Class Outline

1
Class Outline

• First Best World
• Free Trade
• Second Best World
• Characteristics
• Government Policies
• Specificity Rule
• Tariffs and Externalities
• Infant Industry Argument
• Dying Industry Argument
• Developing Country
• Other Non-Economic Arguments
• Reading Chapter 10 Textbook

2
The Ideal World of First Best

• First Best assumption world in which all private
  incentives aligned perfectly with benefits and
  costs to society as a whole
• Supply and demand curves represent private and
  social benefits

3
First Best World

• Price (P) Buyers Private marginal benefit (MB)
  Social marginal benefit (SMB) Sellers
  private marginal cost (MC) Social marginal cost
  (SMC)
• PMBSMBMCSMC

4
First Best World

• First Best World
• Trade is economically efficient
• Free trade allows invisible hand of market
  competition to reach globally
• Private producers expand production to levels
  that are as good as possible for the world
• Private consumers expand purchases to levels that
  make the whole world as well off as possible

5
First Best World
6
Realistic World of Second Best

• Incentive distortions are gaps between the
  private and the social benefits or costs of an
  activity
• We live in a second-best world, one that
  includes incentives distortions
• We will address Externalities or Spillover effects

7
Government Policies and Externalities

• How should society solve Externalities problems?
• Pigou method tax or subsidy approach
• Ronald Coase method property rights approach
• We address the case of taxes because of the
  tariffs applied to International trade
• Which are the best cases for government
  intervention?
• Caution possibility of government failure
• Could tariffs help to solve externalities from
  international trade?

8
Specificity Rule

• In a Second Best World, each case has its own
  characteristics, so there are no general rules
• However, we have the Specificity Rule
• It is usually more efficient to use the
  government policy tool that acts as directly as
  possible on the source of the distortion
  separating private and social benefits or costs.

9
Promoting domestic Production or Employment

• Local Production produces spillover benefits
  because other industries benefit from know-how,
  techniques introduced by this industry
• Employment in this industry imparts new worker
  skills and attitudes
• By producing at high costs industries can find
  ways to lower costs in the long run
• Extra costs to workers from switching to other
  industries
• The country and their citizens take pride from
  producing locally this product
• The product is essential to national defense
• Employment is a way to redistribute income to poor

10
Tariffs and Externalities

• We analyze the first two cases for intervention
• We assume the case of a small country

11
Tariffs and Externalities
Price
540
Sd (Domestic Supply)
Domestic Price with Tariff
330
Tariff
d
b
World Price
300
Dd (Domestic Demand)
210
1.6
0.6
0.8
1.4
Quantity
Marginal Social Side Benefits from Domestic
Production ( per bike)
g
MSSB
0.6
0.8
Quantity
12
Subsidies and Externalities
Price
540
Sd (Domestic Supply)
Production Subsidy
330
b
World Price
300
Dd (Domestic Demand)
210
1.6
0.6
0.8
Quantity
Marginal Social Side Benefits from Domestic
Production ( per bike)
g
MSSB
0.6
0.8
Quantity
13
Subsidy and Tariff

• According to the Specificity Rule Subsidy is
  better than tariff since it is less costly to
  solve the production problem without having to
  distort the price for consumers

14
The Infant Industry Argument

• A temporary tariff is justified because it cuts
  down on imports while the infant domestic
  industry learns how to produce at low enough
  costs.
• Eventually, the industry will be able to compete
  without a tariff

15
The Infant Industry Argument
Price
Price
Sd (Domestic Supply)
Sd (Domestic Supply)
Sdf (Domestic Supply)
4000
Tariff
b
d
3000
3000
v
Dd
Dd
50
20
Quantity
Quantity
60
85
85
16
Validity of the Argument

• First, is Government needed? This situation is
  very common and private firms solve it through
  private credits
• Imperfections in capital markets
• Benefits from early business investments do not
  accrue to the firms making these early investments

17
Validity of the Argument

• Second, if government intervention is justified,
  is a tariff the best policy?
• Subsidies can be better
• The specificity rule should be applied

18
Validity of the Argument

• Third, will the infant industry really grow up?
• Easy to be a firm in an infant industry but
  harder to became international competitive.
• Examples, Japan, Brazil

19
Validity of the Argument

• Conclusions on the Infant Industry Argument
• There can be a case for Government encouragement
• A tariff may or may not be good
• Some other form of help is better than a tariff
• It is hard for government to know which
  industries to support, because is difficult to
  predict success

20
The Dying Industry Argument and Adjustment
Assistance

• Similar analysis than before, tariffs are not
  usually the best policy
• In some developed countries there are Trade
  Adjustment Assistance for workers and firms in
  import-threatened industries.

21
The Developing Government Argument

• In a poor nation, the tariff as a source of
  revenue may be beneficial and even better than
  any feasible alternative policy, both for the
  nation and for the world as a whole.

22
Other Arguments for Protection

• Non-economic objectives
• Modified specificity rule To achieve the
  non-economic objective with the least economic
  cost to the nation, use a policy that acts as
  directly as possible on the specific objective.

23
Other Arguments for Protection

• National Pride Subsidy
• National DefenseSubsidy
• Income Redistribution Tax transfer or other
  types of tax programs