BA 187 International Trade Homework #5: Tariffs and other Protectionist Policies

A. What do increasing returns to scale do to the ability of trade theory to predict patterns of trade between countries? Increasing returns to scale in an industry generally reduces the ability of trade theory to predict patterns of trade. The gains to scale tend to offset any factor considerations in a good’s cost of production. Thus many IRS trade models have the property that factor intensity/endowments do not matter for where the good is produced matters. Often what matters is which country is first to market which may be influenced by technology or may simply be a historical accident. This type of indeterminacy is not always the case. The Product cycle model and the Linder model have well-defined, but evolving, patterns of trade associated with them. You should be able to provide specific examples of indeterminacy and determinacy in trading patterns for different IRS models. 1. Size Matters After All. Recognizing that economies of scale exist in certain industries makes trade theory more “realistic” but it has a number of disturbing implications for the traditional “mutual gains from trade” argument.

B. Increasing returns to scale is said to introduce potential conflict between countries, since each country is better off if it can increase its production in these types of industries. Evaluate this statement for Krugman’s model of a monopolistically competitive industry. Look at the slides for the Krugman model used in class. Increasing the size of the market allows firms to reap IRS, leading to more varieties in the single international market than when there were two separate national markets. It also says, however, that there will be fewer firms in total across both countries after trade. The model says nothing about where these new, but fewer, firms will be located. The potential conflict in the Krugman model is not over the scale of any single firm, but rather over where the new firms are located after trade is opened up. Nations “win” by having more of the new firms locating in their country. Think of the auto industry; as the industry has become international, the variety of types of cars has increased even as the number of firms has fallen. 1. Size Matters After All. Recognizing that economies of scale exist in certain industries makes trade theory more “realistic” but it has a number of disturbing implications for the traditional “mutual gains from trade” argument.

C. What does the specialization necessary to attain economies of scale say about the Stolper-Samuelson result? (i.e. Does trade equalize relative factor returns across countries? Do some factors win and other factors necessarily lose with trade?) The Stolper-Samuelson effect may fail to hold with IRS. Why? 1. Trade patterns don’t necessarily depend on factor intensity and endowments under IRS, so no guarantee good uses the abundant factor intensively as relative return SS result requires. 2. IRS means that possible for both factors to gain in absolute terms with specialization. Remember IRS means double capital and labor more than doubles output. Hence it is not only possible, but likely that return to both factors increases under IRS even if country specializes in a good which uses its scarce factor intensively.

2. What Goes Around, Comes Around (maybe) A. If a tariff is imposed to reduce imports, the balance of trade will surely improve. T, F, or U? Explain briefly. B. A tariff targeted towards decreasing unemployment may eventually generate an increase in aggregate unemployment instead. T, F, or U? Explain briefly. Both are Uncertain for the same reason. If we assume the tariff has no effects on the level of the nation’s exports or the level of its exchange rate then it is likely that the balance of trade (X – Im) will improve (A. = T) and that aggregate unemployment will fall (B. = F). If the tariff has negative effects on exports, either directly by lowering ROW incomes or indirectly by appreciating the domestic currency, then fall in exports offsets the effects of the tariff on the trade balance and the level of aggregate unemployment. Since no info is given about the size of the negative effects on exports, the best answer is U to both parts, with a reason.

3. Waiting for WTO? Four men are discussing why the U.S. should provide special support for its high-technology industries. Which of these statements are valid arguments for the United States to have a policy targeting these industries? Vladimir: “They deserve protection because they hold the prospect for rapid future growth...” Uncertain. It is not enough that an industry have potential for rapid future growth, trade policy is only justified if the industry will be more competitive than existing firms and will not develop otherwise because of pre-existing barriers to entry. We are of course making the infant industry argument for temporary protection of the industry. So Vladimir is only partly correct. Estragon: “No, rather they provide inputs to many other industries, and …’ False in general. A country benefits from cheaper imported inputs rather than more expensive protected domestic inputs. Protecting home input industries will raise costs of domestically produced goods and also reduce the competitiveness of Home exports that use these inputs.

3. Waiting for WTO? Four men are discussing why the U.S. should provide special support for its high-technology industries. Which of these statements are valid arguments for the United States to have a policy targeting these industries? Lucky: “Fool! They generate technology that benefits the whole economy!” True, to the extent that an industry generates external economies of scale, trade policy benefiting the industry benefits the country as a whole, and perhaps even the world. We should note that it is very difficult to identify the scope of these spillovers, so we might take this argument with a grain of salt. Pozzo: “There’s no call to be rude. Its most certainly because they are challenged by government-supported foreign competitors.” False, foreign subsidies reduce the gains to be captured in the industry. Subsidies to domestic firms simply reduce the profits available in the industry even further. The only winners of a subsidy competition are consumers in the 3 rd country.

4. Copper-bottoming Price, P Quantity, Q SHSH $.65 $ DHDH A. Consumer surplus rises by areas: a + b + c + d = $33.75 million B. Producer surplus falls by area: a = $19.5 million C. Government revenue falls by area: c = $6 million D. Gain from removing protection: b + d = $8.25 million Need to assume that the Demand and Supply curves are linear. a=$19.5 b= $4.5 c=$6 d=$3.75 E. Disagree. Tariff is clearly paid for by domestic consumers who face higher price than rest of world. In this case, removing tariff lowers price to consumers. Domestic Market

5.A. Import Quota for Small Country Price, P Quantity, Q PWPW MD 3. Market effects of tariff and a quota are identical but not welfare effects. no 5. Quota brings no Government revenue increase of a tariff. Who quota profit or rent earns this quota profit or rent depends on structure of quota. 4. Consumer surplus, producer surplus and associated Deadweight loss (= pro’dn loss + consump loss) are identical. XS’ equivalent tariff, t q, 2. There exists an equivalent tariff, t q, for any quota that has same result. tqtq Q0Q0 XS World Market PqHPqH 1. Import quota level set at Q q. Raises domestic P q H,, ROW price same. QqQq Quota

5.B. Import Tariff for Small Country Price, P Quantity, Q SHSH PWPW D0D0 DHDH 2. Consumer surplus falls by areas: a + b + c + d 3. Producer surplus rises by area: a 4. Government revenue rises by area: c 5. Deadweight loss (cost of protection): b + d (= pro’dn loss + consump loss) a bcd STST DTDT PTPT 1. Import tariff, t, raises domestic price P T = P W + t for small country. t S0S0 Home Market

3. Producer surplus rises by area: a 4. Government subsidy (cost) is area: a+b b a 5.C. Domestic Prod’n Subsidy Price to Consumer, P Quantity, Q SHSH D0D0 DHDH 2. Consumer surplus unchanged. 5. Deadweight loss (cost of policy): b (= pro’dn loss) PWPW S0S0 Home Market PW+sPW+s S su b 1. Domestic subsidy, s, raises price received by producers to P W + s. Price to consumer unchanged at P W. s S H sub 6. Domestic prod’n rises, domestic demand stays unchanged, level of imports falls.

6. The Next Big Thing, Again Two firms, one industry, new information appliance. –Produce or Not Produce? Payoffs to firms given strategy choices of each given in table. Foreign firm will always produce the new good because their payoff is higher for this strategy regardless of home firm strategy. Home firm will never produce the new good because given foreign firm’s best strategy to produce, Home’s best choice is no prod’n. To induce Home to produce, their payoff to producing when foreign firm produces must be larger than zero (which they get if they don’t produce). Subsidy must be 30+ for this to occur. ForeignHome ProduceNo Prod’n Produce No Prod’n