Trade Policy Principles and the WTO Will Martin World Bank May 8, 2006
Key issues Why is trade beneficial? What type of trade policy is best? How might WTO help?
Why is trade beneficial? Comparative advantage allows higher living standards in countries that trade Dynamic gains can raise growth rates of countries that trade
Sources of comparative advantage Differences in technology Differences in countries endowments of labor, capital and human capital Presence of specific resources
Differences in technology What matters is comparative advantage When 1 country has advanced technology and 1 has simple technology, both still gain from trade An extremely important insight Perhaps the most fundamental in all of economics Fears in rich countries about competition from poor countries are unjustified Fears in poor countries about competition from rich countries are also unfounded
Can show this with a very simple model Consider economies where goods can be produced using only labor Consider two countries, like Viet Nam and Japan Consider two goods food and electronics Suppose it takes more labor to produce both food and electronics in Viet Nam
Labor required per unit of output Viet Nam Japan Food 4 3 Electronics 12 1 Relative Price of electronics 3 1/3
If Viet Nam has 12 workers Can produce 3 units (12/4) of food Or 1 unit of (12/1) of electronics Or a combination, depending how much labor is used for food & for electronics Food 3 0 1 Electronics
With trade, prices change The world price will end up between the pre-trade price in Viet Nam and the pre- trade price in Japan Probably closer to the price in the larger economy Let s s consider the case where the world price of electronics ends up at 1
Now Viet Nam is much better off Can produce 3 units of food and buy up to 3 units of electronics People in Viet Nam can have more food & more electronics Real incomes have risen in Viet Nam (& in Japan) Food 3 0 1 Electronics 3
Differences in Endowments There are advantages from trade even if technology is the same Suppose production requires both labor & capital And some goods are more labor-intensive (eg( food), while others are capital-intensive intensive (eg( electronics) Suppose Viet Nam has much more labor per unit of capital than Japan Without trade, food will be cheap relative in Viet Nam relative to electronics And wages will be low in Viet Nam
With Trade Based on Endowments The price of food goes up in Viet Nam as consumers in Japan start to buy Wages rise in Viet Nam because of increased demand for labor The price of electronics goes down in Viet Nam because of imports from Japan People in Viet Nam and in Japan can have more food and more electronics Their real income has risen
Specific Resources Viet Nam has specific resources Oil & gas; varied tropical climates; beautiful places These help produce goods and services that are scarce elsewhere Oil & products; coffee; tropical tourism Japan exports manufactures that are difficult to produce in Viet Nam These specific resources also create comparative advantage And allow countries to raise their real incomes
Other Gains from Trade With open trade, competition increases and firms must become more efficient Firms reduce their markups over costs Producers and consumers get access to more goods, and to better goods, than are can be produced at home
Recapping: Reasons for Trade With trade, countries can be better off Poor countries have comparative advantage- in some products-- --over countries with much better technology Rich countries can compete in some products- - with countries with lower wages Key is to use comparative advantage From technology differences, or endowment differences, or specific resources
Comparative Advantage: Important but not enough for development Poor countries can always compete in some exports, even if with poor techniques But incomes stay low while productivity is low To develop requires higher productivity The only sustainable way to raise incomes And it requires adjustments like moving out of labor-intensive manufactures
Dynamic Gains As well as the static gains from trade, countries that are more open seem to have higher growth rates Trade allows countries to take advantage of worldwide improvements in technology And to use new products that increase efficiency of production and/or make consumers better off Exporting firms generally have higher productivity
Poverty Reduction Trade reform is part of a package of policies needed to reduce poverty The linkages are complex and controversial But there is agreement that no country has reduced poverty without liberalizing its trade The growth impacts of liberalization appear to be important And supporting policies such as improvements in rural infrastructure, education & health are clearly important
What type of Trade Policy? Best trade policy for a small country is generally free trade There are many market failures, but these are generally best remedied by policies that target the market failure for example pollution that imposes costs on people is better dealt with by a tax on the pollution, not a tax on trade Similarly, encouraging learning-by by-doing or specific skill development is better encouraged by a targeted subsidy than a tariff on imports
One potential exception? A small country with a large share of the world market (Viet Nam in coffee?) can improve its terms-of of-trade with an export tax But this reduces the income of the importer Viet Nam and the rest-of of-the-world could both could be better without the export tax A key role of the WTO is to try to make everyone better off by taking into account the adverse effects of trade barriers on the rest of the world.
Fundamental effects of protection Important to remember that protection is a tax on all consumption of the good in the country Part of the tax is levied on imports and generates tariff revenues (if tariffs used) Unlike a consumption tax, protection benefits producers And producer interests are frequently much better organized than consumers
Actual Trade Policies Actual trade policies are often quite restrictive Why? Special interests seek protection to raise their incomes at the expense of the people as a whole Some groups are much more easily organized than others Result is frequently a highly distorted trade regime with wide variations in protection rates, nontransparent non-tariff barriers, variable rates of protection
What would good national trade policy look like? Non-discrimination is desirable Differences in protection rates create costs Lose tariff revenues by replacing low-cost imports with higher-cost imports Create incentives for corruption & for conflict between countries Low rates of protection are desirable Costs of protection go up with the square of the rate Predictability & transparency are important
Tariffs versus Quotas & other NTBs A key policy decision is whether to use tariffs or quotas Tariffs have many advantages The extent of protection is known with a tariff The effect of a quota on trade is unknown. What would trade be in the absence of the quota? Divergences in protection are evident with a tariff Tariffs allow adjustment to the emergence of new exporters like Viet Nam
But not all tariffs are equal For transparency, ad valorem tariffs (% of import value) have big advantages Specific tariffs discriminate against imports when prices are low And against poorer countries, which tend to export goods with lower unit values The effects of specific tariffs are also much less transparent What is the effect of a tariff of $100/tonne
Role of the WTO The raison d être d of the WTO is to achieve mutual reductions in protection The potential ability to obtain improved market access changes the balance of political economy forces Exporters become a lobby group for lower protection overseas, and at home In a small country, the most important contribution is through reducing own protection
WTO helps improve trade policy by Reducing discrimination (eg( GATT Art I) Restraining & reducing protection (Art II) Eliminating non-tariff barriers (Article XI) Increasing transparency Protecting members rights by providing a forum for resolving disputes
International Treaty Nature of WTO Since WTO has no enforcement powers, it must seek consensus This makes it more difficult to reach agreement Very clear problem in the Uruguay Round and the Doha Agenda negotiations Many provisions reduce the liberalizing impact of WTO Antidumping, safeguards, smaller tariff cuts for developing countries
Approach of WTO Most agreements are negative integration eg countries agree not to use NTBs,, or to reduce tariffs below their bound levels. Negative integration typically reduces administrative costs & burdens. Does not require development of institutions Some recent agreements eg TRIPS, customs valuation are positive integration require development of institutions
Effectiveness of WTO Considerable debate about the effectiveness of WTO in liberalizing trade It s s clear that WTO has been effective in liberalizing trade in the industrial countries, and in the accession countries Less clear in developing countries But, prior to the Uruguay Round, developing countries were not asked to liberalize Allowed the industrial countries to retain restrictions in eg agriculture and textiles/clothing
Doha Development Agenda Developing countries are planning to undertake some tariff reductions unlike pre-uruguay Rnd. Have already reduced protection enormously Average developing ctry applied tariffs have declined from 33% to 11% The DDA is unlikely to substantially reduce developing country tariffs This will likely reduce the benefits to developing countries but will lock in gains from past liberalization
Conclusions Trade can greatly increase real incomes for rich and poor countries alike Best trade policy involves tariffs that are transparent, relatively uniform & low WTO seeks policies that meet these objectives