The Law and Economics of International Trade Agreements 1802209735, 9781802209730

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The Law and Economics of International Trade Agreements

Alan O. Sykes

The Law and Economics of International Trade Agreements

For Maureen, Maddie and Sophie

The Law and Economics of International Trade Agreements Alan O. Sykes Professor of Law and Warren Christopher Professor in the Practice of International Law and Diplomacy, Stanford University, USA

Cheltenham, UK • Northampton, MA, USA

© Alan O. Sykes 2023

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Control Number: 2023933748 This book is available electronically in the Law subject collection http://dx.doi.org/10.4337/9781802209747

ISBN 978 1 80220 973 0 (cased) ISBN 978 1 80220 974 7 (eBook)

EEP BoX

Contents List of figuresxi Acknowledgementsxii List of abbreviationsxiii 1

Introduction to The Law and Economics of International Trade Agreements1

2

Economic background: The rationale for trade, the case for liberal trade and its critique, and the economics of trade agreements 5 A. The Rationale for Trade 5 1 The Theory of Comparative Advantage: A Stylized Illustration 6 2 Relaxing the Underlying Assumptions 7 3 Sources of Comparative Advantage 9 4 Scale Economies and Variety 10 B. Normative Issues in Trade Policy 11 1 The Traditional Case for Free Trade: Efficiency 11 2 Some Caveats to the Efficiency Argument for Liberal Trade 18 Trade and the Income Distribution 27 3 4 Sovereign Choices, Democratic Legitimacy and 31 International Externalities C. The Positive Economics of Trade Policy and Trade Agreements 34 1 Trade Policy in a Small Country 34 2 Large Country Interaction and Terms of Trade Externalities40 3 Other Rationales for Trade Agreements 49 4 Summary 51

3

An introduction to the history and institutions of international trade A. The Pre-Gatt Era v

52 54

The law and economics of international trade agreements

vi

B.

C. D. 4

5

6

The Gatt Era 1 The Original GATT 2 The Subsequent Evolution of GATT The WTO The Rise of Preferential Trade Agreements (PTAs)

57 57 59 62 64

The interface between national and international trade law A. Negotiation and Ratification: Trade Promotion Authority (TPA) 1 TPA (formerly “Fast Track”) 2 The Effects of TPA B. The Domestic Consequences of International Trade Law 1 Monism, Dualism, Direct Effect and Self-Executing Treaties 2 International Trade Agreements and Direct Effect International Obligations in a Domestic Legal Hierarchy 3 4 Is the Absence of Direct Effect a Problem?

66 66 68 69 71

Enforcement and dispute resolution A. Legal and Historical Overview 1 The Meaning of “Nullification or Impairment” 2 Dispute Resolution Procedure in the GATT Years The WTO Dispute Settlement Innovations 3 4 The Appellate Body Impasse 5 Additional Principles of Dispute Settlement B. Economic Issues in Enforcement and Dispute Settlement 1 The Economic Functions of Adjudication 2 Implications for the History of WTO/GATT Dispute Resolution 3 Further Issues in Dispute Resolution

80 81 82 88 90 94 95 98 99

Tariffs and quantitative restrictions A. Tariffs under National and International Law 1 Administration of Tariff Systems at the National Level: Domestic Practices and International Constraints 2 Tariff Bindings 3 The Tariff Negotiation Process 4 Tariff Renegotiation

71 73 75 77

104 106 127 127 128 134 140 142

Contents

B.

C.

7

8

GATT Rules on Quantitative Restrictions 1 Covered Measures 2 Applicability to Exports 3 Exceptions Further Observations on the Economics of Tariff and Quantitative Restriction Commitments 1 “Tariffication” 2 Exports versus Imports Creeping Liberalization and Negotiating “Rounds” 3

The most-favored nation (MFN) obligation and exceptions (with a note on state trading enterprises) A. The General MFN Obligation Legal Principles 1 2 Economic Implications of Tariff Discrimination and MFN 3 The Conditionality Issue 4 Like Products B. Quota MFN C. PTAs and GATT Article XXIV 1 Legal Prerequisites for the Article XXIV Exception WTO/GATT Supervision of PTAs 2 3 The Scope of PTAs 4 Economic Perspectives on PTAs D. Tariff Preferences for Developing Countries  E. State Trading Enterprises (STEs) and Gatt Article XVII The national treatment obligation A. An Overview of GATT Article III B. Internal Taxation C. Regulation D. Local Content Requirements, Trims and The Division of Labor Between Articles III and XI E. A Note on Government Procurement and The WTO Government Procurement Agreement F. Border Tax Adjustments

vii

144 144 145 146 152 152 155 157

159 160 161 162 168 170 176 177 178 180 183 183 187 190 193 194 197 202 206 209 213

viii

9

The law and economics of international trade agreements

The general and security exceptions 219 A. The General Exceptions in Article XX: Legal Overview 220 1 The Enumerated Exceptions of Article XX 220 2 The Article XX Chapeau  221 3 Applicability of the Exceptions to Other WTO Obligations221 4 The Burden of Proof 222 B. The Extraterritoriality Issue 223 1 Regulation Relating to Processes and Production Methods223 2 Non-PPM issues and extraterritoriality: A clarification 226 3 The Current Status of Extraterritorial Regulation in WTO Law 227 C. Interpretive Issues under GATT Article XX 228 1 Ambiguities in the Scope of the Enumerated Exceptions 229 The Prefatory Requirements: “Necessary” and 2 “Relating to” 234 The Chapeau 240 3 D. The National Security Exception 243

10 Technical barriers to trade and the trade/regulation interface 248 A. A Deeper Look at the Trade and Regulation Interface 248 Regulation as a Potential Impediment to 1 International Commerce 249 The Problem of Regulatory Distortion in Open 2 Economies251 B. Legal Overview of the TBT and SPS Agreements 255 1 The Scope of TBT and SPS 255 2 Key Obligations in the TBT and SPS Agreements 257 C. Selected Conceptual Issues in Technical Barriers Jurisprudence 266 1 “Less Favourable Treatment” 266 2 Legitimate Objectives 269 3 Necessity 270 4 Labelling 272 5 Reference to International Standards 273 6 Scientific Evidence Requirements and Risk Assessment 275 7 Consistency Requirements 277

Contents

D.

The “Race To The Bottom” Issue: Labor and Environment in Recent PTAs

ix

283

11 Safeguard measures A. Possible Policy Justifications for Safeguard Measures B. Preconditions for the Use of Safeguard Measures 1 GATT Article XIX 2 The Agreement on Safeguards C. Jurisprudence on the Preconditions for Safeguard Measures 1 “Unforeseen Developments” and the “Effects of Obligations Incurred” 2 Imports in “Such Increased Quantities” 3 The Domestic “Industry” “Serious Injury” and Threat 4 5 The Causal Link to “Increased Quantities” and “Non-Attribution” Analysis D. Compensation, Retaliation and Gray Area Measures E. Allowable Measures: Scope and Duration

285 286 294 294 296 298

12 Antidumping measures A. The Authority for Antidumping Measures under International Law 1 Elaborating the Concept of “Dumping:” The Antidumping Agreement 2 A Note on Antidumping Provisions in Preferential Trade Agreements B. What is Objectionable about Dumping? The Policy Puzzle 1 Why Does Dumping Occur? 2 Antidumping Policy and Competition Policy: A Closer Look  3 Why Do Trade Agreements Tolerate Antidumping Law? C. The “Zeroing” Saga 1 What is “Zeroing?” Zeroing and WTO law 2 3 The Fallout

324 324

13 Subsidies and countervailing measures, with a note on agriculture A. Policy Perspectives

355 356

298 302 304 306 308 317 320

326 334 334 335 341 344 348 348 352 353

The law and economics of international trade agreements

x

B. C.

D.

E. F. G. H. I.

Legal Overview The Meaning of “Subsidy” and “Specificity” 1 The Legal Principles in Part I of the SCMs Agreement 2 Legal and Conceptual Issues under SCMs Articles 1 and 2 Prohibited Subsidies Export Subsidies 1 2 Import Substitution Subsidies Actionable Subsidies and “Adverse Effects” The “Safe Harbor” Experiment A Further Note on Countervailing Duties The Special Case of Agriculture Concluding Perspectives on the Structure of Subsidies Disciplines

362 364 364 365 386 386 395 396 399 400 402 403

14 Trade in services and GATS A. Defining Trade in “Services” B. The Basic Structure of GATS Commitments C. Implementation Challenges D. Economic Observations E. The Overlap Between Goods and Services: Legal Issues F. A Note on Digital Trade

407 407 409 412 414 418 419

15 China in the world trading system A. Implications of China’s State Control and Industrial Policies: Market Access and Export Competitiveness 1 The Credibility of China’s Market Access Commitments  2 China’s Industrial Policies, Subsidies and the “Public Body” Issue B. Antidumping Law and China  C. “Forced” Technology Transfer D. Currency Manipulation E. China and the Future of International Trade Cooperation

422 424 425 428 432 436 441 447

References450 Index463

Figures 2.1

Consumer surplus

14

2.2

Producer surplus

14

2.3

Effect of trade in a market with imports

16

2.4

Effect of trade in a market with exports

17

2.5

Effect of a tariff – small country case

20

2.6

Effect of a tariff – large country case

21

6.1

Tariffs vs. quotas

154

11.1 Equilibrium in a market with imports

309

12.1 Price discrimination in segmented markets

336

xi

Acknowledgements I have been teaching and writing about international trade for over 35 years, and during that time I have accumulated enormous intellectual debts that make this volume possible. Early in my career, the late John Jackson graciously invited me to join him and Bill Davey to produce a new edition of their casebook on international trade that Bill and I continue to revise and use in our classes today. The experience of working with John and Bill has been transformative. I am also exceedingly grateful to Henrik Horn and Petros Mavroidis for involving me in the American Law Institute project on Principles of World Trade Law. Subsequently I have had the enormous privilege of collaborating with many other distinguished scholars from both law and economics who have taught me a great deal of what I know. These collaborators have included Kyle Bagwell, Chad Bown, Judy Goldstein, Gene Grossman, Douglas Irwin, Damien Neven, Janusz Ordover, Ralph Ossa, Eric Posner, Warren Schwarz, Robert Staiger and Robert Willig. My grounding in economics also owes much to my time as a student of, and long-time teaching assistant for, Alvin K. Klevorick, T.N. Srinivasan, and Sidney G. Winter at Yale. I also thank my many friends through the years in the international trade group at Arnold & Porter, especially Claire Reade and Larry Schneider, for opening my eyes to the fascinating world of international trade law practice. Finally, I wish to thank all my colleagues, research assistants and generations of students at Chicago, NYU and Stanford for supporting my efforts to contribute to the field.

xii

Abbreviations ACP AFTA ASEAN BISD CAFTA CETA COMESA CPTPP CU DSB DSU EC EFTA EU FTA GATS GATT GSP ITA ITC ITO MERCOSUR MFN MPIA

African, Caribbean and Pacific Countries ASEAN Free Trade Area Association of Southeast Asian Nations GATT Basic Instruments and Source Documents Dominican Republic – Central America – United States Free Trade Agreement EU-Canada Comprehensive Economic and Trade Agreement Common Market of Eastern and Southern Africa Comprehensive and Progressive Agreement for Trans-Pacific Partnership Customs Union WTO Dispute Settlement Body WTO Dispute Settlement Understanding European Communities European Free Trade Association European Union Free Trade Area General Agreement on Trade in Services General Agreement on Tariffs and Trade Generalized System of Preferences U.S. Department of Commerce International Trade Administration U.S. International Trade Commission International Trade Organization Southern Common Market Most-Favored Nation Multi-Party Interim Appeal Arbitration Arrangement xiii

xiv

NAFTA NME PTA RCEP SCMs SOE SPS STE TBT TPP TRIMs TRIPS USMCA USTR VCLT WTO

The law and economics of international trade agreements

North American Free Trade Agreement Non-Market Economy Preferential Trade Agreement Regional Comprehensive Economic Partnership Subsidies and Countervailing Measures State-Owned Enterprise Sanitary and Phytosanitary Measures State Trading Enterprise Technical Barriers to Trade Trans-Pacific Partnership Agreement on Trade-Related Investment Measures Agreement on Trade-Related Aspects of Intellectual Property Rights U.S.-Mexico-Canada Agreement United States Trade Representative Vienna Convention of the Law of Treaties World Trade Organization

1. Introduction to The Law and Economics of International Trade Agreements Over the past 75 years, international trade agreements have grown in depth and complexity at an astonishing rate. The General Agreement on Tariffs and Trade (GATT), first negotiated in 1947, began a multilateral effort to reduce the tariff barriers to trade in goods that had risen dramatically during the 1930’s following the passage of the “Smoot-Hawley Tariff” in the United States (the Tariff Act of 1930) and retaliatory measures abroad. As tariffs declined under the auspices of GATT, non-tariff barriers to trade took on greater importance, and the GATT system over time introduced increasing disciplines over non-tariff barriers through plurilateral (limited membership) side agreements on antidumping measures, subsidies and countervailing duties, technical barriers to trade, government procurement, and other issues. This process culminated in 1994 with the creation of the World Trade Organization (WTO), which subsumed the GATT, created a “single undertaking” binding all members to most WTO obligations, and extended global discipline to trade in services and intellectual property rights. It concurrently introduced new agreements on a variety of non-tariff barrier issues, and deepened the agreements that had emerged during the GATT years. The WTO also introduced a “binding” dispute resolution process coupled with a real prospect of centrally authorized sanctions against WTO members that do not comply with adverse rulings. This dispute process was unquestionably among the most important and striking developments in modern international law, although it has recently come under siege. Hundreds of cases have been decided under its auspices, with often far-reaching implications for national commercial and regulatory policies. Concurrently, regional and other preferential trading arrangements (PTAs) have proliferated. The European Union is arguably the most important preferential arrangement notwithstanding “Brexit,” but numerous other important agreements exist such as the United-States-Mexico Canada Agreement (USMCA), the Association of Southeast Asian Nations Economic Community (ASEAN), the Southern Common Market (Mercosur) in South America, the Comprehensive and Progressive Agreement for Trans-Pacific Partnership 1

2

The law and economics of international trade agreements

(CPTPP), the EU-Canada Comprehensive Economic and Trade Agreement (CETA), and the Regional Comprehensive Economic Partnership (RCEP) centered around China. Each of these arrangements creates its own legal order, typically governed by hundreds of pages of treaty text. The growth of international trade law, and the “globalization” that accompanies it, has of course met with considerable resistance. Various groups urge that it has intruded on national sovereignty, or that it clashes with other important values concerning matters such as labor rights and the environment. The intensity of the protestations ebbs and flows, but they have had an important impact on the push for new international agreements. The “Doha round” of WTO negotiations has foundered, and WTO members face great challenges reaching consensus on issues that might seem to be simple (such as curtailing fossil fuel subsidies that can contribute to climate change). Political campaigns on both sides of the aisle in the United States routinely sound protectionist themes and decry the “bad deals” negotiated in the past, blaming them for job loss in various industries. President Trump withdrew the United States from the Trans Pacific Partnership, which had been the product of many years of painstaking negotiations. The current prospects for a Transatlantic Trade and Investment Partnership – a proposed free trade agreement between the United States and Europe – appear bleak. The Biden administration has not to this point signaled receptiveness to significant new agreements. Nevertheless, numerous trade agreements are in effect and continue to govern international trade in goods and services. The goal of this book is to provide a rigorous and balanced overview of the law and economics of these agreements. The core treaty obligations will be explained, and key legal decisions noted. The economic discussion will offer both a positive account of the structure of international obligations, and a normative analysis of their wisdom. The book presumes no technical background on the part of the reader, and develops the important economic points verbally or using numerical illustrations or simple diagrams. The goal is to provide a self-contained overview of the core legal and economic concepts, accessible to readers with little or no background in either subject. The modern proliferation of trade agreements and the increasing scope of their obligations unfortunately necessitates considerable selectivity in the topics addressed by this book. The most important exclusion pertains to international intellectual property law, which was incorporated into the WTO at its founding through the Agreement on Trade-Related Aspects of Intellectual Property and is now routinely included in more recent PTAs. A careful treatment of the associated issues, however, would require its own book length treatment. It would also draw on a body of theoretical and empirical economics that involves issues much different from those associated with the economics of international trade.

Introduction

3

Even with the omission of intellectual property, modern trade agreements span thousands of pages of treaty text and contain an enormous amount of detail. This book is not intended to be a comprehensive treatise on all the concomitant obligations. Instead, topics have been chosen to emphasize matters of greatest economic importance, as well as issues that have become particularly controversial and that have contributed to skepticism about trade agreements among political officials and civil society groups. Finally, although the emphasis of the book is on international law, the reader should understand that much of the international legal order is implemented through domestic laws and regulations. Consequently, some significant attention must be devoted to domestic implementation. In this regard, the book will focus mainly on U.S. implementation measures, albeit with occasional comparative notes on European and other systems.

ORGANIZATION OF THE BOOK Chapter 2 begins with an introduction to the basic economics of international trade and trade agreements. The rationale for trade and the traditional economic case for liberal trade and its modern critique will be reviewed, followed by an extensive discussion of the economic rationale for trade agreements. Chapter 3 then affords an introduction to the history and institutions of international trade regulation, including a brief history of the WTO/GATT system, and some perspective on the growth of preferential trading arrangements. Chapter 4 addresses the intersection between international and domestic law in the trade area. It considers, among other things, the source of negotiating authority for international trade agreements, the creation of the international obligation, and the effect of international agreements on domestic law. Chapter 5 then considers the general problem of how to “enforce” an international trade agreement, and in the process introduces the reader to the structure and operation of the WTO dispute resolution system, its predecessor in GATT, and the approaches found in important preferential trade agreements. Chapters 6–13 then consider the core features of international law governing trade goods. Chapter 6 considers the basic commitments on border measures (tariffs and quotas) that constitute the most direct means by which governments intervene in trade. Chapter 7 addresses the first of the basic non-discrimination obligations – the “most-favored-nation” (MFN) obligation. It then considers in detail an important exception to the MFN principle in the form of authority for the creation of PTAs, and briefly considers preferences for the exports of developing countries. Chapter 8 proceeds to address the second of the fundamental non-discrimination obligations – the “national treatment” limitation on domestic tax and regulatory policies. Chapter 9 continues the focus on the interface between

4

The law and economics of international trade agreements

international trade obligations and national regulatory policies, with particular emphasis on the general “exceptions” to obligations that permit regulations and certain other measures that would otherwise clash with principles such as the national treatment obligation. This chapter will afford an opportunity for discussion of the broader question whether international trade obligations are intrusive on “sovereignty” or on other core values such as labor rights, environmental protection or national security. Chapter 10 also continues the discussion of the trade/regulatory interface, addressing the additional disciplines over domestic regulatory policies introduced by the WTO agreements on “technical barriers to trade” and similar provisions in regional arrangements. Chapter 11 concerns the so-called “escape clause” or “safeguards” authority that allows member nations to deviate from their tariff and other commitments on a temporary basis for the purpose of protecting “injured” industries. It also considers the authority for renegotiation of tariff commitments. Chapter 12 addresses antidumping measures, whereby WTO members may impose additional tariffs to combat the ostensibly “unfair” trade practice of “dumping.” Chapter 13 surveys the WTO commitments and constraints on subsidy practices (with some attention to the special rules for agricultural products), and the rules governing the use of “countervailing duties” that offset “unfair” subsidies. Chapter 14 discusses the General Agreement on Trade in Services (GATS), which in 1994 brought services trade under multilateral discipline for the first time. The analysis will highlight import differences between trade in goods and trade and services, and the resulting differences between the legal architecture of GATS and GATT. In addition, although this book does not undertake to address international investment law in any detail, Chapter 14 will indicate how GATS commitments overlap with investment commitments in services sectors. Finally, Chapter 15 considers the growing role of China in the world trading system and the implications of its state intervention into the economy and its network of state-owned enterprises. The topics include the credibility of China’s market access commitments, the relationship between its industrial policies and concerns about unfair “subsidies,” the application to China of a special approach to antidumping law designed for non-market economies, the issue of “forced technology transfer,” and the problem of “currency manipulation.” I have endeavored not to encumber the book with copious footnotes, and instead to make brief references to the literature using social science citation style. References are collected at the end of the volume.

2. Economic background: The rationale for trade, the case for liberal trade and its critique, and the economics of trade agreements International trade law is a form of economic regulation. It is impossible to think carefully about the wisdom of the law without some understanding of its economic consequences. Likewise, it is impossible to understand the trade policies and trade agreements that arise in practice without some appreciation of the economic forces that shape them through the political process. This chapter provides the economic building blocks to address these issues in the chapters to come. A number of excellent textbooks exist on international economics, including several noted in the references. For readers with little or no background in international economics, however, the basic concepts developed in this chapter should provide an adequate foundation for subsequent discussion. The chapter requires no economic training beyond an ability to understand elementary supply and demand diagrams. All of the apparatus for understanding the more basic propositions is developed in the chapter, while more technical points are simply stated and accompanied by references to relevant literature. We begin in Section A with the most basic issue – why does international trade occur? The chapter then turns in Section B to the normative arguments for and against liberal trade policies. It then concludes in Section C with a discussion of the rationale for international trade agreements.

A.

THE RATIONALE FOR TRADE

The predominant economic account of the rationale for international trade is the theory of comparative advantage. The core insight is that when nations specialize in the production of things that they are relatively good at supplying, and trade them for things that others are relatively good at supplying, the world can produce more goods and services with the same resources and thus enable people to consume more of the things they desire. This process of specialization will occur in the absence of excessive barriers to trade as entrepreneurs pursue the profits associated with trade. 5

The law and economics of international trade agreements

6

Table 2.1

Autarky Price per unit of corn and wheat Corn

Wheat

Country A

$1.00

$2.00

Country B

£2.00

£3.00

1.

The Theory of Comparative Advantage: A Stylized Illustration

Imagine a very simple world comprised of two countries, A and B. The countries each produce two goods, “corn” and “wheat.” Assume for the moment that these goods can be transported from one country to the other at zero cost, and that there are no other barriers to trade (such as tariffs or quotas). Assume finally that the resources used to produce corn and wheat (such as capital and labor) are immobile and do not move from country to country. These are highly stylized assumptions but, as we will see below, relaxing them does not alter the core point. Initially, no international trade occurs between the two countries, a state of affairs known as “autarky” in economic parlance. The unit of currency is the dollar ($) in country A and the pound (£) in country B. Imagine that the prevailing prices in each country in autarky are as given in Table 2.1. Note that the ratio of the prices of the two products in each country differs – the ratio is ½ in country A, and 2/3 in country B. The theory of comparative advantage explains how this difference in price ratios creates an opportunity for profitable trade if transportation costs and any other barriers to trade are low enough. In particular, suppose that an entrepreneur from country A travels to country B. He or she observes that a unit of corn purchased for $1.00 in country A can be sold in country B for £2. The revenue from that sale will buy 2/3 unit of wheat in country B. If that quantity of wheat is then imported into country A, it will sell for approximately $1.33. Drawing on the assumption that the cost of transporting goods back and forth is zero, it is now apparent to the entrepreneur that by buying corn for $1.00 in country A, reselling it in country B, using the proceeds to buy wheat in country B and then importing it for sale in country A, it will be possible to earn a $.33 profit. Similarly, an entrepreneur traveling from country B to country A will observe that it is possible to buy a unit of wheat in country B for £3.00, resell it for $2.00 in country A, and then use the proceeds to buy two units of corn. The corn in turn can be exported to country B and sold for £4.00 altogether, yielding a profit on the transaction of £1.00. In short, there is money to be made by exporting corn from country A to country B and exporting wheat in the other direction (note that an entrepreneur would lose money by exporting corn from country B or exporting wheat from

Economic background

7

country A). We then say that country A has comparative advantage in corn production, while country B has comparative advantage in wheat production. When entrepreneurs take advantage of the profit opportunities attributable to comparative advantage, prices will change. The demand for corn production will increase in country A and the demand for wheat production will increase in country B (because of the new export markets for each good), inducing the respective prices to rise. Likewise, the supply of corn will increase in country B and the supply of wheat will increase in country A (because of the new imports), inducing the respective prices to decline. Country A will be led to shift resources toward corn production, and country B will be led to shift resources toward wheat production. In this fashion, specialization or “division of labor” occurs on the basis of each nation’s comparative advantage. Likewise, as prices adjust as described above, the profitability of trade will decline until, in equilibrium, there will be no further incentive for entrepreneurs to expand trade. A bit of reflection reveals a further insight. With zero transportation costs and no trade barriers, a profitable trading opportunity arises for any difference in the autarky price ratios across countries. Only if the ratios are exactly the same will there be no opportunity for trade to yield profits. Correlatively, as long as the autarky price ratios differ across the two countries, each country will always have comparative advantage in the production of one of the two goods. That would be true even if one of the two countries were more efficient in the production of both goods (i.e., could produce both goods with fewer inputs). Accordingly, even if one country is better at producing everything in the sense that it can produce more of both final goods for a given combination of inputs (i.e., one country has “absolute advantage” in both goods), there is still an opportunity to trade profitably based on comparative advantage. 2.

Relaxing the Underlying Assumptions

How do things change if we relax the restrictive assumptions that underlie this illustration? Regarding the assumption that transportation costs and tariffs are zero, the presence of significant transportation costs and trade barriers in reality will reduce the potential profits from trade and may choke it off completely. For trade to occur, the potential profit opportunity created by the difference in autarky price ratios must be large enough to cover all the costs of engaging in trade, including the costs of transporting tradable things, any tariffs or other charges payable to governments, and still suffice for entrepreneurs to earn a reasonable return to engaging in the import/export business. As long as these various costs are not “too large,” trade will occur in the direction predicted by the theory.

8

The law and economics of international trade agreements

Another feature of our illustration is that it considers only two countries and two goods. The world contains many more than two nations, of course, and the set of tradable goods (and services) includes thousands of distinct things. Accordingly, there would be many thousands of autarky price ratios in every country, and many potential trading partners. The likely result is that every country will have comparative advantage in many things. The task of predicting which countries will export which things, however, becomes immensely more complicated as the number of countries and tradable things increases, and the theory quickly becomes quite technical.1 Nevertheless, profitable trading opportunities arise on the basis of comparative advantage for the same essential reason elucidated in the two-country, two-good illustration. The assumption that the resources used to produce corn and wheat are immobile requires some discussion. The various resources that are used to produce final goods and services are known in economics as “factors of production.” These include land, labor, various forms of capital, and so on.2 Land is obviously immobile, but other factors are not inherently immobile. If factors of production have greater productivity in one nation than in another and can earn more there, and if those factors are mobile, the result may be international factor movements (e.g., foreign direct investment, immigration) rather than international trade in final products. But just as the movement of goods is not costless, the movement of factors is not either. To take the case of labor, not only is the cost of transportation to another country potentially significant, but the costs of learning a new language, the costs of leaving behind culture and loved ones, and so on, can be great. Legal impediments to immigration are also extensive. Thus, in a more general model, one must take all these costs and impediments into account for every factor of production. The equilibrium will entail some mixture of trade and factor flows. But because the costs and impediments to factor mobility are often considerable in practice, we can be confident that factor mobility is not a complete substitute for trade. At that point the theory of comparative advantage takes over to suggest how, in the face of limited factor mobility, international trade flows are likely to emerge. Finally, our illustration does not encompass the realities of foreign exchange markets, in which participants buy and sell not tradable goods but foreign currencies. The introduction of a foreign exchange market does not change the 1 For a reasonably accessible discussion with references to the literature, see Jones and Neary (1984). A more technical treatment of some of the issues is Ethier (1984). Advanced textbook references include Bhagwati, Panagariya and Srinivasan (1998), chapter 8, and Feenstra (2004), chapter 3. 2 Intermediate goods are also inputs into finished products, and trade in intermediate goods can introduce some interesting theoretical wrinkles. See, e.g., Feenstra (2004), chapter 4.

Economic background

9

analysis in any fundamental way. In effect, currency becomes a commodity in trade. With floating exchange rates, as we now have throughout much of the world economy, currency prices will tend to equilibrate at a level that allows advantageous trades to go forward. 3.

Sources of Comparative Advantage

What are the reasons for differences in autarky price ratios or, equivalently, what are the sources of comparative advantage? Economists have given varying answers through the years, all of which are no doubt correct in some cases. One source is differences in technology – some nations will have better (or worse) technology for doing certain things. For example, it might take a worker one hour to produce a unit of a good in one country, but only a half an hour for a comparable worker to produce the same good in another country. This technology-based theory of comparative advantage is associated with the economist David Ricardo, and is accordingly termed Ricardian theory. Closely related to traditional Ricardian theory is the modern product cycle theory, associated particularly with Raymond Vernon, which is based on patterns of technological diffusion. The essential idea of the product cycle theory is that comparative advantage in the production of a good or service initially lies with technologically advanced innovator countries, but later shifts toward less advanced countries that learn to copy the technology. A major alternative to Ricardian theory focuses not on differences in technology across countries, but on differences in the factors of production that are available to each country. Some nations have abundant land and natural resources, and some do not. Some nations have abundant skilled labor, some do not, and so on. The “factor endowment” theory of comparative advantage, associated with the economists Eli Heckscher and Bertil Ohlin (thus “Heckscher-Ohlin” theory), suggests that comparative advantage arises from the relative abundance or non-abundance in each country of various factors of production. Countries with lots of arable land, for example, will tend to have comparative advantage in agricultural production. Countries with abundant unskilled labor will tend to have comparative advantage in industries that use such labor extensively.3 Whatever the explanation for comparative advantage in a given setting, however, the important point is that it arises systematically for all nations, and

3 Both Ricardian and Heckscher-Ohlin theory emphasize supply side explanations for comparative advantage. It is also well known that differences in consumer tastes across countries can produce differences in autarky price ratios and thus opportunities for profitable trade, even if the countries are identical on the supply side.

10

The law and economics of international trade agreements

creates opportunities for profitable trade. As long as the costs of conducting trade are not too high and governments do not prevent it, market forces will generate trade. 4.

Scale Economies and Variety

Theoretical developments over the past few decades suggest a rationale for trade that goes beyond the traditional theories of comparative advantage.4 In particular, suppose that goods that are produced under conditions of “increasing returns to scale” or “economies of scale.” Increasing returns exist when, as firms produce more units of a good, their costs of producing each unit decline. Such conditions may arise, for example, when producers benefit from substantial learning by doing in their production processes. Now imagine a single country in autarky in which some of the goods desired by consumers are subject to increasing returns. That country faces a tradeoff between the number of goods that it produces, and the costs of each good. If it produces fewer of the goods, it can produce more of each good that it produces at a lower cost and thus at a lower price. Consumers benefit from the lower prices, but they suffer from a lack of variety of goods in the marketplace. By contrast, if the country produces a wider variety of goods, it loses economies of scale so that costs and prices must rise. The wider variety of goods benefits consumers, but the higher prices are detrimental to them. Now consider two identical countries like the one described above. Initially, they have access to the same technologies, they are endowed with the same factors of production, and they produce the same variety of goods. We can even assume that the autarky price ratios are identical in both. The indicia of comparative advantage explained earlier are thus absent. Is profitable trade still possible? The answer is yes, because it allows each country to specialize in producing a narrower range of goods, and thereby to reap greater economies of scale in the production of each good. As long as the costs of trade are low enough, the two countries can specialize in certain varieties of goods, exporting them as well as selling them domestically. Consumers in both countries will have access to a wider variety of goods at lower prices. Within this framework, it may be quite indeterminate as to which nation will end up producing which goods, and in that sense comparative advantage does not exist in autarky. A country that manages to get a head start in the

4 Leading references include Helpman and Krugman (1985 and 1989) and Krugman (1990). An accessible introduction to the wrinkles introduced by increasing returns and imperfect competition may be found in Krugman, Obstfeld and Melitz (2023).

Economic background

11

production of a particular good may accumulate a persistent cost advantage and end up specializing in the good. The pattern of trade can then become a product of historical accident. It is even conceivable that the “wrong” country may end up specializing in the production of particular good, in the sense that another country, if it had been able to accumulate the same scale economies by expanding its production, could ultimately produce the good at lower cost. The idea that specialization in each country may depend on which country has a head start in the production of a particular good hints at the possibility of government policies to affect specialization, often termed “industrial policy” or “strategic trade policy.” If particular industries somehow contribute more to the national economy than others, such policies, if successful, may enrich the nation that adopts them. The normative arguments for strategic trade policy and the possible responses to them will be examined in the next section.

B.

NORMATIVE ISSUES IN TRADE POLICY

Government impediments to trade, such as tariffs and quotas, have long been extensive in many countries, and are often politically popular. Historically, economists have generally been critical of these restrictive trade policies. The traditional economic case for free trade rests on claims regarding its “efficiency,” coupled with a belief that any attendant concerns about income distribution can be better handled with other policy instruments. Such orthodoxy remains the view of many economists, but in recent years a number of dissenting voices have emerged. This section is devoted to explaining the traditional economic argument for liberal trade policies, reviewing the critique of this argument, and developing an alternative perspective that relies on democratic legitimacy rather than efficiency to assess trade policy. The Traditional Case for Free Trade: Efficiency

1.

Economist and Nobel Laureate Paul Samuelson once wrote: There is essentially only one argument for free trade or freer trade, but it is an exceedingly powerful one, namely: Free trade promotes a mutually profitable division of labor, greatly enhances the potential real national product of all nations, and makes possible higher standards of living all over the globe.5

The preceding section on comparative advantage develops one piece of this claim – the suggestion that free or freer trade will promote an international “division of labor” as entrepreneurs exploit the profit-making opportunities

5

Paul A. Samuelson, Economics (9th ed. 1973), p. 692.

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The law and economics of international trade agreements

associated with comparative advantage. But Samuelson’s claim is not simply that free trade allows some entrepreneurs to make money. Rather, he suggests that free trade is good for nations as a whole because it increases real (inflation-adjusted) gross domestic product, and brings higher living standards. The basis for these broader claims, and the caveats that accompany them, are our next subject. The traditional case for free trade can be presented in varying ways,6 but a common exposition relies on the proposition that the opportunity to trade expands the “consumption possibilities” of trading economies.7 The effect of trade on consumption possibilities can be understood with reference again to Table 2.1, which was the basis for our simple illustration of how comparative advantage generates profitable trading opportunities. The autarky prices in Table 2.1 reflect the costs of producing each good in the absence of trade. In competitive markets, the autarky prices will equal exactly the marginal cost of production for each good. For simplicity, assume that the only factor of production is labor. Suppose that in country A, a unit of labor costs $1.00, and that it takes one unit of labor to produce a unit of corn and two units of labor to produce a unit of wheat (thus resulting in the respective autarky prices in Table 2.1 of $1.00 and $2.00). As labor is shifted from corn production to wheat production in country A in autarky, two units of corn must be sacrificed to produce each incremental unit of wheat. When the possibility of trade arises, however, a unit of corn can be traded for 2/3 units of wheat in country B (recall the assumption of zero transportation costs). Thus, instead of giving up two units of corn to obtain one unit of wheat produced domestically, country A can instead give up two units of corn (by exporting them) to obtain 1-1/3 units of wheat from country B. The opportunity to trade thus allows country A to obtain more wheat for every unit of corn that it sacrifices. It follows that at any level of wheat consumption in country A, the amount of corn consumed can be higher when country A engages in trade. Likewise, for every level of corn consumption consistent with some positive level of wheat consumption, trade allows a higher level of wheat consumption.

6 Readers desiring a more complete or formal discussion of the gains from trade may wish to consult some of the advanced textbooks in the references. A particularly elegant treatment is that of Dixit and Norman (1980), chapter 3. It is also worth noting that the case for free trade is subject to a standard caveat associated with what economists term the theory of the second best – if certain other types of distortions exist in the economy and remain uncorrected, it is conceivable that a movement toward “free or freer trade” will actually make matters worse. This point, and its relationship to what has come to be known as the problem of “immiserizing growth,” is discussed in Bhagwati, Panagariya and Srinivasan (1998), chapter 29. 7 See, e.g., Krugman, Obstfeld and Melitz (2023).

Economic background

13

In short, the consumers of country A can, in the aggregate, consume more of both goods because of trade. A parallel argument applies, of course, to country B. Assuming that both goods enhance the well-being of consumers in both countries, each country can be said to gain from an expansion of its consumption possibilities set, and thus to gain from trade. This demonstration of the gains from trade, however, suppresses some important details about the composition and distribution of the gains that are useful to unpack. For this purpose, let us again consider a country in which two goods can be produced. After the opening of trade, one will be imported and one will be exported. Let us then focus on the effect that trade has on prices, and trace the attendant effects on the welfare of consumers and producers. The change in prices in each country will have two components as noted in the previous section. Once a country begins exporting a good, it faces higher demand for that good because foreign demand has now been added to domestic demand. The price of the exported good will increase as a result. Reciprocally, when a country begins importing a good, it faces greater supply of that good in the face of its fixed domestic demand. The price of the imported good will fall. As shall be seen, the traditional case for free trade rests on the notion that each of these two phenomena (falling price of the imported good and rising price of the exported good) confers a net gain on trading nations. To understand why, it is helpful to introduce two additional concepts – consumer surplus and producer surplus. Consumer surplus arises when consumers are able to purchase something for a price that is less than the value they place on it. For example, imagine that a consumer is willing to pay up to $1.00 for a 12-ounce Coca-Cola – that is, the consumer considers herself indifferent between parting with a dollar and obtaining the Coca-Cola, or retaining the dollar to spend on something else. If such a consumer can purchase the Coca-Cola for $0.60, however, she considers herself clearly better off, and prefers to go through with the transaction than to forego it. The consumer surplus from the transaction can be conceptualized as the difference between the maximum willingness-to-pay for the good (here, $1.00), and the price actually paid (here, $0.60) – $0.40 on these numbers.8 Consumer surplus can be approximated by an area under the demand curve in a standard economic diagram. Figure 2.1 depicts a demand curve for some arbitrary good, which slopes downward from left to right. As the price declines (the variable on the vertical axis), more consumers find it attractive to purchase the good and the quantity that they will buy increases (the variable on the horizontal axis). One can loosely think of each point on the curve as represent-

8 One could also define it with reference to the consumer’s minimum price for parting with the good in question. For further discussion see Varian (1992), chapter ten.

14

Figure 2.1

The law and economics of international trade agreements

Consumer surplus

ing an individual consumer, and as denoting the maximum amount that the consumer will pay to obtain the good. Now suppose that the prevailing market price is p*. Each consumer located on the demand curve above and to the left of a horizontal line drawn at p* then has an opportunity to buy the good for less than their maximum willingness-to-pay, and will earn consumer surplus equal to the difference between that amount (given by their position on the demand curve) and p*. The total consumer surplus in the market is thus equal to the sum of the consumer surplus for all these individuals. It is possible to show using calculus methods that the amount of consumer surplus in this market is approximated by the area under the demand curve and above the prevailing price, that is, the area represented by triangle abc.9

Figure 2.2

Producer surplus

9 For complicated reasons, this area is only an approximation, although it will often be a pretty close one. The classic treatment of the issue is Willig (1976). See also Varian (1992), chapter 10.

Economic background

15

Producer surplus will be a more straightforward concept to those without economic backgrounds. It is simply the profit earned by producers in a market – the difference between revenue and cost for each producer, summed over all of the producers. It can also be seen in a simple economic diagram. Figure 2.2 depicts a “supply” curve for some arbitrary good.10 Each point on the supply curve denotes the amount of production that the industry will deliver at the corresponding price. In a competitive industry, producers will supply their output up to the point where the price no longer covers their incremental or “marginal” cost of additional output. Thus, each point on the supply curve also represents the marginal cost of incremental production at that quantity level. Total profit will equal the difference between the prevailing price and the marginal cost of each unit of output up to the total amount produced at the prevailing price. It can again be shown by calculus methods that this profit is equal to the area above the supply curve and below a horizontal line drawn at the prevailing price. At the prevailing price of p* in Figure 2.2, therefore, producer surplus is equal to the area of the triangle def. Note that the notion of producer surplus as “profit” is slightly misleading, as that phrasing implies that producer surplus is earned entirely by firms. In fact, producer surplus may also be captured by workers or the suppliers of other factors of production such as land. To the degree that a worker in a particular job earns a wage that exceeds what the worker could earn elsewhere, for example, that part of the wage is producer surplus. With this background, we can now examine further the argument for free trade. As noted, trade causes the price of the imported good to fall, which benefits consumers in that market but harms domestic producers of the good. In the market for the good that the country exports, prices will rise, which benefits domestic producers of the exported good but harms domestic consumers of that good. To make the argument that the nation benefits on balance from trade, one must have some basis for aggregating these effects and deciding whether the net impact is favorable or unfavorable. One way to do so is simply to add up the effects of the price changes on consumer and producer surplus in each market, thus presupposing as a normative matter that all such surplus should receive equal “weight.” Proceeding in this fashion, consider first the market in which trade results in imports that compete with the products of domestic firms, lowering prices. Suppose first, and counterfactually, that the influx of imports causes prices of 10 The use of a supply curve implicitly assumes that the industry producing the good is “competitive,” that is, that it consists of many firms lacking power over price. The concept of producer surplus is perfectly valid for imperfectly competitive industries as well, but in the interest of brevity I will focus on the competitive case only to develop the concept.

16

The law and economics of international trade agreements

the good in question to fall, but has no impact on the quantities purchased by domestic consumers or produced by domestic producers. On this counterfactual assumption, there is no net change in the sum of producer and consumer surplus. All consumers receive a benefit equal to the drop in price on what they were already purchasing, while all domestic producers incur a loss of revenue and profit equal to the drop in price multiplied by their initial quantity of production. The sum of the two effects is a wash. Now note that in actuality, the gain in consumer surplus will be greater than in this counterfactual, because when prices fall, some new consumers will come into the market and earn surplus on their purchases (the market moves farther down the demand curve). Likewise, the loss to domestic producers is smaller than in the counterfactual, because they will reduce their output and cushion the loss of profits by cutting back production to the point where price once again covers their marginal costs (domestic producers move back down the supply curve until the point where the lower price again covers marginal cost). After consumers and producers adapt to the price reduction, therefore, the sum of producer and consumer surplus must increase.

Figure 2.3

Effect of trade in a market with imports

Figure 2.3 illustrates this argument, which for some arbitrary good depicts the demand curve of consumers in the importing country and the supply curve of domestic producers. For simplicity, we will assume that imported and domestic goods are fungible, although that is in no way necessary to the essential argument. The price in autarky is p*, determined by the intersection of the domestic supply and demand curves. At that price, consumer surplus is given by the area abc, and producer surplus by the area bcd. After the opening of trade and import competition, price falls to p**. The difference between the quantity demanded at that price and the amount supplied by domestic produc-

Economic background

17

ers is the quantity of imports. At the new price level, consumer surplus rises to an amount given by the area aeg, while domestic producer surplus falls to an amount given by the area def. It is apparent that consumers gain more than domestic producers lose, however, with the net gain given by the area of the triangle bfg. The net gain in the sum of consumer and producer surplus is also termed a welfare gain, or an efficiency gain.

Figure 2.4

Effect of trade in a market with exports

Now consider the market in which the nation in question is an exporter, and where the opening of trade causes price to rise as depicted in Figure 2.4. The reason for the existence of net gains in such a market is symmetrical to the analysis of the import market. When prices rise, there would be no change in the sum of producer and consumer surplus if, counterfactually, consumers all bought the same amount of the good and producers all produced the same amount. But producers can and will do better by expanding output, moving up the supply curve and earning more surplus. Consumers can and will cut their losses by buying less of the good and shifting their purchases to something else that earns them surplus. The net effect is positive, as Figure 2.4 illustrates. Initial consumer surplus at the autarky price p* is given by the area abc, and producer surplus is given by bcd. When price increases to p**, the difference between the quantity demanded and the quantity produced by domestic producers is exported. Consumer surplus declines to the area aef, while producer surplus grows to deg. The net gain in the sum of consumer and producer surplus is given by the triangle bfg. Here too, trade produces an efficiency gain. Figures 2.3–2.4 assume that markets are competitive. There is a further benefit from trade in markets that are not. If the domestic industry is imperfectly competitive (the extreme case being a monopoly), and the market power

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The law and economics of international trade agreements

of its firms allows them to set price above marginal cost, the initial sum of producer and consumer surplus will be lower than depicted. The advent of import competition can then reduce the market power of domestic firms and reduce or eliminate the loss of aggregate surplus due to the exercise of market power. Also, as noted earlier in this chapter, trade allows nations to specialize to a greater extent in the production of certain things, buying other things from abroad. If production exhibits economies of scale, this phenomenon can enable many things to be produced more cheaply or provide consumers with a greater variety of products. In sum, the traditional case for “free or freer trade” in Samuelson’s phrasing rests on the view that it yields net gains to trading nations, in the form of an increase in the aggregate producer and consumer surplus in the economy. An immediate corollary of this argument, subject to some qualifications below, is that government intervention to reduce trade flows, including restrictions on imports, will impose net losses on an economy. For example, with reference to Figure 2.3, if we suppose that the price p** is the price that arises with “free trade,” any government policy that restricts imports and causes price to rise above p** will impose net losses on the economy – as price rises toward p*, the net gains from trade given by triangle bfg must steadily shrink. Note finally that this discussion implies a general congruence between the effects of trade on the “national welfare” of all trading nations and the “global welfare” of all nations aggregated together. The gains from trade arise for every trading nation, and if free trade increases the welfare of each trading nation, a fortiori it must increase global welfare. 2.

Some Caveats to the Efficiency Argument for Liberal Trade

The most potent objections to the traditional argument for liberal trade rest on concerns about its possible distributional effects, and we will turn to these issues in Subsection 3. But even within a normative framework that focuses purely on economic efficiency, some caveats must be noted. Government revenue and the “optimal tariff” a. Above we considered the effect of trade on consumer and producer surplus, but there is another kind of “surplus” in play when governments impose taxes on trade (i.e., tariffs) – this additional surplus may be termed “government surplus” or, more simply, tariff revenue. Tariff revenue can be used for expenditures on socially productive government activities, and is “counted” as part of national surplus along with producer and consumer surplus. When governments capture some of the surplus from trade through tariff revenue, is it possible that restrictions on trade can increase total national surplus? The answer is “no” for a “small” country, and “yes” for a “large” country. By

Economic background

19

“small,” economists mean a country that cannot influence the prices of the things that it imports from abroad by altering the quantity of those imports. It is an international “price taker” in that sense. A “large” country, by contrast, can affect the price that it pays for imports by altering the quantity that it buys. By purchasing less, the price of the things that it buys from abroad will fall. Such a country has a degree of buyer power or “monopsony power.” The price of imported goods relative to the price of exported goods is known in economics as the “terms of trade.” The ability of large countries to engage in policies that cause the price of goods that they import to fall relative to the price of the goods that they export is thus an ability to influence its terms of trade. As shall be seen below, a large nation can conceivably enhance its welfare by deviating from free trade in a manner that improves its terms of trade. Advanced international economics textbooks develop these points within a “general equilibrium” framework, taking account of the effects of tariffs in all markets (including those not directly impacted by the tariff, but indirectly affected by exchange rate movements). In the interest of brevity and simplicity, the discussion to follow focuses only on the economic effects in the market directly subject to the tariff – a “partial equilibrium” approach – which is adequate to convey the core idea. Readers desiring a general equilibrium treatment should consult one of the more advanced texts in the references. i. Tariffs in small countries Figure 2.5 depicts the small country case. With open trade, the importing nation can obtain all that it wishes to import at the fixed price p. Consumer surplus is given by the area of the triangle abp, while producer surplus is given by the area cdp. If the government then imposes a tariff in the amount t, price to consumers in the market will rise to p+t – foreign suppliers will not lower their price even if the quantity imported declines (in effect, the supply curve for imports is horizontal at p). After the tariff, consumer surplus declines to the area ae(p+t), while producer surplus increases to the area df(p+t). Government tariff revenue also appears in the diagram. Note that the quantity of imports falls as a result of the tariff from an amount z-w to an amount y-x. Each unit imported results in revenue for the government of t, and so the total revenue is t(y-x). That amount is simply the area of the rectangle efgh. Accordingly, when one examines the sum of consumer surplus, producer surplus and government revenue before and after the tariff, it is apparent that total surplus declines by the sum of the two triangles cfg and beh. The first triangle represents the loss due to the expansion of domestic production above the quantity w – above that amount, domestic marginal costs of production exceed the price at which the good can be bought from abroad. The second

20

Figure 2.5

The law and economics of international trade agreements

Effect of a tariff – small country case

triangle represents the loss of consumer surplus to consumers who are priced out of the market when the price rises from p to p+t. ii. Tariffs in large countries If the importing nation is large, the analysis changes in an important way. Figure 2.6 illustrates the point. The price before the tariff is p, yielding an initial consumer surplus of abp and domestic producer surplus of cdp. A tariff is imposed in the amount t, but because the importing country is large, foreign sellers will reduce their prices as the quantity purchased from them declines. The new equilibrium price (inclusive of the tariff) is p’, and the net price to foreign sellers is now p’-t, which is less than p because of the price reduction by foreign sellers. Consumer surplus falls to ahp’, while domestic producer surplus rises to dgp’. The quantity of imports is the difference between demand and domestic supply, and falls as a result of the tariff from z-w to y-x. Tariff revenue of t per unit on imports of y-x is equal to the area of the rectangle ghji. Comparing the sum of consumer surplus, producer surplus and government revenue before and after the tariff, there is a loss in the form of the triangles ceg and bfh analogous to the loss triangles in Figure 2.5. Here, however, there is also a surplus gain in the form of tariff revenue equal to the rectangle efji. This amount represents the surplus extracted from foreign sellers who have lowered their price from p to p’-t as a result of the tariff. The net effect on surplus, therefore, depends on whether the gain efji exceeds the sum of the

Economic background

Figure 2.6

21

Effect of a