Category Archives: Member Contributions

Self-Enforcing Trade Agreements and Lobbying

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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.

References

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.

Endnotes

[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

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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.

References

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

Endnotes

[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?

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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]

References

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.

Endnotes

[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

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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.

References

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]

Endnotes

[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

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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.

References

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).

Beyond Gravity: The Composition of Multilateral Trade

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By Ahmad Lashkaripour (Indiana University Bloomington)

What type of goods does the US export to Canada? What type of goods does it export to New Zealand? Guided by a standard gravity model we know very well that the US exports more (in value terms) to Canada than New Zealand. However, gravity models tell us little about the composition of US exports across various destinations. Standard gravity models focus on the intensive margin of trade. Tracking the evolution of trade patterns and trade theory over time explains why the gravity models were constructed this way, and why it’s time to move forward.

Trade theory, before the 1980s, had a sharp focus: describing the commodity composition of trade. Classical theories described the exchange of dissimilar goods between dissimilar countries in a bilateral world. In a classical framework, the labor abundant country would export the labor-intensive good, whereas the capital abundant country would export the capital-intensive good. In the early 1980s, evidence pointed to a different –non-classical– type of trade: exchange of similar goods between similar countries. To account for this type of trade, trade theory experienced a shift in paradigm, and gravity models were born. Gravity models describe the volume of trade in a multilateral world, where both similar and dissimilar countries engage in two-way trade. In contrast to classical models, gravity models are tractable and easy to estimate in a general equilibrium multi-country setting. Tractability, however, comes at a cost. Gravity models overlook the composition margin, and do not deliver detailed predictions about what type of goods countries trade.

Two recent developments, however, point to the increasing importance of the composition margin. First, poor and remote countries have become increasingly engaged in global trade (in 2006, for the first time, the US did more trade with developing countries than with other developed nations). Second, micro-level evidence indicates that both geography (remoteness) and per capita income have systematic effects on the composition of trade. This evidence is exemplified by three basic facts:

  1. Geography systematically affects the price-composition of exports (faraway countries exchange higher price, higher quality, goods)
  1. Per capita income increases the price-composition of exports (within narrowly defined categories, rich countries export higher price, higher quality goods)
  1. Trade-to-GDP increases systematically with per capita income (rich countries import and export goods that are more tradable).

These facts are beyond the scope of both classical and gravity models. In recent years much progress has been made in explaining these facts individually.[i] Nevertheless, there remains a void. First, we do not have a unified theory that accounts for the effect of both geography and per capita income — existing theories usually confront one aspect of the data in isolation, and overlook the others. Second, to address the composition margin, existing theories generally rely on non-homothetic preferences or non-iceberg trade costs. This involves sacrificing tractability, and tractability has been a major force behind the success of gravity models.

In Lashkaripour (2015a), I confront this void. I argue that a simple extension to the theory of comparative advantage could explain both the effect of geography and the effect of per capita income on the composition of trade.[ii] Building on this idea, I develop a unified model that fully describes both the volume and the composition of trade in a multi-lateral world. Similar to standard gravity models, the unified model adopts homothetic preferences and iceberg trade costs, making it tractable and straightforward to estimate. The main insight of the paper, however, concerns the welfare gains from trade. Estimating the model reveals that the composition margin has profound effects on the gains from trade. Specifically, embedding systematic specialization into a gravity model (to account for composition) more than triples the gains from trade. Furthermore, the gains from trade systematically favor poor and remote nations. This outcome is remarkable, given that incorporating other margins such as firm heterogeneity seem to contribute minimally to the gains from trade (Arkolakis et al. (2011)).

Currently, we are equipped with a rich set of theories that shed light on the composition of trade. More importantly, depending on which theory we believe, the composition margin has deep impacts on the gains from global integration. The next major step is evaluating these theories with micro-level data. Caron et al. (2014), among others, have made notable progress on this front.[iii] Further progress in this direction would allow us to better understand the aggregate effects of global integration, especially on poor and remote nations.

References

Arkolakis, C., A. Costinot, and A. Rodriguez (2012). Clare, 2012, new trade models, same old gains. American Economic Review 102(1), 94.

Baldwin, R. and J. Harrigan (2011). Zeros, quality, and space: Trade theory and trade evidence. American Economic Journal: Microeconomics 3(2), 60–88.

Caron, J., T. Fally, and J. R. Markusen (2014). International trade puzzles: A solution linking production and preferences. The Quarterly Journal of Economics 129(3), 1501–1552.

Dingel, J. I. (2014). The determinants of quality specialization. Technical report, WTO Staff Working Paper.

Eaton, J. and S. Kortum (2002). Technology, geography, and trade. Econometrica 70(5), 1741–1779.

Fajgelbaum, P., G. M. Grossman, and E. Helpman (2011). Income distribution. Product Quality, and International Trade, Journal of Political Economy 118(4), 721.

Fieler, A. C. (2011). Nonhomotheticity and bilateral trade: evidence and a quantitative explanation. Econometrica 79(4), 1069–1101.

Hummels, D. and A. Skiba (2004). Shipping the good apples out? an empirical confirmation of the Alchian-Allen conjecture. Journal of Political Economy 112(6).

Lashkaripour, A. (2015a). The composition of trade in a multilateral world. Technical report, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.

Lashkaripour, A. (2015b). Worth its weight in gold: Product weight, international shipping, and patterns of trade.

Melitz, M. (2003). The impact of trade on aggregate industry productivity and intra-industry reallocations. Econometrica 71(6), 1695–1725.

 

[i]To explain the effect of per capita income on the composition margin, many studies have embedded non-homotheticity into standard gravity models. Fieler (2011), for example, embeds non-homthetic preferences into an Eaton-Kortum model.  She assumes that rich countries consume relatively more of goods, which are more technologically differentiated. Such goods are subject to lower trade elasticities and are more tradable. This entails that rich countries import a higher share of their GDP. Another example is Fajgelbaum et al. (2011), who apply non-homotheticity to a Krugman model. In their framework the home market effect induces firms in rich countries to specialize in high-quality goods. As a result, rich countries become net exporters of high-price, high quality products.

To account for the effect of geography on the composition of trade, most studies abstract from the standard iceberg cost assumption, and assume that trade costs are additive. This approach builds on the Alchian-Allen conjecture, and is exemplified in Hummels and Skiba (2004). Baldwin and Harrigan (2011) offer an alternative theory that reconciles the effect of geography (on composition) with iceberg trade costs. Building on Melitz (2003), they develop a quality-sorting framework where high-quality firms are the most competitive and sort into the toughest, most remote markets.

[ii] I relax a commonly used “gravity” assumption that does not align with micro-level evidence. Standard gravity models assume that all goods offer the same scope for product differentiation, whereas I allow for two types of goods: a highly differentiated type and a less differentiated type. By definition, demand for the highly differentiated type is quality-intensive, whereas demand for the less differentiated type is quantity-intensive. In equilibrium, quality abundant (high-wage) and remote countries have comparative advantage in the highly differentiated type. Labor abundant (low-wage) countries, on the other hand, have comparative advantage in the less differentiated type. This leads to systematic international specialization in production. Production specialization combined with the fact that (in equilibrium) the highly differentiated type exhibits a higher markup and is more tradable, explain the composition of multi-lateral trade.

[iii]Caron et al. (2014) show that income-elastic goods are more skill-intensive. Their results imply that non-homotheticity is an important factor in explaining puzzles relating to composition. Dingel (2015) utilizes firm-level data to discriminate between two theories that explain the higher price-mix of exports from rich countries. He shows that the Home-market effect is as important as comparative advantage in explaining this pattern. In Lashkaripour (2015b), I use product level data to analyze the effect of geography on the price composition of exports. Estimation results indicate that markups are the main driver of the observed patterns.