Events such as the negotiation of international trade agreements and the entry of China into international markets may require a significant reallocation of resources in a country. The reallocation is from import-competing sectors to exportable sectors. For example, Carneiro (2014) finds that adjustment costs in Brazil could represent between 14 and 42 per cent of the gains from trade, and that the adjustment process can take five years or longer. The question of how economic policy can be used to facilitate this reallocation is important. This is so because ineffective management of the transition can undercut the gains from trade liberalization and undermine the political support currently seen for international trade.

The purpose of this chapter is to characterize the optimal path for tariff rates following the negotiation of a trade agreement between two countries, wherein each country incurs costs for moving resources from import-competing to exportable sectors. It is assumed that these countries can commit to a path for tariffs in the agreement, and that their governments have chosen policies to maximize national welfare. The question we address is as to what form the phase-in period for tariff reductions should take. At one extreme end is the ‘big bang’ approach, which has been advocated for transition economies. This approach would call for tariffs to be eliminated immediately once an agreement is signed. The alternative is a gradualist approach, which has been the approach more frequently applied in trade agreements. In this approach, the agreed tariff reductions are phased in over a pre-specified period. The analysis in this chapter will focus on how the answer to this question depends on the efficiency of the adjustment process in the countries.

The model analyzed in this chapter is one in which factors located in the import-competing and exportable sectors are fixed in the short run, but can move between sectors in the long run by incurring a resource cost for moving between sectors. The short-run model is similar to the specific factors model of international trade, which was presented in the classic paper by Ronald Jones (1971), and has become the workhorse model in the political economy of trade literature. The model presented herein adds a dynamic element by considering the relocation decision of workers between sectors and allowing for heterogeneity in the tradable goods sectors.

Introduction

Economists usually think of international trade agreements as attempts to solve the prisoner's dilemma that is inherent in trade policy. Each country would like to protect its own market, either because of powerful political interests in the import-competing sector or the desire to exercise its market power in trade. However, each country's protection has a negative impact on the welfare of its trading partners by denying market access to their exporters and worsening their terms of trade. Unilateral actions of countries in setting trade policy will thus result in an inefficiently high level of protection. The role of international trade agreements, such as the Agreement Establishing the World Trade Organization (WTO), is to provide a forum in which countries may negotiate mutually beneficial reductions in those trade barriers.

As a result of the Uruguay Round of trade negotiations, the scope of the WTO was expanded to include the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS). The TRIPS Agreement represents a substantial departure from previous international conventions on intellectual property rights (IPRs). First, it covers a broad range of IPRs under a single accord. Previously, there were separate agreements covering copyrights (Berne Convention) and industrial property (Paris Convention) that had widespread membership, but other aspects of intellectual property, such as computer software and trade secrets, were not covered by significant treaties.

This chapter analyzes the role for infant industry protection in the presence of capital market imperfections. A two good, two period model of a small open economy will be presented in which one of the sectors has the characteristics of an “infant” industry. Firms in the infant industry are unprofitable at world prices in the first period. During the first period when losses are being incurred, entrepreneurs learn about the production process. In the second period, firms become profitable (on average) at world prices. The approach to capital market imperfections in this paper is to treat them as resulting from the agency costs associated with external finance when there is private information on the part of entrepreneurs. This model will then be used to examine whether government intervention in support of the infant industry can yield Pareto-improvements.

The traditional treatment of capital market imperfections (Baldwin [1969], Corden [1974]) is to model the capital market imperfection as an exogenously given wedge between the social cost of capital and the rate at which firms can borrow from the private sector. Since the future profits are being discounted at too high a rate by private sector lenders, there will be too little entry into the infant industry. Two main policy conclusions emerge from this literature. The first is that subsidies to the infant sector are desirable, because they make the amount of entry closer to the socially optimal level. The second is that direct intervention in the capital market, such as through subsidized loans, is preferable to indirect intervention in the form of production subsidies or tariffs.