The Challenge of Trade Liberalisation - Australian APEC Study Centre

The Challenge of TradeLiberalisationChristis.Tombazos@BusEco.monash.edu.auhttp://www-personal.buseco.monash.edu.au/~tombazos/1

Outline of Discussion• Part 1: Gains from Trade and the Challenge of Liberalisation Why trade? Sources of comparative advantage Optimality of free trade: self evident? The origin of tariffs (the quintessential tool of protection) The menu of trade policies A microeconomic perspective of protection, its winners, and losers A broader view of the benefits of liberalisation The costs of liberalisation• Part 2: Advanced Issues in Trade Liberalisation Unilateral reform: Piecemeal or “Shock” Multilateral reform: Types of agreements and reform commitments Multilateral vs. unilateral reform: what to choose? The measured effectiveness of liberalisation efforts2

Part 1: Gains from Trade and theChallenge of Liberalisation• Why trade?Trade prevails when:Foreign countries are able to supply goodsnot produced domestically……or, are able to supply goods (that are alsoproduced domestically) at a lower price thanthe price charged by domestic producers3

• Why is any country able to export any good at alower price than the importing country? Country X can export a good to country Y whenthe cost of production of this good in X is lowerthan that in Y• Sources of comparative advantage– (See Tombazos, Yang, Zhang, 2004) Technological differences (Ricardian model, circa 1816) Factor endowments (Heckscher-Ohlin, circa 1933) Economies of scale (New trade theory, circa 1980s?) Division on labour (Adam Smith, 1776)4

• Optimality of free trade: self evident? Whatever the reason for comparative advantage, If a foreign country is able to supply a good at a lower pricethan domestic producers …and trade is the natural decision of free agents, …and trade does not generate economic distortions, Then free trade must, by definition, maximise global welfare5

The origin of tariffs (the quintessential tool of protection) If trade is optimal, where do tariffs come from? Economic historians suggest that the first recordedinstances of the implementation of “modern tariffs”were motivated by efforts to raise revenues. Theircapacity to protect domestic industries was simplyviewed as a side-effect. Furthermore, reliance on tariffs to raise revenueappears to relate to the notion that it is easier to“control” borders than households For example, the US relied on tariffs as the only sourceof (transferable) revenue until income taxes becameconstitutional with the 16 th Amendment in 19136

In general, use of tariffs (and other trade barriers)during the 20 th century did not target raisingrevenue, but protecting domestic industries fromforeign competition Tariffs and other trade barriers remain widespreadbecause• Effective tools of protection (refer to the politicaleconomy topic that will be addressed by other speakers)7

• Unlike “comparable” schemes (such as productionsubsidies) trade barriers do not require “visible”transfers, hence their harmful effects are not readilydetectable (and segments of society disadvantagedfrom tariffs do not oppose them as vociferously aswarranted)• Can be easily misdiagnosed as “legitimate” policythat promotes a variety of economic objectives:– economy-wide employment,– Protection of “infant” industries,– economic development and growth, etc.8

• The menu of trade policies Tariffs Ad Valorem: The rate of import duty is expressed as apercentage of the price of the importable (e.g. 36%) Specific: The import tax is expressed in terms of anominal amount per unit of output (e.g. $20 per unit) Quotas Volume: A restriction on the quantity of imports of aparticular category Value: A restriction on the total value of imports of aparticular category Tariff-Quotas A specified quantity is permitted to enter at a givenrate of duty or duty-free. Any additional quantity thatmay be imported is subjected to a higher duty9

Other Non-Tariff Barriers Governments apply many regulations to importswith respect to• Safety• Health• Labelling• Packaging• And Technical standardsAlthough occasionally desirable on social grounds,such regulations often discriminate against importswithout justification by imposing higher standardson foreign producers than on their domesticcompetitors10

• A microeconomic perspective of protection, itswinners, and losers Preliminary concepts: Consumer surplus (CS): The benefit that accrues toconsumers from economic transactions Producer surplus (PS): The difference betweenrevenue (R) and variable cost (VC). This is very similarto, indeed a reflection of, “Profit”. (Profit=R-VC-FC) See interactive animation outlining the impact oftariffs on Consumer Surplus, Producer Surplus,Government Revenue (GR), and Deadweight Loss(DWL)11

An eloquent summary of these results was provided asearly as 1927 by J. B. Brigden who chaired a committeeof five economists appointed by Australian Prime MinisterS. M. Bruce to “inquire into the effects of the tariff”.The report by Brigden (Economic Record, 1927, pg. 29)read:“The protection of manufacturers and of labour marches inone indissoluble unity, and in this manner, at least, thetwo lions of employer and employee lie down in the samefeast with the same “lamb”………. … consuming the consumer”12

• A broader view of the benefits of liberalisationTrade liberalisation facilitates: Efficient “in country” allocation of resources Resources are invested in those activities that are most highlyvalued by the market Enhanced efficiency in the global organisation ofproduction and international exchange made possible byexploitation of comparative advantage (World-wide outputof all commodities expands) In “tangible” terms:• Imports become cheaper – hence, welfare of domesticconsumers increases• Exporters have better access to foreign markets – hence,greater profits13

In addition to the usual (exogenous) sources of comparativeadvantage, free trade promotes:• Exploitation of economies of scale• Economies of specialisation resulting from division of labour (X.Yang, 1994) Greater variety of commodities hence greater social welfare(See “love of variety” models such as Krugman, 1980) Greater international competition leading to greater incentivesto become more efficient by: Adopting new technologies, new entrepreneurial frameworks, andnew distribution models• …leading to “export-led growth” (Feder, 1983) Even in the case of pre-liberalisation “small countries” –liberalisation may bring about an improved internationalbargaining position, leading to better terms of trade14

• The costs of liberalisationA. Industry adjustment effects Such effects concentrate on the transfer ofresources from the production of importablesto the production of exportables (seesimulation) Decrease in the size of the import competing sector(decrease in output, employment, number offirms/farms) Expansion of the export oriented sector (increasein output, employment, number of firms/farms)15

It is important to note that industry adjustment Is not instantaneous – may lead to significant levelsof short term unemployment, and significantdisruption in the economy• For an example, the 1973 25% across-the-board tariffreduction in the Australian TCF sector coupled withelimination of quotas on imported knitwear and wovenshirts (other relevant events coincided: appreciation of the$, equal pay legislation, etc.) led to a significant decrease inemployment:– From March 1974 to March 1975 employment in theTCF sector fell by almost 25%, or 34,000 jobs!16

Of course, the hardship of industry adjustmentshould not discourage governments from followingthrough with liberalisation initiatives that willunambiguously lead to beneficial long termoutcomes• Going back to the TCF example, the Australiangovernments of the 1970s were not prepared to deal withthe fallout– Whitlam gvt. negotiated VERs with major textileexporting nations under the MFA of the GATT– In early 1975 the gvt. replaced the VERs with tariffquotas– The above measures were deemed insufficient by theincoming Fraser gvt. that in 1977 replaced tariff-quotaswith considerably more distortionary volume quotas17

Industry adjustment may requireconsiderable retraining of workers that aretransferred across sectors of the economy inconjunction with the provision of assistanceto these workers• Hence, there is scope for short termgovernment policies that can assist thetransition–But these need to be short termpolicies otherwise liberalisation wouldsimply entail replacing one set ofdistortions with another18

• Going back to the TCF example,In response to the vast lay offs caused bythe 25% tariff cut the Australian gvt.Introduced a scheme of “StructuralAdjustment Assistance” that provided:–Compensation, subsidies, andemployment maintenance to assistemployees, firms and regions affectedby the cuts19

B. Structural implications Infant industry argument (Krueger, 1982) Import Substitution Industrialisation (Schultz, 1964) Employment – last stronghold of liberalisation sceptics There is the presumption (even by many free traders!) thatimports displace demand for domestic labour In Australia, this has translated into concerns that imports fromthe low-wage neighbouring countries of East Asia lead tounemployment Well known contributions in this area that find “evidence” insupport of these suspicions include:• Gregory, Anstie, and Klug (NBER, 1991)• Fahrer and Pease (PCP, 1994)20

Such studies rely on the well known assumption of positivetrade theory that traded goods are “final”Hence, importsa. displace domestic labour that would otherwise be employed inimport competing sectorsb. And have no other effect on employment in other sectors ofthe economyBut this is wrong. All imports (including those of, so called,“final goods”) are intermediate in nature and a significantportion of their shelf price reflects value added domesticallyAnd this is an important point as intermediate importssubject to downstream production processes that arecomplementary with domestic labour have the potential tostimulate demand for labour (most likely in sectors otherthan the import competing sector itself).21

In (Econ. Letters, 1999) I investigate this hypothesis I find that an increase in imports from Asian countriesinto Australia (holding exports fixed) increase overalldemand for Australian labour!22

Part 2: Advanced Issues in TradeLiberalisation• Unilateral reform: Piecemeal or “Shock” In the case of a “small” economy, a “shock” approachthat entails elimination of all distortions (tariffs, quotas,etc.) will establish the optimum result However, in an effort to ameliorate the often significantindustry adjustment effects of the shock approach, apiecemeal initiative that entails a sequence of smalltrade barrier reductions (eventually leading tocomplete liberalisation) may be adopted23

Piecemeal liberalisation can be exceptionallycomplex, and individual liberalisation “steps”may lead to decreases in welfare. Consider for example the case of twoimportables, say X and Y, that are substitutes. Adecrease in the tariff imposed on X:• Increases consumer surplus from X• Decreases the demand for Y, hence decreases tariffrevenues from imports of Y• It can be shown (see Vousden, 1991, p. 201-05) thatunder some circumstances the opposing effectsabove may lead to a net decrease in overall welfare24

In this light, the relevant rules of thumb (subjectto qualifications in Vousden, 1991, p. 205)require that:• More extreme distortions are reduced first• A good whose tariff is reduced has– Few substitutes with low tariff rates– Many complements with relatively high tariffs25

• Multilateral reform: Types of agreements and reformcommitmentsSchemeFreeintraschemetradeCommonexternaltradepolicyFreefactormobilityCommonmonetaryand fiscalpolicyOnegovernementFreetradeareaYesNoNoNoNoCustomUnionYesYesNoNoNoCommonMarketYesYesYesNoNoEconomicUnionYesYesYesYesNoPoliticalUnionYesYesYesYesYes26

• Multilateral vs. unilateral reform: what to choose? Consider the choice between comprehensive elimination of trade barriers, and the formation of a custom union In the following example we consider a commodity in whichthe exporting nation is not the least cost producer27

Whether the formation of a custom union improves welfaredepends on the relative size of the trade diversion andtrade creation effects Of course, the previous diagram does not consider thebenefits of multilateral agreements that derive fromincreased exports However, given sufficient trade diversion effects, there isno guarantee that multilateral agreements will generatesuperior outcomes to unilateral liberalisation initiatives. Given the questionable benefit of custom unions, there is astrong argument to be made for aggressive unilateralliberalisation initiatives Incurring the distortions of trade barriers in the hope that, intime, other countries may agree to multilateral liberalisationefforts (that may, or may not, be superior to unilateralinitiatives) is a policy of questionable merit29

• The measured effectiveness of liberalisation efforts Studies that investigate the effectiveness ofliberalisation initiativesUtilise models that capture the “reaction” thatflows from tariffs to importsSuch studies find a remarkably small effect• For an extreme example, consider Simmonsand Smith (1994) who determine that, at least inrelation to the examined manufacturing sector,“…removal of the tariff would have no effect onthe level of imports…” (p. 57)30

Policy-makers are perplexed by such results In a recent paper (Southern Econ. Journal, 2003)I show that such results derive from a widespreadmisspecification of the adopted frameworks insuch researchThe flow of “reaction” is bi-directionalTariffsImportsIn this paper I show that when bothvariables are determined simultaneously theimpact of tariffs on imports doubles!31

Consider these results in the context ofthe 1970s dynamics pertaining to theAustralian TCF sector25% 1973 across-the-board tariff cut ⇒imports increase ⇒job losses emerge ⇒political costs generated ⇒VERs, tariff-quotas, and then quotas introduced (i.e.protection resumes) ⇒imports decrease32

In short: Liberalisation initiatives can beeffective, as long as countries areprepared to handle the short termnegative industry adjustment effects inpursuit of the greater long term good33