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Summary of week 7 of International Trade and Investment
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Summary of week 7 of the course of International Trade and Investment. Includign chapters: 12 and 17.
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Chapter 12: Controversies in Trade PolicySophisticated Arguments for Activist Trade Policy
The difficulty with market failure arguments for intervention is being able to recognize a market
failure then you see one. Economists studying industrial countries have identified two kinds of
market failure that seem to be present and relevant to the trade policies of advanced countries: (1)
the inability of firms in high-technology industries to capture the benefits of that part of their
contribution to knowledge that spills over to other firms and (2) the presence of monopoly profits in
highly concentrated oligopolistic industries.
Technology and Externalities
If firms in an industry generate knowledge that other firms can use without paying for it, the industry
is in effect producing some extra output – the marginal social benefit of the knowledge – that is not
reflected in the incentives of firms. Where such externalities can be shown to be important, there is
a good case for subsidizing the industries. At an abstract level, this argument is the same for the
infant industries of less-developed countries as it is for the established industries of the advanced
countries. In advanced countries, however, the argument has a special edge because in those
countries, there are important high-technology industries in which the generation of knowledge is in
many ways the central aspect of the enterprise. The point for activist trade policy is that while firms
can appropriate some of the benefits of their own investment in knowledge, they usually cannot
appropriate them fully. Some of the benefits accrue to other firms that can imitate the ideas and
techniques of the leaders. Because patent laws provide only weak protection for innovators, one can
reasonably presume that under laissez-faire, high-technology firms do not receive as strong an
incentive to innovate as they should. Should the government subsidize high-technology industries?
Two questions in particular arise: (1) Can the government target the right industries or activities? And
(2) How important, quantitatively, would the gains be from such targeting? A general principle is that
trade and industrial policy should seek to subsidize the generation of knowledge that firms cannot
appropriate. The problem, however, is that it is not always easy to identify that knowledge
generation; industry practitioners often argue that focusing only on activities specifically labeled
“research” is taken far too narrow a view of the problem. It’s a difficult debate to settle, in large part
because it’s not at all clear how to put numbers to these concerns. It seems likely, however that the
debate over whether or not high-technology industries need special consideration will grow
increasingly intense in the years ahead.
Imperfect Competition and Strategic Trade Policy
In some industries there are only a few firms in effective competition. Because of the small number
of firms, the assumptions of perfect competition do not apply. In particular, there will typically be
excess returns; that is, firms will make profits above what equally risky investments elsewhere in the
economy can earn. There will thus be an international competition over who gets these profits.
Spencer and Brander noticed that, in this case, it is possible in principle for a government to alter the
rules of the game to shift these excess returns from foreign to domestic firms. In the simplest case, a
subsidy to domestic firms, by deterring investment and production by foreign competitors, can raise
the profits of domestic firms by more than the amount of the subsidy. The Brander-Spencer analysis
can be illustrated with a simple example in which only two firms compete, each from a different
country. Bearing in mind that any resemblance to actual events may be coincidental, let’s call the
firms Boeing and Airbus and the countries the US and Europe. Suppose there is a new product that
both firms are capable of making. For simplicity, assume each firm can make only a yes/no decision:
either to produce or not. Either firm alone could earn profits making superjumbo aircraft, but if both
firms try to produce them, both will incur losses. Which firm will actually get the profits? This
depends on who gets there first. Suppose Boeing is able to get a small head start and commits itself
to produce superjumbo aircraft before Airbus can get going. Airbus will find that it has no incentive
to enter. The outcome will be in the upper right of the table. Now comes the Brander-Spencer point:
The European government can reverse this situation. Suppose the European government commits
, itself to pay its firm a subsidy of 25 if it enters. The result will be to change the able of payoffs. In this
case,, it will be profitable for Airbus to produce superjumbo aircraft whatever Boeing does. Boeing
now knows that whatever it does, it will have to compete with Airbus and will therefore lose money
if it chooses to produce. So now it is Boeing that will be deterred from entering. In effect, the
government subsidy has removed the advantage of a head start that we assumed was Boeing’s and
has conferred it on Airbus instead. The equilibrium shifts from the upper right to the lower left. The
subsidy raises profits by more than the amount of the subsidy itself, because of its deterrent effect
on foreign competition. The subsidy has this effect because it creates an advantage for Airbus
comparable with the strategic advantage Airbus would have had if it, not Boeing, had had a head
start in the industry. Critics of the Brander-Spencer Analysis argue that making practical use of the
theory would require more information than is likely to be available, that such policies would risk
foreign retaliation, and that in any case, the domestic politics of trade and industrial policy would
prevent the use of such subtle analytical. The problem of insufficient information has two aspects.
The firs it that even when looking at an industry isolation, it may be difficult to fill in the entries in a
table, like Table 12-1 with any confidence. And if the government gets it wrong, a subsidy policy may
turn out to be a costly misjudgment. Strategic policies are beggar-thy-neighbor policies that increase
our welfare at other countries’ expense. These policies therefore risk a trade war that leaves
everyone worse off.
Globalization and Low-Wage Labor
The rise of manufactured exports from developing countries has been one of the major shifts in the
world economy over the last generation. It should come as no surprise that the workers who produce
manufactured goods for export in developing countries are paid very little by advanced-country
standards. After all, the workers have few good alternative in such generally poor economies. Nor
should it come as any surprise that the conditions of work are also very bad in many cases. Should
low wages and poor working conditions be a cause of concern? Many people think so. It is fair to say
that most economists have viewed the anti-globalization movement as, at best, misguided. The
standard analysis of comparative advantage suggests that trade is mutually beneficial to the
countries that engage in it; is suggests, furthermore, that when labor-abundant countries export
labor-intensive manufactured goods not only should their national incomes rise but the distribution
of income should also shift in favor of labor. But is the anti-globalization movement entirely off base?
Trade and Wages Revisited
Activists pointed to the very low wages earned by many workers in developing-country export
industries. These critics argued that the low wages showed that, contrary to the claims of free trade
advocates, globalization was not helping workers in developing countries. Opponents of the
globalization argue that by making it easier for employers to replace high-wage workers with lower-
paid workers, the globalizations had hurt employees from both countries. We assume there are two
countries, Japan and Vietnam, and two industries, high-tech and low-tech. We also assume that labor
is the only factor of production, and that Japanese labor is more productive than Vietnamese Labor
in all industries. The upper part of the table shows the real wages of workers in each country in terms
of each good in the absence of trade: the real wage in each case is simply the quantity of each good
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