The political economy of trade policy

Deviating from free trade by enacting protectionist policies entails efficiency costs. The literature presents three reasons why policymakers may want to incur these costs: distributional effects of trade policy, the terms-of-trade motive, and the profit-shifting argument. Regarding distributional aspects, trade policy affects domestic agents differently, and policymakers choose trade policy if it favors their constituents. Second, trade policy allows large countries to affect their terms of trade, the price ratio of exports over imports. Trade policy is a means to pay the low monopsony price on imports and obtain monopoly rents on a large country's exports. Beyond unilateral policy, we also consider multilateral trade policy interaction, both in the context of the World Trade Organization (WTO) as well as preferential liberalization in the form of regional trade agreements. The profit-shifting argument, finally, plays an important role for policymakers who seek to shift profits from foreign to domestic firms.

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