1. Controversies in Trade Policy
LECTURE 12
Controversies in Trade Policy
Strategic trade policy (Gasiorek)
Trade and…labor, environment

2. Trade Policy & Imperfect Competition (Michael Gasiorek - U of Sussex)
Review of the gains from trade
more efficient allocation of resources (Ricardo, HOS)
economies of scale (internal eg. under monopolistic competition, or external
increase competition (reciprocal dumping)
increase variety (in models with differentiated products)
promote economic growth (especially with respect to endogeneous growth theory)
Conclusion from perfectly competitive models is:
free trade is best
under perfect competition tariffs and quotas can be seen to be equivalent

3. In what way does imperfect competition impact upon the traditional policy conclusions?
1) Models that explore the relationship between trade policy and imperfect competition, but which do not consider the nature of strategic interaction between firms
eg. the impact of trade policy on the domestic market in the presence of monopoly power. Is a tariff then equivalent to a quota?
The extent to which trade policy can be used to extract any of the foreign monopolists profits
trade policy enabling firms to take advantage of economies of scale
2) Models that explore the ways in which governments / policy can impact upon the nature of strategic interaction between firms  strategic trade policy

4. 1.1) Trade policy and the domestic market (Bhagwati, 1965)
Focusses on (a) the pro-competitive impact of trade liberalisation; (b) shows how different trade policy instruments can have a different impact on competition MC Pm
If tariff world price (Pw) is sufficiently low to allow for imports than the monopolist cannot charge a price above Pw and hence supplies Qm’ Pw D MR Qm
Qm’

5. If tariff inclusive world price (Pw) is sufficiently low to allow for imports than the monopolist cannot charge a price above Pw and hence supplies Qm’ MC Pm
Pw(1+t) D MR Qm
Qm’
Even if tariff is set higher, the monopolist is constrained. It cannot set a price which is higher than the tariff inclusive price because of the threat of imports. MR D MC
Qm’ Qm
Pw(1+t) Pm
therefore effect of tariff on domestic production can be seen by red line (as tariff )

6. a monopolist protected by a tariff, cannot raise its price above the tariff inclusive price without losing the domestic market to imports. MC Pm
Pw(1+t) D
Suppose you set a quota to the same level of imports as above (red line) MR Qm
Qm’
once the quota has been filled, the effective demand curve facing the domestic monopolist is given by “D-q”
Setting MC=MR means charging a price of Pquota. D
D-q MC
Pquota
Pw(1+t) Pw
a quota creates more domestic monopoly power than a tariff MR Qm
Qm’

7. 1.2) Extracting a foreign monopolist’s profits (Brander & Spencer 1984)
assume a linear demand curve, constant MC
specific tariff is imposed therefore MC curve  by the amount of the tax
Since the demand curve is 1/2 as steep as the MR curve, the price goes up by 1/2 the amount of the tax
 W:  CS = -(a+b)
 GR = c
but, c = 2a
 c > a + b
so the tariff generates more revenue than the cost to the consumer of higher prices pT a b
pft
MC+t c MC D MR qT
qft

8. 1.3) Import Protection as export promotion (Krugman, 1984)
Protecting the domestic market enables an expansion of domestic production
As a result of that expansion costs decline (either because of economies of scale, or through a more dynamic process of learning by doing, or through increased investment in R&D)
The decline in costs makes the industry more competitive in world markets, therefore exports increase
Note the similarities (and differences) between this, and the infant industry argument

9. 2) Strategic Trade Policy
An STP is a policy which impacts upon the nature of competitive interaction between firms, and hence impacts upons firms’ strategies in a game-theoretic sense.
Firms recognise the interdependencies between them in making their decisions and then government policy impacts upon their equilibrium decisions.
Main insights from Brander & Spencer (1985) “rent shifting / profit shifting”.
Assume firms act as Cournot competitors and produce a homogeneous product
Domestic and foreign firms compete in a third market (ie no domestic consumption of the good)
“game” is played in two stages (1) government(s) set tax/subsidy level; (2) firms simultaneously decide output (export) levels.

10. Q*
Firms compete in quantities (Cournot competition) which gives the Nash equilibrium at the intersection of the reaction function at “e”. R’ R e
Now assume that the government of the home firm offers a production subsidy.
The effect of the subsidy is to lower the firms costs (MC), and therefore increases the firms’ output level P Q MC
MC’ e’ R* Q
This is true for all output levels of the competitor therefore is represented by an outward shift of the home firms’ reaction function, to a new equilibrium at e’

11. The new equilibrium involves the home firm producing more, and getting more profits, the foreign firm producing less and getting less profits  profit shifting.
Formally the equilibrium with the subsidy puts the domestic firm in the same position as being a “Stackelberg” leader
Note also that domestic welfare has risen ie that the rise in domestic profits is greater than the amount paid out by the government in subsidy
the subsidy is effectively a transfer from the taxpayers to the owners of the firm
the profits of the firm rise, but by more than the value of the subsidy because the subsidy induces the firm to act more aggressively towards its rival - this is the “strategic effect”
Note also that the rise in welfare is also at the expense of the foreign rival
but note also that there have been various extensions and generalisations of the basic model
to incorporate domestic consumption,
to allow for competition in R&D subsidies
to consider retaliation

12. Strategic trade policy more broadly interpreted:
A “strategic industry” is one which is considered to be important to the economy:
industries that promote significant externalities to the economy
high growth industries (which may therefore generate higher rates of economic growth for the economy) perhaps characterised by economies of time (learning curves) which implies that first movers may have a significant and continuing advantage
industries which may simply be important in terms of their contribution to GDP
with regard to the first two, the general perception is that these are likely to be high R&D, high technology industries probably characterised by imperfect competition  strategic trade policy

13. It may be therefore tempting to argue...
Governments should pursue policies that maximise growth and competitiveness
comparative advantage is not static, but is dynamic ie changes over time. Governments have a legitimate role in trying to shape that comparative advantage
government intervention is also justified where there is market failure (eg. externalities and spillovers)
spillovers are prevalent in high tech, R&D intensive industries
High tech R&D industries will lead to higher rates of productivity growth + give rise to spillovers hence result in higher rates of economic growth

14. R&D intensive industries (aerospace, pharmaceuticals, telecommunications) tend to be highly imperfectly competitive (and have high economies of scale)
trade theory suggests that appropriate policy can increase domestic output, profits and welfare in imperfectly competitive industries
in addition firms can take advantage of economies of scale, and increase domestic competitiveness (cf. Import protection as export promotion)
therefore strategic trade and industrial policy should be undertaken by governments

15. However...
if both governments grant a subsidy, then welfare ends up being lower in each country (prisoner’s dilemma)
if:
raising revenue involves incurring distortionary costs than the opportunity cost of a unit of public funds is greater than 1  gains from the policy are reduced
if the government attaches less weight to shareholders welfare than to tax payer’s welfare; or if some of the domestic firm’s shareholders are foreign  gains from the policy are reduced
suppose we allow for n firms in each country as opposed to a duopoly:
with free entry there may be no profits to be shifted as the initial equilibrium is one of zero profits
even with positive domestic profits, competition for subsidies could result in output levels being too high domestically& prices too low. An export tax , rather than a subsidy, would then restrict output hence increasing output levels.

16. In summary...
fragility of the results
The analysis has assumed that governments made their announcements first, and then firms made their decisions. How realistic is this?
The analysis ignored general equilibrium interactions
rent seeking
is the relevant information available to governments?
retaliation
beggar-thy-neighbour
Hence, while the literature suggests that in the presence of distortions there is scope for government intervention but this is not necessarily the same as advocating government intervention