3 Trade policy

In this chapter, we discuss countries’ incentives and opportunities to influence trade flows and the welfare implications of trade policy. In particular, we provide information on how the World Trade Organization organizes the world trading system.

3.1 Globalization

The term “globalization” is often used in different contexts and is usually implicitly associated with diverse and sometimes contradictory ideas about how the world works. There is no clear and generally accepted definition of the term. The use of the term carries a high risk of being misunderstood, as the conversation partner may have a different understanding of the term.

Nevertheless, it is important to understand the various meanings of the term to be able to understand the arguments that involve the term. Additionally, it allows you to phrase your own argument more precisely.

So, how can we get known to the various meanings of the term globalization. One way is to ask ChatGPT. Below you find my take on asking OpenAI (2024).

OpenAI. (2024). Chat GPT-4o mini. Large language model. https://nextgeneration-ai.crf-education.com

Discuss: What do people mean when they use the term “globalization”? NextGeneration:AI

Globalization is a multifaceted concept that refers to the increasing interconnectedness and interdependence of countries and cultures around the world. When people use the term “globalization,” they often mean several interrelated processes:

Economic Globalization: This aspect emphasizes the integration of national economies through trade, investment, and capital flows. It involves the reduction of trade barriers, the rise of multinational corporations, and the spread of global supply chains. Economic globalization has led to increased access to goods, services, and jobs across borders.

Cultural Globalization: This involves the sharing and blending of cultural elements such as language, traditions, music, and values. Through media, travel, and technology, cultural practices and ideas can spread more freely, leading to both cultural exchange and homogenization. It raises discussions around the preservation of local cultures versus the influence of dominant global cultures.

Political Globalization: This refers to the increasing influence of international institutions and agreements, such as the United Nations, the World Bank, and trade treaties. It encompasses the idea of global governance and the shared responsibility of nations to address global challenges like climate change, human rights, and security.

Technological Globalization: This highlights the role of technology in fostering globalization. Advances in communication, transportation, and information technology have made it easier for people and businesses to connect globally. The internet, for example, enables instantaneous communication and the transfer of information across borders.

Social Globalization: This aspect focuses on the movements of people around the world, including migration, tourism, and the exchange of ideas and social practices. It emphasizes how global interactions affect societal structures and relationships.

Environmental Globalization: This addresses the global nature of environmental issues, such as climate change and biodiversity loss, which require international collaboration and efforts to manage resources sustainably.

Critically, globalization is also a subject of debate and contention. Advocates argue that it can lead to economic growth, cultural exchange, and improved living standards. Critics, however, point to issues such as economic inequality, cultural erosion, and exploitation as consequences of globalization. Additionally, events like the COVID-19 pandemic have sparked discussions about the vulnerabilities and risks associated with a highly interconnected world.

Overall, globalization encompasses a broad range of interactions and dependencies that shape contemporary society, economy, and culture on a global scale.

3.2 Political arguments for trade restrictions

Like most things in real life, trade is never all good or all evil. There are arguments in favor of opening up foreign markets and promoting international cooperation, but there are also plausible arguments that justify restricting international trade. Very often it is an empirical question as to which line of argumentation dominates.

When politicians and interest groups debate the pros and cons of trade, we must be aware of the unfortunate circumstance that not everything that is plausible is logically correct or empirically dominant. Below I will discuss some plausible arguments in favor of trade restrictions. The list is incomplete. Each argument is a topic in itself, and it needs to be further investigated whether these arguments are really valid arguments in favor of trade restrictions.

3.2.1 The desire to reduce domestic unemployment

As we learned in the previous sections, the domestic production is the result of the world market price in the long-run. However, in the short run this means that production factors need to reallocate from one sector to the other. So far, we assumed that this reallocation happens without any frictions. Thus, we just moved along the PPF curve. In reality the transformation process is costly because the people loose their jobs without finding a job in another sector instantaneously without any costs. In reality a transformation process comes along with costs such as social costs and search and matching costs. Thus, it can be a rational strategy to decrease the reallocation/transformation pressure in order to organize the reallocation of productions factors properly holding the external negative effects of transformation low. Nevertheless, we should not forget that (in the long run) reallocation of production factors and the adaption of new technologies is basically one of the most important sources of welfare growth, if not the only source.

3.2.2 The key enabling technology argument

If domestic industries are fostered, there might be technological spillovers to other industries in the country. As the government internalizes these spillovers, they have an incentive to protect and support these key to growth industries and technologies, respectively.

3.2.3 The need to counteract dumping in international trade

Selling goods in a foreign market below the price charged domestically can be called dumping. This sort of price competition is harmful when foreign producers hamper competition and discourage innovation and upgrading. For example, predatory dumping can give arguments for anti-dumping policy interventions. Predatory dumping is a type of anti-competitive behavior in which a foreign company prices its products below market value in an attempt to drive out domestic competition. This may lead to conditions where the company has a monopoly in a certain product or industry in the targeted market with bad implications for social welfare.

3.2.4 The government revenue argument

Government can finance their budget by raising tariffs.

3.2.5 The national defense argument

National defense is an obviously legitimate goal for any sovereign government and hence, domestic industries that supply goods and services that are important for a potential military emergency should have a special protection.

3.2.6 The wish to decrease the national balance of payments deficit

Countries that have a large trade deficit wish – for whatever reason (see Section 1.3}) – to increase import restrictions in order to decrease the export deficit.

3.2.7 The income redistribution argument

As we have learned, trade generates winners and losers and hence is a source for the distribution of wealth. Government can use this knowledge to redistribute income or decrease income inequality. However, it is almost certain that this politic is not the most efficient and best way to achieve the said goals because we have also learned that trade is beneficial for a country as a whole.

3.2.8 The infant industry argument

Figure 3.1: The infant industry argument

The basic idea is that no economic activities will happen in industries in which there are no possibilities to make positive profits because competition from abroad is currently to strong. A finite protection from international competition can make firms to grow and become more productive so that they can face foreign competition after the protection is abolished. The core of the argument is that infant industries do not have economies of scale like competitors from abroad and, hence, need to be protected until they can attain similar economies of scale.

Figure 3.1 provides a visualization that may help to understand the infant industry argument. In the left panel you see that the domestic supply curve lies above the world market price, $P^W$. Thus, the domestic industry is not competitive enough to produce at costs lower than the world market price. A tariff in time $t$ would protect the domestic market so that some firms start to produce and sell their goods at home. The hope of the government now is that the firms become more productive over time and in turn their supply curve shifts downwards. The downward shifted supply curve in time $t+1$ is shown in the right panel. Here, the government can remove the tariff without crowding out the domestic production.

Exercise 3.1 Arguments for trade restrictions (Solution 3.1)

Explain briefly (2-3 sentences) the infant industry argument.

Solution 3.1. Arguments for trade restrictions (Exercise 3.1)

A finite protection from international competition can make firms to grow and become more productive so that they can face foreign competition after the protection is abolished. The core of the argument is that infant industries do not have economies of scale like competitors from abroad and, hence, need to be protected until they can attain similar economies of scale.

Exercise 3.2 Buy local be happy?

In many countries, including the U.S. (see Figure 3.2), people tend to believe that it is better to buy at home than abroad. A Statement of The White House on July 28, 2021 says:

“The President believes that when we spend American taxpayers’ dollars, it should support American workers and businesses. In his first week in office, President Biden signed Executive Order 14005, Ensuring the Future is Made in All of America by All of America’s Workers, launching a whole-of-government initiative to strengthen the use of federal procurement to support American manufacturing.’’

There are intuitive reasons to think that way. However, there are also some logical and persuasive arguments that confront that point of view. Please read the following quotes and discuss whether or not buying locally can be a welfare-enhancing strategy.

The first excerpt is entitled with 15 Reasons to Buy American Made Products and stems from www.buydirectusa.com:

Next time you are in a store or shopping online look for the Made in USA label. The job you save by doing so could one day be your own!

When you buy American products you support American workers. Existing jobs are saved and more employment opportunities are created.

When you buy American Made products you support companies that are doing business in America.

Hundreds of major American corporations are continuing to ship thousands of jobs overseas. Displacing the American worker.

Since 2000. the United States has lost an incredible 32% of its manufacturing jobs.

To prevent more of our manufacturing cities all over America from being transformed from thriving communities into crime infested hellholes. What happened to Flint, MI and Camden, NJ can happen in any American city when corporations decide to move production overseas.

China is now the number one supplier of components that are critical to the operation of US defense systems. Does this bother anyone else?

According to the Economic Policy Institute The economy has been unable to create jobs due to America’s massive trade deficit.

U.S. trade policies encourage businesses to relocate production of goods to other nations without penalizing them for selling those goods back to the United States. This has resulted in millions of lost jobs for the American people.

Since 1975, the US has imported more goods than it has exported. In 2010, the US had a deficit of $478 billion in global trade.

Over 30 years of trade policies such as NAFTA and CAFTA have taken jobs from the American people.

For every $1 billion in goods imported, the economy loses 9,000 jobs.

No regulation or safety standards in products made overseas. Chinese-made drywall used in US homes is creating health and safety hazards.

Moral implications of the exploitation of foreign workers and violations of child labor laws overseas.

Environmental standards are minimal or non existent in how products are made overseas. This has an impact on everyone on the planet.

Chinese imports accounted for more than 60% of the recalls announced by the Consumer Product Safety Commission in 2007

UPDATE

COVID – Where did that get released from?

When you buy products from the CCP, you are helping to fund their military which are a growing threat around the globe.

You don’t have to swim to get the products you need.

The second quote stems from Federal Reserve Bank of Dallas (2002, p. 16) who try to de-mystify the intuition of the buy local propagandists using a lot of data and some logical arguments of which you can read one here:

“A common myth is that it’s better for Americans to spend their money at home than abroad. The best way to expose the fallacy in this argument is to take it to its logical extreme. If it’s better for me to spend my money here than abroad, then it’s even better to buy in Texas than in New York, better yet to buy in Dallas than in Houston… in my own neighborhood… within my own family… to consume only what I can produce. Alone and poor.”

Federal Reserve Bank of Dallas. (2002). The fruits of free trade [Annual Report].

3.3 Stylized facts on trade openness

While often mentioned in the academic literature and heavily discussed in politics, the term trade openness lacks an accepted definition. Mostly it refers to the outward or inward orientation of a given country’s economy and touches many things including some measureable indicators such as

Volume of trade: the sum of exports and/or imports (see Figure 3.3)
Trade openness: trade to GDP ratio (see Figure 3.4, and Figure 3.5)
Trade policy regime: tariff profile, border efficiency, …
Openness to FDI: FDI inflow to GDP, ease of doing business
Infrastructure: logistics performance, communications infrastructure, telephone lines, Internet
Political regime: stability, democratic, open minded, reliable, …

Figure 3.3: Global sum of exports

Figure 3.4: Export plus imports as a share of GDP

Figure 3.5: Globalization is not a new phenomenon

Figure 3.6: Transportation and communication costs

Figure 3.7: Number of Preferential Trade Agreements

Figure 3.8: Number of Regional Trade Agreements

3.4 World Trade Organization

Figure 3.9: The World Trade Organization (WTO)

The World Trade Organization (WTO) (see Figure 3.9) is an intergovernmental organization that regulates international trade and replaced in 1995 the General Agreement on Tariffs and Trade (GATT). 164 (!) countries are currently member of the WTO. The WTO facilitates the smooth and free flow of global trade through the administration and monitoring of a rules-based system that should among others help to make international trade (policy) more predictable. This set of rules is embodied in the WTO Agreements which are based on basic principles, that are described in the following three sub-sections.

Watch: The World Trade Organization (WTO) - Explained With Maps

3.4.1 Non-discrimination:

3.4.1.1 The Most Favoured Nation rule (MFN)

The MFN ensures non-discrimination between trading partners as it states that if a WTO member grants a country an advantage, it has to give such advantage to all WTO members. Thus, a WTO member has to grant the most favorable conditions under which it allows trade in a certain product type to all other WTO members. However, there is no rule without an exceptions.¹

¹ For example, a member may provide preferential treatment only to some countries within a free trade area or customs union, without having to extend such better treatment to all members. Another exception enables developed members to give unilateral preferential treatment to goods imported from developing countries and least-developed countries (LDCs), without having to extend such better treatment to other members.

Watch: E-Learning short videos - Most-favoured nation (MFN)

3.4.1.2 The National Treatment Principle (NTP)

The NTP ensures non-discrimination between domestic and foreign products or services. It prohibits a member from favoring its domestic products over imported products. The NTP aims to provide equality of competitive conditions for imported products in relation to domestic products. Again, no rule without exceptions.²

² For example, there may be a security need to develop and purchase products domestically, or government procurement may, as is often the case, be used as a policy tool to promote smaller business, local industry or advanced technologies, see GATT Article III:8(a).

Watch:

E-Learning short videos - General Exceptions

E-Learning short videos - The National Treatment Principle

3.4.2 Transparency

All WTO members must publish their trade regulations and changes therein. Moreover, members should respond to requests for information by other members.

3.4.3 More open and predictable trade

While the use of tariffs and quotas is not prohibited, members have committed to carry out multilateral negotiations periodically with a view to reduce the general level of trade barriers.

3.5 Trade anecdotes

3.5.1 The Dispute Settlement Body

To make decisions on trade disputes between governments that are adjudicated by the organization, the WTO has established the Dispute Settlement Body (DSB). The Dispute Settlement Body is a meeting of the WTO General Council that brings together all representatives of WTO member governments, usually at the ambassador level. Any WTO member that believes another member is in violation of an obligation or WTO rule can file a complaint. The goal of the Dispute Settlement Body is then to find a solution to the dispute, including any violation. The first step is consultations between governments. If the dispute cannot be resolved through discussions, the DSB makes a decision and the offending country is ordered to correct its policies. In most cases, countries find a mutually acceptable solution to the dispute. If the offending country does not correct its policy or provide other compensation, the WTO authorizes retaliatory action by the complaining country against the offending country. The adjudication process can take some time, as can the implementation of remedies to enforce or compensate for the violation of a WTO rule. Figure 3.10 provides an overview of the average number of active, that is, unresolved, complaints in recent years.

Up-to-date sources of information

Book about trade disputes from 1995 to 2020: Organization (2010): WTO Dispute Settlement: One-page Case Summaries 1995–2020.
WTO landing page about Dispute settlement
Map of disputes between WTO Members

Figure 3.10: Average annual number of active proceedings per month 1995-2018

Figure 3.11: Duration of each stage of proceedings

Figure 3.12: Most active countries at the trade dispute settlement body

Referring to Reich (2017) the USA was a sinner. As Figure 3.12, Figure 3.14, and Figure 3.13 show, the US was the respondent in a relatively high proportion of all issued panel reports, namely in 38% of them (78 out 207). However, this high rate of US participation as respondent to complaints on trade violations is still much lower than its share in suspension requests. In the years I reviewed, there were 75 complainants that prevailed over the US. These are the cases where there is a potential for suspension requests in case of non-compliance. Indeed, 26 of these complainants ended up submitting suspension request against the US. That corresponds to 34.6% of the total. In other words, more than one third of the complainants who prevailed over the US in dispute settlement procedures, were forced to turn to trade sanctions in their effort to obtain compliance by the US.

Suspension requests are…

…the “last station” on the long winding road of the WTO dispute settlement procedures and they represent the targeted member state’s unwillingness to submit to the system and to respect its international obligations.

When China acceded to the WTO, many scholars and policy makers were very skeptical about the willingness and ability of China to comply with international trading rules. However, the number of suspension requests that have been filed against China is zero (at the time when Reich (2017) published his study). China’s record on compliance, at least for now and at least as measured by the number of suspension requests filed against it, seems to be perfect.

Reich, A. (2017). The effectiveness of the WTO dispute settlement system: A statistical analysis (EUI Working Paper LAW 2017/11). European University Institute (EUI).

Figure 3.13: Map of trade disputes of the European Union

Figure 3.14: Map of trade disputes of the United States of America

Exercise 3.3 God’s diplomacy

Watch the speech of Boris Johnson and discuss what is meant with free trade is god’s diplomacy.

3.5.2 The Regional Comprehensive Economic Partnership (RCEP)

Figure 3.16: The Regional Comprehensive Economic Partnership (RCEP)

The leaders of China and another 14 countries in the Asia-Pacific region (see Figure 3.16) have signed one of the biggest free trade deals in history, covering 2.2 billion people and 30% of the world’s economic output. The deal will cover nearly 28% of global trade.

The Regional Comprehensive Economic Partnership (RCEP) was signed over a video link on November 15th after eight years of negotiations.

The deal sets the terms of trade in goods and services, cross-border investment and new rules for increasingly important areas such as electronic commerce and intellectual property. The effect on the trade of finished goods between Asian nations will be particularly marked, analysts have said.

Trade and investment flows within Asia have vastly expanded over the past decade, a trend that has accelerated amid feuding between the US and China, in which the two superpowers have imposed billions of dollars’ worth of punitive tariffs on each other’s exports.

Unlike the CPTPP – the Comprehensive and Progressive Agreement for Trans-Pacific Partnership – and the EU, it does not establish unified standards on labor and the environment or commit countries to open services and other vulnerable areas of their economies.

Donald Trump in 2017 pulled out of the Trans-Pacific Partnership, a deal previously envisaged as a way of curbing China’s influence.

3.5.3 Trade dispute between the USA and the European Union

Watch: Trade wars: How they work and who they impact

In June 2018, the U.S. government imposed tariffs on € 6.4 billion worth of European steel and aluminum exports, followed by additional tariffs in January 2020 affecting approximately € 40 million worth of EU exports of certain steel and aluminum derivatives. The EU imposed countervailing measures on € 2.8 billion worth of U.S. exports to the EU in June 2018 (a similar EU response followed the second set of U.S. tariffs in 2020). The remaining countervailing measures, affecting up to € 3.6 billion worth of exports, were scheduled to take effect on June 1, 2021. The EU suspended these measures until December 1, 2021, to allow the parties to work together on a longer-term solution. Following today’s announcement by the U.S., these measures will not be imposed. (see European Commission, 2021)

European Commission. (2021). EU and US agree to start discussions on a global arrangement on sustainable steel and aluminium and suspend steel and aluminium trade disputes (Press Release IP/21/5721).

Figure 3.17: Biden and von der Leyen on G20 leaders’ summit in Rome, October 31

In November 2021, President Biden has signed a deal to end tariffs on steel imports from the EU, which were imposed by his predecessor Donald Trump. But the agreement does not cover exports from the UK, putting British steelmakers at a disadvantage as is discussed in an article of the BBC, see UK steel makers ‘left behind’ as US ends trade war.

3.5.4 Boeing vs. Airbus

Boeing has continually protested over launch aid in the form of credits to Airbus, while Airbus has argued that Boeing receives illegal subsidies through military and research contracts and tax breaks. All that yielded litigation at the WTO and a series of decisions that allowed (trade) penalties of both sides.

For example, on 2 October 2019, the WTO approved US tariffs on $7.5 billion worth of European goods, and officially authorized them on 14 October, despite the European Union urging for a negotiated settlement. On 30 September 2020, however, the WTO approved the European Union’s retaliatory tariffs on $4.1 billion worth of US goods, this is in addition to the previous unimplemented sanction allowing the EU the right to impose tariffs of up to $8.2 billion on US goods and services

This is a trade war where nobody will probably be better of in the end. For more details on this dispute, I recommend reading the Wikipedia entry.

On June 15, 2021, the U.S. and the EU achieved a major breakthrough in the trade dispute between Boeing and Airbus, agreeing to end the 17-year dispute. All tariffs were suspended for five years.

3.5.5 Trump vs. the European Union (a.k.a. Jean-Claude Juncker)

Under president Trump, United States imposed tariffs on goods such as cars, olives, single malt whiskey, pecorino cheese, and wine. The EU, in turn, has raised tariffs on goods such as orange juice, bourbon, peanut butter, power boats, and Harley-Davidson motorcycles. This escalation was brought to a halt on July 25, 2020, Jean-Claude Junker and Donald J. Trump met at the White House to discuss the ongoing trade dispute, see Figure 3.18. They announced that the United States and the European Union would work to reduce tensions created by Trump’s confrontational trade policies in the past. Before that meeting they made their standpoints clear as paraphrased below.

Figure 3.18: Juncker and Trump made a deal

Donald J. Trump wrote via Twitter on March 3, 2018:

“The United States has an $800 Billion Dollar Yearly Trade Deficit because of our very stupid trade deals and policies. Our jobs and wealth are being given to other countries that have taken advantage of us for years. They laugh at what fools our leaders have been. No more!”

Jean-Claude Juncker said on March 2 (see euronews.com):

“So now we will also impose import tariffs. This is basically a stupid process, the fact that we have to do this. But we have to do it. We will now impose tariffs on motorcycles, Harley Davidson, on blue jeans, Levis, on Bourbon. We can also do stupid. We also have to be this stupid.”

Donald J. Trump wrote via Twitter on March 3, 2018:

“If the E.U. wants to further increase their already massive tariffs and barriers on U.S. companies doing business there, we will simply apply a Tax on their Cars which freely pour into the U.S. They make it impossible for our cars (and more) to sell there. Big trade imbalance!”

3.5.6 Trump and the WTO

Read the following excerpt of an article entitled with “Trump Trade Fight Heads to Global Court as WTO Nears the Rubicon” by Bryce Baschuk at www.bloomberg.com published on 21. of November 2018:

The Geneva-based WTO has long avoided this politically fraught confrontation, which could irreparably harm the organization tasked with deciding international trade disputes. But barring any unforeseen developments, the WTO on Nov. 21 will grant requests from members including China and the European Union to determine if U.S. steel and aluminum tariffs imposed in March – and based on national security concerns – are legal.

U.S. trade officials say that the WTO has no authority to mediate national security matters and should simply issue a decision that says the matter is outside of the WTO’s remit. WTO Director-General Roberto Azevedo has gone so far as to warn countries against taking this dispute to the WTO, arguing that it instead “requires conversation at the highest political level.” The fight could end up sidelining the WTO.

“If the WTO finds that Trump’s tariffs are permitted under the national security exception, it opens a gaping hole that would allow any other country the right to impose trade barriers on any product at any moment and for no particular reason other than protectionism” Chad Bown, a senior fellow at the Washington-based Peterson Institute for International Economics, said in an interview.

In applying the tariffs, Washington relied on a rarely-used WTO national security exemption, which permits governments to take “any action which it considers necessary for the protection of its essential security interests.” The Trump administration has already blocked the process once, and since the rules don’t allow further preventative actions, the WTO will likely create a dispute settlement panel, which would consist of three experts. Any decision would likely be rendered in 2019 or 2020.

3.5.7 Trump and his trade war with China

Donald J. Trump said in his 2016 presidential campaign, see time.com:

“We allowed foreign countries to subsidize their goods, devalue their currencies, violate their agreements and cheat in every way imaginable, and our politicians did nothing about it. Trillions of our dollars and millions of our jobs flowed overseas as a result. I have visited cities and towns across this country where one-third or even half of manufacturing jobs have been wiped out in the last 20 years. Today, we import nearly $800 billion more in goods than we export. We can’t continue to do that. This is not some natural disaster, it’s a political and politician-made disaster. Very simple. And it can be corrected and we can correct it fast when we have people with the right thinking. Right up here. […] To understand why trade reform creates jobs, and it creates a lot of them, we need to understand how all nations grow and prosper. Massive trade deficits subtract directly from our gross domestic product. From 1947 to 2001, a span of over five decades, our inflation-adjusted Gross Domestic Product grew at a rate of 3.5 percent. However, since 2002, the year after we fully opened our markets to Chinese imports, the GDP growth rate has been cut in half. [] A Trump administration will change our failed trade policies, and I mean quickly.”

I don’t want to go into details about the trade disputes of China and USA. A concise and continually revised overview is offered by Wikipedia.

The following charts show the trade surplus/deficit (exports minus imports) for the USA, China, Russia, and Germany. The data were downloaded on 15th of June 2022 from tradingeconomics.com.

Figure 3.19: Balance of trade of the U.S. over time

Figure 3.19 indicates that Trump was not successful in reducing the trade deficit. Overall, it seems to be the case that trade wars are not that easy to win as he claimed. It is rather difficult to impact the trade deficit within some years. Moreover, it is almost impossible to create more jobs that are lost and boost the economy with starting trade disputes.

For those who are interested: Here is a well researched article about that topic by Ryan Hass and Abraham Denmark, entitled More pain than gain: How the US-China trade war hurt America.

Exercise 3.4 Balance of payments across countries

Figure 3.20 shows the balance of trade over time for China, Russia, and Germany. Discuss the impact of COVID-19 on the balance of payments over time across the three countries.

Figure 3.20: Balance of trade of China, Russia, and Germany over time

Exercise 3.5 Trump complains about the WTO

In an bloomberg interview Donald Trump said:

“I called NAFTA the second-worst trade deal ever made. I would say the WTO was the single worst trade deal ever made.

And if they don’t shape up, I would withdraw from the WTO. We rarely won a lawsuit except for the last year. You know, in the last year, we’re starting to win a lot. You know why? Because they know if we don’t, I’m out of there. I’ll take them out.”

Discuss the legal constitution of the WTO and whether Donald Trump is right when he claims that other countries treat the United States unfair. Thereto, I recommend the article Why Trump’s wrong about WTO treating US unfairly from Kucik (2018).

WTO members are not permitted to increase import tariffs without justification. An exception to this rule, however, is given when the national security of a nation is at risk. On this basis (which has been challenged within the WTO by several nations, including Canada), U.S. President Trump has issued executive orders imposing import tariffs on steel and aluminum imports for a set of different countries. Discuss whether this behavior can be considered as fair.

Solution

Trump’s claims are difficult to assess because it is unclear what he means by fairness or how to define fairness in trade relations in general.

When referencing WTO rules, U.S. policy is far from a model of fairness to others, as too many countries have sued the U.S. for its discriminatory policies. Although he is wrong in his claim that the U.S. has “rarely won a lawsuit, with the exception of last year” (the U.S. win rate is similar to the average win rate), the U.S. is the country that has sued other members more often than any other country.
Imposing and increasing tariffs based on the exception rule could irreparably damage the WTO’s authority to adjudicate trade disputes. This is because U.S. trade representatives contend that the WTO does not have the authority to mediate national security issues and should simply issue a ruling that the matter is not within the WTO’s jurisdiction. This argument puts a gun to the WTO’s head. If the WTO’s Dispute Settlement Body follows this line of reasoning, any country could easily impose tariffs in the future, citing national security, without the WTO being able to judge whether or not the issue is truly one of national security. This reminds (me) of the Mexican standoff, that is, a confrontation between three or more parties in which there is no strategy that allows one party to win.

Kucik, J. (2018). Why trump’s wrong about WTO treating US unfairly. The Conversation. https://theconversation.com/why-trumps-wrong-about-wto-treating-us-unfairly-102562

Exercise 3.6 Please read the following article “What’s behind Trump’s trade war?” by Derviş & Conroy (2018) and reflect on the arguments presented by the two authors. Do you comprehend their points in light of everything you’ve learned in the course so far? If anything is unclear, please specify what you find confusing.

What’s behind Trump’s trade war?

Derviş & Conroy (2018):

“Donald Trump’s justifications for his aggressive trade policy – that it will reduce the US current-account deficit and save vulnerable American industries – do not withstand scrutiny. At the heart of Trump’s trade war is an impulse to free American power from the supposed shackles of multilateralism.

WAHINGTON, DC – Since World War II’s end, trade has grown 50 percent faster than global GDP, owing largely to successive rounds of liberalization under the auspices of the World Trade Organization (previously the General Agreement on Tariffs and Trade, or GATT). But now, U.S. President Donald Trump’s latest dose of import tariffs could push the world into a full-blown trade war, undoing much of that progress.

Proponents of free trade have always celebrated the growth of international commerce because they regard it as a sign that countries are capitalizing on their comparative advantages through specialization, which implies increased efficiency overall. By contrast, critics of free trade worry that it might lock poor countries into producing goods that offer little room for productivity growth, and point out that even if there are aggregate gains from globalization, there are also clear losers.

In fact, few would disagree that a static comparative advantage theory is a poor guide for development policy. A more dynamic framework is needed to determine whether trade also brings knowledge and learning to new markets. If it does, then it can be an engine of future economic growth and social progress.

Overall, there is overwhelming evidence that trade has indeed enriched developing countries where supportive policies have been in place. Over time, developing countries have learned to complement trade policies with higher investment in infrastructure and education. But with the world trading system now under assault by the United States, the question for developing countries is how to respond.

To justify his tariffs, Trump points to America’s bilateral (or multilateral) trade deficits with its trading partners. But while tariffs can change the composition of trade flows, they will have little bearing on the current-account balance, which is determined by national savings and investment. If savings fall short of investment—as they do in the U.S.—the current account will necessarily be in deficit.

To be sure, tariffs can have an incidental effect on the current-account balance. As a tax on domestic consumers and a subsidy for certain domestic producers, tariffs reduce consumers’ disposable income and augment capital income. To the extent that more capital income is saved relative to labor income, tariffs will increase the economy’s overall savings rate. Nevertheless, this effect on the savings-investment balance is both weak and indirect.

At the micro level, Trump might argue that tariffs are necessary to protect particular sectors. But many of the goods imported into the U.S. actually contain intermediate inputs that were originally produced domestically (this is even more the case for China). So, to determine whether tariffs are actually protecting the value added-wages and profits in a particular U.S. sector, one must also account for the U.S. value added within imports that are now facing levies. Assuming that Trump’s advisers have explained these complications to him, one wonders what his real rationale is.

While Trump’s desire to prop up politically important industries and reduce the U.S. current-account deficit has certainly played a role in his trade policy, it is clear that his main target is the WTO and the multilateralism that it represents. Trump seems to think that multilateralism dilutes American power, given that the U.S. can always use its economic and geopolitical clout to win a bilateral dispute. What he doesn’t realize is that even the world’s most powerful country still needs impartial global rules and disinterested institutions to oversee them.

Over the past 70-odd years, the GATT/WTO system has developed into a multilateral arrangement whereby the same rules apply to all countries alike. That is not to say that bigger and richer countries lack advantages over smaller and poorer countries. Countries like the U.S. can allocate more staff and specialists to support their own producers in complicated trade negotiations, while also pursuing parallel (back-channel) diplomacy. Legally, however, the WTO is a grouping of equals. The “most favored nation” provision means that an advantage extended to one country’s producers must be extended to all.

Perhaps most important, the WTO has a dispute-settlement mechanism (DSM) that provides for the timely resolution of disagreements between member states. Though the U.S. has won most of the cases that it has brought before the WTO’s arbitration panel, it has also lost some. With the ability to hand down binding judgments, the DSM is a unique feature of the WTO system. No other multilateral body has such a mechanism.

There are many ways that the multilateral system could be improved, of course. The WTO, the World Bank, and the International Monetary Fund should be devising new approaches to address the growing influence of Big Tech; and competition policy needs to be brought into the twenty-first century. It might also be appropriate for the WTO to adopt a form of weighted voting, similar to the procedure used by the IMF and World Bank.

As for the criticism that globalization produces both winners and losers, this is not an argument against trade; it is an argument for policies to compensate those who have been left behind. On that basis, those who have rightly criticized the WTO in the past should join forces with its supporters. Both sides have an interest in defending this key institution of global governance from the xenophobic unilateralism embodied by Trump’s policies.”

Derviş, K., & Conroy, C. (2018). What’s behind trump’s trade war? Project Syndicate. https://www.project-syndicate.org/commentary/trump-tariffs-attack-world-trade-organization-by-kemal-dervis-and-caroline-conroy-2018-10

3.6 Gains from trade

Figure 3.21 and Figure 3.22 contain domestic supply and demand curves. In autarky with no possibilities to trade, supply and demand must meet. Under free trade and a given world market price, $P^W$, countries can trade with each other. This has implications for the producer surplus (yellow area) and the consumer surplus (blue area), as shown in the figures. The area of the triangles a and b as denoted in Figure 3.22 represents the welfare gain from free trade that can be achieved given the world market price, $P^W$.

Figure 3.22: Two countries that trade with each other

3.7 Tariffs in small open economies

Figure 3.23 can teach us a lot about the impact of a tariff $t$ on trade and welfare. A tariff raises the domestic price of imported goods. If we assume that the imposition or change of a country’s tariff has no effect on the world price, we consider what is called a small open economy, which is so small that the country’s consumption and production decisions do not affect the world price. In other words, the country takes the world price for granted because its import demand does not change the world price.

In autarky, the economy represented in Figure 3.23 would consume 5 units at price $P^A$, and total welfare would be represented by areas $a+b_2+b_1$. Under free trade without tariffs, the country imports 8 units and consumes 9 units at the price of $P^W$. The consumer surplus corresponds to areas $a+b_2+d_1+c+d_2$ and the producer surplus corresponds to area $b_1$. After the introduction of tariff $t$, the consumer surplus is equal to area $a$ and the producer surplus is equal to area $b_1+b_2$. Thus, consumer surplus has decreased while producer surplus has increased. The area $c$ is equal to the government’s revenue. It represents the portion of the consumer welfare loss that is transferred to the government. Overall, welfare has decreased. The welfare loss is equal to the areas of the two triangles $d_1$ and $d_2$. These triangles represent what is called the deadweight loss due to the tariff.
Specifically, triangle $d_1$ represents the reduction in imports that is replaced by domestic production, and triangle $d_2$ represents the loss in consumption due to a reduction in imports and a reduction in domestic consumption.

Figure 3.23: Tariff in a small open economy

The implications of a tariff in a small economy

While a tariff protects domestic producers and increases their surplus, it reduces the surplus of consumers and leads to a deadweight loss of revenue. Overall, a tariff leads to a reduction in a country’s welfare.

3.8 Quotas in small open economies

A trade restriction that sets a physical limit on the quantity of a good to be imported is called an import quota. It gives government officials more power and control than a tariff because they can strictly limit the quantity of goods traded and have the administrative authority to grant (or sell) import licenses to certain foreign exporters.

Figure 3.24 shows the impact of an import quota that allows an import quantity of 4 units. In this scenario, 7 units are consumed, four of which are imported. The price at which all seven units are consumed is $P*$. This is somewhat surprising because the world price $P^W$ is less than $P^*$. The reason is that all firms that are allowed to sell their products do so at the highest possible price, that is, $P^*$. As above, the blue area is the consumer surplus and the yellow area is the producer surplus. The gray area is the loss in value due to the import rate. The rectangle $c$ is only part of this loss, since we assume that the government does not sell the licenses to the best bidding exporting firm

Figure 3.24: Tariff in a small open economy

3.9 Tariffs in large open economies

So far, we have assumed that the country of interest is small and takes the world market price as given. However, large countries’ demand for imported goods can have an impact on world prices. If this is the case, we can show that a tariff can actually improve a country’s welfare. Figure 3.25 illustrates the effects of a tariff on welfare, prices, and trade. In particular, we show the impact of a small tariff of 6 euros per bicycle.

Figure 3.25: The effect of a tariff in a large country

Under free trade, the market for bicycle imports is cleared at a price of €300 and the country imports one million bicycles.

Now, if a tariff of 6€ per bicycle is imposed, the tariff drives a wedge between the price foreign exporters receive and the price domestic buyers of imports pay. That is, it becomes more expensive for domestic buyers to purchase imported bicycles. This, in turn, leads to an immediate drop in domestic demand for bicycles and pushes the world market price for bicycles to €297 Given the new world market price for bicycles, the domestic price for imported bicycles is €303 (297+6).

The consumer surplus is now represented by the blue area and the producer surplus by the yellow area. The green area represents the tariff revenue collected by the government. The two gray triangles, in turn, show the tariff-related deadweight losses. Compared to the free trade scenario, the country gains rectangle $c_2$. If the revenue in this area is greater than the deadweight loss, the country has improved its overall welfare by imposing a tariff.

Let us calculate whether this is the case here:

Area $c_2$: \[ (1.58 \text{ million bikes} - 0.62 \text{ million bikes})\cdot (\text{€} 300-\text{€} 297)=\text{€} 2.88 \text{ million} \]
Deadweight loss: \[\begin{align} \underbrace{\frac{(0.62 \text{ mio b.}-0.6 \text{ mio b.})\cdot (\text{€} 303 - \text{€} 300)}{2}}_{\text{left triangle}} + \\ \underbrace{\frac{(1.6 \text{ mio b.}-1.58 \text{ mio b.})\cdot (\text{€} 303 - \text{€} 300)}{2}}_{\text{right triangle}}\\ =\text{€} 0.06 \text{ million} \end{align}\]
Indeed, the net gain is €2.82 million. Thus, a small tariff can increase the welfare of a country.

3.10 Other nontariff trade barriers

In addition to tariffs, there are a variety of other trade barriers. These so-called non-tariff barriers (NTBs) include quotas, export subsidies, domestic production subsidies, government buy-at-home policies, and product standards. Here is a more complete list:

Import quotas
Voluntary export restraints
Antidumping laws
Exchange-rate controls
Countervailing duties
Government subsidies
Licensing, labeling and packaging restrictions
Quality controls and technical standards
Domestic-content laws
Political rhetoric
Embargoes and sanctions
Most/least-favored nation status

For example, product standards are much more important than you might think. For example, no car from the United States can be sold in the European Union without modifications because our safety standards are different. Another example is the CE marking (see below). Harmonization of product standards is usually an important issue in trade agreements.

CE Marking

The CE marking shown in Figure 3.26 is one example for a non tariff trade barrier. It is not an abbreviation for China Export, as many believe. While CE is sometimes indicated as an abbreviation of Conformite Europeenne (French for European Conformity), it is not defined as such in the relevant legislation. The mark indicates that the product may be sold freely in any part of the European Economic Area, irrespective of its country of origin. The CE marking is a declaration by the manufacturer (not by some authority!) that the product complies with EU standards for health, safety and environmental protection for products sold within the European Economic Area (EEA). Thus, it is not a quality indicator or a certification mark and may also be found on products sold outside the EEA. You may also know the _FCC Declaration of Conformity} which is used for selling certain electronic devices in the United States.

Exercise 3.7 Tariff (Solution 3.2)

Referring to Figure 3.27, the government of a large country needs your help to decide whether the introduction of a tariff of $100 per metric ton of on steel is a good idea, or not. At the current world market price of $p^W=$ 600$, the country imports 14 millions metric tons of steel. The government expects that a tariff of $100 per ton of steel would decrease the world market price of steel for $1.

Calculate how much the overall welfare gain (or loss) of the country would be in case the government decides to introduce a tariff of $ 100 per ton of steel. Assume thereby that the supply curve is given by \[ P^s=400+\frac{1}{2}Q^s \] and the demand curve is given by \[ P^d=1500-\frac{1}{2}Q^d. \] These curves are also shown in the figure below.
What would be the tariff so high that it makes an import of steel prohibitively expensive.
What would be the world market price so low that it makes any domestic production unprofitable.
What would be the world market price so high that the country exports steel.

Solution 3.2. Tariff (Exercise 3.7)

By analogy with Figure 3.25, here we should compare the two gray triangles with area $c_2$.

The price per metric ton of steel from foreign suppliers will be $699 because government will charge $100 on each ton of steel which is now worth $599 on world markets. As $699 is still below the autarky price of $950, domestic suppliers will set prices to be equal to $699. Thus,

\[\begin{align*} 699&=400+\frac{1}{2}Q^s \Leftrightarrow Q^s=598\\ 699&=1500-\frac{1}{2}Q^d \Leftrightarrow Q^d=1602\\ 1602-598 &=1004 \end{align*}\] That means, at a price of $699 domestic supply is 598 and domestic demand is 1602 tons of steel. 1004 tons will be imported.

To calculate the welfare loss (the two triangles), we can calculate the left triangle only and double it (please note that this is only possible if both triangles really have the same size which is only the case if both supply and demand curves have the same slope in absolute terms!): \[\begin{align*} & \overbrace{\left(\underbrace{(598-400)}_{\text{loss in quantity}}\cdot \underbrace{\frac{1}{2}}_{\text{to get the triangle}}\cdot \underbrace{(699-600)}_{\text{increase in price}}\right)}^{\text{left triangle}} \cdot \overbrace{2}^{\text{right triangle is of same size}}\\ &=9801\cdot 2\\ &=19602 \end{align*}\] The welfare gain (the new square that is due to the change in world market price, a.k.a. $c_2$) is \[ 1004 \text{tons} \cdot 1 \left[ \frac{\text{\$}}{\text{tons}} \right] = 1004 \text{\$}. \] Thus, overall welfare gain is \[ 1004-19602=-18598. \] That means, the welfare loss exceeds the welfare gain by $ 18598.

\[\begin{align*} 400+\frac{1}{2}Q&=1500-\frac{1}{2}Q\\ \Leftrightarrow Q&=1100\\ P^s&=400+\frac{1}{2}\cdot 1100\\ P^s&=950 \end{align*}\] At a price above $950, no steel would be imported. Thus, a tariff must be so high that the price of foreign steel within the country exceeds $950, that is, $P^W+t>950$. Assuming that the world market price would have a lower bound of $599, that is, any tariff above $100 would not decrease the world market price any further, a tariff of $351 (950-599=351) would make imported steel prohibitively expensive.

Below a price of $400 any domestic production would be unprofitable because the supply curve tells us that no domestic producer would be able to supply anything at and below the price of $400. To proof that just set $Q^s=0$ in the function of the supply curve and you get $P^s=400$.
At a world market price above $950, it would be profitable to export steel because domestic supply exceeds domestic demand and the world market price is higher than the production costs.