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MAN3100: INTERNATIONAL
TRADE
Lecture 7
Controversies in Trade Policy
Dr. Juan Carluccio
j.carluccio@surrey.ac.uk
53 AP 02
Learning objectives
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To discuss different arguments for activist
government intervention in trade and its limits.
To understand the case for subsidizing innovation in
high-technology industries and the caveats of this
policy.
To understand the concept of strategic trade policy
and its effectiveness.
To discuss the effect of globalization on the welfare
of workers in developing countries.
Reading list for today
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Essential reading:
Krugman, P. and Obstfeld, M. (2006) International Economics: Theory and Policy.
Chapter 11 “Controversies in Trade Policy”
Reading list for today (ctd)
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Additional readings:
Robert, L., and Lawrence, E. (2012) Shattering the Myths About U.S. Trade Policy. Havard Business Review. 90.3:149-
153.
http://www.hks.harvard.edu/fs/rlawrence/ShatteringMyths.pdf
Hertel, T., Keeney, R., Ivanic, M., and Winters, L. (2009) Why Isn’t the Doha Development Agenda more poverty
Friendly? Review of Development Economics, 13,4: 543-559
Working paper version: http://docs.lib.purdue.edu/cgi/viewcontent.cgi?article=1036&context=gtapwp
Aisbett, Emma, Ann Harrison, Alix Peterson Zwane (2007), Globalization and Poverty: What is the Evidence? Trade,
Globalization, and Poverty edited by Elias Dinopoulos, Pravin Krishna, Arvind Panagariya, and Kar-yiu Wong,
Oxon, U.K: Routledge, December 2007. http://bear.warrington.ufl.edu/dinopoulos/Bhagwati/PDF/Harrison.pdf
Rodriguez-Clare, A. (1996) Multinationals, Linkages, and Economic Development, American Economic Review, vol.
86(4), pages 852-73, September. (advanced)
http://www.econ.psu.edu/~aur10/Papers/AERMultinationalsLinkages.pdf
Ann Harrison, Jason Scorse (2004), Globalization’s Impact on Compliance with Labor Standards, Brookings Trade
Forum 2003 Brookings Institute. Washington DC, 2003. (good discussion of labor standards) http://mpra.ub.uni-
muenchen.de/36450/1/MPRA_paper_36450.pdf
The Economist “Robocolleague”, March 2nd 2013 http://www.economist.com/news/finance-and-
economics/21572741-robots-are-getting-more-powerful-need-not-be-bad-news
Plan for today
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1. Sophisticated Arguments for Activist Trade Policy:
A) High-Technology Industries
B) Strategic Trade Policy
2. Globalisation and Low-Wage Labor
Activist Trade Policy
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An activist trade policy means government policies
that actively support export industries through
subsidies.
Arguments for activist trade policies are justified in
the light of market failures.
Today we will discuss two cases of market failures
which are relevant for international trade, their
possible solutions and the problems with these
solutions.
Market Failure: Definition
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In a perfectly functioning market, individuals actions lead
to the maximization of society’s welfare through an
efficient allocation of resources (Adam Smith’s “invisible
hand”)
A market failure arises when the free market fails to
deliver an efficient allocation of resources.
Government intervention is required to correct market
failures and improve economic efficiency.
But intervention might no be easy (and lead to
“government failure” if wrongly undertaken).
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1. Sophisticated Arguments for Activist Trade Policy:
A) High-Technology Industries
High-Technology Industries
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High-technology industries are those that produce
technology.
Knowledge creation is an essential part of business.
One usual way of measuring the importance of
knowledge is by looking at R+D expenditures
High-Technology Industries
10
OECD Classification based on R+D expenditures
Knowledge externalities
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An important characteristic of High-Technology industries is the
presence of strong knowledge externalities, also labeled as
knowledge spillovers.
Knowledge externalities are the market failure that justifies
government intervention in these industries
Before going into details, let us first provide a definition of
externalities.
Externalities: Definition
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An externality is the cost or benefit that affects a party who
did not choose to incur that cost or benefit.
Examples:
Smoking creates a damage for people other than the smoker:
negative externality
A homeowner embellishes his house, the neighborhood benefits
through higher home values: positive externality.
Externalities are a kind of market failure
Technology and Externalities
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High-Technology Industries are characterized by the
importance of knowledge externalities
Knowledge externalities arise when a firm creates knowledge
(e.g. a new product or a new production process) that other
firms might implement for free they are positive
externalities or « spillovers »
The innovator paid the costs required to generate the
innovation (e.g. R+D) but other firms also benefit from the new
knowledge at no cost.
Realizing this, it will spend less in R+D which can be harmful to
society Market Failure.
Technology and Externalities
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The government might intervene to provide incentives for firms
to generate knowledge
The objective is to correct the underinvestment in R+D
generated by the fact that knowledge is not fully-
appropriable.
One common way is to subsidize high-technology industries.
Example: RAM memory chips
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Strong developments in the RAM memory chip industry in
Japan in the 1980’s. RAMs are a type of semiconductor.
The Japanese goverment had « targeted » this industry,
providing subsidies. The belief was that know-how acquired in
RAM production would generate strong externalities and boost
exports of other high-tech sectors such as microprocessors.
Generated fear in the US of losing market shares.
But Japan’s expected dominance did not materalize in the end.
Subsidies to High-Technology industries:
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implementation issues
1. How to pick up the right industries?
Example of RAM memory chips
2. Which activities should the government subsidize?
Economists’ general principle: only those that generate externalities (e.g.
subsidize R+D workers but not blue-collars )
But industry leaders argue against this narrow view
3. How big are externalities?
Very difficult to quantify the importance of externalities.
Hard to know the value of the right subsidy
High-Technology industries: summary
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High-technology industries are characterized by the
importance of knowledge externalities (a market failure).
The result is lower-than-optimal expenditures in R+D.
Subsidies might correct for this.
However, their implementation carries many uncertainties.
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1. Sophisticated Arguments for Activist Trade Policy:
B) Strategic Trade Policy
Imperfect Competition
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Some industries are dominated by a small number of firms
These firms have market power and generate excess profits
(above what equally risky investments elsewhere in the economy can earn)
Market power is a market failure (what fails us here is the assumption of
perfect competition)
In these industries, there will be an international competition
for the excess profits.
A government policy to give a domestic firm a strategic
advantage in production is called a strategic trade policy.
Brander-Spencer Analysis
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Main idea: governments can use subsidies to shift excess
profits from a foreign firm to a domestic firm.
If the increase in the profits of the domestic firms is higher than
the amount of the subsidy, then the subsidy raises national
income (otherwise it will reduce it).
For a subsidy to be successful we need to have gains > costs
Increase in profits after the subsidy > cost of the subsidy
Naturally, the increase in national income is at the expense of
the other countries’ income (whose firms lost profits).
Brander-Spencer Analysis: an example
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Two firms: Airbus and Boeing.
Airbus is located in Europe and Boeing in the US.
They both produce airplanes.
Each firm’s profits depends on the actions of the
other key point.
Each firm decides to produce or not depending on
whether its profits are positive.
Brander-Spencer Analysis: an example
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Production costs are of £5
Possible situations:
1. Only 1 firm is active (monopoly): profits are £100
2. Both firms are active: profits are -£5 (negative)
3. No firm is active: profits are zero.
The market is too small for both firms to coexist
the firm that prevails takes all of it
Brander-Spencer Analysis: an
example
Slide 11-23
Airbus
Boeing Produce Don’t produce
-5 0
Produce
-5 100
100 0
Don’t produce
0 0
Brander-Spencer Analysis: an example
Slide 11-24
What will the market outcome be?
If both firms produce (upper-left panel), then profits are
negative for both
hence, it will not be the case that both firms produce.
If no firm produces (lower-right panel), there will be profitable
opportunities to produce
hence, it will not be the case that both firms produce.
The outcome necessarily involves a monopoly
Brander-Spencer Analysis: an example
Slide 11-25
Who will get the monopoly profits?
- If Boeing produces first, then Airbus will not find it profitable
to produce.
-If Airbus produces first, then Boeing will not find it profitable
to produce.
Conclusion: the firm that enters first gets the monopoly profits
(and eliminates its competitor’s incentives to enter the market)
Suppose the EU provides a subsidy of £25 to Airbus
The subsidy increases Airbus revenues by £25
Brander-Spencer Analysis: an example
Slide 11-26
Effects of a £25 subsidy to Airbus
Airbus
Boeing Produce Don’t produce
20 0
Produce
-5 100
125 0
Don’t produce
0 0
A subsidy of 25 to Airbus given by Europe results in A=125, B=0.
Brander-Spencer Analysis: an example
Slide 11-27
Effects of unilateral subsidy to Airbus:
Airbus will always choose to produce, no matter if
Boeing enters or not (see the upper-left panel)
Boeing will not enter, and Airbus will become a
monopolist with profits of £125
The subsidy of £25 generates profits of £125 for Airbus.
The subsidy raises profits more than the amount of the
subsidy itself because of its deterrent effect on foreign
competition.
It increases Airbus profits at the expense of Boeign
profits: it is an example of “Beggar-thy-Neighbor” type of
policy
Problems with the Brander-Spencer Analysis
Slide 11-28
1. Practical use of strategic trade policy requires more
information about firms than is likely available
2. Strategic trade policy could be manipulated by
politically powerful groups (for example through
lobbying for unjustified subsidies)
3. Retaliation might lead to a “subsidy war” where
everyone losses
The US government retaliates by giving Boeing a
similar subsidy of £25.
Brander-Spencer Analysis: an example
Slide 11-29
Effects of retaliation by the US (subsidy of £25 to Boeing)
Airbus
Boeing Produce Don’t produce
20 0
Produce
20 125
125 0
Don’t produce
0 0
A subsidy of 25 to Boeing by the US results in A=20,B=20
Foreign Retaliation
Slide 11-30
When both firms are subsidized by their respective
governments, the equilibrium has both firms
producing
However the subsidy costed £25 and generated
profits of £20.
It decreased national income.
Hence, retaliation leaves both countries worse-off
Sophisticated Arguments for Activist
Trade Policy : wrap up
Slide 11-31
Activist trade policies are those through which the government policies
actively supports export industries through subsidies
Arguments for activist trade policies are justified in the light of market
failures. A market failure arises when the market fails to deliver an
efficient allocation of resources.
Individuals actions do not lead to the maximization of society’s welfare
Government intervention is might correct market failures and improve
economic efficiency (but it is subject to issues of its own, called “government
failures”).
Sophisticated Arguments for Activist
Trade Policy : wrap up (ctd).
Slide 11-32
High-technology industries are characterized by the importance of
knowledge externalities. The result is lower-than-optimal expenditures in
R+D. Subsidies might correct for this, but their implementation carries many
uncertainties.
In industries with a few firms and excess returns, goverments can use
subsidies to shift profits from foregin to domestic firms. Such policy is
labeled « strategic trade policy » or alternatively « Brander-Spencer
analysis ». Such policy is generally not effective and might generate
welfare losses: this is the case when governments have insufficient
information, when power groups manipulate the allocation of subsidies and
when retaliation leads to subsidy wars.
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2. Globalisation and Low-Wage Labor
Globalisation and Low-Wage Labor: 3 Facts
Slide 11-34
Fact1: the importance of low-wage countries’ exports
grew over the last decades.
Fact 2: there was a change in the structure of exports,
with a shift from exports of agricultural goods to
manufactures.
Fact 3: most of low-wage countries’ exports in
manufactures concern goods that use labor intensively
(e.g. textiles).
Fact 1: growing importance of exports by developing economies
Slide 11-35
Evolution of the volume of exports (Index, 2000=100)
Fact 1: growing importance of exports by developing economies
Slide 11-36
Share of developing economies in the value of world exports, by region (in %)
Fact 1: growing importance of exports by developing economies
Slide 11-37
Exports of developing countries into the US (in % of US GDP)
Fact 2: shift to manufacturing in exports by developing
economies
Slide 11-38
See Lecture 1 (Thanks Gio for the graph!)
Fact 3: Exports by low-wage countries are mainly
composed of labor-intensive goods
Slide 11-39
The Debate
Slide 11-40
The facts we just outlined depicts the « new
international organization of production »
They generated a passionate debate among
advocates and opponents of free trade
A part of this debate concerned how trade
affected the well-being of workers in low-wage
countries
We will oppose the two main views driving this
debate
The Anti-Globalization Movement’s view
Slide 11-41
Activists of the anti-globalization movement focused on the fact that
globalization makes it easier for employers in rich countries to
replace high wage workers with low wage workers in poor countries.
They argue the following: wages for workers in the developing
economies are very low, both in absolute terms and in comparison
with the wages of production workers in the advanced economies.
Thus, globalization must be bad for those workers.
This (true fact) leads them to the (unjustified) conclusion that trade is
harmful to workers in developing countries.
At the end of the nineties the movement was strong: demonstrations
disrupted the meeting of the WTO in Seattle (the meeting was
considered a failure).
Differences in wages across selected countries
Slide 11-42
The Economists’ View
Slide 11-43
The theory of comparative advantage predicts that low-
wage countries will specialize in the exports of goods that
use labor intensively (e.g. textiles).
It also predicts wages should rise in the export sectors
(known as Stolper-Samuelson theorem).
Thus, the economist view is that wages in developing
countries must be higher with trade than without.
Hence, the view shared by economists is that trade is
beneficial for low-wage countries.
The debate
Slide 11-44
One key difference is that, contrary to the activists,
economists do not focus on the comparison between
wages in rich versus poor countries.
Rather, they compare wages in developing countries
before and after trade. Are these workers better-
or worse-off with trade?
The evidence shows that real wages (that is, in terms
of purchasing power) increased in developing
countries.
Example: wage increases in China
Slide 11-45
Globalization and Wages in Rich Countries
Slide 11-46
An important part of the debate concerns the impact of trade on
wages in rich countries.
Economists agree that trade with low-wage countries leads to
wage and employment losses for unskilled workers in rich
countries, and to wage and empolyment gains for skilled
workers.
Trade brings important aggregate gains but creates a
redistribution that favors skilled workers
The solution should not lie in protectionism, but rather on policies
helping workers along the transition to new jobs (unemployment
benefits, training, etc).
For the Tutorial
Slide 11-47
Download the exercise for Tutorial 4 from
SurreyLearn
Lecture 6’s slides will be useful to have with
you during the Tutorial.
Adam Smith’s “invisible hand”
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As every individual, therefore, endeavours as much as he can
both to employ his capital in the support of domestic industry,
and so to direct that industry that its produce may be of the
greatest value; every individual necessarily labours to render the
annual revenue of the society as great as he can. …By directing
that industry in such a manner as its produce may be of the
greatest value, he intends only his own gain, and he is in this, as
in many other cases, led by an invisible hand to promote an
end which was no part of his intention. …. By pursuing his own
interest he frequently promotes that of the society more
effectually than when he really intends to promote it.
From “An Inquiry into the Nature and Causes of the Wealth of
Nations” Back
