IMPORT TARIFFS AND QUOTAS UNDER IMPERFECT COMPETITION 9 1 Tariffs and Quotas with Home Monopoly 2 Infant Industry Protection 3 Tariffs with Foreign Monopoly 4 Policy Response to Dumping 5 Conclusions IMPORT TARIFFS AND QUOTAS UNDER IMPERFECT COMPETITION

Tariffs and Quotas with Home Monopoly We will assume a Home monopolist. A single firm selling a homogeneous good. Firm has influence over price charged—charge prices above marginal costs. Free trade introduced many new firms into the market, which eliminates the monopolist’s ability to change a price greater than MC. Free trade results in a perfectly competitive Home market. Because the firm has market power however, tariffs and quotas affect the trade equilibrium differently. International Economics

Tariffs and Quotas with Home Monopoly Figure 9.1 Monopoly no-trade equilibrium produces QM where MR=MC. PM comes from D A perfectly competitive market would produce where MC = D giving PC and QC. Price Monopoly equilibrium Notice that quantity is lower and price is higher in a monopoly than in a perfectly competitive market. PM A QM Marginal cost, MC PC B QC Figure 9.1 No-Trade Equilibrium In the absence of international trade, the monopoly equilibrium at Home occurs at the quantity QM, where marginal revenue equals marginal cost. From that quantity, we trace up to the demand curve at point A, and the price charged is PM. Under perfect competition, the industry supply curve is MC, so the no-trade equilibrium would occur where demand equals supply (point B), at the quantity QC and the price PC. Perfect competition equilibrium Home demand, D Marginal revenue, MR Quantity International Economics

Tariffs and Quotas with Home Monopoly Figure 9.2 Under free trade, the Monopolist will take fixed world price, PW, and set it equal to MC to determine quantity, S1. With free trade, Home faces Foreign export supply of X* which is the Monopolist’s new demand and MR curve Price No-Trade Monopoly This is the same result as a perfectly competitive market would give. Free Trade Equilibrium At PW, consumers demand D1 which leads to imports of M1 = D1 – S1. A PM MC Figure 9.2 Home Monopoly’s Free-Trade Equilibrium Under free trade at the fixed world price PW, Home faces Foreign export supply of X * at that price. Because the Home firm cannot raise its price above PW without losing all of its customers to imports, X* is now also the demand curve faced by the Home monopolist. Because the price is fixed, the marginal revenue MR* is the same as the demand curve. Profits are maximized at point B, where marginal revenue equals marginal costs. The Home firm supplies S1, and Home consumers demand D1. The difference between these is imports, M1 = D1 − S1. Because the Home monopoly now sets its price at marginal cost, the same free-trade equilibrium holds under perfect competition. B S1 PW X* = MR* D1 MR D M1 QM Quantity International Economics

Tariffs and Quotas with Home Monopoly Suppose Home imposes a tariff, t, on imports Price at Home increase from PW to PW+t. The foreign export supply curve shifts up to X*+t. Again this is the new demand curve and marginal revenue curve for the monopolist. Maximizing profits where MR=MC at point C gives Home supply of S2 and a Home demand of D2. Since Home production increases and Home demand falls, imports fall to M2 = D2 – S2. International Economics

Tariffs and Quotas with Home Monopoly Figure 9.3 At the new price, supply rises to S2, demand falls the D2, and imports fall to M2 = D2-S2. Price With the tariff, price increases by t, X*+t becomes the new Demand and MR curve faced by the Home monopolist. Equilibrium With Tariff MC We have a new trade equilibrium with the tariff, at C. PM Free Trade Equilibrium C S2 D2 M2 PW+t X*+t = MR* Figure 9.3 Tariff with Home Monopoly Initially, under free trade at the fixed world price PW, the monopolist faces the horizontal demand curve (and marginal revenue curve) X*, and profits are maximized at point B. When a tariff t is imposed, the export supply curve shifts up since Foreign firms must charge PW + t in the Home market to earn PW. This allows the Home monopolist to increase its domestic price to PW + t, but no higher, since otherwise it would lose all of its customers to imports. The result is fewer imports, M2, because Home supply S increases and Home demand D decreases. B S1 PW X* D1 D M1 Quantity International Economics

Tariffs and Quotas with Home Monopoly Figure 9.3 Consumer surplus falls by (a+b+c+d). Producer surplus rises by (a). Government revenue increases by (c). Price We are again left with a deadweight loss of (b+d). MC PM PW+t X*+t = MR* Figure 9.3 Tariff with Home Monopoly Initially, under free trade at the fixed world price PW, the monopolist faces the horizontal demand curve (and marginal revenue curve) X*, and profits are maximized at point B. When a tariff t is imposed, the export supply curve shifts up since Foreign firms must charge PW + t in the Home market to earn PW. This allows the Home monopolist to increase its domestic price to PW + t, but no higher, since otherwise it would lose all of its customers to imports. The result is fewer imports, M2, because Home supply S increases and Home demand D decreases. The deadweight loss of the tariff is measured by the area (b + d). This result is the same as would have been obtained under perfect competition because the Home monopolist is still charging a price equal to its marginal cost. D2 a b c d PW X* D1 M2 D M1 Quantity S1 S2 International Economics

Tariffs and Quotas with Home Monopoly Effect of Home Quota Now we can look at the effect of a quota and compare it to the effect of a tariff. The quota will end up with higher prices for Home consumers since it allows the monopolist to keep its market power, which we know leads to higher prices. This is another reason why the WTO has encouraged countries to replace quotas with tariffs. International Economics

Tariffs and Quotas with Home Monopoly Figure 9.4 Under a tariff, the monopolist produces at C, selling S2, charging PW+t. Consumers demand D2, giving M2 imports. Price MC MR D - M2 Under free trade, the monopolist produces at B, selling S1, charging the world price, PW. Consumers demand D1, giving M1 imports. Under Quota, original demand, D, shifts back by the amount of the quota, M2. New demand at D-M2 with new MR Quota, M2 P3 D3 E S3 With a quota, the monopolist sets quantity where new MR=MC, at E and S3, with price from new demand, P3. At P3, demand is D3, giving Imports of M2, same as tariff. C S2 D2 PW+t B S1 PW Figure 9.4 Effect of Quota with Home Monopoly Under free trade, the Home monopolist produces at point B and charges the world price of PW. With a tariff of t, the monopolist produces at point C and charges the price of PW + t. Imports under the tariff are M2 = D2 − S2. Under a quota of M2, the demand curve shifts to the left by that amount, resulting in the demand D − M2 faced by the Home monopolist. That is, after M2 units are imported, the monopolist is the only firm able to sell at Home, and so it can choose a price anywhere along the demand curve D – M2. The marginal revenue curve corresponding to D − M2 is MR, and so with a quota, the Home monopolist produces at point E, where MR equals MC. The price charged at point E is P3 > PW + t, so the quota leads to a higher Home price than the tariff. D D1 Quantity Imports, Quota Imports, Tariff. M2 Imports, Free Trade, M1 International Economics

Tariffs and Quotas with Home Monopoly Home Loss due to the Quota Since price rises more with a quota than a tariff, it is clear that consumers will lose more surplus under a quota than they would under a tariff. Although we will not make a detailed calculation, you can expect that the deadweight loss will always be higher for a quota than for a tariff. The higher price benefits the monopolist but harms the Home consumers and creates an extra deadweight loss due to the exercise of its monopoly power. International Economics

U.S. Imports of Japanese Automobiles A well known VER occurred in the 1980s when the U.S. limited the imports of cars from Japan. In the early 1980s, the U.S. suffered a deep recession and unemployment in the auto industry rise sharply. In 1980 the United Automobile Workers and Ford Motor Comp. applied to the International Trade Commission (ITC) for protection under Article XIX of GATT and Section 201 of U.S. trade laws. International Economics

U.S. Imports of Japanese Automobiles The ITC determined that the U.S. recession was a more important cause of injury to the auto industry than increased imports. It did not recommend that the auto industry receive protection. In response, several congressmen from states with auto plants pursued other means. A bill was introduced in the U.S. Senate to restrict imports. Aware of this, the Japanese government announced it would “voluntarily” limit Japan’s export of autos to the U.S. International Economics

U.S. Imports of Japanese Automobiles By 1988, Japanese exports were below the VER because Japanese firms were producing their cars in the U.S. Price and Quality of Imports Under the VER, the average price rose $2900 from 1980 and 1985. Of that, $1100 was due to quota rents earned by Japanese producers. $1650 was due to quality improvements in Japanese cars. $150 is what prices would have risen under free trade. International Economics

U.S. Imports of Japanese Automobiles Quota Rents If we take the quota rents per car and multiply it by the number of imports, we can estimate the total rents to be about $2.2 billion. This is the lower estimate of the annual cost of quota rents for autos we saw in Table 8.4. The Japanese firms’ stock prices rose during the VER period after it was clear that the Japanese government would administer the quotas to each producer. Japanese firms had a strong incentive to export the more expensive models—quality upgrading. International Economics

U.S. Imports of Japanese Automobiles Price of U.S. Cars Under the VER, the average price of U.S. cars rose very rapidly—43% increase from 1979 to 1981. This was due to the exercise of market power by the U.S. producers, who were sheltered by the quota. The quality of U.S. cars did not rise by as much as the quality of Japanese imports seen in figure 9.5. The fact that the U.S. and Japanese firms were both able to raise prices substantially indicates the policy was VERY costly to U.S. consumers. International Economics

U.S. Imports of Japanese Automobiles Figure 9.5 Figure 9.5 Prices of Japanese Car Imports Under the “voluntary” export restraint (VER) on Japanese car imports, the average price rose from $5,150 to $8,050 between 1980 and 1985. Of that $2,900 increase, $1,100 was the result of quota rent increases earned by Japanese producers. Another $1,650 was the result of quality improvements in the Japanese cars, which became heavier and wider, with improved horsepower, transmissions, and so on. The remaining $150 is the amount that import prices would have risen under free trade. International Economics

U.S. Imports of Japanese Automobiles Figure 9.6 Figure 9.6 Prices of American Small Cars Under the VER on Japanese car imports, the average price of U.S. cars rose very rapidly when the quota was first imposed: from $4,200 in 1979 to $6,000 in 1981, or a 43% increase over two years. Only a very small part of that increase was explained by quality improvements, and in the later years of the quota, U.S. quality did not rise by as much as for the Japanese imports. International Economics

U.S. Imports of Japanese Automobiles The GATT and WTO Because the export restraint was enforced by the Japanese instead of the U.S., it did not necessarily violate Article XI of GATT. Countries should not use quotas to restrict imports, but this was not a quota. This loophole was closed when the WTO was established. As a result of this rule, VERs can no longer be used unless they are a part of some other agreement in the WTO. International Economics

Infant Industry Protection Despite losses, nearly all countries use tariffs in the early stages of economic development, often in industries composed of a small number of firms. This means they are more often acting under conditions of imperfect competition. Why? They argue because their industries are too young to withstand foreign competition. If given time to grow, the industries will be able to compete in the future. Some short-term protection from imports is needed. International Economics

Infant Industry Protection This is called the infant industry case for protection. We will assume only one Home firm. Increasing output today will lead to lower costs in the future through learning. Should the Home government intervene with protection? There may be two cases where it is potentially justified: A tariff today increases Home production and lowers future costs. A tariff today increase output and reductions in future costs for other firms in the industry or other industries. International Economics

Infant Industry Protection Figure 9.7 Today, panel (a), the firm loses money at the world price PW The country imposes a tariff so now making zero economic profits, at PW+t, with a dead weight loss of b+d In the Future, panel (b), the firms average costs fall. They can now earn zero economic profits at the world price PW, without the tariff, earning e in producer surplus. Price Price MC MC AC PW+t AC’ Figure 9.7 Infant Industry Protection In the situation today (panel a), the industry would produce S1, the quantity at which MC = PW. Because PW is less than average costs at S1, the industry would incur losses at the world price of PW and would be forced to shut down. A tariff increases the price from PW to PW + t, allowing the industry to produce at S2 (and survive) with the net loss in welfare of (b + d). In panel (b), producing today allows the average cost curve to fall through learning to AC ’. In the future, the firm can produce the quantity S3 at the price PW without tariff protection and earn producer surplus of e. b d PW e D D S1 S2 D1 D2 Quantity S3 Quantity D1 (a) Today (b) Future International Economics

Infant Industry Protection Effect of the Tariff on Welfare To evaluate whether the tariff has been successful, we need to compare the future gain with the present losses. We need to compare (e) with (b+d). If (e) is greater than (b+d) then it was worthwhile. If (e) is less than (b+d), then the costs of protection today do not justify the future benefits. The challenge for government policy is to try and distinguish worthwhile cases from cases that are not. The textbook shows three examples International Economics

Tariffs with Foreign Monopoly Now let’s consider what happens when a Foreign exporting firm has a monopoly. It will be assumed that there is no competing home firm We will show that applying a tariff under a Foreign monopoly leads to an outcome similar to the large country case in Chapter 8. The tariff will lower the price charged by the Foreign exporter. A tariff may now benefit the Home country. International Economics

Tariffs with Foreign Monopoly Figure 9.10 MC rises by the amount of the tariff, t. Loss in consumer surplus is (c+d) and gain in government revenue is (c). Price falls for the exporter to P3, so importing country gets terms of trade gains equal to (e). Welfare depends on (e) versus (d). Price Increase in P is less than t, the increase in MC c d P2 P1 e P3 = P2 – t B Figure 9.10 Tariff with a Foreign Monopoly Under free trade, the Foreign monopolist charges prices P1 and exports X1, where marginal revenue MR equals marginal cost MC*. When an antidumping duty of t is applied, the firm’s marginal cost rises to MC* + t, so the exports fall to X2 and the Home price rises to P2. The decrease in consumer surplus is shown by the area c + d, of which c is collected as a portion of tax revenues. The net-of-tariff price that the Foreign exporter receives falls to P3 = P2 − t. Because the net-of-tariff price has fallen, the Home country has a terms-of-trade gain, area e. Thus, the total welfare change depends on the size of the terms-of-trade gain e relative to the deadweight loss d. MC*+t t t MC* A D MR X2 X1 Foreign Exports International Economics

Tariffs with Foreign Monopoly Effect of the Tariff on Home Welfare With the increase in price, consumers are worse off and consumer surplus falls by (c+d). The increase in price will benefit Home firms, but we have assumed there are no Home firms. Tariff revenue equals the tariff, t, times the amount of imports X2, which is area (c+e). Fall in Home consumer surplus (c+d) Rise in Home government revenue (c+e) Net change in Home welfare (e-d) International Economics

Policy Response to Dumping Our discussion of a Foreign monopolist brings us back to the topic of dumping we discussed in Chapter 6. Dumping occurs when a firm is exporting goods at a price that is below the price in its local market, or below its average cost of production. We now want to understand the policy response in the Home importing country. Under the WTO, an importing country is entitled to apply an antidumping tariff anytime that a foreign firm is dumping its product. International Economics

Policy Response to Dumping Anti-dumping Duty The amount of the antidumping duty is calculated as the difference between the exporter’s local price and the “dumped” price in the importing country. The purpose of the duty is to raise the price of the dumped good and protect domestic producers. The fact that the higher price also raises prices for domestic consumers and causes a deadweight loss for the importing country is not taken into account with deciding on whether or not to apply the tariff. For example, if the local price is $10 and the export price to Home is $6, the antidumping duty is $4—the difference in the local price and the export price. International Economics

Policy Response to Dumping Figure 9.11 Foreign exporters increase their prices to Home due to the threat of anti-dumping duties, which decreases imports from M1 to M2. S Price P b d b+d P2 c c a c P1 Figure 9.11 Home Loss Due to Threat of Duty A charge of dumping can sometimes lead Foreign firms to increase their prices, even without an antidumping duty being applied. In that case, there is a loss for Home consumers (a + b + c + d) and a gain for Home producers (a). The net loss for the Home country is area (b + c + d). M D S1 S2 D2 D1 Quantity M2 M1 Imports (a) Home market (b) Import market International Economics