Profits in the "New Trade" Approach to Trade Negotiations

Ever since Johnson’s (1954) seminal work initiated the formal analysis of trade negotiations, the terms-of-trade theory has been the dominant paradigm of the field. As is well known, it holds that trade negotiations serve to internalize terms-of-trade externalities resulting from countries’ noncooperative tariff choices. Its standard formulation is due to Bagwell and Staiger (1999), who show that it can not only explain the purpose of trade negotiations but also rationalize many features of the GATT/WTO’s institutional design. For all its merits, this standard theory has two significant limitations. First, it predicts that trade negotiations should revolve solely around the issue of terms-of-trade manipulation, which seems implausible to many observers of GATT/WTO negotiations. Second, it is based on conventional neoclassical trade models, which are difficult to calibrate convincingly so that little is known about its quantitative implications for important variables such as the gains from GATT/WTO negotiations. In this article, I present a variant of my analysis in Ossa (2011a) which aims to overcome these limitations. The main idea is to depart from the conventional neoclassical trade model and instead build on a Krugman (1980) “new trade” model. The key difference from Ossa (2011a) is that I now rule out free entry, which turns the production relocation effects into profit shifting effects. Such profit shifting effects are intuitively appealing, since they allow for a view of trade negotiations in which producer interests play a prominent role. I keep the analysis deliberately simple to highlight the novel elements of my approach. Specifically, I shut off all terms-of-trade effects and allow trade policy to operate only at the most aggregate level so that a single tariff is assumed to apply against all imports from a given country. Naturally, these simplifications imply that the quantitative results are only illustrative. In Ossa (2011b), I have provided more definite results based on a multisector model which nests terms-of-trade, profit shifting, and political economy effects.

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