Summary of the 5th InsTED Workshop at Syracuse University

We would like to thank The Department of Economics and the Maxwell School of Citizenship and Public Affairs, Syracuse University, for hosting and sponsoring the 5th InsTED Workshop.  We are also grateful for sponsorship and organizational support from the Moynihan Institute of Global Affairs, as well as sponsorship from the Program for the Advancement of Research on Conflict and Collaboration (PARCC) and the University of Exeter Business School.  The workshop took place at the Maxwell School from May 15th-16th 2018.  Special thanks go to Kristy Buzard and Devashish Mitra as joint chairs of the local organizing committee, and Juanita Horan for her extremely helpful interactions with everyone.

The program comprised of 18 papers ranging over four broad topics at the intersection of institutions, trade and economic development.  The first was global value chains, focusing on how they are determined at the firm level, and what their implications are for economic outcomes, especially in the developing world.  The second topic examined ongoing concerns about the implications of trade integration for income distribution, with emphasis on a developing country perspective.   The third concerned the interaction between trade integration or other institutional reform and resource allocation.  The fourth was on institutional constraints on international trade policy, including a look at the implications of restrictions imposed by the World Trade Organization.  There now follows a summary of all the papers presented at the workshop, organized under these four topic headings.  A bibliography, together with links to papers where available, is provided at the end.  Please note that for brevity the summary mentions presenters’ names but not those of their co-authors.  This information is contained in the bibliography.

Global Value Chains: Their Determinants and Implications

The spread of global value chains (GVCs) over the last thirty years or so has been a key new feature of the current wave of globalization, and important for the integration of developing countries into the world economy.  At the broadest level, the spread of GVCs has been facilitated by innovations in information and communication technology, the deepening of trade liberalization and ongoing reduction in transport costs, and political developments principally involving the fall of the iron curtain.  But in this globally more integrated environment, there is growing appreciation that firm-level decisions play a critical role in the determination of how global value chains actually form.  The outcome of these decisions has been characterized in terms of GVCs forming either as ‘spiders’, where a central ‘body’ imports inputs for assembly from various ‘legs’ that originate in different countries, or where a product is assembled sequentially along the length of a ‘snake’.  Such trade in intermediate inputs now accounts for 70% of global trade, spanning not just developed but developing countries as well.

The keynote address by Pol Antràs discussed his research project to model how firm-level extensive margin sourcing decisions are made, that give rise to the formation of GVCs.  His motivation of the need for a new model was that the canonical Melitz model renders firm export decisions tractable by assuming constant (exogenous) marginal costs, while firm import decisions are made specifically to lower marginal costs which are therefore endogenous.  The interdependence in a firm’s extensive margin import decisions complicates the firm’s problem considerably.  In the case of a spider, this involves a combinatorial problem with 2J possible choices, where J denotes the number of possible source countries.  In the case of a snake, the problem is similarly complex.

Antràs presented two papers, which provide tractable ways to model firm decisions in the cases of spiders and snakes respectively in ways that can be estimated structurally in the data.  In the case of spiders, the modelling approach is to apply an iterative algorithm that exploits complementarities in the decision of a firm to import from particular markets, and uses lattice theory to reduce the dimensionality of the firm’s optimal sourcing strategy problem.  The results show that while the ‘China shock’ resulted in an overall decline in domestic sourcing by US firms, the most productive firms actually increased domestic sourcing due to the cost savings derived through sourcing from China.  In the case of snakes, where the value chain is sequential, Antràs showed that the lead firm’s problem becomes one of solving the least cost path through a sequence of suppliers.  By applying a different algorithm the paper shows that, other things equal, it is optimal to locate relatively downstream stages of production in relatively central locations.  He then discussed counterfactual exercises that illustrate how changes in trade barriers affect the extent to which various countries participate in domestic, regional or global value chains, and traces the real income consequences of these changes.  Using this approach, substantial income gains are shown to arise from the increased participation of low-income countries in GVCs.

A key question motivating the literature on the extensive margins of trade is whether better firm performance gives rise to exporting or, conversely, exporting improves firm performance.  A particular form of this question is as follows: if offered the opportunity to export through a marketing arrangement in a developed country, can firms in developing countries upgrade the quality of the goods they produce and export, thereby increasing their incomes?  Rocco Macchiavello presented a paper on the case of the Nespresso sustainable quality program in Colombia.  The dataset constructed for the paper matches detailed administrative data on the universe of Colombian Coffee farmers with transaction-level data along three stages in the coffee chain, from the export gate to the farm gate.  Machiavello and his collaborators find that the program induced farmers to upgrade their coffee plantations, expand their farms as well as production, increase the quality of the coffee produced, and the loyalty of their marketing arrangement.  Most notably, a price premium of approximately 5-8% is fully transmitted along the supply chain, from the export gate to the farm gate, thereby bringing significant income gains to farmers in the developing world.  This paper therefore adds to the evidence supporting the view that gaining the opportunity to export can indeed enhance firm performance.

While GVCs can potentially increase incomes by creating cost advantages and quality improvements, there is widespread concern that cost advantages may be gained through lax environmental and labor regulation in countries where suppliers are located.  Sebastian Krautheim presented a paper studying this issue both theoretically and empirically.  In the model of his paper, a Northern firm can save costs by outsourcing to a Southern supplier that uses a cost-saving but unethical technology.  Contracts are incomplete, so that a firm has limited control over unethical technology choices of suppliers along the value chain.  The technology is a credence characteristic, in that consumers care about it but cannot know what it is.  However, the model features a non-governmental organization (NGO) that can reveal the technology being used.  Using the unethical technology creates an incentive to increase scale, but this also increases the probability of being detected by the NGO.  The paper provides empirical support for the model’s prediction that a high cost advantage of ‘unethical’ production in an industry and a low regulatory stringency in the supplier’s country favor international outsourcing as opposed to vertical FDI.

Trade Integration and Income Distribution

There has long been a concern that deeper trade integration causes an increase in inequality.  This is the focus of the famous Stolper-Samuelson Theorem, which arises directly from the classic Hecksher-Ohlin model and in a wider set of settings as well.  It predicts that if, compared to the South, skilled labor is relatively abundant in the North while unskilled labor is relatively scarce, then deeper trade integration will drive an increase in inequality in the North and a decrease in the South.  Previous academic debates tended to focus on the rise in inequality in the North, and the extent to which trade integration with the South was ‘to blame’.

In her keynote address, Nina Pavcnik presented her literature review that assesses the current state of evidence on how international trade shapes inequality and poverty.  Her review focuses mainly on developing countries, reflecting the fact that there is now more evidence in that context, but her discussion drew parallels to the empirical evidence on developed countries as well.  Her review also discusses perceptions about international trade in over 40 countries at different levels of development, including perceptions on trade’s overall benefits for the economy, trade’s effect on the livelihood of workers through wages and jobs, and trade’s contribution to inequality.  In framing the review, she noted that while most studies of developed countries focus on import shocks, studies of developing countries present evidence on export shocks as well to provide a more nuanced picture.

One insight that emerges from Pavcnik’s review is that losers from trade liberalization tend to be geographically concentrated and persistent over time because the costs are large.  Another insight is that worker-firm affiliation matters for how individuals are affected by trade liberalization.  Better performing firms tend to be better equipped to respond to the opportunities arising from trade liberalization.  Declines in industry employment from import competition are concentrated in less productive firms and workers.    A third insight is that one cannot ignore the effects of the informal sector in developing countries.  In some cases, international trade supports economic development by promoting the transfer of labor from inefficient informal firms to more efficient formal firms.  In others, especially where labor markets are poorly functioning or government support for those displaced from employment by trade is absent, the informal sector can serve as a coping mechanism for trade shocks.  Pavcnik noted that these outcomes are in some cases at significant variance to the predictions derived from the classic H-O model, especially because it does not have a role for firms.  The main policy recommendation to come out of her review was that governments must support workers and not jobs, because it is inevitable that the gains from trade are realized through the destruction of jobs, and the costs to workers are substantial.

The program featured two papers that studied the effects of trade policy in India.  The paper presented by Beyza Ural Marchand studies the distributional implications, with a particular focus on the poor, by asking: ‘what would be the distributional effects of eliminating the current protectionist structure?’  Thus her focus is on the welfare implications of a move from current trade policies to free trade.  The welfare effects are estimated through household expenditure and earnings effects of liberalization. The results indicate that Indian trade policy is pro-poor through the earnings channel, as its elimination leads to higher welfare losses for poorer households. But it is pro-rich through the expenditure channel, as its elimination leads to higher welfare gains for poorer households.  On balance, surprisingly, Marchand finds that Indian trade policy is regressive overall.

The paper presented by Ariel Weinberger investigates the liberalization episode in India during the 1990’s, which has been characterized by large and unexpected changes in trade and foreign investment policies.  Contrary to what might have been expected, given the secular decline in labor shares since the 1980s, his paper finds that trade reforms mostly raised the labor-to-capital relative factor shares in India. A reduction in capital tariffs and liberalization of FDI raise the share of income paid to labor relative to capital. His results reveal access to foreign capital as a new mechanism through which openness affects factor shares: imported capital augments technical change and potentially reduces rental rates, both of which raise the relative labor share.  Weinberger and his collaborator attribute the observed overall decline in the labor share to domestic deregulation policies and credit expansion.

Richard Chisik reversed the direction of enquiry relative to the papers above.  Rather than look at the effects of trade on inequality, his paper considers the effect of inequality on trade.  The prior literature notes that a foreign transfer may generate a ‘Dutch disease’ type effect in the recipient country: a transfer brings about a real exchange rate appreciation via an increase in wages that can reduce the size of the manufacturing sector.  This may reduce manufacturing exports or even eliminate a comparative advantage in manufacturing altogether.  In this literature, remittances have been considered isomorphic to foreign aid in causing the Dutch disease. Chisik’s paper questions this apparent similarity.  His paper argues that, whereas aid generates a Dutch disease effect, remittances can lead to growth of manufacturing.  The reason is that (ironically) aid tends to go to wealthier individuals who spend the money on non-traded services, which does appreciate the real exchange rate and shrinks the manufacturing sector, while remittances tend to go to poorer individuals who spend on manufactures which tends to increase the size of that sector.  The differing effects on the relative size of the manufacturing sector have, in turn, different bearings on comparative advantage.  The paper presents econometric results supportive of their model.

Rather than focus directly on trade and inequality, Ben Zissimos looked at how the inequality created by international trade can threaten the survival of dictatorships, especially in the face of world price shocks.  In his paper, the survival of dictatorships is taken to be a bad thing because they tend to support extractive economic institutions that fail to promote economic development.  The theory developed in the paper predicts that, in food exporting dictatorships, a world food price spike can provoke the threat of revolution.  Dictatorships are predicted to respond by making transfers using export taxes, hence defusing the threat of revolution and forestalling democratization.  The prior literature on institutions and development has tended to focus on the use of domestic redistributive taxation for the purposes of defusing the threat of revolution.  But the paper presented by Zissimos draws on evidence to suggest that dictatorships do not install domestic redistributive capacity for fear that it will be used to tax away their wealth.  Trade taxes, which are available to dictators, are used instead for this purpose.  Hence the paper proposes a new motive for the use of trade policy.  It also provides econometric results supportive of the predictions of the model.

Trade and Resource Reallocation Effects of Trade Integration and Institutional Reform

As tariffs have been reduced through multilateral trade rounds and the formation of free trade agreements, attention has shifted to other measures such as product standards, intellectual property protection, and infrastructure in an effort to facilitate integration where appropriate.

The paper presented by Walter Steingress quantifies the heterogeneous trade effects of harmonizing standards on product entry and exit as well as export sales.  Using a novel and comprehensive database on cross-country standard equivalences, the paper identifies standard harmonization events.  To track harmonization events, the paper presents a new correspondence table between the International Classification for Standards (ICS) and Harmonized System (HS) codes.  The results Steingress reported show that, on average, standard harmonization leads to a 0.5% increase in export sales. This effect is driven by an increase in the intensive margin, a decrease in prices and an increase in the quantities sold.  The paper argues that these results are compatible with a theoretical framework where standard harmonization leads to higher fixed costs as companies have to adapt to the new standards, but simultaneously reduced variable costs, thus increasing overall trade flows.

In her paper, Magdalene Silberberger broaches the impact of trade liberalization on health, safety and environmental (HSE) standards.  She and her collaborator ask whether tariff liberalization causes ‘regulatory chill’, meaning that countries are reluctant to implement HSE standards, or instead causes a race to the top as governments seek to use standards as non-tariff barriers to trade.  Her paper analyzes annual country-by-industry data on notifications of changes in sanitary and phytosanitary standards by WTO members. The results suggest that the impact of increased trade pressure depends on whether domestic producers are likely to gain or lose from a change in standards. Regulatory chill is the dominant response in most countries, but countries in which producers can adapt to standards relatively cheaply appear to race to the top.  Consequently, that paper concludes that tariff liberalization is associated with a divergence in standards across countries.

Shifting the focus from standards to patents, Tom Zylkin explored the effects of cross-border patents on international trade.  His paper highlights an ambiguity as to what one might expect here.  On the one hand, a firm might file a patent in another country because it wants to protect a good that it plans to export there.  On the other hand, the reason for filing a patent in another country might be that the firm wants to produce a good there instead of exporting it.  So, he argued, cross-border patents could be complements or substitutes to trade.  Using a highly disaggregated database of all patents filed in and out of developed and developing countries, his paper provides the first systematic analysis of how bilateral trade responds to bilateral filings.  It reports results suggesting large roles for geographic as well as industry-level heterogeneity, suggestive of competing motivations for cross-border patenting.  Patents promote bilateral exports—and negate bilateral imports—in high-demand elasticity industries, but can have the opposite effect in industries where the products are primarily used as intermediate inputs and/or between countries that are not far apart geographically.

The final two papers in this section consider the effects on economic performance of fundamental changes to the domestic economic and political environment.  Mingzhi (Jimmy) Xu‘s paper studies the aggregate and distributional impacts of China’s high-speed railway (HSR) network.  China’s HSR is a passenger rail network that covers 29 of the country’s 33 provincial-level administrative divisions and exceeds 25,000 km/16,000 miles in total length, accounting for about two-thirds of the world’s high-speed rail tracks in commercial service.  Xu argued that HSR connection generates productivity gains by improving firm-to-firm matching efficiency and leading firms to search more efficiently for suppliers.  His paper first provides reduced-form evidence that access to HSR in China significantly promotes exports at the prefecture level.  It then constructs and calibrates a quantitative spatial equilibrium model to perform counterfactuals, taking into account trade, migration, and outsourcing. The quantitative exercise reveals that the construction of HSR between 2007 and 2015 increased China’s overall welfare by 0.46%, but was also associated with an increase in national inequality. In addition, the paper finds that gains from HSR are larger when labor migration costs are higher, implying that the HSR project is well suited to a country like China, which features high internal migration barriers.

Ama Baafra Abeberese’s paper considers the implications of democratic reform for firm productivity, and in particular the impact of President Suharto’s unexpected resignation from the Presidency of Indonesia in 1998, after more than three decades in the post.  The basic idea underpinning the paper is that politicians can create high entry barriers for firms in order to collect rents from those that do enter.  Arguably, since this concentrates the gains from economic activity, democratically elected politicians will be less able to create such barriers without being displaced from office, and so the environment under democracy should be more competitive.  However, the effect on firm productivity is ambiguous since a more competitive environment may make it more difficult for firms to become established.  Baafra’s paper uses the fact that, in Indonesia, local mayors’ terms were asynchronous.  This asynchronicity of terms means that the paper can identify variation in the productivity of firms operating under mayors appointed by Pres. Suharto versus mayors who were democratically elected after Suharto stepped down.  The main result Baafra presented was that democratization did in fact boost productivity, and more so in industries that were shown to be politically connected to the Suharto regime and hence presumably more sheltered when he was in office.

Institutional Constraints on Trade Policy

While it might be collectively rational for countries to adopt free trade, it is often individually rational for a government to adopt some degree of trade protection.  This observation has been used to provide motivation for why governments sign up to institutional measures that constrain their abilities to set trade policy unilaterally, often in the form of a trade agreement.  This way of thinking forms the basis for the literatures on the purpose of the General Agreement on Tariffs and Trade (GATT), now absorbed into the Articles of the World Trade Organization (WTO), as well as the purpose of preferential trade agreements.

David DeRemer opened the discussion of these issues at the workshop with a paper that provides a new framework for thinking about international trade agreements in modern trade environments such as those involving offshoring, and rent seeking by foreign governments.  These are environments that extend beyond those which standard models of trade agreements are set up to consider.  His presentation started out by taking a stance on what distinguishes modern trade negotiation environments from the earlier era.  The new framework he developed focuses on how trade agreements help countries to escape from prisoner’s dilemmas in which each government disregards the effects of local price, as opposed to world price, changes on trading partners.  He argued that, typically, these local prices matter because they affect foreigners’ producer surplus or value-added.

His paper considers trade agreements that achieve the stable end-point of reciprocal negotiations, meaning a situation where neither government can gain from policy changes that affect net export value equally.  The paper shows this end point is Pareto efficient for governments, so it is a suitable prediction for the trade negotiation outcome.  This stable and efficient outcome for modern trade environments yields new predictions that are consistent with empirical evidence.  For example, more politically organized exporters with large supply elasticities compel governments to undertake greater reductions in cooperative import tariffs from trade negotiations.  In this setting, governments jointly pursue gains for exporters to the extent that they would assess losses for domestic firms from import competition to be outweighing gains for consumers.

Woan Foong Wong’s paper focused specifically on the main WTO rules that govern free trade agreement (FTA) formation.  Her paper is based on a three country ‘competing exporters model’, where any two countries compete to export a given product to the third country.  An FTA can then be formed between two countries, leaving the third one out, or all three countries can adopt global free trade, with the outcome being endogenously determined.  FTA formation under Article 24 of the GATT/WTO requires that external tariffs not be raised, and all internal tariffs be removed.  Wong’s paper examines the implications of the requirement to remove internal tariffs by comparing the outcome when this requirement is adhered to with when it is relaxed.  She showed that requiring FTAs to eliminate internal tariffs makes the non-member better off although it simultaneously reduces the likelihood of achieving global free trade by encouraging free-riding on its part.  The reason is that setting lower internal tariffs creates an incentive for members to set lower external tariffs, since they compete more aggressively for the third market, which benefits the non-member.  This problem is avoided by customs union members who, unlike FTA members, coordinate their external tariff.  Therefore, surprisingly, in the case of FTA formation removing the ‘free internal trade requirement’ increases the parameter space where global free trade is a stable outcome.

Other papers at the workshop undertook econometric work to explore the implications of trade agreement formation.  The paper presented by Kishore Gawande undertook the first econometric test of the commitment-based theory of trade agreements.  The idea of this theory is that import-competing sectors where industry interest groups know they can lobby the government for protection will end up with tariffs set above efficient levels and over-investment in capital.  But if governments realize that they cannot receive sufficient compensation for such long-run distortions, they may choose to sign a trade agreement and thus tie their hands to efficient trade policy, thereby shutting down lobbying altogether.  Gawande’s presentation reported econometric results testing this theory against industry-level and firm-level data, and found supportive evidence for the model in the data.

Yifan Zhang‘s paper investigates the impacts of trade liberalization on household behavior and other outcomes in urban China resulting from that country’s entry to the WTO in 2001.  The identification strategy employed in the paper exploits regional variation in the exposure to the resulting tariff cuts.  The paper finds that workers in regions initially specialized in industries facing larger tariff cuts experienced relative declines in wages. Households responded to these income shocks in several ways. First, household members were found to work more, especially if they moved into the non-tradable sector. Second, young adults were more likely to live longer in the parental household, and so average household size increased. Third, households tended to save less. These changes in bahavior were interpreted as being motivated by attempts by households to buffer themselves against the negative wage shocks induced by trade liberalization.

There is a long-held view in the trade policy literature that traditional tariff instruments and temporary protection (TP) measures such as anti-dumping and countervailing duties are substitutes. However, David J. Kuenzel argued in his presentation that there is only mixed empirical evidence for a link between tariff reductions and the usage pattern of antidumping, safeguard and countervailing duties. Based on recent theoretical advances, his paper argues that the relevant trade policy margin for implementing TP measures is instead the difference between WTO bound and applied tariffs, or ‘tariff overhang’ as it is often known. Lower tariff overhangs constrain countries’ abilities to raise their MFN applied rates without legal repercussions, independent of past tariff changes. Using detailed sectoral data for a sample of 30 WTO member countries during the period 1996-2014, Kuenzel finds strong evidence for an inverse link between tariff overhangs and TP activity. This result implies that tariff overhangs and TP measures are substitutes.  Based on this finding, he argues that this indicates the importance of existing tariff commitments as a key determinant of alternative TP instruments.

Bibliography of Papers Presented with Links Where Available (Presenters’ Names Shown in Bold)

Abeberese, A.B., P. Barnwal, R. Chaurey, and P. Mukherjee “Firms Under Dictatorship and Democracy: Evidence from Indonesia’s Democratic Transition.”

Aisbett, E., and M. Silberberger “Tariff Liberalisation and Protective Product Standards.”

Antràs, P., T.C. Fort and F. Tintelnot, “The Margins of Global Courcing: Theory and Evidence from US Firms.

Antràs, P., and A. de Gortari, “On the Geography of Global Value Chains.

Abeberese, A.B., P. Barnwal, R. Chaurey, and P. Mukherjee, “Firms under Dictatorship and Democracy: Evidence from Indonesia’s Democratic Transition.”

Baccini, L., H. Cheng, K. Gawande, and H. Jo, “The Political Economy of Trade Agreements: A Test of a Theory.”

Behzadan, N., and R. ChisikThe Paradox of Transfers: Distribution and the Dutch

Brunel, C., and T. ZylkinDo Cross-Border Patents Promote Trade?

Dai, M., W. Huang, and Y. Zhang,How Do Households Adjust to Trade Liberalization? Evidence from China’s WTO Accession.

DeRemer, D.R., “The Principle of Reciprocity in the 21st Century: New Predictions for Trade Agreement Outcomes.

Gawande, K., and B. Zissimos,How Dictators Forestall Democratization Using International Trade Policy.”

Herkenhoff, P., and S. Krautheim, The International Organization of Production in the Regulatory Void.

Kuenzel, D.J., WTO Tariff Commitments and Temporary Protection: Complements or Substitutes?

Leblebicioglu, A., and A. Weinberger, “Openness and Factor Shares: Is Globalization Always Bad for Labor?”

Machiavello, R., and M. Florensa, “Improving Export Quality and What Else? Nespresso in Colombia.”

Marchand, B.U.,Inequality and Trade Policy: Pro-Poor Bias of India’s Contemporary Trade Restrictions.”

Pavcnik, N., “The Impact of Trade on Inequality in Developing Countries.”

Saggi, K., W.F. Wong, and H.M. Yildiz, “Preferential Trade Agreements and Rules of the Multilateral Trading System.”

Schmidt, J., and W. Steingress, “No Double Standards: Quantifying the Impact of the Standard Harmonization on Trade.”

Xu, M., “Riding on the New Silk Road: Quantifying the Welfare Gain from High-Speed Railways.”

Trade Liberalization and Intergenerational Occupational Mobility in Urban India

By Reshad N Ahsan (University of Melbourne) and Arpita Chatterjee (University of New South Wales)

Economic globalization is currently under threat from a populist political backlash.  A common narrative is that this backlash is partly a result of a trade-induced increase in inequality.[1]  In our recent research, we show that the same mechanism that causes greater trade-induced inequality – a higher relative demand for skill – also allows an increasing number of Indian sons from underprivileged backgrounds to enter better occupations than their father.[2]  This suggests that, when thinking about the effects of trade on labour-market opportunities for the poor, we must keep in mind international trade’s ability to provide a pathway for children from underprivileged backgrounds to move up the occupational ladder.

Once regarded as one of Asia’s least open economies, India experienced a rapid increase in trade following its trade reforms in 1991.  These reforms led to a decrease in India’s average manufacturing tariffs from 149 percent in 1988 to 45 percent in 1998. This dramatic trade reform occurred in a country where occupations are highly persistent across generations.  This is vividly illustrated in Figure 1 below, where we show that conditional on having a father who is at the bottom decile of the fathers’ occupational distribution in 1999 there is a 57 percent chance that a son in 1999 is also in the bottom decile of the sons’ occupational distribution.  We also observe high levels of persistence at the other end of the occupational distribution.  In particular, we find that, conditional on having a father who is at the top decile of the fathers’ occupational distribution in 1999 there is a 39 percent chance that a son in 1999 is also in the top decile of the sons’ occupational distribution.

Figure 1: The occupational deciles of sons who have fathers in the bottom decile of the fathers’ occupational distribution.

To identify the impact of trade on occupational mobility, we use nationally representative household surveys collected by the National Sample Survey Organisation (NSSO).  These data are for the year 1999 and allow us to categorize individuals in our sample in to 335 three-digit occupations.  With these data in hand, we examine whether, all else equal, a son residing in an urban district with greater exposure to trade liberalization is more likely to be in an occupation that is higher ranked than that of his father.[3]  We define a district’s exposure to trade liberalization as the change in the weighted average tariffs of all manufacturing industries located in that district between 1987 and 1998.  A key advantage of our context is the fact that India’s trade reforms were enacted under pressure from the International Monetary Fund and provides us with exogenous variation in tariffs in the post-reform period.[4]

Our analysis shows that greater exposure to trade liberalization allows an increasing number of sons from underprivileged backgrounds in India to enter better occupations than their father.  This result is both statistically significant and economically meaningful.  It suggests that differential exposure to trade explains 46 percent of the difference in upward occupational mobility between a district at the 25th percentile of upward mobility when compared to a district at the 75th percentile.

What explains this effect?  We show that sons residing in more liberalized districts in 1999 are more likely to be employed in skill-intensive industries. This is consistent with the idea that trade induces an increase in the relative share of skilled occupations.[5] While this effect goes hand-in-hand with a rise in the gap in skilled and unskilled wages, it also creates exactly the type of occupations that underprivileged sons need to move up the occupational ladder.  Interestingly, we also find evidence of spillover effects where manufacturing tariff liberalization leads to greater intergenerational occupational mobility amongst sons working in non-manufacturing industries.  We show that this result can be partly explained by the rising demand for skill in downstream manufacturing industries spilling over in to upstream non-manufacturing industries.

An alternate explanation for our results is that trade liberalization improved occupational mobility via its impact on educational mobility.  This means that households that invest more in their son’s education as a result of trade are the ones that experience greater upward intergenerational occupational mobility.  However, our results do not support this conjecture.  Interestingly, in a second new result, we show that greater investment in education only facilitates greater intergenerational occupational mobility in areas where we expect to see the largest increases in the employment share of high-skill occupations.  These results suggest that education can act as a harbinger of social mobility only if there is a sufficient increase in the demand for skill.

Our results offer a more nuanced perspective on the prevailing narrative that trade leads to adverse labour-market outcomes for underprivileged individuals. While trade may increase the skill premium, it also has longer-term effects that facilitate upward intergenerational mobility. For developing countries in particular, these longer-term effects of trade on occupational mobility have the potential to significantly improve the lives of underprivileged individuals.


Aghion, P., Blundell, R., Griffith, R., Howitt, P., and Prantl, S., 2009. “Online Supplement to The Effects of Entry on Incumbent Innovation and Productivity.The Review of Economics and Statistics, 91(1): 20–32.

Ahsan, R.N., and Chatterjee, A., 2017. “Trade Liberalization and Intergenerational Occupational Mobility in Urban India.Journal of International Economics, 109(1): 138-152.

Rodrik, D., 2017. “Populism and the Economics of Globalization.” NBER Working Paper Number 23559.

Topalova, P., 2010. “Factor Immobility and Regional Impacts of Trade Liberalization: Evidence on Poverty from India.American Economic Journal: Applied Economics, 2(4), 1–41.


[1] See Rodrik (2017).

[2] See Ahsan and Chatterjee (2017).

[3] We rank occupations by calculating the average education of individuals in that occupation in 1987, which is prior to the trade reform of 1991.  Thus, we do not allow this ranking to change over time. Our results are robust to ranking occupations based on average wages instead.

[4] See Topalova (2010).

[5] We develop this idea more formally in an appendix to our paper. Following Aghion et al. (2009), we show that the threat of foreign entry encourages domestic firms that are relatively close to the technology frontier to increase their innovation effort, thereby leading to an increase in the share of high-skill occupations.

Growth, Import Dependence, and War

By Roberto Bonfatti (University of Nottingham) and Kevin Hjortshøj O’Rourke  (University of Oxford)

World trade has increased tremendously in recent decades, driven by the rise of China and other emerging economies. The reliance of world trade on choke points (such as the Strait of Hormuz, the Malacca Strait and the South China Sea) creates the need for someone to guarantee the freedom of navigation. Traditionally, this role has been upheld by the naval hegemon of the day: Britain during the 19th century’s Pax Britannica, and the United States today. While the naval hegemon may in fact be providing a global public good by behaving in this manner, its activities may not always reassure everyone, especially if strategic tensions are gradually building up between itself and rising powers such as China.

Rising tension between the US and China is often analyzed in the context of the broader challenge that the rise of China poses to US military hegemony. Political scientists have long cautioned against the risks posed by shifts in relative power. In fact, in the eyes of some theorists, such shifts are the main reason why war can occur. Robert Powell shows, in the context of a two-country world, that if one of the two countries is catching up militarily on the other, it may be impossible to dissuade the established power from launching a pre-emptive war against the rising power.[1]

This is because from the perspective of the established power, not going to war carries a future cost: in the future, the rising power, having become more powerful, will be better able to impose its will on the established hegemon when it comes to disputes between the two. The follower has an incentive to forestall a pre-emptive war by the leader, by promising the leader a sufficiently big slice of the pie in the future. Since it cannot pre-commit to this, and has an incentive to use its greater power in the future to secure a greater share of the pie, the leader may choose to launch a pre-emptive war in order to lock in a higher share of the spoils while it still has the chance.

Applied to the case of industrial catching up, this model seems to have clear implications. Military power goes hand in hand with growth and industrial development; thus, an established industrial leader should be the one to consider launching a pre-emptive war against a catching-up, late industrializing, follower.

In our recent work, we show that, if international trade is taken into account, the implications of the model can be quite different.[2] Central to our analysis are the assumptions that the follower needs to import increasing amounts of raw materials from the rest of the world, as it undergoes structural change, and that the leader may be able to blockade the follower’s trade.

An industrial leader may well be losing out to a catching-up follower in terms of potential military power; however, this does not necessarily imply that it is actually becoming militarily weaker over time. Industrial catching up is a double-edged sword for the follower: while it makes its military apparatus potentially more powerful, rapid growth and structural change also makes it more dependent on imported raw materials. If the leader has the capacity to blockade these imports in case of war, the follower may actually become militarily weaker, rather than stronger, over time. In this case, it may be the follower who launches a pre-emptive war on the leader, and not the other way around.

By generalizing the model in this manner, we open up a rich menu of theoretical possibilities. For example, the follower may decide to attack resource-rich peripheral areas in an attempt to become more self-sufficient, or entirely self-sufficient, in raw materials. It may do so instead of, or prior to, launching an attack on the leader. The follower may even attack the resource-rich region in circumstances when it knows that this will provoke an attack upon it by the leader, when otherwise the two countries would not have gone to war.

We argue that our model can shed light on why it was Japan who attacked the United States in 1941, and not the other way around.[3] This was unambiguously a case of an industrial follower catching up on the leader. And yet Japan was also becoming rapidly more dependent on imported raw materials. Japan’s invasions of resource-rich Manchuria, China, and Southeast Asia were attempts to break free from this pattern of increased dependence: they correspond to attacks on the resource-rich region in our model, prior to an eventual attack on the leader.

Like Japan, late 19th and early 20th century Germany had been rapidly catching up on the Britain and the United States. However, Germany had also become more dependent on imports of food and raw materials. While we do not argue that this strategic dependence explains the origins of either world war in Europe, Avner Offer has argued that it was a key factor explaining the Anglo-German naval rivalry which preceded World War I.[4] After World War I, Hitler was obsessed with German dependence on imports of food and strategic raw materials. The importance of securing the resources needed to fight his wars is a constant theme of Adam Tooze’s classic book on the Nazi economy.[5] One obvious solution was to attack Eastern Europe, which corresponded to the resource-rich peripheral region in our model, even though attacking Poland risked war with the UK and France. And in the long run, conquering Russia was seen as the only way to achieve complete self-sufficiency in raw materials.

Such theoretical and historical considerations suggest that it is Chinese vulnerability, rather than American, that we should be worried about. As long as the United States retains control over maritime choke points, it may be China, rather than the United States, that fears becoming more vulnerable over time. In that context, Chinese expansionism in the South China Sea, while potentially dangerous, may not be so surprising.


Barnhart, M.A. (1987). Japan Prepares for Total War: The Search for Economic Security, 1919-1941. Cornell University Press.

Bonfatti, R. and K.H. O’Rourke (forthcoming). “Growth, Import Dependence and War.” Economic Journal. An earlier version is available as CEPR Discussion Paper 10073.

Offer, A. (1989). The First World War: An Agrarian Interpretation. Clarendon Press.

Powell, R. (2006). “War as a Commitment Problem.” International Organization, vol. 60(1), pp. 169-203.

Tooze, A. (2006). The Wages of Destruction: The Making and Breaking of the Nazi Economy, Allen Lane.


[1] See Powell (2006).

[2] See Bonfatti and O’Rourke (forthcoming).

[3] See Barnhart (1987).

[4] See Offer (1989).

[5] See Tooze (2006).

Foreign Investment Boosts Sophistication of Domestic Manufacturing: New Evidence from Turkey

By Beata Javorcik (University of Oxford), Alessia Lo Turco, (Marche Polytechnic University), Daniela Maggioni (University of Catania)

Recently, there has been a renewal of interest in industrial policy across the world. Advanced economies promise to use industrial policy to revive their declining manufacturing, while emerging markets hope that industrial policies will help them upgrade their production structure and in this way stimulate economic growth. Yet, little is known about the micro determinants of product upgrading.

The existing research suggests that inflows of foreign direct investment (FDI) can foster host countries’ production upgrading, where upgrading is measured in terms of the unit values of exports (Harding and Javorcik,  2012).[1]

In our recent work, we move away from unit values – a highly imperfect proxy for product quality –  and examine the link between FDI and product upgrading, as captured by complexity of new products introduced by domestic firms.[2] We focus on manufacturing firms in Turkey, a country that has experienced a spectacular surge in FDI inflows during the 2000s and dramatically increased the sophistication of its productive structure in the last decades.[3]

Anecdotal evidence

Anecdotal evidence suggests that foreign affiliates stimulate product upgrading among their suppliers. For example, Indesit Company, an Italian white good producer – recently acquired by Whirlpool – has produced refrigerators in Turkey since the 1990s. In 2012, Indesit built a new plant to produce washing machines. To become a supplier of this new plant, a local company purchased new presses and automated its production process. This allowed it to start producing a new and more sophisticated product, a washing machine flange, and to increase efficiency and production volumes. The flange is a very complex product as it needs to be produced with no aesthetic defects by an 800-1,000 tonne metal presses. It also needs to withstand the stress of between 1,000 and 1,400 revolutions per minute while remaining within a certain range of vibration and noisiness. Indesit has shared essential tacit knowledge, information processes, instructions and control procedures with the local company, thus stimulating and supporting the supplier’s complexity upgrading.

Inspired by the anecdotal evidence, our study examines the link between the presence of foreign affiliates and production upgrading by Turkish firms located in the same region and active in the input-supplying industries.

Measuring product complexity

To capture product complexity we use a measure proposed by César Hidalgo and Ricardo Hausmann, who relate the concept of product complexity to the extent and exclusivity of capabilities needed to produce a given product.[4] It is easiest to explain this measure using a Lego analogy. Think of a country as a bucket of Lego pieces with each piece representing the capabilities available there. The set of products (i.e., Lego models) a country can produce depends on the diversity and exclusiveness of the Lego pieces in the bucket. A Lego bucket that contains pieces that can only be used to build a toy bicycle probably does not contain the pieces to create a toy car. However, a Lego bucket that contains pieces that can build a toy car may also have the necessary pieces needed to build a toy bicycle.  While two Lego buckets may be capable of building the same number of models, these may be completely different sets of models. Thus, determining the complexity of an economy by looking at the products it produces amounts to determining the diversity and exclusivity of the pieces in a Lego bucket by simply looking at the Lego models it can build.

Our findings

Our analysis suggests that the presence of foreign affiliates does not affect the propensity of Turkish firms to innovate. However, the presence of foreign affiliates is positively correlated with the complexity level of products newly introduced by Turkish firms active in the supplying industries and located in the same region.

The estimated effect is economically meaningful. A 10 percentage point increase in foreign presence implies moving about half of the way from the production of pot scourers to producing stainless sinks. An increase of about 17 percentage points in FDI in the relevant sectors would be necessary in order to move from the production of stainless sinks to the production of the washing machine flanges.


Our findings matter for policy. Dani Rodrik argues that enhancing an economy’s productive capabilities over an increasing range of manufactured goods can be considered an integral part of economic development.[5] As foreign affiliates facilitate the upgrading of the host country’s productive capabilities, our results, then, imply that FDI inflows can act as an important stimulus for economic growth. Thus, there is room for investment promotion activities, a policy that is quite effective in developing countries.[6] In contrast to many other industrial policies, investment promotion is relatively inexpensive and causes few distortions. Therefore, there is little downside when the government gets it wrong.


Harding, T. and Javorcik, B.S. (2011). ‘Roll out the red carpet and they will come: investment promotion and FDI inflows’, Economic Journal, vol. 121(557), pp. 1445–1476.

Harding, T. and Javorcik, B.S. (2012). ‘Foreign direct investment and export upgrading’, The Review of Economics and Statistics, vol. 94(4), pp. 964–980.

Hidalgo, C.A. and Hausmann, R.(2009). ‘The building blocks of economic complexity’, Proc. Natl. Acad. Sci., vol. 106, pp. 10570–10575.

Javorcik, B.S., Lo Turco, A., Maggioni, D. ‘New and Improved: Does FDI Boost Production Complexity in Host Countries?‘ Economic Journal, forthcoming.

Rodrik, D. (2006). ‘Industrial development: stylized facts and policies’, Kennedy School of Government.


[1] See Harding and Javorcik (2012).

[2] Javorcik, Lo Turco and Maggioni (forthcoming).

[3] See Hidalgo (2009).

[4] See Hidalgo and Hausmann (2009)

[5] See Rodrik (2006)

[6] Harding and Javorcik (2011)

Self-Enforcing Trade Agreements and Lobbying

By Kristy Buzard (Syracuse University)

Going back to the mid-1980s, the repeated prisoner’s dilemma has been used to model the absence of strong external enforcement mechanisms for trade agreements.[1] Cooperation is enforced by promises of future punishment for any deviation from the agreement, and the amount of cooperation that can be achieved depends on the severity of the chosen punishments. The strongest incentive-compatible punishment is often the grim trigger strategy in which all players play the static Nash equilibrium forever when any of them defects.

More recent work shows that grim trigger punishments can be improved upon in some circumstances. Jee-Hyeong Park, for instance, has demonstrated that the presence of asymmetric information and imperfect monitoring can make it more efficient to choose shorter punishments.[2] In a similar setting, Alberto Martin and Wouter Vergote show that retaliation — i.e. delayed punishment — dominates reciprocity.[3]

In a recent paper, I identify a different rationale for limiting punishments: endogenous politics.[4] This paper is the first to incorporate endogenous lobbying along the lines of the classic Grossman-Helpman “Protection for Sale” model — the standard model for endogenizing politics in trade policy — into a repeated-game setting. In place of a unitary government, this model has two branches of government who share policy-making power.[5] By endogenizing the political economy weights, one can address questions about the commitment value of trade agreements, and examine the implications of self-enforcement constraints for the design of trade agreements.

I assume that the social-welfare maximizing executives of two countries choose trade agreement tariffs that must then be implemented by politically-susceptible legislatures.[6] For simplicity, only the import-competing industry is represented by a lobby. The weight the legislature puts on the import-competing industry’s profits increases in lobbying effort, which can be thought of as including campaign contributions as well as broader measures of lobbying activity. The lobby will choose its effort level to optimally influence the legislature’s decisions about whether to abide by the trade agreement and how to set tariffs in the absence of an agreement. Assuming there is no uncertainty about the effect of lobbying effort on the outcome of the political process, the lobby either exerts the minimum effort needed to derail the agreement or exerts no effort at all. The executives maximize social welfare by choosing the lowest tariffs that make it unattractive for the lobbies to provoke the legislature to violate the trade agreement. There will thus be no trade disputes in equilibrium, but the out-of-equilibrium threat that a lobby might provoke one is crucial in determining the equilibrium trade agreement structure.

Adding a lobby to the usual repeated-game model adds a new constraint. The constraint on the legislature is loosened by an exogenous increase in the length of the punishment: defections become relatively more unattractive as the punishment becomes more severe as in the standard prisoner’s dilemma. However, the new constraint due to the presence of lobbying becomes tighter because the lobby prefers punishment periods. The higher tariffs during punishment periods give the lobby increased incentive to exert effort as the punishment lengthens. In the face of this heightened lobbying incentive, the executives must raise the trade agreement tariff to avoid a trade dispute.

The optimal Nash-reversion punishment strikes a balance between these two competing forces, so adding endogenous politics suggests an optimal length for punishments: it is  finite for most values of the political weighting function and can be derived directly from the players’ incentive constraints.[7] Shortening the punishment in models with uncertainty serves to increase welfare by minimizing time spent in punishment periods. Since there is no uncertainty in this model, the players remain in the cooperative state in all periods.[8] Here, social welfare improves because shorter punishments weaken the lobby’s incentive to exert effort and this allows the executives to reduce the trade agreement tariffs.

For a given punishment length, increases in the patience of the legislature mean the lobby must exert more effort to induce the legislature to endure the punishment. The executive can thus reduce trade agreement tariffs without fear that the agreement will be broken. Increases in the lobby’s patience and the lobby’s ability to influence the legislature (as measured by the political weighting function) work in the opposite direction: they allow the lobby to exert less effort to provoke a trade dispute, and therefore higher equilibrium trade agreement tariffs are necessary to avoid a dispute.

The optimal punishment length itself also depends on how readily special interests are able to influence the political process. If the lobby is weak, the optimal punishment converges to that of the model without a lobby: longer punishments are better because the key constraint is the legislature’s. As the lobby becomes more influential, the optimal punishment becomes shorter because the lobby’s incentive becomes more important. That the optimal length of punishments is a function of the influence of the lobbies reinforces the idea that endogenizing politics can be critically important for institutional design questions.


Bagwell, K., and R.W. Staiger, (2005); “Enforcement, Private Political Pressure, and the General Agreement on Tariffs and Trade/World Trade Organization Escape Clause.Journal of Legal Studies, 34(2): 471–513.

Buzard, K., (2017a); “Self-Enforcing Trade Agreements and Lobbying.Journal of International Economics, 108(1): 226–242.

Buzard, K., (2017b); “Trade Agreements in the Shadow of Lobbying.” Review of International Economics, 25(1): 21–43.

Dixit, A., (1987); “Strategic Aspects of Trade Policy.” in: T.F. Bewley (ed.), Advances in Economic Theory: Fifth World Congress. Cambridge University Press, pp. 329–362.

Maggi, G., and A. Rodríguez-Clare, (2007); “A Political-Economy Theory of Trade Agreements.” The American Economic Review, 97(4): 1374–1406.

Martin, A., and W. Vergote, (2008); “On the Role of Retaliation in Trade Agreements.” Journal of International Economics, 76(1): 61–77.

Milner, H.V., and B.P. Rosendorff, (1997); “Democratic Politics and International Trade Negotiations: Elections and Divided Government as Constraints on Trade Liberalization.” Journal of Conflict Resolution, 41(1): 117–146.

Park, J.-H., (2011); “Enforcing International Trade Agreements with Imperfect Private Monitoring.” Review of Economic Studies, 78(3): 1102–1134.


[1] See for example Dixit (1987).

[2] Park (2011).

[3] Martin and Vergote (2008).

[4] Buzard (2017a).

[5] This approach follows Milner and Rosendorff (1997).

[6] The model admits an interpretation in which the same branch of government both negotiates the trade agreement and decides on the applied tariff ex-post, and thus the one-shot game shares much in common with Maggi and Rodríguez-Clare (2007).

[7] In Park (2011), the finite punishment length is due to imperfect monitoring and/or uncertainty.

[8] In Buzard (2017b), I show how uncertainty can be incorporated into this model.

Trade and Growth with Heterogeneous Firms and Asymmetric Countries

By Takumi Naito (Vanderbilt University and Waseda University)

Trade liberalization encourages more productive firms to start exporting, while it forces more unproductive firms to exit from their domestic markets. The increase in the average productivity because of tougher selection contributes to higher welfare of countries. This idea, captured by the Melitz model of heterogeneous firms, has now become one of the standard principles of international economics.[1] However, the implications of liberalization-induced selection for countries’ growth was not explored until Richard Baldwin and Frédéric Robert-Nicoud (henceforth BRN) set up a two-country R&D-based endogenous growth model that embodies this underlying feature.[2] In the BRN model, trade liberalization has mixed effects on long-run growth: on the one hand, it allows knowledge to flow across borders more freely through trade in goods, which is good for growth; on the other hand, it makes it more difficult for a potential entrant to survive, which is bad for growth. The total growth effect of liberalization depends on the specification of R&D technologies.

Since BRN, many researchers have developed models of trade and growth with heterogeneous firms based on a common assumption: symmetric countries.[3] This is clearly unrealistic in the context of developing and developed countries: they are totally different in terms of endowments, preferences, and technologies. Not only that, the assumption also prevents us from studying the effects of policy shocks that are necessarily asymmetric across countries such as unilateral trade liberalization, regional trade agreements, and so on. To enlarge the scope of heterogeneous firm models of trade and growth for policy analysis, we have to extend them to allow for asymmetric countries.

In spite of the demand, there has been no successful attempt to deal with asymmetric countries in heterogeneous firms and endogenous growth settings. The problem is to evaluate an entrant’s future profits possibly growing at different rates across markets and over time, which makes it almost impossible for us to determine the entrant’s entry decision. How can we resolve the technical difficulty?

In a recent research project, which so far consists of two papers, I have provided two possible solutions to resolve this difficulty.  In the first paper, the solution I provide involves giving up the assumption that firms have an infinite horizon.[4] In my framework, each firm’s product life ends in each period, and they have to pay the initial and market entry costs every time they reenter their markets. By embedding the static Melitz framework in a two-country AK model (i.e., an endogenous growth model with constant returns to capital), I show that unilateral trade liberalization increases the numbers and revenue shares of exported varieties and the growth rates of all countries for all periods, and welfare of all countries, compared with the old balanced growth path (BGP), where all variables grow at constant rates. Intuitively, a country’s import liberalization directly encourages exports and domestic selection in the partner country, while it indirectly promotes exports and domestic selection in the liberalizing country through the decreased relative rental rate clearing its trade deficit.[5] More domestic selection implies the higher return to, and hence the growth rate of, capital. The greatest advantage of the model is the ability to describe the transitional dynamics caused by policy changes, distinguishing between the short- and long-run effects.

In the second paper of this project, the solution I provide involves giving up transitional dynamics in order to focus on a BGP in an asymmetric BRN model where firms do have infinite horizons.[6] Then we can still determine the relative number of varieties from the balanced growth condition, and also the relative wage from the balanced trade condition. It turns out that unilateral trade liberalization has similar selection effects to the first paper described above, and the symmetric BRN model: a country’s import liberalization encourages exports and domestic selection in both the partner and liberalizing countries. As a result, even unilateral trade liberalization can speed up global growth if it sufficiently facilitates international knowledge spillovers.

With the two solutions in hand, we are no longer restricted by the assumption of symmetric countries in endogenous growth models with heterogeneous firms. Our models are so flexible that they can be extended to study the effects of trade policies, domestic policies, or combinations thereof. For example, for governments of developing countries who depend heavily on import tariffs as a revenue source, it has been a serious concern how to design a domestic tax structure which recovers the revenue lost from trade liberalization. It will be interesting to see how such tariff and tax reform affects growth and welfare of developing and developed countries in a Melitz world. It should also be noted that the above two-country models can be extended to more than two countries, although the analysis will be much harder. This allows us to examine the effects of a regional trade agreement on member and nonmember countries. It is hoped that the papers will trigger applications of asymmetric heterogeneous firm models of trade and growth to more relevant policy issues.


Baldwin, R. E., and F. Robert-Nicoud (2008) “Trade and growth with heterogeneous firms,” Journal of International Economics 74(1), 21-34

Demidova, S., and A. Rodríguez-Clare (2013) “The simple analytics of the Melitz model in a small economy,” Journal of International Economics 90(2), 266-272

Felbermayr, G., B. Jung, and M. Larch (2013) “Optimal tariffs, retaliation, and the welfare loss from tariff wars in the Melitz model,” Journal of International Economics 89(1), 13-25

Gustafsson, P., and P. Segerstrom (2010) “Trade liberalization and productivity growth,” Review of International Economics 18(2), 207-228

Melitz, M. J. (2003) “The impact of trade on intra-industry reallocations and aggregate industry productivity,” Econometrica 71(6), 1695-725

Naito, T. (2017a) “An asymmetric Melitz model of trade and growth,” Economics Letters 158, 80-83

Naito, T. (2017b) “Growth and welfare effects of unilateral trade liberalization with heterogeneous firms and asymmetric countries,” Journal of International Economics 109, 167-173

Sampson, T. (2016) “Dynamic selection: an idea flows theory of entry, trade, and growth,” Quarterly Journal of Economics 131(1), 315-380


[1] Melitz (2003).

[2] Baldwin and Robert-Nicoud (2008)

[3] See, for example, Gustafsson and Segerstrom (2010) and Sampson (2016).

[4] Naito (2017a)

[5] The reallocation mechanism induced by unilateral trade liberalization described here is the same as that in the static asymmetric Melitz models of Felbermayr et al. (2013) and Demidova and Rodríguez-Clare (2013), except that they consider labor as the only factor.

[6] Naito (2017b)

Global Tariff Negotiations as a Stumbling Bloc to Global Free Trade?

By James Lake (Southern Methodist University) and Santanu Roy (Southern Methodist University)

The principle of non-discrimination lies at the heart of the WTO. GATT Article I mandates that, for a given product, a country cannot set different tariffs on different trading partners. Indeed, GATT Article I has provided the bedrock for the various rounds of global trade negotiations, including the 1994 Uruguay Round. However, GATT Article XXIV allows Free Trade Agreements (FTAs) whereby members eliminate tariffs on each other while maintaining tariffs on non-members. Thus, FTAs directly contradict the non-discrimination principle. In turn, an important and long standing issue in the FTA literature is whether FTAs help or hinder global trade negotiations. In the famous language of Jagdish Bhagwati, are PTAs “building blocs” or “stumbling blocs” to global trade liberalization?

A long literature has tackled Bhagwati’s question.[1] However, the interdependence between FTAs and global trade negotiations need not only run from FTAs to global negotiations. The process of global negotiations may also impact the process of FTA formation and, in turn, the degree of global trade liberalization. That is, the tariff concessions embedded in the Uruguay Round may have shaped the subsequent process of FTA formation and, in turn, the ultimate degree of global trade liberalization. Yet, as noted by Caroline Freund and Emanuel Ornelas in their review of the literature, the impact of global negotiations on FTAs has received surprisingly little attention in the literature.[2]

In a recent paper, we investigate how an initial round of global negotiations over tariff bindings (i.e. the upper bound on tariffs) impact the subsequent process of FTA formation in a three-country world where governments favor the interests of their import competing sector due to political economy motivations.[3] To do so, we compare the outcomes of two extensive form games that differ only because of the presence or absence of an initial round of global tariff negotiations. In the first game, global negotiations precede FTA negotiations and forward looking governments anticipate the possibility of FTA formation during global negotiations. In the second game, there are no global negotiations preceding FTA negotiations. In either game, FTA negotiations take place sequentially through a randomly chosen order. This framework generates interesting insights.

Our main result is that, when political economy motivations are not too strong, global tariff negotiations actually prevent global free trade. When global tariff negotiations precede FTA negotiations, a tariff ridden world emerges with globally negotiated tariff bindings above zero and no more than one pair of countries linked by an FTA. However, in the absence of global tariff negotiations, FTA formation continues until global free trade is attained via all pairs of countries linked through FTAs. Thus, global tariff negotiations are the cause of a world stuck short of global free trade. In other words, global tariff negotiations are a stumbling bloc to global free trade!

The driving force behind our main result is the different level of tariff concessions given by the eventual FTA non-member in the presence and absence of global tariff negotiations. In the absence of global tariff negotiations, the FTA non-member has no pre-existing tariff bindings. To gain tariff concessions from the outsider, FTA members have strong incentives to form subsequent FTAs with the non-member. Indeed, as long as government political economy motivations are not too strong, sequential FTA formation leads to global free trade. However, global negotiations produce significant tariff binding concessions by all countries before FTA negotiations. These tariff concessions obtained through forward looking global negotiations are deep enough that, upon FTA formation, FTA members no longer have any incentive for FTA formation with the non-member and global free trade does not emerge. In this sense, the success of global tariff negotiations in lowering tariffs drives our result that global tariff negotiations prevent global free trade.

From a practical standpoint, our analysis explains how globally negotiated tariffs depend on anticipations regarding future FTA formation and how binding overhang and tariff complementarity depend on political economy motivations.[4] Indeed, our analysis can shed light on the different empirical results of Antoni Estevadeordal, Caroline Freund and Emanuel Ornelas versus Nuno Limao and Baybars Karacaovali.[5] The former find empirical evidence for tariff complementarity among South American FTA members (i.e. FTA members choose to lower their tariffs on non-members after FTA formation). However, the latter find no evidence that preferential tariff liberalization begets multilateral tariff liberalization for the US and the EU. Our theoretical results suggest the former (latter) should emerge among governments with relatively strong (weak) political economy motivations. Indeed, these predictions based on political economy motivations square well with the recent cross-country empirical estimates of political economy motivations by Kishore Gawande, Pravin Krishna and Marcelo Olarreaga.[6]


Estevadeordal, A., C. Freund, and E. Ornelas (2008); “Does Regionalism Affect Trade Liberalization Toward Nonmembers?” Quarterly Journal of Economics 123(4): 1531-1575.

Freund, C. (2000); “Multilateralism and the Endogenous Formation of Preferential Trade Agreements.Journal of International Economics 52 (2): 359-376.

Freund, C. and E. Ornelas (2010); “Regional Trade Agreements.Annual Review of Economics 2(1): 139-166.

Gawande, K., P. Krishna, and M. Olarreaga (2012): “Lobbying Competition over Trade Policy.International Economic Review 53 (1), 115-132.

Karacaovali, B. and N. Limão (2008); “The Clash of Liberalizations: Preferential vs. Multilateral Trade Liberalization in the European Union.Journal of International Economics 74(2): 299-327.

Krishna, P. (1998); “Regionalism and Multilateralism: A Political Economy Approach.Quarterly Journal of Economics 113(1): 227-251.

Lake, J. and S. Roy (2017); “Are Global Trade Negotiations Behind a Fragmented World of Gated Globalization?Journal of International Economics 108, 117-136.

Limão, N. (2006); “Preferential Trade Agreements as Stumbling Blocks for Multilateral Trade Liberalization: Evidence for the United States.American Economic Review 96(3): 896-914.

Ornelas, E. (2005a). “Endogenous Free Trade Agreements and the Multilateral Trading System.Journal of International Economics 67(2): 471-497.

Ornelas, E. (2005b); “Trade Creating Free Trade Areas and the Undermining of Multilateralism.European Economic Review 49 (7): 1717-1735.


[1] Some influential contributions include Krishna (1998), Riezman (1999), Ornelas (2005a,b) and Saggi and Yildiz (2010).

[2] See Freund and Ornelas (2008) for two exceptions, and see Freund and Ornelas (2010) for their review of the literature.

[3] In our paper Lake and Roy (2017), we model global tariff negotiations over tariff bindings because countries negotiate over tariff bindings rather than the actual tariffs (i.e. applied tariffs) in practice.

[4] Binding overhang is the difference between the tariff binding and the actual tariff set by a country. Tariff complementarity is the phenomenon where, upon FTA formation, the FTA members choose to lower their tariffs on non-members.

[5] Estevadeordal et. al. (2008), Limao (2006) and Karacaovali and Limao (2008).

[6] Gawande, Krishna and Olarreaga (2012).


Dictatorship, Democratization, and Trade Policy

By Ben Zissimos (University of Exeter Business School)

In a landmark paper, Daron Acemoglu and James Robinson argue that a key purpose of democratization is to resolve a commitment problem faced by a ruling elite under the threat of revolution.[1]  Their motivation focuses on 19th and early 20th Century Europe, during which time a number of countries in the region democratized, thus originating a number of today’s mature democracies.  The commitment problem that Acemoglu and Robinson characterize arises if the elite cannot make sufficiently large transfers within a single period, to compensate the rest of society for the gains that they would enjoy from a revolution.  If transfers must be made over multiple periods, and if the threat of revolution may dissipate prior to the transfers being completed, then the elite will not be able to credibly commit to transfers large enough to defuse the threat of revolution. By extending the franchise, the elite transfer power to set taxes to the rest of society.  Thus, democratization enables the elite to make a credible commitment to transfers over multiple periods sufficiently large to defuse the threat of a revolution.

In Acemoglu and Robinson’s model, domestic lump-sum redistributive taxation is the policy instrument used by the elite to make transfers from the elite to the rest of society.  This policy instrument simplifies the framework nicely in order to focus on the commitment role of democratization.  Yet subsequent research has shown that domestic fiscal capacity did not exist for redistributive taxation prior to extension of the franchise.  The power to tax is taken for granted in a great deal of mainstream public finance.  But, as Tim Besley and Torsten Persson note, a ruling elite may have an incentive not to install domestic fiscal capacity if they think it will facilitate redistribution from them to the rest of society.[2]  Supportive of this view, Toke Aidt and Peter Jensen show for the time period that Acemoglu and Robinson discuss, that countries in Europe and elsewhere typically did not have domestic redistributive taxation prior to extension of the franchise.  These observations open the door to a discussion of whether domestic redistributive income taxation could in fact have been used as part of a strategy to resolve the commitment problem through democratization.

In a recent paper, I identify the circumstances under which trade taxes, the capacity for which did exist in 19th-20th century Europe both prior to and after extension of the franchise, can be used to make such redistributions and hence resolve the commitment problem identified by Acemoglu and Robinson.[3]  I do this by combining Acemoglu and Robinson’s model with a classic Heckscher-Ohlin model with trade policy due to Wolfgang Meyer.[4]  The resulting new model yields insights that would not be available from either of the original models on their own.  For example, contrary to the recommendation of classical scholars, I show that when the group in power chooses its optimal trade policy, democratization may in fact go hand in hand with increased protectionism and a decline in economic efficiency.  This suggests that although democratization would broadly be regarded as desirable, it may have some adverse consequences.  In Acemoglu and Robinson’s original model, because taxation was lump-sum, policy changes associated with democratization could have no adverse efficiency implications.

My paper also identifies a new role for trade policy: that of maintaining political stability for a ruling elite regime.  Since the elite would always prefer to retain power (including the power to set trade taxes) rather than extend the franchise, the paper provides a way to think about when the elite can use trade policy to forestall democratization.[5] As an alternative to extending the franchise, the elite may be able to neutralize the threat of revolution and forestall democratization by making temporary concessions to the rest of society over trade policy, thus using trade policy to maintain their grip on power.  The framework that I develop makes it possible to delineate precisely where the elite face a commitment problem and hence must extend the franchise, and where they do not face a commitment problem and hence can use trade policy to forestall democratization.  I use the framework to motivate British and Prussian trade policy in the 19th Century, arguing that both of their ruling elites used trade policy to forestall democratization.


Daron Acemoglu and James A. Robinson (2000); “Why Did the West Extend the Franchise? Democracy, Inequality, and Growth in Historical Perspective.Quarterly Journal of Economics, 115(4): 1167-1199. [Working paper version]

Daron Acemoglu and James A. Robinson (2006); Economic Origins of Dictatorship and Democracy.  Cambridge University Press, Cambridge.

Toke S. Aidt and Peter S. Jensen, (2009); “Tax Structure, Size of Government and the Extension of the Voting Franchise in Western Europe, 1860–1938.International Tax and Public Finance, 16: 160-175. [Working paper version]

Timothy Besley and Torsten Persson, (2009); “The Origins of State Capacity: Property Rights, Taxation, and Politics.American Economic Review, 1218–1244. [Working paper version]

Timothy Besley and Torsten Persson, (2014); “Why Do Developing Countries Tax So Little?Journal of Economic Perspectives 28(4): 99–120. [Working paper version]

Sebastian Galiani and Gustavo Torrens (2014); “Autocracy, Democracy and Trade Policy. Journal of International Economics,  93(1): 173-193. [Working paper version]

Wolfgang Mayer, (1984); “Endogenous Tariff Formation.” American Economic Review, 74(5): 970-985.

Ben Zissimos (2017); “A Theory of Trade Policy under Dictatorship and Democratization.Journal of International Economics, 109: 85-101. [Working paper version]


[1] Acemoglu and Robinson (2000). See also Acemoglu and Robinson (2006) for a broader discussion.

[2] Besley and Persson (2009); see also Besley and Persson (2014)

[3] Zissimos (2017)

[4] Mayer (1984)

[5] Galianni and Torrens (2014) also have an element of this, in that an elite can choose between autarky and free trade to help maintain political stability.  In my paper, the full spectrum of trade policy between autarky and free trade can also be considered, including the trade policy revenue implications, making it possible to analyze incremental changes to trade policy.  This makes it possible to show how trade policy can be used to defuse the threat of revolution in the absence of all domestic fiscal capacity.  In turn this opens the door to a consideration of elite trade policy reactions to world price shocks.

The GATT/WTO’s Special and Differential Treatment of Developing Countries

By Ben Zissimos (University of Exeter Business School)

Special and differential treatment (SDT) is effectively a set of exemptions from MFN extended to developing country members of the General Agreement on Tariffs and Trade (GATT)/World Trade Organization (WTO).[1]  (MFN (most favored nation) treatment is the principle that any terms agreed between two parties to a trade agreement will automatically be extended to all others, and is a central pillar of the GATT/WTO).  SDT has two components: an access component, whereby developing countries are granted access to developed country markets, and a ‘right to protect’ component, whereby they do not have to reciprocate market access concessions that the developed countries make.  The intellectual underpinnings of SDT were: (i) that under the Gold Standard poor countries would tend to suffer from balance of payments problems that could be remedied through protection; (ii) the Prebisch-Singer thesis that developing countries would face secular decline in their terms of trade, which could be remedied by preferential access to developed country markets; and (iii) by the logic of infant industry protection, whereby fledgling industries need an initial period of protection to grow in a secure domestic market, before eventually competing abroad.  Ironically, there was no SDT during the 1950s-60s when the research community was broadly sympathetic to the idea that development can benefit from protectionism.  SDT measures were formally adopted mainly in the Tokyo Round that took place in the 1970s, right around the time that the research community was beginning to argue that development should be supported by outward-looking trade regimes to enhance economic efficiency.[2]

As a result of this history, there is an awkward mismatch between what mainstream economics would prescribe, an outward oriented development strategy, and the protectionism that is allowed for under SDT.  According to one mainstream view, a trade agreement enables countries to escape from a terms-of-trade driven prisoner’s dilemma, whereby they have a collective incentive to liberalize trade to maximize efficiency globally but an individual incentive to adopt protection in order to improve their terms of trade.  Accordingly, the benefits to a trade agreement are based on the exchange of balanced concessions.  So developing countries are currently hurt by high protection of agriculture in developed countries because, under SDT, developing countries have not come to the table offering balanced concessions of their own.  Under this view, developing countries should eschew SDT.  A second view holds that the purpose of a trade agreement is to enable governments to tie their hands against protectionist interests in their own countries.  In line with this view, many developing countries have cited commitment to openness against protectionist interests at home as the main reason why they wanted to become members of the WTO.  Here again, the aim would seem to be to eschew the kinds of protectionist measures allowed by SDT.  So a basic recommendation from mainstream economic research would be that while trade agreements under the WTO have a role to play in economic development, SDT may in fact be inimical to the development process.[3]

Several recent papers have called into question key elements of the arguments on which the above basic recommendation rests.  For example, a key implication of the terms-of-trade motivation for a trade agreement is that, if developing countries do not make any concessions of their own while developed countries do, the terms of trade will adjust to ensure that trade flows will not change at all for developing countries.  Consequently they cannot gain from any market access concessions that developed countries make.  Yet careful econometric research has found evidence (though not yet fully conclusive) that developing country exports have increased significantly for trade agreements involving SDT.  However, it is not yet clear what the basis is for this increase.  Has the surge in exports facilitated scale gains that could underpin an export-led growth strategy?  Or has it only allowed exporters to collect rents as the terms of trade adjust?[4]  A different line of research suggests that under the commitment-based motivation for a trade agreement, liberalization by a developing country must be delayed relative to a developed country if it is to be incentive compatible.  This would provide motivation for the use of SDT measures as support for phased liberalization by developing countries, akin to how they were used in the Uruguay Round, rather than using them as the basis for an outright exemption from liberalization.[5]  There appears to be a significant opportunity both to further our understanding of the effects of SDT in past trade agreements and to assess the role that it should play (if any) in future development strategies.


Bagwell, K., C.P. Bown, and R.W. Staiger, (2016); “Is the WTO passé?” Journal of Economic Literature 54 (4): 1125-1231. [Working paper version]

Bagwell, K., and R.W. Staiger, (2014) “Can the Doha Round be a Development Round? Setting a Place at the Table.” Published in R.C. Feenstra and A.M. Taylor (eds.), Globalization in an Age of Crisis: Multilateral Economic Cooperation in the Twenty-First Century, NBER, University of Chicago Press, 2014, 91-124. [Working paper version]

Conconi, P., and C. Perroni, (2012); “Conditional versus Unconditional Trade Concessions for Developing Countries.” Canadian Journal of Economics 45, 613-631. [Working paper version]

Conconi, P., and C. Perroni, (2015); “Special and Differential Treatment of Developing Countries in the WTO.” World Trade Review 14, 67-86. [Working paper version]

Gil-Pareja, S., R. Llorca-Vivero, and J.A. Martínez-Serrano (2014); “Do Nonreciprocal Preferential Trade Agreements Increase Beneficiaries’ Exports?” Journal of Development Economics 107, 291-304.

Little, I.M.D., T. Scitovsky, and M. Scott, (1970); Industry and Trade in some Developing Countries: A Comparative Study, London: Oxford University Press, for the Organization of Economic Cooperation and Development.

Ornelas, E., (2016); “Special and Differential Treatment for Developing Countries.” Chapter 7 in K. Bagwell & R. W. Staiger (eds.), Handbook of Commercial Policy, Elsevier/North Holland, Volume 1B:  369-432. [Working paper version]

Whalley, J., (1999); “Special and Differential Treatment in the Millennium Round.” World Economy, 22(8): 1065-1093. [Working paper version]

[1] This piece summarizes background research for a book that I am editing, titled The WTO and Economic Development.

[2] Whalley (1999) provides an excellent historical discussion of the origins of SDT, together with details of each of the relevant GATT Articles in which it is codified and when each was introduced.  He also provides a detailed discussion of the intellectual underpinnings. Little, Scitovsky and Scott (1970) were particularly influential in turning the tide toward outward oriented development strategies.

[3] See Bagwell, Bown and Staiger (2016) for a comprehensive review of the literature on the purpose of trade agreements under the GATT/WTO.  Bagwell and Staiger (2014) argue that, by the terms-of-trade motive, developing countries cannot benefit (nor loose) from multilateral trade agreements if they fail to make concessions under SDT because the volume of their trade does not change.

[4] See Gil-Pareja, Llorca-Vivero and Martinez-Serrano (2014) and the references therein for details.  See Ornelas (2016) for an excellent overview of the theoretical and econometric literature on SDT.

[5] See Conconi and Perroni (2012, 2015) for specific details, as well as the discussion by Ornelas (2016).

Understanding Fair Trade

Fair Trade is a social initiative that attempts to aid small producers and workers in developing countries, by offering them better terms of trade and helping them to organize, both economically and politically.  It works through a certification system overseen by nongovernmental organizations, such as Fairtrade International.   A certified product signals to consumers that producers were paid a minimum price and that the product meets specific requirements for certification.  Most of the products are commodities, including coffee, tea, cocoa, flowers, sugar, fruits, gold, and honey.  Coffee has received most of the attention from research due to the large number of producers located in various developing countries.  Over time, researchers in economics have asked important questions about the effectiveness of Fair Trade in achieving its proposed economic development goals and the long term implications of the certification system.

Fair Trade sceptics are concerned about the distortions that price floors and the requirement that firms be ‘small’ to qualify for benefits introduce to incentives.  For example, it has been argued that producers will not seek to improve their production methods because remaining small enables them to keep Fair Trade certification (and the rents from the price floor). This perpetuation of inefficiency, it is argued, will prevent them from lifting themselves out of poverty. Sceptics also claim that a higher price can lead to over-supply and create additional distortions in the world market.

One response to the latter criticism is a theoretical model showing that when a Fair Trade certified product is treated as a differentiated product, with distinct supply and demand curves, and the number of Fair Trade contracts satisfies demand, the certification system does not result in over-supply.  If the intermediaries buying the certified products are oligopsonistic, the Fair Trade system enables producers to recover profit from the intermediaries.  Although this model, as well as other models in the literature, rely on the assumption that consumers care about the production process being socially or environmentally responsible, the market outcome improves without introducing additional distortions.  Other economic models that explore how free entry dissipates rents in the long run derive different conclusions. One model shows that, if demand is inelastic, producers have an incentive to continue entering the market until the expected benefit of Fair Trade certification equals the cost of acquiring it.  This means that the rents from the price floor are channeled towards the costs of certification, which would defeat the purpose of Fair Trade in helping poor producers.  However, this detrimental outcome is not assured in an environment where there are barriers to entry, such as an upper limit to firm size.

Finally, there are methodological issues related to the empirical evaluation of Fair Trade.  It is well documented in the literature that certified producers sell and produce more with better quality than non-certified ones.  However, it is unclear whether there is an omitted variable that causes them to produce more or, alternatively, whether the certification itself causes them to perform better.  Moreover, it is unclear what is driving producers into the certification process.  On the negative side, they are small, have limited access to credit, and limited market access.  On the positive side, they are found to be more entrepreneurial, have better organizational skills, and are more willing to co-operate with others.  This mix of findings suggests that some aspects of Fair Trade and its consequences are not yet well understood and more research in the topic is necessary.

Booth, Phlip and Linda Whtstone (2007) “Half a Cheer for Fair Trade,” Economic Affairs, 27 (2): 29-36. [working paper]

Collier, Paul (2007) The Bottom Billion, New York: Oxford University Press.

de Janvry, Alain, Craig McIntosh and Elizabeth Sadoulet (2015) “Fair Trade and Free Entry: Can a Disequilibrium Market Serve as a Development Tool?The Review of Economics and Statistics, 97 (3): 567-573. [working paper]

Dragusanu Raluca and Nathan Nunn (2015) “The Impacts of Fair Trade Certification: Evidence From Coffee Producers in Costa Rica,” Working Paper

Dragusanu, Raluca, Daniele Giovannucci and Nathan Nunn (2014) “The Economics of Fair Trade,” Journal of Economic Perspectives, 28 (3): 217-236.

Griffiths, Peter (2012) “Ethical Objections to Fairtrade,” Journal of Business Ethics, 105 (3): 357-373. [working paper]

Podhorsky, Andrea (2013) “Certification Programs and North-South Trade,” Journal of Public Economics 108: 90-104.

Podhorsky, Andrea (2015) “A Positive Analysis of Fairtrade Certification,” Journal of Development Economics, 116: 169-185.