Political Economy

1. Political Economy

2. Median Voter Model • In majoritarian systems, the policies are established by a majority vote. • To avoid the classic problems of Arrow, we assume that preferences are single peaked over the policy being voted upon. • In this environment, the policy adopted will be the preferred policy of the median voter. • Depending on the factor endowment of the median voter, the society may adopt a tariff. • Specifically, if the median voter is endowed with more labor than the overall economy, and imports are labor intensive, the voter will prefer a positive import tariff.

3. Model setup • Assume each individual has quasi-linear utility for where L is the number of consumers/workers, each of whom has one unit of labor and units of capital • Consumers all have the same optimal consumption , which means all consumers choose • Individual utility is then • Total endowments of labor and captial are L and K, the world price is fixed at , with a specific tariff t. • y(p) is the supply function, y’(p) > 0 • Imports are just • Tariff Revenue is , which is distributed to each citizen. • Individual income is Where is the capital labor ratio of each worker relative to the overall capital labor endowment of the economy

4. Total GDP Take the derivative of individual utility with respect to the tariff: Using this equation, we can get the equation for the preferred tariff of the median voter. Note that is the capital labor ratio for the median individual relative e to the capital labor endowment for the economy, which is less than 1 for all countries. If the import good is labor intensive, . If the import good is capital intensive, it is negative. This implies that tariffs should be positive in capital abundant countries, but subsidies should be used in labor abundant developing countries (not generally true). By the envelope theorem

5. Income inequality and trade policy Dutt and Mitra (2002) • Assume that the lower is the median voter’s capital to labor endowment, the higher is inequality. Taking the total derivative of the first order condition we get Plugging back in the equation from the previous slide, we get: The second order conditions give us that Which means that tariffs are positively associated with inequality in developed countries, but negatively associated with inequality in developing countries.

7. Why no subsidies? • Import subsidies would alter the domestic income distribution, because voters cannot predict their individual outcomes, they vote for policies which maintain the status quo. Fernandez and Rodrick (1991) • Many governments are resource constrained, and may find it difficult to collect the funds.

8. Grossman and Helpman (1994) Protection for Sale • Tariff rates, post Ancient Greece, are generally not set by majority vote. • Delegating authority to representatives drives a wedge between the preferences of the median voter and policy outcomes. Campaigns, lobbying efforts, and donations matter. • Grossman and Helpman developed a model of how governments compare the contributions of competing lobbies. • They use a framework of menu auctionsin which industries bid for tariff schedules Bernheim and Whinston (1986).

9. Model setup • There are N goods plus the numeraire, all of which are additively separable in utility. Maximizing utility gives us, as before, per capita consumption with the remaining income spent on the numeraire good.

10. Production • Each industry operates according to production function Where is the capital specific to each sector. Each bit of capital is owned by people, whereas all people own 1 unit of labor. The capital owners of industry i receive: The total population includes some individuals who own no capital at all, they get: Summing up we get:

11. Politics • Assume that subset of industries is organized into lobbies. • The purpose of each lobby is to give money to politicians in exchange for their favored tariff schedule. • Each lobby announces a campaign contribution schedule that they are willing to pay, which depends on the prices that prevail in each of N industries. • The government decides which Lobbyists money to take, taking into account the cost in terms of welfare of each lobbyists proposal, maximizing: Lobbyists decide how much to offer considering how much others will offer, and knowing the government welfare function. Lobbyists do best to offer: This offer will reflect the true welfare levels obtained by the lobby for tariffs.

12. The Government’s Choice The first order condition for an organized industry j: Where is the fraction of the population owning a specific factor in an organized industry. Using the fact that

13. The Government’s Choice The first order condition for an unorganized industry j: Where is the fraction of the population owning a specific factor in an unorganized industry. Using the fact that

14. The Government’s Choice • Setting each of the first order conditions for organized and unorganized firms equal to 0, solve for equilibrium tariffs • The first term is the weighted fraction of the population that owns a capital in an organized industry. The second term is the share of imports relative to output in the industry, the third term is the import elasticity. • Unorganized industries make the indicator variable 0, and receive import subsidies (or export taxes) to lower domestic prices. • The magnitude of the tariffs are determined by the ratio of production to imports and the inverse of the import demand elasticity.

15. Testing “Protection for Sale” • Goldberg and Maggi use non-tariff barriers in the United States, because tariffs are subject to trade agreements. • They find that the weight on consumer welfare is between 50 and 100 times higher than that of political contributions. • They also find that the proportion of people owning the specific factor of politically organized firms is .88. • Alternative specifications find that consumer welfare is weighed 1750 times higher than government revenue (Gawande and Bandyopadhayay, 2000) • The model performs reasonably well in Mexico, Australia, and Turkey.

16. Endogenous Lobbies • Derive results from a model in which lobbies are endogenously formed to influence politics. • Rewrite Holding the second two terms constant, we have So a rise in either the fraction that owns a specific factor (a decline in inequality) or a rise in the fraction of industries that are organized will lower • If a change in inequality has both an effect on the tariff and the number of organized industries, we could imagine andmoving in opposite directions. An increase in inequality would raise the returns to creating a lobby.

17. Lobby Entry Decision • Assume and do not vary across industries, and that demand and production functions are symmetric across products. • There are then just two tariff/subsidy levels, for organized and unorganized industries, which depend on the product of . • The benefit of creating a lobby depends just on the difference in welfare between the two states, net the cost of political contributions. • Net benefits • As inequality increases ( declines), the tariffs rise, raising the returns to the organized industry, so profits increase. <0. • Mitra finds that taking into account of the effects of the number of lobbies on contributions, the net benefits fall with an increase in the number of lobbying groups.

18. Costs of organizing a lobby A>B , we can say that and, falls NB, C A B A=B, therefore doesn’t change The overall impact of income inequality on protection depends on the cost of organization. NB, C A B

19. Application of Protection for Sale to FDI in China How should China choose its tariffs to influence foreign investment? Higher tariffs will result in foreign companies being forced to use FDI to “jump the tariff” The model from Branstetter and Feenstra (2002) has state owned enterprise as well as operating markets. This analysis shows that in the face of political economy weights, some of the benefits of liberalization are attenuated.

20. Model Setup • Consumer Utility: Where CES aggregate is: There are home firms, foreign firms, and M multinationals in China. Assume The domestic firms are state owned, and receive more weight in the objective function.

21. Provincial Politics and Entry Barriers • Provinces of China have autonomous control over multinational entry and trade between provinces face prohibitive internal barriers. • Labor is the only factor of production, and there is a numeraire, so wages are 1. • Multinationals pay a wage premium, , which captures the spillovers that a multinational brings to an economy. • Costs for the locally produced products are but foreign products face a specific tariff t. • Prices are a markup over marginal cost, and we assume that so that multinational price lower than foreign imports. • As more multinationals enter, product prices decline, and the demand for products of state owned firms goes down.

22. Foreign firm decision • The foreign firm may become a multinational by paying a cost F to set up a plant and a profit tax to the government. • Net profits earned locally are: Profits earned by export are . So entry will occur iff: This generates the number of Multinationals, , Higher tariffs increase the number of Multinationals, higher profit taxes decrease the number of Multinationals.

23. Government Revenue • The objective function for each Province is: Profit tax and tariffs solve: FOC: