Trade Policy: Arguments

1
Trade Policy Arguments

• Appleyard Field ( Cobb) 14 and 15
• Krugman Obstfeld Chapters 9 and 11

2
Todays 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

3
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?

4
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

5
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 doesnt
  the industry proceed on its own?
• Implementation
• Problem with identifying the right industries
• Time consistency will the protection eventually
  become permanent?

6
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)
7
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
(1t)Pint
(1t)Pint
increase of producer surplus
tariff to the government
Loss of consumer surplus
deadweight loss
deadweight loss
Pint
Pint
DD
DD
imports after tariff
Q
Q
imports after tariff
imports in free trade
imports in free trade
8
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

9
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
10
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.
11
Terms-of-Trade Argument

• Restrictive trade policy can improve countrys
  terms-of-trade and thus increase its welfare
• Objectives
• increase the ratio PX/PM ( to make imports
  cheaper)
• increase countrys aggregate welfare
• Consistency Implementation
• IF the country is large enough, imposing a tariff
  may result enough decrease in world price and
  thus improvement in countrys 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), countrys
  welfare increases
• optimum tariff a tariff structure that
  maximizes countrys welfare

12
Single Market, Two Countries, Free Trade
Country B
Country A
P
P
SA
SB
DB
DA
Q
Q
13
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.
14
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)
15
Effect of a Tariff in a Single Market and
Two-Countries
Country B
Country A
P
P
DA
SA
DB
SB
PA
D
e
a
b
tariff
PFT
price decrease in country B
C
PB
Q
Q
Country A Loss of consumer surplus eaDb
increase of producer surplus e Increase of
government revenue CD. Gain for Country A
gainslosses (eCD)-(eaDb) C a b.
That is, if C gt a b country A has gained from
the imposition of the tariff (due to lower prices
of imports before tariff).
16
Impact of Elasticises
Country B
Country A
P
P
DA
SA
SB
PA
DB
tariff
e
D
a
b
price decrease in country B
PFT
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
17
Analysing the Terms-of-Trade Argument

• Winners
• Home countrys import-competing producers
• Home countrys government
• Foreign countrys consumers
• Losers
• Foreign countrys exporters
• Home countrys 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

18
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

19
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

20
Rationale for Persistent Dumping Domestic
Monopoly
Domestic monopoly is able to get Pint from the
world market ? Pint minimum marginal revenue
Price
The monopolists maximizes profits by selling QD
at home for price PD and QT-QD abroad for Pint
MC
PD
PA
MRT
Pint
D
MRA
QD
QA
QT
Quantity
exports
21
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)

22
Impact of Dumping

• Persistent 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

23
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, it creates a
  positive net welfare
• 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?

24
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

25
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

26
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.

27
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 countrys 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

28
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

29
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

30
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

31
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 RD companies,
  subsidizing the domestic production

32
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

33
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

34
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

35
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.

36
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)

37
Case 1 Tariff to Extract Foreign Monopoly Profit

• Market Structure
• Home country faces a foreign monopoly that is the
  worlds only supplier
• Objective
• to increase home countrys 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
38
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
MCtACt
Government revenue
tariff
MCAC
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).
39
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
40
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 firms
  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 others behaviour

H
F
Foreign firm sales
F
H
Home firm sales
41
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
42
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
43
Is the Economies of Scale in Duopoly an Model an
Argument for Protection?

• Krugman
• No. This is just an explanation for why e.g.
  Japans 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

44
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

45
The Impact of a Export Subsidy to Reaction Curves
Foreign firms 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 firms
  reaction curve rightwards and the threat becomes
  credible

H
H
F
E
QF(QH)
E
QF(QH)
F
H
H
QH(QF)
QH(QF)
Home firms sales
46
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

47
Hypothetical Example Airbus and Boeing
Airbus gets 10 as subsidy if it produces
Without subsidy
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.
48
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 gt 0)
• Welfare Impact
• When countries individually choose optimum tariff
  suboptimal trade equilibrium follows

49
Tariff Game (1)

• In a two-country case, both countries can use the
  terms-of-trade effect ? optimum tariffgt0
• ? Free trade is not an equilibrium

T2(T1)
Country 1s tariff rate
T2(T1)
T1(T2)
T1(T2)
Country 2s tariff rate
50
Tariff Game (2)

• 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

51
Concluding Remarks on Strategic Trade Policy

• Imperfect markets create an opportunity where
  tariff / quotas / subsidies may increase
  countrys 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