash tariffs than at efficient tariffs.

We turn now to our second question and explore whether a mutually beneficial trade agreement requires reciprocal trade liberalization. Our preceding discussion already establishes that a trade agreement that delivers symmetric changes in total trade costs can generate greater joint welfare if and only if total tariffs are reduced from Nash levels. Thus, at least in the context of trade policy adjustments that maintain symmetric total trade costs, ι = ι*, mutual gains are possible starting at Nash only if reciprocal trade liberalization occurs in the sense that τh+τf=τf*+τh*is reduced. Just as in our discussion of the partial-equilibrium model with perfect competition, such efficiency-enhancing paths may involve adjustments in underlying tariffs that are asymmetric across countries. Mutual gains are again possible, however, only if each government makes adjustments to its policies that contribute to some degree to the fall in total tariffs.

Finally, we consider whether terms-of-trade motivations represent the sole rationale for trade agreements in the monopolistic competition model. To explore this issue, we again define the politically optimal tariffs to be those tariffs that hypothetically would be chosen by governments unilaterally if they did not value the pure international rent-shifting associated with the terms-of-trade movements induced by their unilateral tariff choices. For the monopolistic competition model under consideration here, when making their respective politically optimal tariff selections, the home-country government acts as if Vp*w=0=Vpwwhile the foreign-country governments acts as if Vpw*=0=Vp*w*.ac Formally, and following Bagwell and Staiger (2015), we define the politically optimal tariffs for the monopolistic competition model as the vector of tariffs satisfying

(42)Vpfdpfdι=Vph*dph*dι*=0=Vph**dph*dι*=Vpf*dpfdι.

The four equations in (42) determine the politically optimal tariff vector, (τhPO,τh*PO,τf*PO,τfPO). In the symmetric model considered here, a common total tariff is determined for each direction of trade, τhPO+τfPO=τf*PO+τh*PO, so that the resulting total trade cost is also symmetric: ιPO≡1+ϕ+τhPO+τfPO=1+ϕ+τf*PO+τh*PO≡ι*PO. Using (40) and (42), it is now immediate that the politically optimal tariffs are efficient. Thus, in the monopolistic competition model as well, the terms-of-trade externality is the sole rationale for a trade agreement.

Intuitively, in the Nash equilibrium of the monopolistic competition model, each government is mindful of the beneficial firm-delocation effect that import tariffs and export subsidies offer, and each government is also attentive to the terms-of-trade gain that export tariffs provide. The effects of trade policies on trade volumes and thereby tariff revenue are also considered. By contrast, when governments select politically optimal policies, they ignore the terms-of-trade impacts of trade (namely, export) policies and focus on the local-price implications of trade policies. The local prices that can be influenced by trade policy in this model are the domestic prices of varieties produced abroad, ph*and pf, where these prices in turn are determined by total trade costs, ι = 1 + ϕ + τh + τf and ι*=1+ϕ+τf*+τh*. A key point is that, when a government selects its politically optimal export policy, it does so to deliver its preferred local price abroad for its domestically produced varieties, which in turn neutralizes the externality that travels from the trading partner's import tariff through this price. Likewise, a government's politically optimal import tariff delivers its preferred local price in the domestic market for varieties produced abroad, which in turn neutralizes the externality that travels from the trading partner's export policy through this price.

Thus, while the monopolistic competition model admits a rich set of local-price externalities that complement the traditional terms-of-trade externality, the local-price externalities are “shut down” when each government selects its politically optimal import and export policies, leaving only the terms-of-trade externality, which by itself amounts simply to a lump-sum transfer between governments. In this sense, the terms-of-trade externality remains the sole rationale for a trade agreement. From this perspective, it is also apparent that politically optimal trade policies would not in general be efficient were governments to possess an incomplete set of trade-policy instruments. For example, if export policies were unavailable, then a government would not be able to use its export policy to deliver its preferred local price abroad for domestically produced varieties, and its trading partner's import tariff would then induce a local-price externality through this channel.ad As in the partial-equilibrium perfect competition model discussed earlier, the efficiency of politically optimal policies relies deeply on the assumption that governments possess a complete set of trade-policy instruments.ae

The finding just described—that politically optimal policies are efficient in the monopolistic competition model when governments have a complete set of trade-policy instruments—extends to a range of other imperfect competition settings. For example, Bagwell and Staiger (2015) show that this finding holds as well in the Cournot delocation model considered by Venables (1985), wherein firms engage in Cournot competition and markets are segmented. In complementary work, Bagwell and Staiger (2012b) show that the finding holds as well in various “profit-shifting” models, where the number of firms is fixed and trade policy can shift profits from one country to another. An important direction for future research concerns the extent to which this finding extends to settings with multiple countries, domestic policies and other forms of imperfect competition.af Another extension, which we discuss below, concerns whether this finding extends in “offshoring” settings where prices may be determined through bilateral bargaining between sellers and buyers.

Finally, while the results summarized here indicate that the terms-of-trade externality remains the sole rationale for a trade agreement in important imperfect-competition settings, non-terms-of-trade externalities may nevertheless be important for understanding key features of actual trade agreements. First, actual trade agreements may constrain the trade-policy instruments that are available to governments, so that local-price externalities are not neutralized when politically optimal policies are selected. As one important example, we note that the WTO prohibits export subsidies. As Ossa (2011) argues and as we discuss further in a later section, in such a restricted-instrument setting, novel externalities may influence trade-agreement purpose and design. Second, and relatedly, models with imperfect competition may deliver novel interpretations of certain design features of trade agreements. For instance, as Bagwell and Staiger (2012a) show, the Cournot delocation model can provide a novel interpretation of the WTO's restrictions on export subsidies.ag Finally, our discussion here emphasizes international externalities that travel through prices. Trade policies also may be associated with international nonpecuniary externalities, such as global warming. The purpose and design of trade agreements in settings characterized by pecuniary and nonpecuniary international externalities is a very important direction for future research.ah

4.3.1 Direct Effects

A traditional way to estimate the effects of AD duties is through computable partial or general equilibrium models, and examples of their application to AD activity include Murray and Rousslang (1989), US International Trade Commission (1995), DeVault (1996a), Morkre and Kelly (1998), and Gallaway et al. (1999). All the classical predictions are typically found by these models, with significantly lower imports; higher domestic output, employment, and profits; and overall net welfare losses. The results from these models indicate that AD imposes as large (or larger) welfare costs than any other current commercial policy.

Analysis of trade policies in computable equilibrium models is useful, particularly for providing a large range of results and the ability to estimate aggregate statistics (eg, net welfare estimates), but also has well-known issues. First, these models make functional form assumptions about the nature of demand, market competition, and costs, which can largely dictate the direction of impacts that will be found.bb They also rely on a number of parameters, such as demand elasticities, that have to be assumed or drawn from existing estimates in the literature.

An alternative approach is statistical analysis. While such analyses are typically more targeted on a particular outcome variable, they have a better ability to estimate the magnitude of the responses of the outcome variable and how various factors affect the response. One group of early statistical studies of the direct effects of AD actions examines product-level trade data and includes Krupp (1994), Krupp and Pollard (1996), and Brenton (2001). These papers confirm that AD actions restrict trade, but they also find that the effects on imports vary during the AD investigation and with the type of outcomes (eg, AD duties vs withdrawn or suspended cases).

A number of other statistical studies, including Hartigan et al. (1989), Mahdavi and Bhagwati (1994), Hughes et al. (1997), and Blonigen et al. (2004) use event study methodology to assess the effect of AD activity on firms’ stock market returns—a measure of a firm's current and expected profitability. These studies find that AD actions can, but do not necessarily, lead to greater profitability for the petitioning domestic firms. For example, Hartigan et al. (1989) find that AD decisions do not help domestic firms when the agencies rule that there has been actual injury to the domestic firms from the dumped imports, as opposed to when they only find that there is a threat. Blonigen et al. (2004) show that positive gains only occur for domestic firms when the foreign firms are not able to tariff jump the AD duty and locate production in the domestic market. This is a clear example where an indirect/unintended effect of AD actions (here, tariff-jumping) can impact the effectiveness of AD actions. We discuss these indirect effects next.

4.3.6 Antidumping in Historical Perspective

The last trade policy exception from the GATT period that we introduce is antidumping.cg As described in Section 3.1, the GATT system permitted countries to impose antidumping import restrictions against products sold at low (dumped) prices if such imports caused injury to the domestic, import-competing industry. Today antidumping is in use by a wide range of high-income and emerging economies.

Prior to the 1990s, only four economies—Australia, Canada, the EEC and the United States—used antidumping import restrictions with any regularity.ch In the 1980s, for example, the United States began to use antidumping with increased frequency to address the import growth in a number of different sectors from Japan, as well as some of the other newly industrializing economies of East Asia, such as Korea and Taiwan.ci

Here, we take advantage of newly compiled data on historical use of antidumping by the GATT's high-income economies so as to compare their use of the policy during the 1970s with their more contemporary use. Fig. 15 depicts the share of antidumping investigations across industrial sectors for three different decades.cj

Interestingly, the figure reveals a number of similarities arising for antidumping use by both the United States and Europe. In the 2000s, the industry demands for new import restrictions were mostly concentrated into the metals (steel) sector. However, this was not always the case. In the 1970s, less than 25% of US antidumping investigations were in the metal sector. In both economies in the 1970s, antidumping use was much more evenly dispersed across sectors, including chemicals, machinery, plastics, stone, and transportation equipment.

Macro–Meso–Micro Policy Linkages in the Context of Nutrition

Macro and trade policies can have a profound influence on the nutritional outcomes at household and individual levels. For example, food self-sufficiency policies mostly focusing on procuring cereal crops provide little incentive for diversification of farming into nutrient rich crops. Minimum support prices announced for rice and wheat (which are sometimes more than the market prices) and assured procurement of such crops from farmers for storage and price stabilization purposes do not allow market forces to play their role in ensuring best allocation of land and water resources to crops that are more profitable and nutritionally enriching. Further, limited opportunities to trade in food commodities can restrict the local production of nutrient-rich foods. Restrictions on the movement of food commodities and infrastructural challenges result in high prices in one region of the country due to high demand, while in another part of the country the produce can be rotting without buyers. Such imbalances in market policies can be detrimental to diversification away from cereal crops to perishable high value commodities, affecting dietary diversity and nutritional intake at the household level. Low incomes and high inflation in salient commodities, such as pulses in south Asia, and among vegetarians can affect nutritional status as well.

Macro level issues need to be studied in the context of the micro level nutritional impacts. These linkages and challenges are brought out in a recent paper by Heady et al. (2015) in the context of Bangladesh. They find farm level constraints in diversification, weak market and trade infrastructure, and low level demand for nutrient-rich foods are basic problems of macro level policies having a micro level nutritional impact. They identify several causes that could be addressed through policy interventions.

Heady et al. (2015) argue that competing uses for land and water resources in a highly populated country where per capita availability of land is shrinking over time, limits the expansion of land to nutrient-rich crops. Further, emphasis on rice production for food security goals has focused the research and extension investments to major food crops such as rice and wheat. In addition, poor development of the value chains, including the marketing infrastructure and cold storage facilities for the perishable commodities, have limited crop diversification. This is compounded by the low level of demand for micronutrients. These factors resulted in limited crop diversification and continue to constraint households. As a result, Bangladesh has one of the least diversified diets in the world. Given that income is increasing among the middle income groups and demand for high value commodities is increasing due to changes in the dietary patterns, the limited crop diversification away from cereals crops has resulted in high prices of high value commodities pushing Bangladesh to rely on imports of these commodities.

5.3.1.3 Public finance

In addition to trade policy, another area where CGE models have played an important role in public policy is, not surprisingly, public finance (Shoven and Whalley, 1972). On the tax side, general equilibrium tax incidence analysis was used to dispel the notion that increasing energy taxes (or, equivalently, lowering energy subsidies) was regressive in the Philippines (Devarajan and Hossein, 1998), a finding that contributed to the government's decision to raise energy taxes during an election year. In a novel application, Dabla-Norris and Feltenstein (2005) used a CGE model to simulate the effects of tax evasion on the macroeconomy in Pakistan – a country where this was a major policy issue. On the expenditure side, a few papers examined whether government infrastructure expenditure crowds out private investment and exports, or crowds them “in” by lowering the costs of production. Feltenstein and Ha (1999) showed, in the case of Mexico, that the latter effect is unlikely to exceed the former. The pressure that increased infrastructure spending puts on the interest rate and inflation greatly reduces any benefits from higher infrastructure stocks. Similarly, Feltenstein and Ball (2001) looked at the general equilibrium effects of government bailouts of insolvent banks in Bangladesh. Their model was operational at the Bangladesh Ministry of Finance for several years.

CGE models have been used extensively in developing countries to explore the implications of adopting a value-added tax (VAT). A good example is Mozambique, where CGE model analysis was part of an extensive work program concerning the economic impacts of adopting a VAT system, and the problems of implementing and administering the new tax system. Tarp and Arndt (2009) describe the overall work program and Arndt et al. (2009) describe the CGE application. The model was adapted to incorporate in detail the European-style destination VAT system in Mozambique, with exempt sectors, zero-rated sectors and a complicated rebate system. The analysis focused on problems of applying the VAT and noted that, in some cases, it operated more like a tariff than a VAT, since it was easy to tax imports, but difficult to tax domestic producers of the same products.

2 Trade Policy in a Competitive Small Open Economy

Devising criteria for trade policy which will hold universally is a daunting task, and it makes sense to begin with a simple benchmark case. The classical starting point is an economy which is both competitive—individual consumers and firms cannot affect domestic prices—and small—the economy as a whole cannot affect world prices. Free trade must then maximize real national income, since it removes the constraint requiring an exact match between domestic production and consumption patterns. Specialization in production increases the value of aggregate output at world prices, while consumers benefit by being able to buy from the cheapest supplier worldwide.

However, individuals are both consumers and income recipients, and aggregate gains can mask big shifts in internal income distribution. The near certainty that there will be some losers is implied by the Stolper–Samuelson theorem. This was originally formulated for a special model, where it predicts that protection will raise real wages (so trade liberalization will lower them) if imports use labor relatively intensively. More generally, the logic of the theorem implies that there are almost always some factor-owners who will lose from a reduction in trade barriers. Most obviously, this will be true of factors which are specific (even if only in the short run) to import-competing sectors.

Losers notwithstanding, the existence of national gains from trade ensures that ‘aggregate welfare’ must rise, meaning that it would be possible to tax some of the winners' gains, compensate the losers, and still leave no one worse off. Free trade is thus the archetype of a situation which is potentially Pareto efficient or simply ‘efficient’ (confusingly, the term has a more precise sense than in common parlance). The same result holds even if the government has limited taxing and spending powers, and can only redistribute income through changes in commodity (or ‘indirect’) taxes. Of course, all this is poor consolation for the losers if the compensation is not actually carried out. Nonetheless, trade theorists tend to emphasize the efficiency gains, and prefer to try and devise programs of adjustment assistance to help those adversely affected rather than to recommend foregoing the national gains. In this they are motivated by professional division of labor (losses to particular groups mandate changes in the tax and social welfare system, not protection), and a belief that the poor rarely gain from highly restricted trade, rather than heartlessness. For the same reasons, the remainder of this article concentrates on the effects of trade liberalization on aggregate welfare, and will not repeat these essential qualifications about its distributional consequences.

Even though the case for free trade is clear, the best way to move towards it may not be (except in the trivial case where there is only a single tariff). Abolishing all tariffs at once is unlikely to be politically feasible. Two rules of piecemeal trade liberalization are then available. The first is the uniform reduction rule: reduce all tariffs by an equiproportionate amount. Heuristically, this kind of reform leaves relative tariff rates unchanged, so it is ‘as if’ there is only a single tariff rate, which is steadily reduced. Hence it is not surprising that (pathological cases apart) it guarantees a welfare improvement. The second is the concertina rule: reduce the highest tariff rate. A sufficient condition for this to raise welfare is that the good in question is a substitute for all other goods subject to tariffs. Substitutability is not necessary, however. For example, if all goods subject to tariffs are complements for each other, then a reduction in any tariff (not just the highest) raises imports of all tariff-constrained goods and a welfare gain is again assured. Finally, the concertina rule does not justify increasing the lowest tariff, unless all exports are subsidised at higher rates: only raising the lowest distortion guarantees a welfare gain.

This discussion illustrates the distinction between ‘first-best’ and ‘second-best’ welfare economics. Policy recommendations are more complicated in the latter case, when some pre-existing distortions cannot be abolished. Nevertheless, a general principle applies: activities which from a welfare perspective are undersupplied in the absence of intervention should be encouraged and vice versa. A related rule of thumb with many useful applications in practical policy making is the principle of targeting: intervention should be applied as closely as possible to the desired target, whether this is to offset an irremovable distortion or to attain a ‘noneconomic’ objective (such as restricting imports of certain types of goods or protecting industries deemed essential to cultural independence or national security). From this perspective, trade policy is rarely a first-best instrument. For example, if there is a minimum wage in the import-competing sector, protection may raise welfare because it partially offsets the minimum wage. But other forms of intervention, such as employment or production subsidies, would have the same effect at lower welfare cost.

Protectionists Versus Free Trade Arguments

The debate on trade policy is much the same as it was 200 years ago. Arguments today that favor increased protectionism incorporate several mercantilists’ concepts, including the importance of a positive trade balance to a nation prosperity. A trade surplus supposedly creates a cascading series of increased expenditures, that is, the foreign trade multiplier, while a trade deficit supposedly represents a leakage of demand from domestic to foreign goods and products, reducing with a multiplier income, profits, and employment.

Import tariffs and export subsidies are advocated as a set of polices capable of improving the trade balance of trade. Supporters of these policies observe that tariffs raise domestic price of imported goods and subsidies reduce the price of goods exported to foreigners. This reduction in imports and thus the stimulus to exports are believed to improve the domestic economic conditions. If the advocates of trade restrictions were correct, then across-the-board protectionist policies would be associated with the increased profitability (i.e., stock returns) and employment.

On the other hand, free trade advocates harken back to the principles propounded by Adam Smith and his predecessors. They argue that imports and exports are two sides of the same transaction. Goods are exported to ultimately be able to import and consume the goods produced by foreigners. Free traders argue that a restriction on imports is equivalent to a restriction on exports and can be expected to have little or no effect on the trade balance. Similarly, a subsidy on exports is equivalent to a subsidy on imports. This proposition is nothing more than Lerner’s famous Symmetry Theorem [6]. Free trade advocates conclude that trade restrictions do not improve the trade balance, but do impair the efficient of the economy. To the extent that restrictions are effective, the benefits of free access to foreign goods and markets are lost to the economy. That is the case called gains of trade are reduced. Production incentives shift away from those goods produced more efficient domestically. If the advocates of free trade are correct, then protectionist policies would be associated with decreased profitability and employment. The assumption that protectionist policies will save jobs in America is static thinking that will take the administration down the wrong policy path.

Redistributionist policies may be justified in a zero-sum world. However, in an interdependent world of expanding opportunities, protectionism will bring everyone down. Conversely, a pro-growth, pro-free trade agenda will make us all better off. If market forces are operating, the production of lower value added items will be exported to us at much lower prices than if they were produced here. The gains to the United States come in two forms: the lower prices paid by consumers and the freeing up of resources that can now be invested in higher value added activities.

In real life, the adjustment process is not costless. However, the long-run benefits are obvious. One only needs to look at the Midwest. During the early Reagan years, we referred to it as the rustbelt. The smokestacks in the industrial Midwest were having a tough time. Yet looking back, one can see that the region retooled and recovered. In Cleveland, the river does not catch fire anymore and the Midwest became a thriving dynamic region. The technological revolution taking place in the world today is forcing similar adjustments. Add to that the adoption of market-oriented tendencies in the rest of the world and we have the makings of another major readjustment in trade and production patterns. The sad part is that rather than accelerating the transition, the government actions retarding the adjustment to a new world order.

What is it called when member countries agree to remove import taxes and trade barriers?

What is Theory of encourage exports and discourage imports?

What are the main reasons for removing tariffs?

Why would a government wish to restrict the flow of imports?