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Loss aversion and trade policy

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  • Freund, Caroline
  • Ozden, Caglar

Abstract

This paper provides new survey evidence showing that loss aversion and reference dependence are important in shaping people's perception of trade policy. Under the assumption that agents'welfare functions exhibit these behavioral elements, we analyze a model with a welfare-maximizing government and with the lobbying framework of Grossman and Helpman (1994). The policy implications of the augmented models differ in three important ways. One, there is a region of compensating protection, where a decline in the world price leads to an offsetting increase in protection, such that a constant domestic price is maintained. Two, protection following a single negative price shock will be persistent. Three, irrespective of the extent of lobbying, there will be a deviation from free trade that tends to favor loss-making industries. The augmented models are more consistent with the observed structure of protection, and in particular, explain why many trade policy instruments are explicitly designed to maintain prices at a given level.

Suggested Citation

  • Freund, Caroline & Ozden, Caglar, 2004. "Loss aversion and trade policy," Policy Research Working Paper Series 3385, The World Bank.
  • Handle: RePEc:wbk:wbrwps:3385
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    References listed on IDEAS

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    11. David Austen‐Smith, 1991. "Rational Consumers And Irrational Voters: A Review Essay On Black Hole Tariffs And Endogenous Policy Theory, By Stephen Magee, William Brock And Leslie Young, Cambridge University Press 1989," Economics and Politics, Wiley Blackwell, vol. 3(1), pages 73-92, March.
    12. Rodrik, Dani, 1995. "Political economy of trade policy," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 28, pages 1457-1494, Elsevier.
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    Cited by:

    1. L'Haridon, Olivier & Malherbet, Franck, 2009. "Employment protection reform in search economies," European Economic Review, Elsevier, vol. 53(3), pages 255-273, April.
    2. Tovar, Patricia, 2009. "The effects of loss aversion on trade policy: Theory and evidence," Journal of International Economics, Elsevier, vol. 78(1), pages 154-167, June.
    3. By Kishore Gawande & Pravin Krishna & Marcelo Olarreaga, 2012. "Lobbying Competition Over Trade Policy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 53(1), pages 115-132, February.

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