Geographic politics, loss aversion and trade policy: The case of cotton in China

Abstract

AbstractThis paper seeks to explain how China's trade policy responses to world price fluctuations by considering the role of loss aversion and reference dependence. In order to analyse the effect of loss aversion on trade distortion in one‐party dominated countries where monetary contribution may not be feasible, we modify the model of Freund and Özden (American Economic Review, 2008, 98, 1675) to obtain a model in which loss aversion no longer works through monetary contribution but through political supports from politically sensitive groups. We then test the theoretical predictions by using data from China's cotton sector. The modified theoretical model predicts that loss aversion and reference dependence still have effects on the trade distortion in countries where monetary contribution may not be feasible and that the trade distortions are higher (lower) when the world price is lower (higher) than the targeted domestic reference price, which measures reference dependence. Our empirical evidence from China's cotton sector supports these theoretical predictions.