BA 187 – International Trade Krugman & Obstfeld, Chapter 11 Strategic Trade Policy

Problems with Achieving Free Trade Strategic Interaction and Trade Wars

Strategy & Trade Warfare Two Countries with two policy choices. Free Trade or Protection. Payoff Table at right. Payoffs to each given strategy choice of other. Assume particular structure. Japan U.S. Free Trade Protection 10 20 -10 -5 Assumptions: Each nation chooses protection if other’s policy is taken as given. Each nation better off if both acted jointly to choose free trade. Example of the “Prisoner’s Dilemma” Game Each acting unilaterally chooses to protect, together get worst payoff. If each could credibly commit to free trade, both better off. International agreements one way to enforce cooperation for free trade.

International Trade Agreements General Agreement on Trade and Tariffs, GATT (1947) Multi-lateral commitment to reducing trade barriers, sponsored Kennedy Round (1962 – 67) Tariffs reduced average 35% on 2/3 of manufactured goods. Tokyo Round (1974 – 79) Tariffs fall 1/3 on manufactures, restrict NTB’s, Non-reciprocity principle for developing countries. Uruguay Round (1986 – 93) Tariffs fall 34% on manufactures, agricultural subsidies cut 36%, textile quotas (MFA) phased out, nat’l treatment for services under GATS, establish WTO to replace GATT. Omnibus Trade & Competitiveness Act (1988) Strategic Impediments Initiative, SII (1990)

Strategic Trade Policy I Tariffs in the face of a Foreign Monopolist

Tariff to Gain Foreign Monopoly Profit 1. Foreign monopolist sells q0 in Home market, at price p0 earns excess profits, Profit0. Cost, C and Price, P 2. Home gov’t imposes tariff t, monopolist sets quantity q1 < q0, earns less profit, Profit1. MC+t =AC+t 3. Loss of consumer surplus from higher price. p1 Profit1 4. Gov’t tariff revenue captures part of previous excess monopoly profits. Tariff p0 Profit0 5. Net result to Home is Gain from 4. less Loss in 3. MC=AC 6. Net efficiency loss to world as quantity falls from tariff. D MR Q1 Q0 Quantity, Q

Strategic Trade Policy II Subsidies and Imperfect Competition

Strategy in a Duopoly Model Two firms, one industry, new aircraft decision. Produce or Not Produce. Payoff Table at right. Payoffs to each given strategy choice of other. Assume particular structure. Airbus Boeing Produce No Prod’n -5 100 Features: If both firms choose to produce new aircraft, both suffer losses. If either firm is sole producer, then they make substantial profits. Equilibrium: Advantage to firm that moves first. First-mover captures entire market, no incentive for other firm to enter. No unique equilibrium. A firm could guarantee market if had a credible commitment to enter.

Effects of a Subsidy to Airbus Targeted Gov’t subsidy can provide a credible entry commitment. Assume EU guarantees Airbus a $25 mill. Subsidy to produce new aircraft. New Payoff Table at right. Payoffs to Airbus change. Airbus Boeing Produce No Prod’n 20 -5 100 125 Features: Profitable for Airbus to enter regardless of Boeing strategy. Boeing knows Airbus will enter, so Boeing will not to avoid loss. Equilibrium with Subsidy Subsidy ensures Airbus produces new aircraft & Boeing does not enter. EU Subsidy acts as deterrent to U.S. firm, allows EU industry to capture industry.

Strategic Trade Policy III What Types of Industries might be subsidized?

Strategic Trade Policy Targets Domestic gain from a targeted gov’t export subsidy depends on how gov’t intervention affects strategic interaction between domestic & foreign firms. Argument requires imperfect competition in targeted industry. Depends on form of strategic competition. Credible commitment to large expenditures on capital and R&D can play central role in strategic interaction. If this strategic game occurs early in product lifecycle, it will have major impacts on profitability in mature product phase. Avoid industries where Foreign Gov’t providing subsidies. Matching subsidies “levels the playing field” for domestic firms Industry as a whole likely to face lower prices, and profits. Why export subsidies rather than subsidy to domestic prod’n? Export targeting based on raising profits of domestic firms at expense of foreign rivals. Ignores consumer benefits/costs from policy.

Preferred Industry Characteristics Substantial Barriers to Entry Additional returns expected to exceed cost of subsidy. Serious Foreign Competition or Potential Competition Subsidy should force foreign rivals to cut back capacity. High Concentration in Domestic Industry Domestic industry at least as concentrated as foreign rival. Factor Prices increase little in face of subsidy Lack of strong union, profit-sharing, no key input in fixed supply. Subsidy Targeting most effective when: Domestic industry has cost advantage over foreign firms. Substantial scale/learning economies from increased production. R&D subsidies most effective when: Minimum spillovers to rivals/subsidies aid transfer rival tech. Domestic Industry an especially good candidate if: R&D & capital are major costs or winning product in early development.

Strategic Trade Policy IV Micro-level problems with Strategic Trade Policy.

Problems with Strategic Policies Optimal Policy depends on specific strategic interaction. Firm has beliefs about rival’s actions, each pair of beliefs has different equilibrium outcome and so optimal gov’t policy. If price competition, then optimal policy is an export tax, not subsidy. If more than one domestic firm then different optimal policy. Competition among firms leads to prefer export tax over subsidy. Barriers to entry necessary for policy to secure excess profits. Subsidy brings excess domestic entry, competition, inefficient scale. Difficult to identify excess profit industries from ex post returns. Barriers determined in earlier round of capacity, R&D or advertising. Effect on Domestic Consumers of strategic trade policies. Ignores effects of normally higher prices from strategic policy on consumer surplus.

Problems with Strategic Policies Which Oligopoly to Choose to Promote? If common pool of resources, subsidy to one industry hurts all others. Theoretical result is that indirect losses generally outweigh direct gains. Do not choose industry with highest returns, rather industry that shifts highest profit from foreign rival. How to determine this in real world? Information requirements excessive. Threat of Foreign Retaliation Strategic trade policies are “Beggar thy Neighbor” policies that transfer profits from foreign rivals to domestic producers. Foreign retaliation highly likely, net result is loss to both countries. Capture of Strategic Trade Policies Trade policy susceptible to pressure by special interest groups. Choice of industry not optimal, fewer benefits but same potential loss.

Duopoly Model Revisited Two firms, one industry with new good. Produce or Not Produce. New Payoff Table at right. Assume Boeing has cost advantage in prod’n over Airbus of $25 million. Airbus Boeing Produce No Prod’n -20 5 125 100 Features: Boeing will produce regardless of decision by Airbus due to advantage. Airbus loses with certainty, so will not enter industry. Equilibrium: Boeing is the single low-cost producer that captures entire market. No need for first-mover advantage, no uncertainty about market structure.

Effects of a Subsidy Revisited Effects of same targeted Gov’t subsidy as before. EU guarantees Airbus a $25 million Subsidy to produce new aircraft. New Payoff Table Payoffs to Airbus change. Airbus Boeing Produce No Prod’n 5 125 Features: Each firm would be better off if the other chose not to produce. Both firms will choose to produce the aircraft as their best strategy. Another Example of Prisoner’s Dilemma. Both firms will produce the aircraft, both firms get low payoff. EU subsidy is worst possible policy here as both firms lose.

Strategic Trade Policy V Philosophical problems with Strategic Trade Policy.

Goals of Strategic Policy? The Rhetoric of Competition and Industrial Policy Popular counterpart of strategic trade policy is industrial policy. Asserts that nations compete for desirable industries. Encourage High Value Added Industries? Industries with high value added per worker tend to be capital-intensive, i.e. low value-added per unit of capital. Capital is also a scarce factor, so no guarantee max. nat’l income. Encourage High Wage Industries? Wage differential argument that manufactures better than services. Deindustrialization from tech. change, not international trade. Encourage High Technology Industries? Effects of trade on jobs & high wages of this sector fairly small. Increase tech. progress in economy through tech. Spillovers.