Loss Aversion and Trade Policy *

Transcription

1 Publc Dsclsure Authrzed ss Aversn and Trade Plcy Carlne Freund and Çağlar Özden Publc Dsclsure Authrzed Publc Dsclsure Authrzed Abstract We rvde new survey evdence shwng that lss aversn and reference deendence are mrtant n shang ele s ercetn f trade lcy. Under the assumtn that agents welfare functns exhbt these behavral elements, we analyze a mdel wth a welfare-maxmzng gvernment and wth the lbbyng framewrk f Grssman and Helman The lcy mlcatns f the augmented mdels dffer n three mrtant ways. One, there s a regn f cmensatng rtectn, where a declne n the wrld rce leads t an ffsettng ncrease n rtectn, such that a cnstant dmestc rce s mantaned. Tw, rtectn fllwng a sngle negatve rce shck wll be ersstent. Three, rresectve f the extent f lbbyng, there wll be a devatn frm free trade that tends t favr lss-makng ndustres. The augmented mdels are mre cnsstent wth the bserved structure f rtectn, and n artcular, exlan why many trade lcy nstruments are exlctly desgned t mantan rces at a gven level. Wrld Bank Plcy Research Wrkng Paer 3385, Setember 2004 Publc Dsclsure Authrzed The Plcy Research Wrkng Paer Seres dssemnates the fndngs f wrk n rgress t encurage the exchange f deas abut develment ssues. An bectve f the seres s t get the fndngs ut quckly, even f the resentatns are less than fully lshed. The aers carry the names f the authrs and shuld be cted accrdngly. The fndngs, nterretatns, and cnclusns exressed n ths aer are entrely thse f the authrs. They d nt necessarly reresent the vew f the Wrld Bank, ts Executve Drectrs, r the cuntres they reresent. Plcy Research Wrkng Paers are avalable nlne at htt://ecn.wrldbank.rg. We are grateful t Smen Dankv, Kshre Gawande, Bernard Hekman, Pravn Krshna, Sendhl Mullanathan, Marcel Olarreaga, Davd Tarr, and artcants at the Crnell/SE/MIT cnference n Behavral Ecnmcs and at the Wrld Bank trade semnar seres fr cmments n an earler draft. Wrld Bank. Malng address: DECRG, Wrld Bank Malst MC H Street NW Washngtn, DC Phne: , Emal: cfreund@wrldbank.rg Wrld Bank. Malng address: DECRG, Wrld Bank Malst MC H Street NW Washngtn, DC Phne: , Emal: czden@wrldbank.rg

2 I. Intrductn Free trade s amng the mst cmmnly exunded themes n ecnmcs, yet gvernments rarely mlement lberal trade lces. As a result, a large lterature n the ltcal ecnmy f trade lcy has emerged ver the years t exlan the medments t free trade. Mst mdels nclude a characterzatn f ndvduals' references ver the trade lcy dman and defne a mechansm fr aggregatng references nt demand functns fr actual lcy. 1 Preferences are based n hw trade lces affect ndvduals ncme levels, ether thrugh factr endwments r sectr-secfc sklls, deendng f the underlyng ecnmc envrnment s based n a Hecksher-Ohln r Rcard-Vner framewrk. In ths aer, we rvde survey evdence shwng that ele s trade lcy references are nt nly nfluenced by the level f ncme, but als by devatns frm t. Secfcally, a marty f ele surt the mlementatn f rtectnst lces f rft lsses and salary cuts wuld therwse be ncurred. Hwever, they d nt surt the mlementatn f dentcal lces that wuld ncrease rfts and salares by the same amunt. Mrever, nce a lcy that ncreased rfts and salares s n lace, a marty f ele d nt surt remvng t. Under standard references, all three scenars shuld yeld dentcal resnses. Ths dvergence mles that behavral elements, such as lss aversn and reference deendence, lay an mrtant rle n shang references tward trade lces. ss aversn mles that an ncme lss reduces welfare mre than a gan f equal magntude ncreases welfare, and reference deendence ndcates the resence f a crtcal level frm whch the welfare lss s measured. Mtvated by the survey results, we, then, cnstruct a ltcal-ecnmy mdel where the ndvduals utlty functns exhbt lss aversn and reference deendence. We shw that the ntrductn f such behavral features nt ndvdual references leads t mrtant effects n trade lcy frmatn, regardless f whether the lcymaker s maxmzng scal welfare r s nfluenced by ltcal cntrbutns a la Grssman and Helman Due t lss aversn, reventng lsses, as sed t 1 The lcymakers references and the nsttutnal settng f the ltcal rcess are the ther tw elements f these mdels Rdrk, 1985,

3 btanng gans, lms larger n gvernment s bectve functn. Hence, all else equal, the gvernment resnds t a negatve shck wth rtectn. We refer t ths as the behavral effect. In cntrast, the tmal lcy s free trade f the gvernment s maxmzng standard scal welfare. In a standard ltcal ecnmy mdel, where the gvernment s nfluenced by ther mtvatns such as lbbyng, the equlbrum rtectn level s ncreasng n utut snce the gan frm a margnal ncrease n the rce level s drectly rrtnal t the sze f the utut f the ndustry. Hence, a negatve shck that reduces sales fr a gven rce level reduces the value f rtectn and leads t lwer equlbrum tarff level. We refer t ths as the standard effect. These tw smle frces generate rtectn dynamcs that are smlar t thse bserved n many ndustres. If an ndustry exerences a negatve wrld rce shck that reduces ncme t belw ts reference nt, the behavral effect leads t an ncrease n rtectn whle the standard effect damens the demand fr t. Intally, wthn a gven range f wrld rces, the behavral effect dmnates the standard effect generatng a regn f cmensatng rtectn: trade lcy exactly ffsets the wrld rce shck and a cnstant dmestc rce s mantaned. If cndtns wrsen and the ndustry further cntracts due t even lwer wrld rces, the standard effect becmes strnger whle the behavral effect becmes less rmnent due t dmnshng senstvty t lsses. Thus, the level f rtectn n a declnng ndustry s hum-shaed: frst ncreasng then decreasng, and eventually arachng free trade as the ndustry cntnues t becme less cmettve. The regn f cmensatng rtectn, where trade lcy s used t shelter the dmestc frms frm glbal rce fluctuatns, s ne f the mrtant redctns f the aer. In ur mdel, ths tye f rtectn ccurs n sectrs wth sgnfcant resence utut, emlyment, etc but that are nt very cmettve n wrld markets. In ractce, many frms f rtectn, ncludng qutas, rce flrs, and vluntary restrant agreements, serve recsely ths urse n sectrs such as agrculture, aarel and steel. They bnd nly when wrld rces fall and there s effectvely free trade fr rces abve a certan level. Anther cmmn rtectnst measure, antdumng charges, can nly be ntated when the mrt rces fall and there s nury t dmestc frms. Thus, the 3

4 tye and mtvatn fr rtectn redcted by ur mdel exhbts remarkable verla wth exstng lces. Our mdfed mdel rvdes exlanatns fr sme f the uzzles n recent emrcal aers that am t examne the Grssman and Helman 1994 mdel. Fr examle, bth Magg & Gldberg 1999 and Gawande & Bandyadhyay 2000 nfer frm ther estmatn results that the gvernment attaches t lttle weght t ltcal cntrbutns, as sed t scal welfare, n ts decsn rcess, t the extent that ltcal cnsderatns d nt seem t affect lcy. When lss aversn s frmally ntrduced nt the mdel, the theretcal relatnsh between the estmated ceffcents f the emrcal mdel and weghts attached t the scal welfare and mnetary cntrbutns changes. As a result, fr the same set f estmatn results, the nferred value f the weght f scal welfare n gvernment s bectve functn ges dwn t a mre accetable level. Our enhanced mdel als ffers addtnal nsghts nt several lng-standng uzzles n the lterature. A rmnent ne s referred t as the Ant-Trade-Bas Puzzle by Rdrk 1995: trade lcy s systematcally used t transfer resurces t mrtcmetng sectrs rather than t exrt-rented sectrs. Ths s clsely related t the declnng ndustry rtectnsm where the level f rtectn s bserved t ncrease as ndustres start t declne. As mentned abve, standard mdels tend t redct the ste 2, whereas ur redctns are very clse t the bserved lces. We als ffer an exlanatn fr anther emrcal regularty - the ersstence f rtectnst lces. Once n lace, rtectn becmes dffcult t remve because t gets ncrrated nt the reference welfare level. If a shck erssts, rtectn becmes ermanent and the ndustry never fully adusts t the new market structure. Past levels f rtectn therefre becme very mrtant determnants f current rtectn. The next sectn resents results frm ur survey and demnstrates the mrtance f lss aversn and reference deendence n eles ercetns f trade lcy. Sectn III dscusses hw ths mdel fts nt the ltcal ecnmy lterature n 2 In the GH mdel lbbyng leads t hgher subsdes n an exrt sectr, as cmared wth the tarffs that an therwse-dentcal mrt cmetng sectr receves [see evy 1999 fr a dscussn]. The same feature hlds fr ther ltcal ecnmy mdels such as the tarff-frmatn arach f Fndlay & 4

5 rtectn. Sectn IV resents an analytcal mdel where the gvernment maxmzes scal welfare that features behavral elements. In Sectn V, we mdfy ths mdel t ncrrate nt the nfluental lbbyng mdel f Grssman and Helman. In Sectn VI we analyze the bserved lcy atterns and tls n lght f ur analytcal redctns. Sectn VII cncludes. II. ss Aversn n Trade Plcy: An Exerment 3 Numerus emrcal studes frm the behavral lterature fnd that the value ele assgn t a lss s sgnfcantly larger than the value assgned t an equvalent gan. In artcular, fr small r mderate gans and lsses f mney, the estmated value assgned t a lss s abut twce as large as a smlar gan see Kahneman, Knetsch, and Thaler 1991 fr a survey f the lterature. sses are als by defntn tme deendent, and reflect a artcular reference nt. Fr examle, a frm accustmed t a hgh rft level wll regard a lw rft level as unaccetable, whle a frm accustmed t a lw rft level wll fnd mantanng that level t be satsfactry. An mlcatn f lss aversn and reference deendence s that the value assgned t fregne gans s lwer than that assgned t lsses. Ths s reflected n many udcal utcmes, where the weght assgned t unrealzed rfts s tycally well belw the weght assgned t ncurred lsses. Survey evdence als bears ths ut. Fr examle, faced wth excess demand fr a artcular car mdel, a cmany that dscntnues a dscunt f $200 s cnsdered far; but, a cmany that rases the rce by $200 s cnsdered unfar by a marty f resndents Kahneman, Knetsch, and Thaler, Ths mles that msng a surcharge erceved as a lss s cnsdered less accetable than elmnatng a dscunt erceved as a gan. ss aversn and reference deendence als have mlcatns fr ele s ercetns f trade lcy. Tharakan 1996, ntes that []erhas the weakest nt n the ltcal ecnmy analyss f rtectn has been the rather suerfcal way n whch t has s far taken nt accunt the ublc ercetn f trade relatns. Indeed, very few studes examne ele s sentments n trade lcy. Tw excetns are Wellsz 1982, ltcal surt functn f Hllman 1989 and camagn cntrbutns arach f Magee, Brck and Yung

6 Scheve and Slaughter 2001 and Mayda and Rdrk 2003, whch use survey evdence t evaluate determnants f ndvdual references. They fnd that factr endwments gude trade references. But ther fcus s n the relatnsh between ndvdual characterstcs and rtectnsm and nt n the cndtns fr trade barrers t be cnsdered accetable by a marty. ss aversn may lay a very mrtant rle n ele s ercetns, as the argument fr free trade reles n the same weght beng gven t gans and lsses. In rder t test t what extent lss aversn carres ver t eles ercetn f trade lcy, we cnducted a smle survey. The fllwng three questns were asked wth each ersn answerng nly ne f the questns: 4 1. A manufacturng ndustry faces cmettn frm mrts. Its lsses are exected t be $20 mlln ths year and frms are exected t reduce salares by 10%. If a tarff s laced n mrts f cmetng gds then lsses wll be avded and salares wll be mantaned. The tarff wll cause the rce f the gd, whch everyne cnsumes, t rse frm $30 t $40. D yu surt the tarff? N= 102 Yes: 60 ercent N: 40 ercent 2. A manufacturng ndustry faces cmettn frm mrts. If a tarff s laced n mrts f cmetng gds then rfts wll ncrease by $20 mlln and frms n the ndustry wll ncrease salares by 10%. The tarff wll cause the rce f the gd, whch everyne cnsumes, t rse frm $30 t $40. D yu surt the tarff? N= 100 Yes: 37 ercent N: 63 ercent 3. A manufacturng ndustry faces cmettn frm mrts, whch are subect t a tarff. Remval f the tarff wll cause rfts t declne by $20 mlln and 3 We wuld lke t thank Sendhl Mullanathan fr suggestng us t cnduct a survey t mtvate the aer. 4 The survey was gven t 303 ele vstng the Washngtn Mall n June

7 salares t fall by 10%. As a result f the tarff remval, the rce f the gd, whch everyne cnsumes, wll fall frm $40 t $30. D yu surt mantanng the tarff? N= 101 Yes: 61 ercent N: 39 ercent The frst questn rses mlementng a tarff t revent lsses and the secnd rses usng a tarff t rmte gans f equal magntude. The cst f the tarff t cnsumers s dentcal n bth settngs. The marty f ele fnd t accetable t use a tarff t revent rft lsses and wage cuts, but d nt fnd t accetable t use a tarff t rmte rfts and rases. 5 Usng a tw-taled t-test and allwng fr dfferent varance acrss samles, the means f the tw samles are dfferent at the 1 ercent level. The thrd questn hghlghts the mrtance f reference deendence and hw lss aversn s dfferent frm rsk aversn. Thugh the marty f ele d nt favr msng a tarff n questn 2, they wuld favr mantanng t f t were n lace. Ths mles that tarffs, nce mlemented, are lkely t be ersstent. Nte that f resndents were smly exressng rsk aversn there shuld be n dfference between the resnses t questns 2 and 3 snce the nly dfference s the reference nt. Agan, the means f the tw samles are sgnfcantly dfferent at the 1 ercent level. In sum, the results f ths exerment mly that rtectn as a means f reventng lsses s cnsdered t be desrable by a marty f ele, but smlar rtectn t facltate gans s erceved as undesrable. It als shws that nce n lace, a tarff that may nt have been surted ntally s dffcult t elmnate. These effects are cnsstent wth the structure f rtectn n mst cuntres and als wth Rdrk s 1995 Ant-Trade-Bas Puzzle. III. The Pltcal Ecnmy f Trade Plcy Our analytcal mdel bulds n ltcal ecnmy mdels f lbbyng fr trade lcy and declnng ndustry rtectnsm. The frst generatn f ltcal ecnmy 5 We als asked the questn t a smaller samle wth b cuts and b ncreases t a smaller samle and the result was mantaned. 7

8 mdels reled n a reduced frm gvernment welfare functn that laces mre weght n certan sectrs f the ecnmy t generate rtectnst lces fr them. Amng these, the mst rmnent examles are the tarff-frmatn functn arach f Fndlay and Wellsz 1982, the ltcal surt functn arach f Hllman 1989, the medanvter arach f Mayer 1984, and the camagn cntrbutns arach f Magee, Brck and Yung We d nt g nt detals, as these are revewed n Baldwn 1989 and Rdrk 1995 and ther laces. Smlar gvernment bectve functns were als used n earler studes n senescent ndustry rtectn. In ne f the earlest studes, Crden 1974 uses a cnservatve welfare functn, whereby the gvernment seeks t avd any sgnfcant abslute reductns n real ncmes f any sgnfcant sectn f the cmmunty.107. Crdn s welfare functn dslays lss aversn reductns n ncme have greater weght than ncreases n rder t generate bserved rtectn fr declnng sectrs. Hwever, the cnservatve welfare functn was nt derved frm cnsumer utlty, but chsen because t mst clsely reflected rtectnst lces. But erhas mre mrtantly, because f ts ad hc nature, t des nt ffer secfc redctns abut trade lcy. Hllman 1982 and ng and Vusden 1991 use a ltcal surt functn t exlan why declnng ndustres get mre rtectn. In ther mdels, the lcymaker wants t sread the cst f a rce declne n a mrtcmetng sectr ver the whle ulatn. The ntutn n these mdels cmes frm rsk sharng as sed t reventng lsses. A shrtcmng f ths class f mdels s ther use f a reduced-frm gvernment welfare functn that essentally laces mre weght n certan sectrs n rder t generate rtectn fr thse sectrs the trade lcy utcme s effectvely assumed at the nset. In an nfluental cntrbutn, Grssman and Helman 1994, hencefrth GH devel a mdel that derves the gvernment s bectve functn endgenusly frm mcr-fundatns. The references f lbby grus and the lcymaker are exlctly secfed and there s a secfc lbbyng game layed between them. The weghts that the gvernment laces n nterests f dfferent grus are derved endgenusly. Althugh the structure f the mdel s mre rgrus, sme f ts redctns are at dds wth bserved lcy utcmes. Frst, the GH mdel redcts that f all ndustres are reresented thrugh lbbes, the equlbrum lcy utcme wll be free trade n all 8

9 sectrs. As a result, ne needs t assume that nly sme f the sectrs are rganzed t generate rtectn. Ths mles that, as wth the revus mdels, the extra weght gven t lbbyng sectrs s t sme extent determned exgenusly. 6 Secnd, the mdel redcts that exrt sectrs shuld receve mre rtectn, whch runs cunter t the emrcal evdence. Thrd, accrdng t the lbbyng mdels, f a sectr suffers a negatve rce shck, rtectn shuld fall. In realty, t s the sectrs that face negatve shcks that receve mre rtectn. Fnally, the mdel des nt ffer any nsghts abut the ersstence f rtectn. Our wrk s als clsely related t anther strand f the lterature that exlans rtectn usng rsk aversn and ncmlete nsurance markets. Eatn & Grssman 1985 and Fscher & Prusa 2003 exlan bserved rtectn atterns as a frm f nsurance. If agents are rsk averse and catal s allcated befre the state f the wrld s knwn, then there wll be sce fr a small tarff t ffset lsses n a bad state. In these mdels, the tarff reallcates ncme t the lsng sectr, where the margnal value f ncme s lwer. Whle sme f the behavral elements that we nclude are smlar t rsk aversn, there are als sme mrtant dfferences. Frst, as nted n the revus sectn, rsk aversn des nt ncrrate reference deendence. Ths mles that sme mrtant redctns frm ur mdel such as cmensatng rtectn wuld nt be art f a mdel wth rsk aversn alne. Secnd, because f the cncavty assumtn, very hgh levels f rsk aversn wuld be needed t generate szeable tarffs n a standard mdel. Thrd, rsk aversn als fals t exlan the dfferences n the resnses t the questns n ur survey. As nted, under rsk aversn, the resnses t questns 2 and 3 shuld have been smlar. The dfference s caused by a sudden change n the sle f the welfare functn due t the reference nt. Fnally, rsk aversn can nt accunt fr ersstence f rtectn nce t has been mlemented. Ths has been dentfed many tmes n the emrcal lterature. Hwever, behavral elements can exlan ths bservatn. Esecally f rtectn causes the reference nt t shft, t becmes very dffcult t remve t nce t s n lace. 6 T endgenze the lbby frmatn rcess, Mtra 1999 assumes that there are varyng levels f exgenus fxed csts t frm a lbby. Only the sectrs fr whch t s cst effectve wll frm a lbby and 9

10 IV. Analytcal Mdel We begn wth a standard secfc-factrs mdel and ncrrate standard behavral assumtns. The key nsght frm the behavral lterature s that welfare s nt nly deendent n the current state but n the change n states. In artcular, Tversky and Kahneman 2000 defne three characterstcs f value functn that dffer frm standard utlty thery. The frst s reference deendence: gans and lsses relatve t a reference nt are mrtant. The secnd s lss aversn: lsses have larger effects n welfare than crresndng gans. The thrd s dmnshng senstvty: the margnal value f gans and lsses decreases wth ther sze. The ntrductn f these behavral assumtns nt the bectve functn f the gvernment reslves many f the ncngrutes between redctns f the ltcal ecnmy mdels and bserved lcy utcmes. We d nt address the questn f why trade lcy, as sed t ther less dstrtnary methds f nterventn, s used t redstrbute ncme. In general, a tax cum subsdy wll always be mre effcent. In ur mdel, we smly assume trade lcy s the nly tl. We rely n ther exlanatns havng t d wth feasblty f assstance and ther tental dstrtns that drect assstance mght ntrduce. 7 In descrbng the mdel, we begn wth the rductn sde. There are n+1 cnsumtn gds where gd 0 s the numerare and s rduced wth labr alne usng cnstant returns t scale technlgy. The suly f labr s large enugh t guarantee suly f gd 0 s that ts rce and the wage rate are bth set t 1. All ther gds, ndexed 1 n, requre labr and a sectr secfc nut wth fxed suly; ther rductn technlgy als exhbts cnstant returns t scale. The rewards t the wners f the sectr secfc factr used n the rductn f gd s determned by the dmestc rce the gd,, and s dented by π. Fnally, the suly f the gd s dented by y = π. btan rtectn. 7 ss aversn may rvde nsght as t why a tarff s referred t a tax cum subsdy. A tax wll drectly affect ncmes and thus wll reduce welfare due t lss aversn. A tarff nly affects relatve rces, and whle ths ntrduces a dstrtn, the resultng lss may be smaller than the lss due t lss aversn. Ths s cnsstent wth the fndngs f Kahneman, Knetsch, and Thaler 1991 that the vast marty f ele fnd nmnal salary reductns less accetable than rce ncreases. In rncle, revenue fr the subsdy culd be btaned va nflatn, hwever, there are ther well-knwn csts t nflatn that mght make ths mre cstly fr redstrbutn than a tarff as well as nfeasble due t the ndeendency f central banks. 10

11 The ecnmy s cmsed f ndvduals wh derve utlty frm the cnsumtn f these n+1 cnsumtn gds. In addtn, each ersn wns a share f the sectr secfc factrs. Fr smlcty, we assume that each ndvdual wns nly ne tye f secfc factr and the wnersh levels are dentcal acrss ndvdual wners f the same factr. It s wrth ntng that ths s nt necessarly a mdel abut catal wners, as the return t secfc factrs can als be thught f as a wage remum fr sectr-secfc sklls. The ndrect utlty functn f an ndvdual wh wns secfc factr s π π 1 V = E + s I h, h' > 0, h" < 0, h0 = 0, α N where s the dmestc rce vectr, E s ncme frm labr and secfc factr wnersh, s s the cnsumer surlus, α s the fractn f the ulatn that wns secfc factr, and N s ulatn sze. 8 ss aversn s ntrduced thrugh the functn h.. The functn s ncreasng n the dfference between reference rfts and actual rfts, reflectng the extent f the lss an ndvdual feels fr recevng less than they are accustmed t h.>0. Hwever the margnal ncrease s declnng n the sze f the lss h.<0, whch reresents dmnshng senstvty t lsses. A large bdy f emrcal evdence frm the behavral lterature fnds that ele are rsk lvng n the dman f lsses. 9 I s an ndcatr varable whch takes the value f 1 f exected ncme frm the secfc factr falls belw the reference nt,.e. π π > 0. Snce the reward level, π, s strctly ncreasng n, the reference reward level crresnds t a unque reference rce, dented as. The shae f functn h. tgether wth the ndcatr varable I 8 A utlty functn frm reference nt π that crresnds t ths ndrect utlty functn s u π n x = x0 + u x I h π π. In behavral thery t s cmmn t augment a 1 utlty functn wth the lss aversn term. Thus, we are excludng lss aversn wth resect t rce ncreases f the n gds, whch wuld cmlcate the analyss dramatcally. Mrever, evdence mles that ele are mre averse t ncme lss than changes n rces Kahneman, Knetsch, and Thaler See Kahneman and Tversky 1979 fr the rgnal versn f rsect thery and Rabn 1998 and Barbers and Thaler 2002 fr a summary f the evdence. 11

12 mly that wners f secfc factr erceve a declne n ther welfare when ncme falls belw the reference nt but d nt derve any addtnal utlty fr reward levels abve t. Net ndvdual tarff revenue can be wrtten as the sum f the trade tax n each rduct multled by ndvdual net mrts demand: 1 2 r = [ d y ], N where s the wrld rce f gd, d s the ndvdual demand functn, and y s the dmestc suly functn f gd. The standard scal welfare functn wthut the lss aversn factr s gven by 3 W = l + π + N[ r + s ] n = 1 where l s labr ncme and s the rce vectr. Nw, let the lss aversn fr the whle cuntry be reresented by the fllwng functn: π π 4 H = α Nh α N where reresents the sectrs wth rces belw ther reference levels. The mdfed scal welfare functn wth lss aversn s smly the sum f these tw functns: 5 G = W + H The gvernment sets lcy n sectr t maxmze scal welfare as resented n exressn 5. Snce the cnsumers utlty functns are addtve, we can treat each sectr ndvdually when fndng the tmal lcy. There are several dfferent scenars t cnsder: Case 1: The wrld rce s abve the reservatn rce;.e. : In ths case, we have H=0. The tmum dmestc rce s fund by G ' W ' = 0 whch = 0 mles the tmum dmestc rce s the wrld rce: = r the gvernment sets the tarff at zer and free trade revals. Case 2: The wrld rce s belw the reservatn rce;.e. < : Ths case s shwn n Fgure 1 fr ndustry, where the dmestc rce,, s n the x-axs. Bth W 12

13 and H are drawn as functns f the dmestc rce,, fr a gven level f fregn rce,. W has a unque maxmum at the wrld rce level snce free trade maxmzes the standard scal welfare. H s cnvex and has negatve zer values belw abve the reference rce. As can be seen frm the fgure, the maxmum f the mdfed scal welfare functn G = W + H s gng t be n the regn <. If s less than, then bth W and H are decreasng, and G. cannt attan ts maxmum; fr values larger than, H s zer and W s agan decreasng. At =, we have W =0, H >0 and therefre G >0 whch means G can nt take ts maxmum value at. The alternatves are that ether there s an nterr slutn r a crner slutn at rder cndtn: =. In rder t analyze these tw cases, we frst defne the frst G W H π π 6 = + = m' + I y h ' = 0 where m s net mrt demand, m = Nd y α N Case 2a: FOC s satsfed n the regn < : Suse the FOC s satsfed at nt. Snce G ' > 0, s ether an nflectn nt r maxmum. In rder t rule ut the nflectn nt case, we need t check the secnd-rder cndtn s als satsfed and shw that G '' < Ths scenar s resented n Fgure 2. The tmal lcy fr the gvernment s t chse the tarff level s that the dmestc rce 10 There s a ssblty that the FOC s satsfed multle tmes n ths regn. The resence f multle nts des nt change any f ur results; the gvernment smly has t fnd the glbal maxmum amng these. The ther alternatve s t mse restrctns n these functns t guarantee that FOC s satsfed nly at a sngle nt. Amng the many reasnable restrctns are the fllwng: Suse bth the FOC and SOC s satsfed at nt 0 ; then fr all > 0, H +W <0. Anther tn s t assume that H. s quadratc and the dmestc suly and demand functns are lnear s that W. s als quadratc. Then G.=H.+W. s als quadratc and we are guaranteed t have FOC satsfed at mst nce n any gven range and t avd any nflectn nts. 13

14 level s set at. The tmal tarff s gven by the fllwng exressn whch s derved frm the FOC n 8: t π π z 7 τ = = I h '. 1+ t α N e where z = y / m s the equlbrum rat f dmestc utut t mrts and e = m' / m s the elastcty f mrt demand r f exrt suly. The exressn abve states that nly the ndustres where rces are belw the reference nt receve rtectn. The tmal tarff equates the margnal gan as a result f reducng sectr-secfc lsses t the margnal lss n aggregate welfare that the tarff nduces. As s standard, the tarff s ncreasng n the rat f utut t mrts snce the cst t the ecnmy n terms f lss aversn s hgher f the sectr s large. In addtn, t s greater fr ndustres wth a mre elastc mrt demand r exrt suly snce the welfare cst f the tarff s smaller f mrt demand s nelastc. There wll always be a small stve tarff snce H >0 and W =0. Case 2b: The FOC s nt satsfed r there s an nflectn nt n the regn < : If the FOC s nt satsfed, then we have G ' > 0 fr the whle regn. Alternatvely, suse the FOC s satsfed but the SOC s nt,.e. we are at an nflectn nt and G ' = 0 & G '' = 0. These mly, n ether case, H. s larger than r equal t W. n abslute value at every nt n the entre range. Therefre G. s ncreasng, reaches ts maxmum at and we have a crner slutn as dected n Fgure 3. In ths case, lss aversn at s s large that the margnal gan frm a reductn n lss aversn s always greater than the margnal lss n standard scal welfare frm rtectn,.e. H ' W ' > 0. The gvernment chses trade lcy s that dmestc rce s set at +. Once the reference rce s reached, hwever, lss aversn dsaears. Any further ncrease n tarff smly reduces welfare and therefre never gets mlemented. 14

15 Next, we shw that the magntude f dfference between the wrld rce and the reference rce can determne whether yu are n Case 2a r 2b. Wrld Prces and Dmestc Prtectn In ths sectn, we evaluate hw dmestc rtectn resnds t changes n wrld rces. Fr sectrs where the wrld rce s abve the reference rce level, the tmal lcy s free trade and dmestc rce equals wrld rce. In sectrs where the wrld rce s belw, the tmal lcy s rtectn and the dmestc rce s set abve the wrld rce. The key questn s, fr a gven level f wrld rce, whether the trade lcy utcme s n Case 2a, where dmestc rce s abve wrld rce but belw the reference level, r n Case 2b, where t s set exactly at the reference level. In rder t answer ths questn, suse wrld rce falls frm an ntal level at t a level ε belw t s that = ε. We knw that W ' ε = 0 and H ' ε > 0, whch means H ' + W ' > 0 f ε s small enugh. Thus, fr wrld rces slghtly belw the reference level, we are n Case 2b crner slutn and the tmal lcy s t chse the tarff that brngs the dmestc rce t the reference level. The ntutn s that the lss aversn functn H. s steeest when t s clse t the reference nt due t dmnshng senstvty t lsses. On the ther hand, standard welfare functn W. s flattest when clse t ts maxmum whch s at = ε n ths case. Thus, when rce s slghtly belw the reference nt, lss aversn dmnates the welfare lss and t s tmal t nsttute cmensatng rtectn. Next, we evaluate what haens t rtectn as ε ncreases. We bserve that W ' s ncreasng n but decreasng n abslute value snce t s negatve. Ths s due t the fact that the dstrtn n standard scal welfare declnes as the magntude f the tarff that equates rce t the reference level ges dwn. Therefre as ε ncreases r as mves away frm, W ' becmes mre negatve. In ther wrds, the sle f the standard welfare functn at the reference nt, W ', becmes steeer as 15

16 the reference nt mves away frm the wrld rce. Then, fr ε large enugh r lw enugh, we have G ' = H ' + W ' < 0 snce H ' s cnstant. Ths statement, cmbned wth the fact that G ' > 0 mles there s a nt n between and where G ' ; = 0. In ther wrds, as the wrld rce cntnues t declne and mve away frm the reference level, at sme nt we mve frm a crner slutn t an nterr slutn. Furthermre, the nterr slutn wll als decrease as the wrld rce declnes usng the same arguments. The ntutn s that when the rce shck s very large, the margnal lss frm a cmensatng tarff s larger than the margnal gan frm elmnatng lsses. Instead there s sme tarff level such that the margnal lss n standard scal welfare s exactly ffset by the margnal change n the lss aversn functn. The relatnsh between the wrld rce and tmal dmestc rce exhbts the attern n Fgure 4. Smlarly the relatnsh between tarffs and wrld rces are dected n Fgure 5. Amng the mst mrtant redctns f the mdel s the ntermedate range f wrld rces where trade lcy s used t shelter the dmestc sectr frm wrld rce fluctuatns. In ths regn, dented as A < < n bth fgures 4 and 5, the dmestc rce s set exactly at the reference level and the tarff level adusts t kee the dmestc rce cnstant as the wrld rce changes. Fr wrld rces belw A, there s rtectn but nt hgh enugh t brng the dmestc rce t the reference level. The reasn s straghtfrward. As the wrld rce cntnues t fall, the gvernment needs t cntnuusly ncrease the tarffs t mantan a fxed dmestc rce level. Ths means the margnal cst f ths tarff due dstrtns t standard scal welfare s ncreasng. On the ther hand, due t dmnshng senstvty t lsses h <0, the margnal gan frm the tarff thrugh decreases n lss aversn s als declnng. As a result, t n lnger becmes tmal t mantan the reference rces and the dmestc rce declnes as the wrld rce declnes. Furthermre, the actual rtectn level als declnes wth wrld rces. As the sectr shrnks and the ga between the reference rce and wrld rce ncreases, we nce agan arach free trade. 16

17 The regn f cmensatng rtectn redcted by the mdel s esecally aealng, as n ractce, t s the declnes n wrld rces that generate demands fr rtectn, esecally t mantan the dmestc status qu see Sectn VI. Mst ltcal ecnmy mdels n the lterature generate results that cntradct ths behavr. Fr examle, n Grssman & Helman 1994, rtectn s unfrmly ncreasng n wrld rces. In ur mdel, n the ther hand, declnes n wrld rces belw the reference level can trgger rtectn. Furthermre, rtectn s mlemented n sectrs that stll have sgnfcant resence utut and emlyment but are startng t lse ther relatve cmettveness. In the next sectn, we shw that the result s mantaned n a mdel wth lbbyng fr rtectn. V. bbyng fr Prtectn In ths sectn, we mdfy the revus framewrk by exlctly ncrratng the nfluental lbbyng fr rtectn mdel f Grssman and Helman We shw that the results frm the standard mdel are, n general, magnfed n a mdel wth lbbyng and the basc features f the results are mantaned. We cntnue wth the secfc factrs mdel abve wth gd 0 as the numerare. We allw sme sectrs t be rganzed and lbby fr rtectn as n the rgnal GH mdel. Frm equatns 1 and 3 abve, the nt welfare f the wners f secfc factr s defned as π π 8 G, = { l + π + α N[ r + s ]} I α Nh, h' > 0, h" < 0, α N We refer t ths gru as lbby snce ther nterests are algned and sed t wners f ther secfc factrs. Recall that π s the reference rft level based n rce level. If rfts fall belw reference level.e. f I =1, the members f the lbby gru exerence a lss thrugh the functn h., n addtn t the drect ncme lss thrugh a declne f π, the secnd term n the exressn abve. Snce the cuntry s small, t has n nfluence ver the wrld rce vectr, and the trade-lcy vectr unquely determnes dmestc rces. The gvernment cares abut scal welfare and values mnetary ltcal cntrbutns whch can be used fr a 17

18 varety f urses ncludng camagn sendng. We adt a lnear bectve functn fr the gvernment: 9 Ω = C + ag. O Where G reresent scal welfare nclusve f lss aversn and Σ O C s the sum f the cntrbutns frm the set f rganzed lbbes, O. The scal welfare has a relatve weght f a n the gvernment s bectve functn and the nly restrctn s a>0. Aggregate welfare s defned n equatn 5 abve and ncrrates behavral elements. The lbbyng game layed between the lbby and the gvernment s dentcal t the GH framewrk and s based un Bernhem and Whnstn s 1986 menu auctn. In the frst stage, the lbbes smultaneusly submt cntrbutn schedules cntngent n the trade-lcy vectr mlemented by the gvernment. Gven these schedules, the gvernment maxmzes ts bectve functn gven by 9 and chses a dmestc rce vectr n the secnd stage. The equlbrum utcme s a set f cntrbutn schedules and a dmestc rce vectr r the crresndng trade lcy vectr. Bernhem & Whnstn 1986 shw that the subgame-erfect Nash equlbrum f ths game has sme nce rertes. Fr examle, fr each lbby gru, the equlbrum rce vectr maxmzes the nt welfare f the that gru and the gvernment, gven the cntrbutn schedules f all ther rganzed lbby grus. Furthermre, the cntrbutn schedules are lcally truthful s that they reveal the true references. 11 These mly the equlbrum dmestc rce vectr satsfes the fllwng: 10 = arg max G + ag O In rder t fnd the equlbrum rce vectr, we frst calculate the effect f change n n the welfare f lbby. We btan the fllwng frm 5 and 8, G 11 = δ α y + α m' + δ I y h'. where δ s an ndcatr varable that s 1 f = and 0 therwse, and m s net mrt demand, m = Nd - y. 11 Bernhem & Wnstn and GH dscuss n length why t s enugh t fcus n truthful cntrbutn schedules snce these are caltn-rf. We refer the reader t these aers. 18

19 19 Next, we sum equatn 11 ver the set f rganzed lbbes, O, t btan the change n welfare fr all lbbes wth resect t change n rce, 12. ' ' h y I I m y I G O O + + = α α, where I s an ndcatr varable equal t 1 f ndustry s rganzed and α O s the fractn f the ttal ulatn f vters that are reresented by an rganzed lbby. Recall that the equlbrum cndtn s gven by 10 and mles: 13 0 = + O G a G, fr = 1,, n where a s the weght n scal welfare. Usng equatns 6 and 12, frst rder cndtn s 14 0 ' ' = N h y I a I m a y I α π π α α Agan ths FOC mght nt be satsfed f we are at a crner slutn. In that case, the tmal tarff cmensates the ndustry u t the reference rce level we return t ths stuatn belw. Ignrng the crner slutn fr the mment, the tmal trade tax t, defned as / t =, can be exressed as 15 ' ] ' [ m a N h I a I I y t α α π π α = We can rewrte ths cndtn as 16 n fr e z a N h I a I I t t 1,2,..., ] ' [ 1 = = + = α α π π α τ where / m y z = s the equlbrum rat f dmestc utut t mrts and / ' m e m = s the elastcty f mrt demand r f exrt suly.

20 The exressn fr the equlbrum trade tax s dentcal t the result n GH excet fr the behavral term n square brackets. Many f the nsghts frm the GH framewrk are carred ver. The dstrtn msed subsdy r a tax declnes as the gvernment laces mre weght n scal welfare, exressed thrugh the arameter a. The sze f the dstrtn s stvely related t the rat f dmestc utut t mrts, z. If the level f dmestc utut f an rganzed sectr s hgh, fr a fxed level f mrt demand elastcty, then the lbby has mre t gan frm a margnal ncrease n the dmestc rce. The cntrbutn schedule wll reflect ths and the equlbrum rtectn level wll be hgher. The behavral term, n the ther hand, agan, ntrduces mrtant mlcatns fr trade lcy. One cnsequence f the GH mdel s that f all sectrs are rganzed.e. I =1 fr all and everybdy s reresented by a lbby gru α =1, then there s free trade n equlbrum. Ths utcme s due t the fact that nterest grus neutralze each ther and the nterests f the rducers are exactly matched by the sng nterests f the cnsumers. In ur settng, trade s dstrted even f everybdy s reresented by a lbby gru.e. I =1 fr all and α =1. If all sectrs are rganzed, the equlbrum tarff reverts t t 17 z τ = = I h'.. 1+ t e Ths tarff level s dentcal t exressn 7 whch means when all sectrs are ltcal actve, the mdfed scal welfare functn n 5 s maxmzed. Hwever, unlke the case n ther mdels, the scal tmum nvlves stve tarffs t cmensate fr lss aversn. Furthermre, ndustres wth smaller dmestc utut and hgh elastcty f mrt demand n abslute value receve lwer level f rtectn and smaller devatns frm free trade. Our mdfed mdel als rvdes an exlanatn fr sme f the uzzlng results n the recent emrcal lterature n ltcal ecnmy f rtectn 12. Magg & Gldberg 1999 and Gawande & Bandyadhyay 2000 am t redct the relatve weghts f the frces nfluencng trade lcy based n the GH mdel. In essence, they estmate 12 We wuld lke t thank Kshre Gawande fr callng ur attentn t ths nt. 20

21 varatns f equatn 16, wthut the lss aversn factr.e. I = 0. Fr examle, n bth f these aers ecnmetrc mdels, rtectn estmatn equatn s gven by z z τ + = γ + δi ε where e e I s the ndcatr varable fr beng ltcally rganzed and γ and δ are the ceffcents f z/e fr unrganzed and rganzed sectrs, resectvely. Fr examle, n case f Gldberg & Magg 1999, the weght n the scal welfare n gvernment s bectve functn s gven frm the relatnsh a = γ +1 / δ and they nfer a value between 50 and 70 fr a based n ther estmatn results. Ths s rather hgh ndcatng that the gvernment attaches 50 tmes mre weght t scal welfare cmared welfare f rganzed grus 13. Hwever, abve estmatn s nt the crrect secfcatn when lss aversn s taken nt accunt. Secnd, even under the abve secfcatn, the relatnsh between a and the estmated ceffcents becme a = γ + 1 /[ δ 1 + I h'] whch mles the nferred value f a s lwer fr any gven set f estmated ceffcents 14.. l Wrld Prces and Dmestc Prtectn We next exlre hw equlbrum trade lcy and dmestc rces resnd t changes n the wrld rces, as we dd n the revus sectn. The dstnctn s the resence f lbbyng behavr and hw t resnds t changes n the external ecnmc envrnment. We fllw a slghtly dfferent ath and frst shw hw the rtectn level and dmestc rce level are related. Frst, cnsder an ndustry where the wrld rce s abve the reference level. In the gvernment welfare-maxmzng mdel, the ndustry receves n rtectn. In the lbbyng mdel, under sme mld assumtns, t s straghtfrward t shw that the equlbrum tarff rate f an rganzed lbby s ncreasng n the wrld rce ths s the mlcatn f the GH mdel that we mentned earler. Snce lss aversn des nt enter the bectve functn f the lbby gru hence, f the gvernment, the standard GH effect derves the result. The reasn can be easly seen frm the tmal lcy 13 Gawande & Bandyadhyay 2000 btan even a hgher number fr a - arund 3, Naturally, the emrcal extensn f ur mdel needs t be tested rerly and mght rvde further nterestng results. 21

22 t exressn n Equatn 17. et τ = 1+ t exressn as the fllwng, gven that I =0: I α 1 18 τ =, a + α d ε y ε d y, then we can rewrte the equlbrum tarff where ε y and ε d are, resectvely, the elastcty f dmestc suly and demand f sectr nte we have ε 0, ε < 0. An ncrease n the wrld rce causes a declne n y > d the dmestc demand t suly rat d /y and hence an ncrease n the equlbrum tarff level, assumng that the elastctes satsfy certan mld assumtns. 15 Ths s the regn t the rght f Pnt B n Fgure 6. Next, cnsder the ther extreme scenar where wrld rce s s lw such that, even wth rtectn, the equlbrum dmestc rce s belw the reference rce level. Ths s the nterr slutn we dentfed n the revus sectn. Then the equlbrum trade lcy s gven by the fllwng exressn whch s btaned by manulatng exressn I τ = α + [ I π π 1 + ai h' ] α N 1 a + α d ε y ε d y In ths case, the GH effect, as dentfed n the revus aragrah, stll ushes the rtectn level t declne when the wrld rce declnes. The lss aversn effect wrks n the same drectn due t decreasng senstvty t lsses, exressed as h <0. Nte a declne n wrld rce causes π π t ncrease. Thus, n ths regn, the equlbrum rtectn mves n the same drectn wth the wrld rce as well. In the welfare-maxmzng mdel, a=0 and α=1 and I=1 the result wll be smlar wng t decreasng senstvty t lsses. In Fgure 6, ths s resented as the regn t the left f nt A. 15 Fr examle, t s suffcent fr dmestc demand and suly functns t have cnstant elastcty. 22

23 The key ssue s what haens when the dmestc rce s at the reference level. Ths s akn t the crner slutn frm the revus sectn. Equatns 18 and 19, resectvely, rvde the equlbrum trade lces when the dmestc rce s abve and belw the reference level. We see that exressn 19 has a hgher value at snce h >0. Ths means, when the dmestc rce s slghtly belw the reference nt, the rtectn level s hgher cmared t the rce slghtly abve reference nt. Therefre the tarff level at nt A s hgher than the tarff level at B n Fgure The next ste s t determne the relatnsh between the equlbrum trade lcy and wrld rces. The same lgc revals as n the welfare-maxmzng case frm the revus sectn. In Fgure 6, let tarff levels at nts A and B be dented as τ A and τ B resectvely. Althugh the dmestc rce s dentcal at A and B, wrld rces are dfferent snce the wrld rce s gven by =1- τ. Mre secfcally, at the crresndng wrld rces, we have A< B. The relatnsh between wrld rces and trade lcy fr rces lwer than A and hgher than B s gven frm the dscussn abve and s resented n Fgure 7. The questn s what haens t rtectn fr wrld rces between A and B. We knw that the dmestc rce has t be cnstant at the reference level n ths range. In ther wrds, 1 = / τ fr < <, whch means that the rtectn level wll be declnng n wrld rces. A B Thus, the relatnsh between wrld rces and rtectn exhbts the attern n Fgure 7, where the dstance between A and B deends n the extent f lss aversn, the steeer s the lss aversn functn, the further aart they wll be. Fgure 7 rvdes very nterestng nsghts abut the attern f trade lcy cmared t standard ltcal ecnmy mdels where there s generally a stve crrelatn between the wrld rce and the rtectn level. Frms stll receve ncreasng rtectn when the wrld rce s hgh. Ths can be nterreted as ertanng t sectrs where dmestc frms are cmettve n wrld markets and are exrters. We 16 The shae f the functn t the rght f the reference rce deends n the shae f d /y. In general, t wll be cnvex snce a margnal ncrease n the tarff level s wrth mre when the ndustry s larger. The same ntutn wll hld t the left f the reference rce, mrever, dmnshng senstvty t lsses mles that a margnal ncrease n rce clse t the reference level s wrth mre than a margnal ncrease away frm the reference rce. 23

24 shuld nte ths s dfferent than the results f the revus sectn where there s n rtectn fr rces abve the reference nt due t absence f lbbyng. Hwever, large exrters lbby the gvernment extensvely fr many exrt-frendly lces, that are nt drect subsdes but nevertheless ted t exrt erfrmance. Fr examle, cnsder the U.S. Fregn Sales Crratns tax rvsns and the relacement tax lan, whch effectvely rvde sme 6,000 cmanes ncludng sme f the largest exrters such as Mcrsft, Beng, and Csc Systems wth a tax break n u t 30 ercent f exrt earnngs and are wrth $4 blln t U.S. exrters. As the wrld rce declnes, s des rtectn, untl we reach B. Ths s a crtcal nt snce the crresndng dmestc rce s at the reference level. If the fregn rce cntnues t declne, the gvernment mlements trade lces that exactly ffset these negatve shcks. The regn between A and B reflects the rce range fr whch the gvernment erfectly shelds dmestc frms frm negatve wrld rce shcks. Ths regn f cmensatng rtectn s that same as n the revus sectn. The behavral effect utweghs the standard effect even cmbned wth the addtnal effect f lbbyng when the rce level s nt t far belw the reference level, ushng the dmestc rce level back t ts reference level. The dmestc rce never rses abve the reference rce because agents n lnger exerence lss aversn when rce s abve. If the wrld rce were t fall belw A, the margnal cst f rtectn becmes t hgh n terms f lst cnsumer surlus recall cnsumer surlus s declnng and cncave n rces whereas the margnal beneft s t lw snce the rducer surlus s ncreasng and cnvex n rces. In addtn, the lss aversn exhbts declnng senstvty whch erates n the same drectn as the abve effect. Thus, rtectn starts t declne as the wrld rce cntnues t fall belw A. At sme nt, t s ssble that the dmestc ndustry dsaears and s des rtectn. In shrt, when behavral assumtns are ntrduced, trade lcy n lnger exhbts a mntnc relatnsh wth the wrld rce as s redcted by the GH mdel. In artcular, the regn f cmensatng rtectn fund n the gvernment-maxmzng mdel wll be mantaned even thugh the cutff nts such as A naturally deend n lbbyng mdel s arameters. Ths structure exlans sme f the uzzles that had gne 24

25 unexlaned. In the next sectn, we dscuss cntngent rtectn and the extent t whch t s used t mantan rces abve a gven level. VI. Trade Prtectn n Practce An mrtant redctn f lss aversn and reference deendence n bth mdels s the regn f cmensatng rtectn, where tarffs are geared tward mantanng a dmestc rce at a secfc level. When clsely bserved, the vast marty f the mst restrctve trade lcy nstruments are desgned exlctly t lmt the extent t whch wrld rce declnes are transmtted t the dmestc ecnmy. Quta restrctns, vluntary exrt restrants, safeguards, and rce flrs, nly bnd when the wrld rce s lw and fallng. 17 Other tls f temrary rtectn, such as antdumng dutes and the escae clause, are nly used n a weak rce envrnment. In addtn, n develng cuntres, bund tarffs are set well abve actual levels s that gvernments have the flexblty t rase them when cndtns wrsen. Emrcal evdence als shws that ndustres exerencng lsses are much mre lkely t receve rtectn than therwse smlar grwth ndustres. Marvel and Ray 1983 and Ray 1991 fnd that rtectn s geared tward declnng ndustres, and Trefler 1993 fnds that rtectn s hgher n nes n whch mrt enetratn has ncreased. In addtn, cuntres have ressted lberalzatn n ndustres wth declnng emlyment and rsng mrt enetratn Baldwn The mst restrctve nstruments f rtectn tend t be geared tward mantanng ncmes and rces n declnng sectrs. We fllw wth sme examles frm the Unted States. Qutas are erhas the mst restrctve lces n the Unted States, rtectng the hghly senstve sectrs f agrculture and textles and aarel, and can be easly manulated t reserve rces. Fr examle, a carefully-managed system f blateral qutas has ket the U.S. sugar rce abve $0.20 a und snce 1985, deste lw and hghly vlatle wrld rces see Fgure 8. The rgram uses a cmbnatn f tarff-rate qutas and lan guarantees t mantan the rce. Because 17 VRAs and qutas are stll an anmaly snce n general they transfer rents t the fregn rducer as sed t a tarff whch kees rents thrugh the revenue generated. 18 Baldwn 1989 remarks that lss aversn s a ssble exlanatn. 25

26 exandng sules and fallng wrld rces, qutas have been declnng durng much f ths erd. A smlar rgram s emlyed n Eure. Deste ther name, antdumng dutes, nw the leadng surce f cntngent rtectn, are sught and msed t revent sectr-secfc lsses and nt t cunteract dumng. 19 Fr examle, the steel ndustry, by far the largest user f U.S. antdumng law, 20 has hstrcally benefted frm many tyes f rtectn. The lces were clearly geared tward mantanng rces as evdenced by the 1977 trgger-rce mechansm, whch establshed a mnmum mrt rce, and a seres f vluntary restrant agreements. As thse tyes f rtectn were gradually elmnated by the GATT, the sectr has turned t antdumng t revent lsses when rces declned. A artcularly nterestng feature f the steel ndustry, whch further demnstrates that antdumng s abut lsses, s that durng wrld rce slums nly a declnng subsectr, the ntegrated rducers, called fr rtectn. Frm 1969 t 1999, rce declnes led t ncreased calls fr rtectn frm the ld-fashned ntegrated rducers, where rductn was declnng and rfts were fallng. In cntrast, mnmlls, whch used new electrc-arc technlgy and exerenced utut and rft grwth, refused t sgn n t antdumng ettns. Fgure 9 shws the U.S. and wrld rces f steel. Agan, the clear cture s f ne where dmestc frms are sheltered frm rce declnes. Befre March f 1999, average dmestc rces were ket abve $350 er metrc tn whle the wrld rce fluctuated between $230/tn and $450/tn. Only n recent years, as the ntegrated sectr shrunk and many lants were shut dwn, rtectn level began t declne and dmestc rces fnally brke the $350/tn barrer. mtng lsses s reflected n U.S. Trade Adustment Assstance rgram as well. Fr examle, the extent f assstance rvded t farmers s based n the dfference between the current rce and the average rce f a gven rduct ver the last fve years,.e. the ndustry lsses. Ths s rather dfferent frm the estmated cst f adustng t a mre cmettve envrnment, whch s the rgnal mtvatn behnd the rgram. In sum, the man frms f rtectn n use tday are ntated by rce declnes and aear t be guded by a desre t mantan dmestc rces abve sme reference 19 See Tharakan 1996 fr a survey f the evdence. 20 Abut half f the mre than 200 antdumng rders currently n frce are n mrted steel. 26

27 level. Only when ndustres declne suffcently, des rtectn begn t be hased ut. The elmnatn f the aarel qutas establshed decades ag under the Mult-Fber Agreement MFA s a tycal examle f ths henmenn. VII. Cnclusn We augment a standard gvernment welfare-maxmzng mdel and the Grssman-Helman mdel f lbbyng fr rtectn wth assumtns brrwed frm behavral ecnmcs. The G-H mdel s attractve because t rvdes mcrfundatns fr the abundance f lbbyng and rtectn bserved n the Unted States and ther cuntres. But by emlyng a standard utlty functn, the mdel cannt exlan why rtectn shuld be s cncentrated amng declnng ndustres. Ths s an area where lss aversn lays an mrtant rle, as ndustres are ntceably mre vcal when rfts fall than when they rse. We fnd that ncrratng lss aversn and reference deendence nt the agent s utlty functn hels exlan many f the nterestng features f the structure and the dynamcs f rtectnst lces. Of artcular nterest, the mdels rduce an ntermedate range f wrld rces fr whch a rce declne leads t an ffsettng ncrease n rtectn. We shw that ths regn f cmensatng rtectn s ncreasng n the extent f lss aversn exerenced by agents. Ths result rvdes ntutn fr why s many f the nstruments f rtectn that have been emlyed arund the wrld, such as rce flrs and mrt quantty restrctns, fcus n mantanng dmestc rces at a gven level. Whle the mdel des nt drectly address the ant-trade bas, t rvdes several reasns why an ant-trade bas may result. One, negatve shcks may be mre lkely t ccur n mrt-cmetng ndustres where cmaratve advantage des nt le than n the exrt sectr where technlgy tends t be mrvng. Tw, f tarffs have been n lace hstrcally fr revenue reasns, then the attemt t dsmantle them shuld be met wth resstance rmarly frm the mrt-cmetng sectrs that have the mst t lse. Three, t may have t d wth the erceved farness f tarffs versus subsdes an area we have tuched n wth ur survey but that warrants future research. 27