We develop a political economy model where loss aversion and reference dependence are important in shaping people's preferences over trade policy. The policy implications of the augmented model differ in three ways: 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; protection following a single negative price shock will be persistent; and irrespective of the extent of lobbying, there will be a deviation from free trade that favors loss-making industries. The augmented model explains protections of the US steel industry since 1980.

We examine the effect of regionalism on unilateral trade liberalization using industry-level data on applied most-favored nation (MFN) tariffs and bilateral preferences for ten Latin American countries from 1990 to 2001. We find that preferential tariff reduction in a given sector leads to a reduction in the external (MFN) tariff in that sector. External liberalization is greater if preferences are granted to important suppliers. However, these “complementarity effects” of preferential liberalization on external liberalization do not arise in customs unions. Overall, our results suggest that concerns about a negative effect of preferential liberalization on external trade liberalization are unfounded.