Trade Policy: Arguments Appleyard & Field (& Cobb): 14 and 15 Krugman & Obstfeld: Chapters 9 and 11

Today’s Lecture Traditional Arguments for Protection Infant-Industry, Terms-of-Trade, Anti-Dumping, Offsetting a foreign subsidy, Aggregate unemployment, Promoting a particular industry, National security, Externalities Strategic Trade Policy Tariff to Extract Foreign Monopoly Profit Economies of scale & Duopoly Export Subsidy & Duopoly

Analysing a Policy Proposal: Questions to Ask When you hear an argument about any policy, you should ask: Are the objectives desirable? Does the argument make sense? = what are the critical assumptions needed to make the argument consistent? is there side-effects? is it possible to implement the policy? Who gains, who losses? What is the net effect? Does a more efficient way(s) to achieve the objectives exist?

The Infant Industry Argument There is a potential comparative advantage that cannot be realized in the short run due to foreign competition. However, given a temporary tariff, domestic industry is able to mature, that is, it will achieve a reduction in unit cost by realizing the economies of scale OR trough learning-by-doing

Analysing the Infant Industry Argument Objective to realize a potential comparative advantage Consistency Key assumption: There is a market failure (external economies of scale, imperfect capital markets…). If this does not hold, you should ask why doesn’t the industry proceed on its own? Implementation Problem with identifying the right industries Time consistency: will the protection eventually become permanent?

Consumer and Producer Surplus Price (P) In a partial equilibrium approach we can use the concepts of consumer and producer surplus Both reflect the fact that there is only one market price Hence, there are consumers who would have been willing to pay more for the product Similarly, all but the “last” unit is produced with lesser marginal cost than the market price received S = marginal cost of production consumer surplus P producer surplus D Quantity (Q)

The Impact of Import Tariff: The Small-Country* Case * Small country = cannot affect world prices Increase of producer surplus and government income Loss of consumer surplus SD SD P P (1+τ)Pint (1+τ)Pint increase of producer surplus tariff to the government Loss of consumer surplus deadweight loss deadweight loss Pint Pint DD DD Q imports after tariff Q imports after tariff imports in free trade imports in free trade

Analysing the Infant Industry Argument Winners and losers Protected producers win Government gets tariff revenue Consumers lose in the short-run, but win in the-long run IF protection leads to higher efficiency and thus lower prices Net impact IF efficiency improves the net effect for the country and the world is positive

The Impact of Subsidy to Import-Competing Industry (Small Country Case) SD SD P P increase of producer surplus Cost to the government efficiency loss P P DD DD imports after the subsidy Q imports after the subsidy Q imports in free trade imports in free trade

Analysing the Infant Industry Argument Alternative policy Subsidising the infant industry would deliver the same result with less cost, i.e. a more efficient policy exists Conclusion In the presence of market failure, the infant industry argument is consistent and delivers net benefits. However, identifying the right industry and eventually ending the protection is problematic. Further, the objective could be achieved more efficiently by subsidising the infant industry. For a fresh view on the infant industries see Hausman & Rodrik (2002): Economic Development as Self-Discovery. NBER Working Paper 8952. The “Economics Focus” section of the Economist in Feb 27th 2003 introduces the main points of this paper.

Terms-of-Trade Argument Restrictive trade policy can improve country’s terms-of-trade and thus increase its welfare Objectives increase the ratio PX/PM ( = to make imports cheaper) increase country’s aggregate welfare Consistency & Implementation IF the country is large enough, imposing a tariff may result enough decrease in world price and thus improvement in country’s terms of trade IF the benefits from improved terms of trade are larger than the costs (deadweight loss and reduction of exports due to tariff), country’s welfare increases optimum tariff = a tariff structure that maximizes country’s welfare

Single Market, Two Countries, Free Trade Country B Country A P P SA SB DB DA Q Q

Single Market, Two Countries, Free Trade Country B Country A P P SA SB DB DA Q Q Countries A and B have different supply curves (cost of production) and demand curves (preferences). In free trade equilibrium the world price is such that country B is willing to export the same quantity as country A is willing to import.

Single Market, Two Countries, Tariff Country B Country A P P SA SB DB tariff DA Q Q Price in Country A = Price in country B + tariff. If the price in country B would remain constant after a tariff is set, country B would be willing to export more that country A would be willing to import → price in country B must decrease (next slide)

Effect of a Tariff in a Single Market and Two-Countries Country B Country A P P DA SA DB SB PA e a D b tariff PFT price decrease in country B C PB Q Q Country A: Loss of consumer surplus = e+a+D+b; increase of producer surplus = e; Increase of government revenue = C+D. Gain for Country A = gains–losses = (e+C+D)-(e+a+D+b) = C – a – b. That is, if C > a + b country A has gained from the imposition of the tariff (due to lower prices of imports before tariff).

Impact of Elasticises Country B Country A P P DA SA SB DB e a D b C Q tariff e a D b PFT price decrease in country B C PB Q Q The more elastic in the exporting market and the more inelastic in the importing market supply and demand are, the less chances the importing country has on gaining from tariff

Analysing the Terms-of-Trade Argument Winners Home country’s import-competing producers Home country’s government Foreign country’s consumers Losers Foreign country’s exporters Home country’s consumers Net Impact Home country gains in aggregate, if the benefits from lower import prices are larger than the costs (deadweight costs and the lost of exports) of tariff Foreign country always loses more than the home country gains → loss in world welfare

Analysing the Terms-of-Trade Argument Alternative policy if the objective is just to improve terms of trade, tariff is the most effective instrument Other considerations: retaliation Conclusion a case for terms-of-trade argument exists for large countries. However, this requires that a) suitable conditions exist and b) no retaliation

The Antidumping Argument Foreign firms’ dumping into the home country constitutes a threat to domestic producers. Thus we need to impose an antidumping duty to prevent this unfair practice. Objective to stop an unfair trading practice (dumping) Consistency: Depends on the type of dumping Definitions of dumping Economics: 3rd degree price discrimination (different price in separate markets when there is no difference in the production cost) Trade laws: selling below the cost or “fair value” Types for dumping: a) persistent, b) predatory, c) sporadic

Rationale for Persistent Dumping: Domestic Monopoly Domestic monopoly is able to get Pint from the world market  Pint = minimum marginal revenue Price MC The monopolists maximizes profits by selling QD at home for price PD and QT-QD abroad for Pint PD PA MRT Pint D MRA QD QA QT Quantity exports

Rationales for Temporary Dumping Predatory A foreign firm sells at low price in order to eliminate competition and eventually to reap monopolist profits Sporadic / Cyclical a foreign firm sells a temporary surplus of its production to whatever price it is able to get (i.e. possibly below the production cost)

Impact of Dumping Persistent dumping Predatory dumping Losers: import-competing home firms, foreign consumers Winners: foreign (dumping) firm, domestic consumers (compared to the regime of antidumping duties, which would have the same impact as any tariff) Positive net welfare effect (compared to a tariff regime) Predatory dumping Losers: impost-competing home firms, home and foreign consumers Winner: foreign (dumping) firm Negative net welfare effect (compared to a tariff regime) Sporadic dumping Losers: import-competing home firms Winners: home consumers, foreign firm Net welfare effect is not evident, though does not seem to justify protection if it is a short-term phenomenon

Welfare Effect of an Antidumping Duty The impact of an antidumping duty is the opposite to those discussed in the previous slide Is an antidumping duty desirable? To prevent predatory dumping: yes To prevent persistent dumping : no Alternative policy if we want to promote domestic industry, again subsidy is a more efficient instrument The problem: How to distinguish between predatory and other kinds of dumping?

Argument for a Tariff to Offset Foreign Subsidy The foreign government subsidizes the foreign firm. This unfair subsidy should be matched with a tariff to restore equal footing to the home and foreign industry. Objective to offset a distortion due to a foreign subsidy Consistency The subsidy moves foreign supply curve downwards, a tariff moves it upwards → a tariff can be used to offset the impact of a subsidy

Analysing the Argument for a Tariff to Offset Foreign Subsidy Winners and losers as usual, except that there is a transfer from foreign government to the home government Positive net welfare effect less distortions more efficient allocation of resources However, the first best solution would be that the foreign government would stop the subsidies (collecting taxes to pay for a subsidy will distort the foreign economy and thus decrease world efficiency) Problem: Identifying when a foreign subsidy is occurring

Argument for a Tariff to Reduce Aggregate Unemployment Imposition of a tariff results a shift of demand from imports to domestic goods, which increases the output of import-competing firms. Further, the new workers hired will use their salaries, setting off a Keynesian multiplier process. Hence also other industries will expand and create new jobs.

Analysing the Impact of a Tariff to Aggregate Unemployment Objective to decrease aggregate unemployment Consistency in the models presented in this course, we have assumed full employment (thus the discussion here is quite informal) a tariff/quota will increase the domestic production of the protected good (and hence demand for labour in this sector) however, it will decrease exports due to decrease of the foreign country’s purchasing power, retaliation and appreciation of the home currency the net impact on unemployment is ambiguous, i.e. the policy may not accomplish the objective

Analysing the Impact of a Tariff to Aggregate Unemployment Winners (home country) producers of the import-competing good previously unemployed, who get a job in the import-competing industry government (tariff revenue) Losers (home country) consumers producers of the export good previously employed, who lose their jobs in the export good industry Net Impact depends on the (possible) net decrease of unemployment rate and the efficiency cost of the tariff

Analysing the Impact of a Tariff to Aggregate Unemployment Alternative policy expansionary fiscal and/or monetary policies would increase employment more directly Conclusion While tariff might decrease unemployment under some circumstances, macroeconomic policies would do the job more efficiently and with higher chance of success

Tariff to Increase Employment in a Particular Industry Tariff on imports will increase the domestic production of the import-competing goods and hence labour will move to this sector. We do not care that this may occur as an expense of the other sectors. Objective to increase the production of and reallocate labour to the import-competing industry Consistency setting a tariff will lead to the objective Negative net impact due to efficiency loss Alternative policy again, subsidising the import-competing industry would result the same outcome with less cost

The National Defence Argument for a Tariff Some industries are vital during a time of war or national emergency. Thus these industries must be protected by imposing a sufficient tariff to ensure self-sufficiency. Problem: Identifying the vital industries More efficient policies: stockpiling vital goods, creating joint business-government R&D companies, subsidizing the domestic production

The Externality Argument for Tariffs There is a negative externality in consumption of imports OR There a positive externality in producing import-competing products → Setting a tariff on imports is a way to increase social welfare

Analysing the Externality Argument Objectives To increase social welfare by decreasing the consumption of a imported good that generates an adverse externality To increase social welfare by increasing the production of a import-competing good, which would generate positive externality effects Externalities: costs or benefits arising from an economic activity that affect somebody other than the people engaged in the activity and are not fully reflected in prices → analysis based on consumer and producer surpluses does not apply

Analysing the Externality Argument Critical questions How to measure the size of the externality? Why restrict only consumption of imports, but not that of the domestic produced good? Alternative policy Negative externality: impose a tax on consuming the product, regardless of the location of manufacturing Positive externality: Subsidise the domestic industry

Concluding Remarks of Traditional Arguments for Protection “...most deviations from free trade are adopted not because their benefits exceed their costs but because the public fails to understand their true cost” “[However] ...we need to realize that economic theory does not provide a dogmatic defence of free trade” Krugman & Obstfeld: International Economics: Theory and Policy. Chapter 10.

Strategic Trade Policy Models Introduces the theory of industrial organization (IO) to the context of international trade First papers published in early 1980s A variety of models that share common features: Imperfect competition Recognized interdependence Economies of scale (often, not always)

Case 1: Tariff to Extract Foreign Monopoly Profit Market Structure Home country faces a foreign monopoly that is the world’s only supplier Objective to increase home country’s welfare Consistency theoretically sound argument exists (next slide) Welfare Impact Home country wins, foreign monopoly loses Negative net effect to world welfare James Brander & Barbara Spencer (1984): Tariff Protection and Imperfect Competition. In Kierzkowiski (ed.) Monopolistic Competition in International Trade. Oxford University Press

Tariff to Extract Foreign Monopoly Profit Imposition of a tariff increases prices and decreases quantity → loss of consumer surplus However, part of the monopolists profits are transferred to the government If government revenue is larger than the loss of consumer surplus, the country gains Price P2 Loss of consumer surplus P1 MC+t=AC+t Government revenue tariff MC=AC D MRA Q2 Q1 Quantity For simplicity, we assume a horizontal marginal cost curve (just to make the graph easier to draw, the model does not depend on it).

Case 2: Economies of Scale in a Duopoly Framework Market Structure Duopoly = two firms (home and foreign) Objective increase production and exports of the home firm Consistency requires: economies of scale firms behave strategically (=take each others actions into account) Welfare Impact Home firm wins, foreign firm loses, net impact depends on the starting point Paul Krugman (1984): Import Protection as Export Promotion: International Competition in the Presence of Oligopoly and Economies of Scale. In Kierzkowski (ed.) Monopolistic Competition in International Trade

Reaction Curves The HH curve plots the optimal production of the home firm given the production of the foreign firm (FF curve, vice versa) Reaction curve plots the profit maximizing amounts of production given the other firm’s production Both firms can affect the market price by producing more/less. Then if the foreign firm is e.g. producing a lot, the home firm will maximize profits by producing a little (and not pushing prices further down) In equilibrium, both firms are behaving optimally, given the other’s behaviour H F Foreign firm sales F H Home firm sales

The Interdependence of Marginal Costs and Output MM curve: given a level of output, what is the marginal cost? (downward sloping, since we assume economies of scale) QQ curve: given a marginal cost, what is the profit maximizing output? (downward sloping, i.e. the lower the marginal cost, the larger the output) An import tariff shifts the QQ curve rightwards: there will be less supply from the foreign competitor. That is, for any marginal cost, the firm now maximizes profit with more output. Q Q’ Marginal cost M M Q’ Q Output

The Impact of a Protection to Reaction Curves The home country imposes a import tariff → home firm increases output → more economies of scale → decrease of marginal cost → reaction curve shifts rightwards → Foreign firm decreases output → less economies of scale → increase in marginal cost → reaction curve shifts downwards → Production increases in the home country and decreases in the foreign country H Foreign firm sales F E E’ F H Home firm sales

Is the Economies of Scale in Duopoly an Model an Argument for Protection? Krugman: No. This is just an explanation for why e.g. Japan’s car industry expanded when the domestic producers were initially protected. If this would be used as a basis for protection, the other country would retaliate. The result would be relatively unaffected market shares and less trade Further, to expand one sector in the economy means that resources are taken away from other sectors

Case 3a: Export Subsidy in Duopoly Market Structure Two firms (home and foreign) competing in a third market (no sales in home or foreign market) Objective To increase the sales of the home firm Consistency (key assumptions) firms behave strategically (take each others actions into account) both know each others reaction curves Note that we are not assuming economies of scale here Welfare Impact Home firm wins, foreign firm loses, net impact is not evident

The Impact of a Export Subsidy to Reaction Curves Foreign firm’s sales The home firm wants to move to E’ and announces that it will produce QH’* The foreign firm does not believe the threat (if foreign firm continues to produce at QF* it is optimal for home firm to choose QH*) However, export subsidy shifts the home firm’s reaction curve rightwards and the threat becomes credible H H’ F QF*(QH*) E E’ QF*(QH’*) F H H’ QH*(QF*) QH’*(QF*) Home firm’s sales

Case 3b: Export Subsidy in Duopoly Market Structure Two firms (home and foreign) Such economies of scale that if both produce, both lose Objective To get home firm to produce and foreign firm not to produce Consistency (key assumptions) Sufficient economies of scale (for a natural monopoly to exits) Firms behave strategically Welfare Impact Home firm and home country wins, foreign firm and foreign country loses, net impact not evident

Hypothetical Example: Airbus and Boeing Airbus gets 10 as subsidy if it produces Without subsidy Airbus Boeing Produces Does not produce Airbus: -5 Airbus: 0 Boieng: -5 Boieng: 100 Airbus: 100 Boieng: 0 Airbus Boe i ng Produces Does not produce Airbus: 5 Airbus: 0 Boieng: -5 Boieng: 100 Airbus: 110 Boieng: 0 Without a subsidy the outcome of the game is uncertain. With a subsidy, producing becomes a dominant strategy for Airbus: whatever Boeign does, it is profitable for Airbus to produce. Knowing this, Boeign will not produce, and we have an unique Nash equilibrium [Airbus produces, Boeign does not produce].

Strategic Government Interaction Setting Governments choose trade policy given the trade policy of other governments Objective To maximize national welfare Key Assumptions large countries (terms-of-trade effect exists → optimum tariff > 0) Welfare Impact When countries individually choose optimum tariff suboptimal trade equilibrium follows

Tariff Game (1) In a two-country case, both countries can use the terms-of-trade effect → optimum tariff>0 → Free trade is not an equilibrium T2(T1) Country 1’s tariff rate T2*(T1*) T1(T2) T1*(T2*) Country 2’s tariff rate

Tariff Game (2) Country 1 Country Free trade would maximize the world welfare However, protection is dominant strategy for both countries → the Nash equilibrium is suboptimal → A proper mechanism (institutional setting) could enable free trade to be an equilibrium → Trade negotiations Country 1 Country 2 Free Trade Protection Counry 1: 100 Counry 1: 120 Country 2: 100 Country 2: 50 Counry 1: 50 Counry 1: 60 Country 2: 120 Country 2: 60

Concluding Remarks on Strategic Trade Policy Imperfect markets create an opportunity where tariff / quotas / subsidies may increase country’s welfare (given no retaliation) However, identification and implementation of strategic trade policies is not easy Further, “the extent of the potential gains seems quite small” (Krugman, Pop Internationalism, p. 112) However, we have shown that a suboptimal equilibrium may emerge