Presentation on theme: "Trade Policy: Arguments"— Presentation transcript:
1 Trade Policy: Arguments Appleyard & Field (& Cobb): 14 and 15Krugman & Obstfeld: Chapters 9 and 11
2 Today’s Lecture Traditional Arguments for Protection Infant-Industry, Terms-of-Trade, Anti-Dumping, Offsetting a foreign subsidy, Aggregate unemployment, Promoting a particular industry, National security, ExternalitiesStrategic Trade PolicyTariff to Extract Foreign Monopoly ProfitEconomies of scale & DuopolyExport 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 Objectiveto realize a potential comparative advantageConsistencyKey assumption: There is a market failure (external economies of scale, imperfect capital markets…).If this does not hold, you should ask why doesn’t the industry proceed on its own?ImplementationProblem with identifying the right industriesTime 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 surplusBoth reflect the fact that there is only one market priceHence, there are consumers who would have been willing to pay more for the productSimilarly, all but the “last” unit is produced with lesser marginal cost than the market price receivedS =marginal costof productionconsumersurplusPproducersurplusDQuantity (Q)
7 The Impact of Import Tariff: The Small-Country* Case * Small country = cannot affect world pricesIncrease of producer surplus andgovernment incomeLoss of consumer surplusSDSDPP(1+τ)Pint(1+τ)Pintincrease ofproducersurplustariff to thegovernmentLoss of consumer surplusdeadweightlossdeadweightlossPintPintDDDDQimports after tariffQimports after tariffimports in free tradeimports in free trade
8 Analysing the Infant Industry Argument Winners and losersProtected producers winGovernment gets tariff revenueConsumers lose in the short-run, but win in the-long run IF protection leads to higher efficiency and thus lower pricesNet impactIF 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) SDSDPPincrease ofproducersurplusCost to the governmentefficiencylossPPDDDDimports after the subsidyQimports after the subsidyQimports in free tradeimports in free trade
10 Analysing the Infant Industry Argument Alternative policySubsidising the infant industry would deliver the same result with less cost, i.e. a more efficient policy existsConclusionIn 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 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 country’s terms-of-trade and thus increase its welfareObjectivesincrease the ratio PX/PM ( = to make imports cheaper)increase country’s aggregate welfareConsistency & ImplementationIF the country is large enough, imposing a tariff may result enough decrease in world price and thus improvement in country’s terms of tradeIF the benefits from improved terms of trade are larger than the costs (deadweight loss and reduction of exports due to tariff), country’s welfare increasesoptimum tariff = a tariff structure that maximizes country’s welfare
12 Single Market, Two Countries, Free Trade Country BCountry APPSASBDBDAQQ
13 Single Market, Two Countries, Free Trade Country BCountry APPSASBDBDAQQCountries 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 BCountry APPSASBDBtariffDAQQPrice 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 BCountry APPDASADBSBPAeaDbtariffPFTprice decrease in country BCPBQQCountry A:Loss of consumer surplus = e+a+D+b; increase of producer surplus = e; Increase of government revenue = C+D. Gain for Country A = gains–losses = (e+C+D)-(e+a+D+b) = C – a – b. That is, if C > 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 DB e a D b C Q tariffeaDbPFTprice decrease in country BCPBQQThe 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 WinnersHome country’s import-competing producersHome country’s governmentForeign country’s consumersLosersForeign country’s exportersHome country’s consumersNet ImpactHome country gains in aggregate, if the benefits from lower import prices are larger than the costs (deadweight costs and the lost of exports) of tariffForeign country always loses more than the home country gains → loss in world welfare
18 Analysing the Terms-of-Trade Argument Alternative policyif the objective is just to improve terms of trade, tariff is the most effective instrumentOther considerations: retaliationConclusiona case for terms-of-trade argument exists for large countries. However, this requires thata) suitable conditions exist andb) 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.Objectiveto stop an unfair trading practice (dumping)Consistency: Depends on the type of dumpingDefinitions of dumpingEconomics: 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 getPint from the world market Pint = minimum marginal revenuePriceMCThe monopolists maximizes profits by selling QD at home for price PD and QT-QD abroad for PintPDPAMRTPintDMRAQDQAQTQuantityexports
21 Rationales for Temporary Dumping PredatoryA foreign firm sells at low price in order to eliminate competition and eventually to reap monopolist profitsSporadic / Cyclicala 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 Predatory dumping Losers: import-competing home firms, foreign consumersWinners: 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 dumpingLosers: impost-competing home firms, home and foreign consumersWinner: foreign (dumping) firmNegative net welfare effect (compared to a tariff regime)Sporadic dumpingLosers: import-competing home firmsWinners: home consumers, foreign firmNet 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 slideIs an antidumping duty desirable?To prevent predatory dumping: yesTo prevent persistent dumping : noAlternative policyif we want to promote domestic industry, again subsidy is a more efficient instrumentThe 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.Objectiveto offset a distortion due to a foreign subsidyConsistencyThe 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 governmentPositive net welfare effectless distortionsmore efficient allocation of resourcesHowever, 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 Objectiveto decrease aggregate unemploymentConsistencyin 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 country’s purchasing power, retaliation and appreciation of the home currencythe 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 goodpreviously unemployed, who get a job in the import-competing industrygovernment (tariff revenue)Losers (home country)consumersproducers of the export goodpreviously employed, who lose their jobs in the export good industryNet Impactdepends 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 policyexpansionary fiscal and/or monetary policies would increase employment more directlyConclusionWhile 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.Objectiveto increase the production of and reallocate labour to the import-competing industryConsistencysetting a tariff will lead to the objectiveNegative net impact due to efficiency lossAlternative policyagain, 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 industriesMore efficient policies: stockpiling vital goods, creating joint business-government R&D companies, subsidizing the domestic production
32 The Externality Argument for Tariffs There is a negative externality in consumption of imports ORThere 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 ObjectivesTo increase social welfare by decreasing the consumption of a imported good that generates an adverse externalityTo increase social welfare by increasing the production of a import-competing good, which would generate positive externality effectsExternalities: 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 questionsHow to measure the size of the externality?Why restrict only consumption of imports, but not that of the domestic produced good?Alternative policyNegative externality: impose a tax on consuming the product, regardless of the location of manufacturingPositive 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 tradeFirst papers published in early 1980sA variety of models that share common features:Imperfect competitionRecognized interdependenceEconomies of scale (often, not always)
37 Case 1: Tariff to Extract Foreign Monopoly Profit Market StructureHome country faces a foreign monopoly that is the world’s only supplierObjectiveto increase home country’s welfareConsistencytheoretically sound argument exists (next slide)Welfare ImpactHome country wins, foreign monopoly losesNegative net effect to world welfareJames 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 surplusHowever, part of the monopolists profits are transferred to the governmentIf government revenue is larger than the loss of consumer surplus, the country gainsPriceP2Loss of consumersurplusP1MC+t=AC+tGovernmentrevenuetariffMC=ACDMRAQ2Q1QuantityFor 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 StructureDuopoly = two firms (home and foreign)Objectiveincrease production and exports of the home firmConsistency requires:economies of scalefirms behave strategically (=take each others actions into account)Welfare ImpactHome firm wins, foreign firm loses, net impact depends on the starting pointPaul 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 CurvesThe 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 firm’s productionBoth 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 other’s behaviourHFForeign firm salesFHHome 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.QQ’Marginal costMMQ’QOutput
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 countryHForeign firm salesFEE’FHHome 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. Japan’s 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 tradeFurther, to expand one sector in the economy means that resources are taken away from other sectors
44 Case 3a: Export Subsidy in Duopoly Market StructureTwo firms (home and foreign) competing in a third market (no sales in home or foreign market)ObjectiveTo increase the sales of the home firmConsistency (key assumptions)firms behave strategically (take each others actions into account)both know each others reaction curvesNote that we are not assuming economies of scale hereWelfare ImpactHome firm wins, foreign firm loses, net impact is not evident
45 The Impact of a Export Subsidy to Reaction Curves Foreignfirm’s salesThe 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 firm’s reaction curve rightwards and the threat becomes credibleHH’FQF*(QH*)EE’QF*(QH’*)FHH’QH*(QF*)QH’*(QF*)Home firm’s sales
46 Case 3b: Export Subsidy in Duopoly Market StructureTwo firms (home and foreign)Such economies of scale that if both produce, both loseObjectiveTo get home firm to produce and foreign firm not to produceConsistency (key assumptions)Sufficient economies of scale (for a natural monopoly to exits)Firms behave strategicallyWelfare ImpactHome 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 producesWithout subsidyAirbusBoeingProducesDoes not produceAirbus: -5Airbus: 0Boieng: -5Boieng: 100Airbus: 100Boieng: 0AirbusBoe i ngProducesDoes not produceAirbus: 5Airbus: 0Boieng: -5Boieng: 100Airbus: 110Boieng: 0Without 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 SettingGovernments choose trade policy given the trade policy of other governmentsObjectiveTo maximize national welfareKey Assumptionslarge countries (terms-of-trade effect exists → optimum tariff > 0)Welfare ImpactWhen 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 tariff>0→ Free trade is not an equilibriumT2(T1)Country 1’s tariff rateT2*(T1*)T1(T2)T1*(T2*)Country 2’s tariff rate
50 Tariff Game (2) Country 1 Country Free trade would maximize the world welfareHowever, 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 negotiationsCountry 1Country2Free TradeProtectionCounry 1: 100Counry 1: 120Country 2: 100Country 2: 50Counry 1: 50Counry 1: 60Country 2: 120Country 2: 60
51 Concluding Remarks on Strategic Trade Policy Imperfect markets create an opportunity where tariff / quotas / subsidies may increase country’s welfare (given no retaliation)However, identification and implementation of strategic trade policies is not easyFurther, “the extent of the potential gains seems quite small” (Krugman, Pop Internationalism, p. 112)However, we have shown that a suboptimal equilibrium may emerge