Question

Explain why global free trade maximizes the welfare of the world. Consider two economies of comparable sizes. Explain why each of them has an incentive to restrict trade. What is the Nash equilibrium if both of the countries choose an optimal tariff, assuming that the other country does not retaliate? Use this example to explain the meaning of the Prisoners’ Dilemma. What can the World Trade Organization do to help improve the welfare of the world (and the countries)?

Answer 1

Explain why global free trade maximizes the welfare of the world. Consider two economies of comparable sizes. Explain why each of them has an incentive to restrict trade. What is the Nash equilibrium if both of the countries choose an optimal tariff, assuming that the other country does not retaliate? Use this example to explain the meaning of the Prisoners’ Dilemma. What can the World Trade Organization do to help improve the welfare of the world (and the countries)?

Answer-

Free trade encompasses many practices and theories. The most common application of free trade is the reduction or removal of commercial barriers between countries. This allows a free flow of labor and goods between member countries in a trade pact. As free trade agreements become more common around the globe, the positive impact on countries around the Globe has been touted as one of their greatest successes. There are several advantages to developing countries that participate in free trade.

Higher Employment Rates

As developed countries are able to move their operations into developing countries, new job opportunities open up for local workers. Manufacturing (such as automobiles), assembly (clothing) and service jobs (help desks) have all migrated to developing countries in response to the removal of trade barriers. Generally, increased levels of employment lead to a higher standard of living and more consumer purchasing. This ultimately sparks the country's economy and may help to develop locally owned business.

Less Child Labor

Child labor occurs in developing countries for many reasons but one of the main reasons is the lack of technology. Children are used as a cheap substitute for manufacturing equipment. Free trade allows companies to invest in equipment that minimizes the temptation to employ child workers. International firms are also generally more able to pay higher wages to adult workers. With higher family incomes, children are able to attend school rather than work. Foreign firms also may have internal guidelines and a concern for the corporate reputation that help to reduce reliance on child labor. Brand-sensitive international companies are increasingly unwilling to risk exposure to investigative journalists and others revealing child labor at work in their facilities.

Access to New Markets

Not only does free trade allow foreign-owned companies to establish themselves in developing countries, but it also allows native companies to sell to foreign markets. This expands its customer base and leads to new products and services and the viability of investing in innovation. This is particularly true for small businesses in developing countries. These companies no longer have to worry about absorbing the costs of tariffs and other barriers to market entry and can sell their products freely.

Higher Levels of Investment Capital

Most free trade agreements also reduce restrictions on foreign investment. This change allows foreign firms and financiers to more easily provide funds for in-country projects. With new capital entering a developing country, it begins an upward productivity cycle that stimulates the entire economy. An inflow of foreign capital can also stimulate the banking system, leading to more investment and consumer lending.

Increased Life Expectancy

An increase in employment levels, incomes, and the general standard of living contributes to an upward cycle of improvement that helps alleviate hunger and lack of medical care in developing countries. Preventative medical care including checkups and vaccinations are available to more of the population. It also increases the number of children who are educated and attend school regularly. The ultimate result is an increase in the average life span and a reduction in infant deaths.

This is why the Global free trade maximizes the welfare of the world.

Economists generally agree that restrictions or trade barriers are detrimental and decrease overall economic efficiency. This can be explained by the theory of comparative advantage. In theory, free trade involves the removal of all such barriers, except perhaps those considered necessary for health or national security. In practice, however, even those countries promoting free trade heavily subsidize certain industries, such as agriculture and steel. Trade barriers are often criticized for the effect they have on the developing world. Because rich-country players set trade policies, goods, such as agricultural products that developing countries are best at producing, face high barriers. Trade barriers, such as taxes on food imports or subsidies for farmers in developed economies, lead to overproduction and dumping on world markets, thus lowering prices and hurting poor-country farmers. Tariffs also tend to be anti-poor, with low rates for raw commodities and high rates for labor-intensive processed goods. The Commitment to Development Index measures the effect that rich country trade policies actually have on the developing world. Another negative aspect of trade barriers is that it would cause a limited choice of products and, therefore, would force customers to pay higher prices and accept inferior quality.

Let’s examine the effects of optimal tariffs and retaliation more formally by using a simple game theoretic setup. Suppose the players in the game are the governments of two large countries, the US and Japan. Suppose the US imports a set of products (A, B, C etc.) from Japan while Japan imports a different set of products (X, Y, Z, etc.) from the US. We imagine that each country's government must choose between two distinct trade policies, free trade and optimal tariffs. Each policy choice represents a game strategy. If the US chooses free trade then it imposes no tariffs on imports of goods A,B,C etc. If the US chooses optimal tariffs then it determines the optimal tariff in each import market and sets the tariff accordingly. Japan is assumed to have the same set of policy choices available.

In the above diagram, US strategies are represented by the two columns, Japan's strategies correspond to the two rows. The numbers represent the payoffs to the countries, measured as the level of national welfare realized in each country in each of the four possible scenarios. For example, if the US chooses a free trade policy, while Japan chooses to impose optimal tariffs then the payoffs are shown in the box. Japan's payoff is below the diagonal while the US payoff is above the diagonal. Thus, Japan gets 120 units of welfare while the US gets 70 units.

Note that the size of the numbers used in the example is immaterial but, how they relate to the numbers in alternate boxes is not. We will use the results from the tariff analysis section to inform us about the relationship between the numbers.

To begin, let's assume that each country receives 100 units of national welfare when both the US and Japan choose free trade. If Japan decides to impose optimal tariffs on all of its imports, and the US maintains its free trade position, then a partial equilibrium welfare analysis suggests that,

(1) Japan's welfare will rise (we'll assume from 100 to 120 units),

(2) US welfare will fall (we'll assume from 100 to 70 units), and

(3) World welfare will fall (thus the sum of the US's and Japan's welfare initially is 200 units, but falls to 120 + 70 = 190 afterwards).

Similarly if the US were to impose optimal tariffs on all of its imports while Japan maintains free trade, then the countries will realize the payoffs in the box. The US would get 120 units of welfare while Japan gets 70. To keep the example simple we are assuming that the effects of tariffs are symmetric. In other words, the effect of US optimal tariffs on the two countries is of the same magnitude as the effects of Japan's tariffs.

Finally if both countries set optimal tariffs against each other then we can simply sum up the total effects. Since each country's actions raise its own welfare by 20 units and lowers its trade partner's welfare by 30 units, when both countries impose tariffs, national welfare falls to 90 units in each country.

The Non-Cooperative Solution (Nash Equilibrium)

A non-cooperative solution is a set of strategies such that each country maximizes its own national welfare subject to the strategy chosen by the other country. Thus, in general, if the US's strategy (call it r) maximizes US welfare when Japan chooses strategy (s) and if Japan's strategy (s) maximizes Japan's welfare when the US chooses strategy (r), then the strategy set (r,s) is a non-cooperative solution to the game. A non-cooperative solution is also commonly known as a Nash Equilibrium.

How to Find a Nash Equilibrium

One can determine a Nash equilibrium in a simple two player, two strategy game by answering the following series of questions. First, choose a strategy for one of the players. Then ask,

1) Given the policy choice of the first player, what is the optimal policy of the second player?

2) Given the policy choice of the second player (from step one), what is the first player's optimal policy choice?

3) Given player one's optimal policy choice (from step two), what is the second player's optimal policy choice?

Continue this series of questions until neither player switches its strategy. Then, this set of strategies is a Nash equilibrium.

In the trade policy game the Nash equilibrium or non-cooperative solution is the set of strategies (optimal tariffs, optimal tariffs). That is, both the US and Japan would choose to implement optimal tariffs. Why?

First, suppose the US chooses the free trade strategy. Japan's optimal policy, given the US choice, is to implement optimal tariffs. This is because 120 units of national welfare is greater than 100 units (see diagram). Second, if Japan chooses optimal tariffs, then the US's optimal policy is optimal tariffs, since 90 units of welfare is greater than 70 units. Finally if the US chooses optimal tariffs, then Japan's best choice is optimal tariffs since 90 is greater than 70.

The Cooperative Solution

A cooperative solution to a game is a set of strategies which would maximize the sum total of the benefits accruing to the players. In some instances a cooperative outcome may require the transfer of goods or money between players to assure that each player is made better-off than under alternative strategy choices. In this game, such a transfer is not required, however.

The cooperative solution in the trade policy game is the set of strategies (free trade, free trade). At this outcome, total world welfare is at a maximum of 200 units.

Implications and Interpretations

First of all, notice that in the non-cooperative game, each country is acting in its own best interests and yet the outcome is one that is clearly inferior for both countries relative to the cooperative strategy set (free trade, free trade). When both countries set optimal tariffs, each country realizes 90 units of welfare while if both countries pursued free trade, each country would realizes 100 units of welfare. This kind of result is often referred to as a prisoner's dilemma outcome. The dilemma being that pursuit of self-interest leads to an inferior outcome for both participants.

However, without cooperation it may be difficult for the two countries to realize the superior free trade outcome. If both countries begin in free trade, each country has an individual incentive to deviate and implement optimal tariffs. And if either country does deviate, then the other would either suffer the welfare losses caused by the other's countries restrictions or would retaliate with tariff increases of one's own in order to recoup some of the losses. This scenario in which one country retaliates in response to another's trade policy could be thought of as a trade war.

Finally, although the WTO is not an aid agency, it does have a role to play, particularly as a forum and clearinghouse for information on trade-related development aid.

Aid for Trade. The debate over whether developing countries need aid or trade is at an end.

Today, there is widespread recognition that developing countries need both. But WTO agreements do not guarantee increased trade flows: they provide opportunities. Some countries are better placed than others to grasp those opportunities. Some need help: “Aid for Trade” and various other tools are aimed at enhancing the capacity of developing countries to participate more effectively in the global marketplace.

The WTO is the coordinating agency for the Aid for Trade program and as such regularly brings donors, development agencies, recipient governments and the private sector together. This dialogue helps to highlight what is being provided and what is needed while encouraging the development of more suitably designed projects.

Both donor and recipient countries have responded to these efforts. Donor countries have committed an average of $40 billion a year to trade-related development programs while recipient countries have had success in pinpointing the specific areas where aid is needed and in mainstreaming trade into their development strategies.