Chapter Eight Arguments for Restricting Trade

2 Chapter Outline Categories of Arguments.. Restrictions Other considerations “Infant” Industries? Imperfect Markets Presence of Externalities Level “Playing Field” Compete with Low-Wage Countries? National Security and Defense Issues? Goods and Money Vs just Goods? Threaten others and Liberalizing trade?

3 Introduction  Are there circumstances in which unrestricted trade is not efficient or does not maximize world welfare?  Can protection ever increase welfare, not just for some groups at the expense of others, but for the country or the world as a whole?  Are there aspects of the world economy that we ignored in the earlier chapters? Might goals other than efficiency justify the use of protection?

4 Categories of Arguments for Trade Restrictions 1.Those that question the assumptions used to develop models of international trade. Challenges to assumptions of perfect competition and no externalities in either production or consumption.  Only Optimal Market Conditions meet all of the above.  Presence of a violation of any of these assumptions is referred to as a Domestic Distortion.

5 Categories of Arguments for Trade Restrictions 2.Distributional effects of trade Distribution of income both with each country and among countries. 3.Non-economic arguments  National security  Economic efficiency

6 What about “Infant” Industries?  Arguments for protection make case for short- term protection of a new industry that is temporarily unable to compete with experienced rivals in other countries. In the short run prohibitive tariff on imports imposes a welfare loss but may protect the domestic industry

7 What about “Infant” Industries? If the infant industry matures and becomes capable of competing in world markets without protection, the country’s production possibilities frontier may expand beyond the frontier that would have existed without the temporary protection.  The economy then will be able to produce at higher levels -- a previously unattainable outcome. See graph

8 Figure 8.1: How Does Protection Affect an Infant- Industry? Y X 0 pc 1 p 0 p 2 U 1 U 0 U 2 c 2 c 0 Slope = - (P W X /P W Y ) Slope = - [(P W X /(P W Y + t)] 1 =

9 What about “Infant” Industries?  Economists are generally skeptical of arguments for protection of infant industries because of the following reasons: Difficulty in spotting good industries. Early support of an industry that turns out to be successful provides insufficient evidence that the protection itself constituted a wise policy. Removal of protection has proven very difficult. There might be superior policies available for dealing with the problem.  General rule: the least-cost policy is the one that attacks the problem directly rather than indirectly.

10 What about “Infant” Industries?  A direct policy (such as a production subsidy) is superior over an indirect policy (such as an import tariff). Import tariff both increases domestic production of good Y from Y 0 to Y 1 (the desired goal) and decreases domestic consumption of Y from Y 2 to Y 1 (an additional source of inefficiency). However, production subsidy increases domestic production while leaving consumption unaffected. See next figure

11 How Does an Import Tariff or a Production Subsidy Affect an Infant Industry? Y 0 P Y P Y 1 P Y 0 Y 0 Y 1 Y 2 D d c S w S w + t S d e (a) Tariff

12 How Does an Import Tariff or a Production Subsidy Affect an Infant Industry? Y 0 P Y 0 P Y 0 Y 0 Y 1 Y 2 D d f S w S d S d + s P Y + s (b) Subsidy s

13 What if Markets Are Not Competitive?  Optimal Tariff: Monopoly in a world market Figure 8.3 illustrates the effects of a tariff on imports by a large country.  By exploiting its monopoly power, the country can gain the equivalent of area s in revenue from foreign producers. The areas of triangle m and r measure the deadweight welfare losses due to the tariff. The optimum tariff maximizes the net gain to the country from the tariff (area s – area[m+r]).

14 Figure 8.3: What are the Effects of a Tariff on Imports by a Large Country? P Y P Y 1 0 P Y 0 P Y 2 D d S d + w S + t S d r m s Y t

15 What if Markets Are Not Competitive?  Protection and monopolized industries Price and opportunity cost for a monopolist  A monopolist maximizes profit by producing where marginal revenue equals marginal cost.  The monopolist’s level of output is lower and price higher than the perfectly competitive outcome. Because marginal revenue is less than price, price exceeds marginal cost. Consumers value the marginal unit by more than the opportunity cost of producing it…thus, output is inefficiently low.

16 Figure 8.4: How Does a Monopolist Choose Its Output and Price? P Y P M 0 P C Y M Y C MR Y D Y MC Y Y

17 What if Markets Are Not Competitive?  Trade with a monopolized industry in both countries With two perfectly competitive industries, production and consumption occur at p 0 =c 0. The relative production costs of the two goods equal the goods’ relative prices and consumers’ marginal rate of substitution between the goods. Introduction of a monopoly in Y raises the relative price to above its opportunity cost. The monopoly lowers the level of utility attainable in autarky.

18 Figure 8.5: How Does a Monopoly Affect Production and Consumption in Autarky? X Y Slope =– (P X 0 /P Y M ) Slope =– (P X /P Y ) = c 0 p 0 1 p 1 U 0 U 1

19 What if Markets Are Not Competitive?  Trade with a monopolized industry in one country. A monopolist in a small country cannot ignore the competitive nature of the worldwide industry under free trade.  With no trade, the monopolist produces Y M and charges P M.  With trade, the monopolist produces Y 0 and charges the world price, P W.

20 Figure 8.6: International Trade Can Cause Monopolist to Behave as if the Industry Were Competitive Y 0 P Y D S w P M P w Y M Y 0 Y 1 MR MC

21 What if Markets Are Not Competitive?  Tariffs and quotas with monopoly Panel (a) in Figure 8.7 points out that a tariff on a good produced by a small country’s monopoly firm generates exactly the same effects as if the industry were competitive and subject to a tariff. Panel (b) demonstrates the monopolist’s price and output choices when protection takes the form of a quota, rather than a tariff.  Quota allows the monopolist more market power. Firm produces less output and charges a higher prices under a quota than under a tariff.

22 Figure 8.7: A Monopolist Behaves Differently under a Tariff and a Quota Y 0 P Y D S w S w + t Y 0 P Y D S w MC D MR Y P Q P w 0 Y 2 Y 1 Y Q Q Q Y 0 Y 3 Y 4 Y 1 P w + t P w (a) Tariff(b) Quota MC

23 Strategic Trade Policy  Focuses on trade policy among small interdependent groups of players – firms and governments – in which any action brings a reaction, leading to games of strategy.  Two basic types of strategic trade policy models: Based on profit-sharing; and Based on the learning curve.

24 Profit-Sharing Strategic Trade Policy  If a world market for a good is one in which economic profits exist, individual firms will enact strategies designed to capture the largest possible share of these profits. In designing its strategy, each firm will take account of rivals’ actions.  From a national perspective, each country wants its firms to capture the largest possible share of available profits (called profit shifting). Government policy may be able to accomplish something domestic firms cannot do. Profit-shifting strategic trade policy cannot work in competitive industries.

25 The Learning Curve and Strategic Trade Policy  Learning-curve models of strategic trade policy. Similar to infant-industry models. Firms in some industries learning by producing…a phenomenon known as moving down the learning curve or learning by doing.  As the firm accumulates production experience, its production costs fall, making it more competitive in world markets.

26 The Learning Curve and Strategic Trade Policy  One way to provide domestic firms with a large market is to restrict imports. Tariffs, quotas, or a variety of import restrictions. Domestic firms clearly gain from export-promotion policies. Domestic consumers must pay higher prices in the protected market.  Country as a whole is likely to experience negative net welfare effects.

27 Problems and Precautions  Basic problems in using strategic trade policies: 1.Difficulty in defining nationality of firms. 2.Difficulty of pinpointing industries that satisfy the requirements for successful strategic trade policy. 3.These policies rely on the assumption that rival governments do not retaliate. 4.Uncertain distributional effects of such policies. 5.System is subject to abuse by special-interest groups.

28 What if There Are Externalities?  When deriving the result that unrestricted trade maximizes world welfare, we assumed the absence of externalities in production and consumption. Externality exists whenever production or consumption of a good generates effects on bystanders not taken into account in the production or consumption decision.

29 What if There Are Externalities?  Negative externality imposes costs on others. Example: pollution.  Positive externality generates benefits for third parties not considered in the decision-making process. Example: education.

30 What if There Are Externalities?  Production externalities Increasing (decreasing) production in industries that involve positive (negative) production externalities can raise welfare. By increasing domestic production of good Y from Y 0 to Y 1, the tariff allows the country to capture external benefits equal to shaded area in (b).

31 What if There Are Externalities?  Similarly, the production subsidy in (c) increases domestic production without distorting prices and consumption. The country captures the same external benefits as under the import tariff, but avoids the welfare loss caused by inefficient consumption.

32 Figure 8.8: An Import Tariff and a Production Subsidy by a Small Country Y 0 P Y D d S w S w + t S d Y 0 P Y D d S w S d S d + s (a) Import Tariff s (c) Production Subsidy Y 0 Y 0 Y 1 MEB Y Y Y 0 Y 0 Y 1 Y Y (b) External Benefits (d) External Benefits

33 What if There Are Externalities?  When consumption generates positive or negative externalities, consumption subsidies or taxes lead to more efficient outcomes than do trade restrictions. Best policy is one that alters consumption directly without interfering with production decisions.  Consumption subsidies of taxes accomplish this – trade restrictions do not.  Figure 8.9 represents conditions in the market for cigarettes.

34 What if There Are Externalities?  Figure 8.9: An import tariff reduces consumption, allowing the country to avoid the external costs represented by shaded area in (b).  Tariff also imposes welfare losses associated with the two triangles in (a).  Tariff’s net welfare effect is uncertain. However, a consumption tax would be a superior policy, since it could reduce consumption by same amount as the tariff without leading to inefficient production.

35 Figure 8.9: Effect of a Tariff as a Policy Response to a Negative Consumption Externality (a) Import Tariff 0 0 P Y S w + t S w D d Y S d MEC Y YY 1 Y 0 Y (b) External Costs

36 Shouldn’t the “Playing Field” Be Level?  Some policymakers argue for Scientific Tariffs: Specifically designed to offset cost advantage enjoyed by foreign producers of the tariffed good.  Have same effect as prohibitive tariffs. Primary fallacy in the argument lies in its failure to recognize across-country cost differentials as reflection of comparative advantage.  Every country will be low-cost producer of some goods.  These tariffs would eliminate all trade based on comparative advantage. Result? Return to autarky and reduction in world welfare.

37 How Can We Compete with Low-Wage Countries?  High wages in countries like the USA must be justified by labor productivity. Productivity gains allow industrialized countries to compete with low-cost countries. As productivity rises in any country, so do wages.  Asian “Tigers” experienced this. High wages not justified by high productivity can make industries uncompetitive.  Examples: U.S. auto and steel industries. Increases in union wage rates far exceeded productivity gains.

38 Aren’t Goods and Money Better than just Goods?  When a consumer buys a domestic good, both the good and the money paid for it remain in the country.  When a consumer buys an import, the good comes into this country and the money leaves.  Some people say that a country must be better off producing all goods domestically than engaging in international trade, but Fallacy is: failure to recognize that the country loses the resources used in producing the domestic good.

39 Can We Threaten Other Countries into Trade Liberalization?  Many in the U.S. support threats of protectionism as a means of lowering foreign trade barriers. Omnibus Act of 1988 provided for Super- 301 Cases:  U.S. Trade Representative must issue annual list of countries that maintain “priority” unfair trade barriers that have harmful effects on U.S. exports. After negotiations, if the named country fails to sufficiently alter its policy, then retaliation by U.S. can follow.

40 Can We Threaten Other Countries into Trade Liberalization?  Special-301 Provides framework for the U.S to threaten retaliation against countries that do not enforce copyrights, patents, trademarks, and other intellectual property rights.  Protectionism is not the best policy response to most problems posed in this chapter. Benefits to protected industry rarely match, much less exceed, the losses to domestic consumers.  See Table 8.2 on page 300 for examples.