From Protection to Retaliation: The Welfare Cost of Trade Wars

Abstract:

This paper explores the welfare costs of trade impediments, which depend on trade elasticities. State-of-the-art literature uses tariffs as instruments to structurally identify them. Studies using Trump tariffs in the US estimate modest elasticities, implying low welfare costs. In this paper, I build a model of political economy to explain these results and introduce a novel identification strategy for estimating them. The model features a selection mechanism for goods chosen for treatment, based on the government’s objective function and the state of the economy. When raising revenue, the government imposes tariffs on sectors with low demand elasticity and strong lobbying power. In response, the other country retaliates by targeting goods with high demand elasticity to maximize economic harm on the trade partner. This model provides a framework for two possible instruments: protectionist and retaliatory tariffs. As trade policy targets the extremes of the elasticity distribution, Trump’s protectionism aligns with the observed low elasticity estimates. In this paper, I find the demand elasticity for imports ranges between 2.5 and 5.2, while the supply elasticity of exports is zero. This suggests that welfare costs could double, reaching up to $22 billion.