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BOOK REVIEW INTERNATIONAL TRADE AND TRADE POLICY Edited by Elhanan Helpman and Assaf Razin, MIT Press, 1991. Pp. 292. Reviewed by Henry Thompson This book is a collection of papers on international trade theory from a 1989 conference at Tel Aviv University. There is a wide range of topics and methodologies. As a collection, the book has the merit of illustrating the methodology of a number of first class international economists. Each paper is reviewed briefly below. A final assessment of the book as a whole follows. PART I TRADE POLICY: THEORY A. Paul Krugman, ‘ls Bila tera /km Bad” Trading blocs create free trade among members and adopt a common tariff with the rest of the world. Krugman reviews the literature on trade diversion and trade creation, which concludes that exclusive trade agreements may be welfare damaging. He assumes each country produces a differentiated product, although production is not modelled explicitly. Consumers have a CES utility function which values variety. The optimal tariff for a trading bloc is calculated. It is found that there is a negative relationship between the number of blocks and the average tariff. Also, a trading bloc lowers welfare because countries in the Direct all correspondence to: Henry Thompson, Department of Economics, Auburn University, Auburn, AL 36849. International Review of Economics and Finance 3(2) 239-243 Copyright 0 1994 by JAI Press, Inc. ISSN: 1059-0560 All rights of reproduction in any form reserved. 239

International trade and trade policy : Direct all correspondence to: Henry Thompson, Department of Economics, Auburn University, Auburn, AL 36849

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BOOK REVIEW

INTERNATIONAL TRADE AND

TRADE POLICY

Edited by Elhanan Helpman and Assaf Razin, MIT Press, 1991. Pp. 292.

Reviewed by

Henry Thompson

This book is a collection of papers on international trade theory from a 1989 conference at

Tel Aviv University. There is a wide range of topics and methodologies. As a collection, the

book has the merit of illustrating the methodology of a number of first class international

economists. Each paper is reviewed briefly below. A final assessment of the book as a whole

follows.

PART I TRADE POLICY: THEORY

A. Paul Krugman, ‘ls Bila tera /km Bad”

Trading blocs create free trade among members and adopt a common tariff with the rest

of the world. Krugman reviews the literature on trade diversion and trade creation, which

concludes that exclusive trade agreements may be welfare damaging. He assumes each

country produces a differentiated product, although production is not modelled explicitly.

Consumers have a CES utility function which values variety. The optimal tariff for a trading

bloc is calculated. It is found that there is a negative relationship between the number of

blocks and the average tariff. Also, a trading bloc lowers welfare because countries in the

Direct all correspondence to: Henry Thompson, Department of Economics, Auburn University,

Auburn, AL 36849.

International Review of Economics and Finance 3(2) 239-243 Copyright 0 1994 by JAI Press, Inc. ISSN: 1059-0560 All rights of reproduction in any form reserved.

239

240 HENRY THOMPSON

bloc may trade less with countries outside the bloc, but increases trade by expanding trade

between countries within the bloc. And, welfare is optimized if there is only one bloc, since

the world would trade freely. If there were many blocs, each would set a low tariff, there

would be a high degree of trade, and welfare would be relatively high. For some number of

blocks in between, welfare must be minimized. Using simulations, Krugman concludes that

a few blocks (three perhaps) would result in the lowest welfare.

B. James A. Levinsohn, “Strategic Trade Policy and Direct Foreign Investment: When are Tariffs and Quotas Equivalent?”

Levinsohn examines the difference between tariffs and quotas in the presence of direct

foreign investment. If there is a domestic market where the only supplier is a foreign

monopolist, a tariff will reduce the foreign monopolist’s rent. The optimal tariff is calculated

by the importing country, and has an advantage over a quota for creating revenue. Tariffs

and quotas are not equivalent in the presence of monopolies. Suppose the foreign monopolist

has the option of jumping the tariff and setting up a plant in the home country if the tariff is

set too high. This potential action limits the level of the tariff. If a quota is set high enough,

the result will be equivalent to the tariff: the foreign monopolist jumps the border and builds

a domestic plant through direct foreign investment. In the presence of the potential of direct

foreign investment, tariffs and quotas are equivalent if they are high enough.

C. Kala Krishna, “Making Altruism Pay in Auction Quotas”

Auctioning import quotas is a way to create revenue and secure some of the scarce rent

from foreign monopolists. In competitive models, the potential yearly gains from auction

quotas have been estimated to be in the seven to nine billion dollar range. Krishna develops

a model of auction quotas in a small economy facing a foreign monopolist. Quota licenses

might be granted to the foreign monopolist to keep the monopolist from pricing away all of

the rents of domestic importers. The monopolist would consider the value of its quota license

in its pricing decision. In this manner, domestic importers may gain rents as well. Instances

of foreign monopolies in international trade are fortunately rare. Krishna presents some

intriguing simulation results.

0. Aaron Tornell, “On the Ineffectiveness of Made-to-Measure Protectionist ProgramY

Protectionism alters the investment decisions of firms, ideally internalizing social benefits

into the protected firm’s decision. The government may precommit to end the protection at

some future date. If a firm invests, it may not need the protection. If it does not invest, it may

be able to have the protection extended. This paper examines protectionist policy which is

contingent on investment, and finds such policy does not necessarily eliminate the time

inconsistency problem.

Book Review 241

E. Peter Neary, ‘Export Subsidies and Price Competition”

The Brander-Spencer case for an export subsidy is based on the possibility of shifting

foreign profits to the home country in the situation of an international duopoly. Neary

examines the outcome in both ex ante games (where the government sets the quota first) and

ex post games (where the firm moves first and expects the subsidy). The ex ante game always

produces higher welfare. If the home firm and foreign firm compete in price, an export

subsidy cannot maximize welfare. It would be interesting to examine this issue in a

simultaneous game, under the assumption that fis continuously lobby for subsidies and

the government continuously determines policy. This paper reinforces the impression that

the political economy of the Ex-Im Bank is not a happy chapter in US trade policy.

F. Harry F/am and Robert W. Staiger, “Adverse Selection in Credit Markets and Infant Industry Protection”

In a model of asymmetric information about firm risk, Elam and Staiger show that

protection can stimulate entry. A risk premium on loans would reflect the default risk of the

pool of potential fiis. Entry of the safest firms would be discouraged by this risk premium.

Protection would encourage entry of the safest firms and lower the average risk in the

industry. The authors develop a model with characteristics of an infant industry in an LDC.

Due to adverse selection, firms on average would be too risky in the absence of protection.

While such protection may lower average risk, it is not clear what would happen if the

government subsequently lowered protection. The main dilemma of this and the usual infant

industry argument remains what to do once the infant has grown up.

G. Arye L. Hillman, “‘Protection, Politics, and Market Structure”

A political economy model of endogenous protection is developed to investigate the

relationship between industry characteristics (number of firms and concentration ratios) and

protection. The Alchian-Demsetz model of the firm is used, with firms able to influence their

value through protectionism. A representative democratic model gives rise to problems of

agency. Firms play the game of splitting managerial effort between lobbying for protection

and managing the firm. The concentration ratio of an industry is not necessarily associated

with increased protectionist activity in the model.

H. Gene M. Grossman and Elhanan Helpman, “Growth and Welfare in a Small Open Economy”

Grossman and Helpman examine a small, open economy trading two finished goods

produced with an intermediate good which relies on R&D. Innovation is naturally under-

supplied because of the public nature of knowledge created by R&D. Subsidies to R&D can

increase the growth rate and perhaps welfare, which raises the question of whether subsidies

have encouraged growth historically. Rent seeking in commercial policy formation can lead

242 HENRY THOMPSON

to lower levels of growth and welfare, which suggests the link between subsidies and growth

can only be settled empirically.

PART II TRADE POLICY: EVIDENCE

1. Randi Boorstein and Robert C. Feenstra, “Quality Upgrading and its Welfare Cost in US Steel imports, 1969-74”

Quotas are generally expected to lead to quality upgrading, at least in competitive

industries. The applied literature on quotas and quality upgrading includes studies of the

auto, footwear, and cheese markets. Boorstein and Feenstra extend the literature to US steel

imports during the period when the US first became a net importer of steel. They find solid

evidence of quality upgrading, and utilize price index schemes (exact and divisia) to measure

the welfare loss of the quota.

J. Alasdair Smith and Anthony J. Venables, “Counting the Cost of Voluntary Export Restraints in the European Car Market”

Like the preceding paper, this one examines the effects of quotas (VERs) on an import

market, in this case the market for imported autos in Europe.

The model of an imperfectly competitive market is developed, and numerical simulation

leads to “estimates” of effects. Simulation estimates are inherently different from empirical

estimates based on ideal econometric estimation, and would be well supplemented by an

econometric study. It would also be interesting to extend this literature to include income

redistribution and possibly general equilibrium effects. VERs are found to be an inefficient

and expensive means of protection in the imperfectly competitive European car market. The

appendix completely develops the rather involved partial equilibrium model of imperfect

competition.

PART Ill STRUCTURAL ISSUES

K. Wilfred J. Ethier and Henrick Horn, “Services in international Trade”

Ethier and Horn develop a general equilibrium model of production and trade in services

and manufactures. The structure of production in services is meant to capture four charac-

teristics the authors see as typical:

1) services are specialized for the buyer;

2) firms provide various services;

3) fixed overhead costs give rise to economies of scope; and

4) service markets are competitive.

Book Review 243

Labor produces services and differentiated intermediate goods which are combined to

produce final differentiated outputs. Welfare is examined under service autarky, embodied

service trade, and free trade in services. The clearest results occur between two identical

countries, with trade in services giving higher welfare than service autarky, which outranks

complete autarky. This paper is clearly written and well developed, making a nice contribu-

tion to the growing literature on trade in services.

L. James R. Markusen, “First Mover Advantages, Blockaded Entry, and the Economics of Uneven Development”

A model of entry into a dynamic increasing returns to scale industry in which first entrants

have a comparative advantage is developed. Later entrants will not generally be able to catch

up due to blockaded entry (less efficiency) or at least a lower level of entry. Simulation with

CES production and Cobb-Douglass consumption leads to interesting results.

M. Ronald W. Jones and Peter Neary, “Wage Sensitivity Rankings and Temporal Convergence”

This paper develops the notion of an imperfect dynamic link across sectors in the labor

market. Wage changes in each sector are postulated to only imperfectly adjust to wage

changes across the economy. This labor market structure is set in a simple production

structure. Sectors can be ranked according to wage sensitivity, or how much rents are affected

over time when wages change in the sector. Intersector capital mobility hinges on the degree

of wage sensitivity. This model has definite appeal for applied trade theorists who are faced

with differing wages across sectors. The partial adjustment model can in principle be applied

in trade studies.

SUMMARY

This book will be useful to international trade economists. References in each of the papers

are complete and comprehensive. Various methodologies, from abstract theory to applied

empirical work, are carefully developed and utilized. Of particular note are the papers which

use simulations to arrive at conclusions when the qualitative aspects of the models are

unclear. Computers have relieved theorists from always having to make assumptions

stringent enough to lead to unambiguous qualitative conclusions. If the book has a short-

coming, it is simply that the papers do not relate very well to each other, which may only

reflect the state of the science.