Exploring welfare maximizing SPS standards in a game-theoretic framework: a case of Indo-US trade in wheat and mango

Abstract

As the trade quotas have been eliminated under GATT and tariffs have been rationalized under WTO; the focal point of disputes and negotiations in international trade has shifted to non-tariff barriers, particularly Sanitary and Phytosanitary (SPS) standards. SPS standards are commodity specific standards, adopted by WTO members to protect domestic flora and fauna and environment from the impact of invasive foreign organisms. However, in the absence of any past experience and concrete scientific or empirical evidence, standards are usually kept at prohibitively high levels, thereby inducing sub-optimal outcomes. Therefore, it is imperative to assess the impact of SPS standards on various dimensions and base the decision making on expected net welfare gains to the nation as a whole. Most of the impact assessment approaches in the literature focus on trade gains or level of risk only; however, cost benefit analysis based studies are more flexible, comprehensive, and apt for policy formulation due to welfare oriented outlook. All the studies so far have considered the impact of SPS standards for a single commodity and on the importing nation only. Since unilateral decision on standards leaves out the possibility of choosing mutually beneficial level of standards, it is not in the best interest of the nation. The present research addresses this gap. A negotiation based SPS regime is considered, wherein a country may settle for lower benefits or a loss on trade of one commodity due to lower domestic SPS standards, yet a reciprocal change in SPS standards for another commodity by the trade partner may provide higher net gains. In such a case, unilateral decision making suggests for stringent SPS standards, leading to low or no trade whereas an interactive decision would facilitate trade and augment welfare. A game-theoretic framework for strategic negotiation on SPS standards between two countries and two commodities is proposed. The framework poses various alternate scenarios and the possible payoffs therein. Analysis of Nash equilibrium under different scenarios is presented with theoretical observations. A range of methodologies for quantifying payoffs is studied and their relative advantages and disadvantages are analyzed. To implement the proposed framework for empirical justification, the case of Indo-US trade in wheat and mango is chosen, as it would be more meaningful to compare the welfare implications to developing south with developed north. At present, India does not permit import of wheat from the US due to high weed infestation, whereas mango export from India to USA was banned between 1989 and 2006 due to high pesticide levels and incidence of pests. Since both the countries and commodities are economically significant, this dual trade embargo harms both the nations. With this context, a range of welfare gains to India and US under different SPS regimes is estimated. The policy choices act as strategies and include two ends of spectrum, complete ban and full liberalization. Intermediate strategy for India is to demand Methyl Bromide (MB) treatment of wheat and for US, to demand nuclear irradiation or hot water treatment (HWT) of mangoes. For estimation, the welfare-representing payoffs are defined as potential gain or loss to the parties affected directly (consumers and producers) or indirectly (by spillover effects). Partial equilibrium framework with stylized microeconomic models for different components is used. Benchmark data of three years (2004-06) is employed in order to avoid the effect of abnormal observations. The principle of conservatism is followed by considering losses on a higher side and gains on a lower side. This ensures that even if there is some margin of error, the outcomes would not change drastically. The estimation process breaks the impact of standards into smaller components and estimates them separately. Change in consumer surplus to Indian consumers due to export of Indian mangoes to the US is captured through Harbergers triangle, whereas the same for US consumers is estimated through a measure of consumers willingness to pay. The producer surplus is measured by change in value received net of compliance cost. The estimates for loss due to different regimes are quoted and modified from relevant research, whereas the pest invasion probabilities are quoted from literature or collected from relevant specialists. Costs of compliance and transportation are collected from traders, research institutions, and government agencies. The estimates are then summed up over countries for the respective commodities and compared in the game-theoretic framework. The strictly dominant Nash equilibrium is consistent with the present regime. The payoffs also conform to the policy arguments by the two countries negotiating to maximize own net welfare. The findings justify Indias insistence for MB treatment of wheat, as the loss from untreated wheat would be devastating for India. On the other hand, the present policy of nuclear irradiation of mangoes is the best strategy for US; however, the difference in payoff with complete ban and HWT strategies ranges within 2 to 4 per cent of the net welfare gains. This shows that SPS standards are more critical for the developing world. The results show that it is more welfare augmenting for both the countries, individually as well as jointly, to adopt moderate level of SPS standards instead of complete ban or complete liberalization. As a possibility for future research, a multilateral, multi-commodity negotiation process can be explored in a general equilibrium framework.