BA 187 International Trade Problem Set #4: IRS & Protectionist Policies

1. Size Matters After All. Recognizing that economies of scale exist in certain industries makes trade theory more “realistic” but it has a number of disturbing implications for the traditional “mutual gains from trade” argument. A.     What do increasing returns to scale do to the ability of trade theory to predict patterns of trade between countries? Increasing returns to scale in an industry generally reduces the ability of trade theory to predict patterns of trade. The gains to scale tend to offset any factor considerations in a good’s cost of production. Thus many IRS trade models have the property that factor intensity/endowments do not matter for where the good is produced matters. Often what matters is which country is first to market which may be influenced by technology or may simply be a historical accident. This type of indeterminacy is not always the case. The Product cycle model and the Linder model have well-defined, but evolving, patterns of trade associated with them. You should be able to provide specific examples of indeterminacy and determinacy in trading patterns for different IRS models.

1. Size Matters After All. Recognizing that economies of scale exist in certain industries makes trade theory more “realistic” but it has a number of disturbing implications for the traditional “mutual gains from trade” argument. B. Increasing returns to scale is said to introduce potential conflict between countries, since each country is better off if it can increase its production in these types of industries. Evaluate this statement for Krugman’s model of a monopolistically competitive industry. Look at the slides for the Krugman model used in class. Increasing the size of the market allows firms to reap IRS, leading to more varieties in the single international market than when there were two separate national markets. It also says, however, that there will be fewer firms in total across both countries after trade. The model says nothing about where these new, but fewer, firms will be located. The potential conflict in the Krugman model is not over the scale of any single firm, but rather over where the new firms are located after trade is opened up. Nations “win” by having more of the new firms locating in their country. Think of the auto industry; as the industry has become international, the variety of types of cars has increased even as the number of firms has fallen.

1. Size Matters After All. Recognizing that economies of scale exist in certain industries makes trade theory more “realistic” but it has a number of disturbing implications for the traditional “mutual gains from trade” argument. C.     What does the specialization necessary to attain economies of scale say about the Stolper-Samuelson result? (i.e. Does trade equalize relative factor returns across countries? Do some factors win and other factors necessarily lose with trade?) The Stolper-Samuelson effect may fail to hold with IRS. Why? 1. Trade patterns don’t necessarily depend on factor intensity and endowments under IRS, so no guarantee the export good uses the abundant factor intensively as the relative return SS result requires. 2. IRS means that it is possible for both factors to gain in absolute terms with specialization. Remember IRS means double capital and labor more than doubles output. Hence it is not only possible, but likely that return to both factors increases under IRS even if country specializes in a good which uses its scarce factor intensively.

2. Waiting for WTO. Four men are discussing why the U. S 2. Waiting for WTO? Four men are discussing why the U.S. should provide special support for its high-technology industries. Which of these statements are valid arguments for the United States to have a policy targeting these industries? Vladimir: “They deserve protection because they hold the prospect for rapid future growth...” Uncertain. It is not enough that an industry have potential for rapid future growth, trade policy is only justified if the industry will be more competitive than existing firms and will not develop otherwise because of pre-existing barriers to entry. We are of course making the infant industry argument for temporary protection of the industry. So Vladimir is only partly correct. Estragon: “No, rather they provide inputs to many other industries, and …’ False in general. A country benefits from cheaper imported inputs rather than more expensive protected domestic inputs. Protecting home input industries will raise costs of domestically produced goods and also reduce the competitiveness of Home exports that use these inputs.

2. Waiting for WTO. Four men are discussing why the U. S 2. Waiting for WTO? Four men are discussing why the U.S. should provide special support for its high-technology industries. Which of these statements are valid arguments for the United States to have a policy targeting these industries? Lucky: “Fool! They generate technology that benefits the whole economy!” True To the extent that an industry generates external economies of scale, trade policy benefiting the industry benefits the country as a whole, and perhaps even the world. We should note that it is very difficult to identify the scope of these spillovers, so we might take this argument with a grain of salt. Pozzo: “There’s no call to be rude. Its most certainly because they are challenged by government-supported foreign competitors.” False Foreign subsidies reduce the gains to be captured in the industry. Subsidies to domestic firms simply reduce the profits available in the industry even further. The only winners of a subsidy competition are consumers in the 3rd country.

3.A. Import Quota for Small Country PqH 1. Import quota level set at Qq. Raises domestic PqH,, ROW price same. Qq Quota World Market Price, P XS’ 2. There exists an equivalent tariff, tq , for any quota that has same result. tq 3. Market effects of tariff and a quota are identical but not welfare effects. 4. Consumer surplus, producer surplus and associated Deadweight loss (= pro’dn loss + consump loss) are identical. 5. Quota brings no Government revenue increase of a tariff. Who earns this quota profit or rent depends on structure of quota. XS PW MD Q0 Quantity, Q

3.B. Import Tariff for Small Country ST DT PT 1. Import tariff, t, raises domestic price PT = PW + t for small country. t Price, P Home Market SH 2. Consumer surplus falls by areas: a + b + c + d 3. Producer surplus rises by area: a 4. Government revenue rises by area: c 5. Deadweight loss (cost of protection): b + d (= pro’dn loss + consump loss) a b c d PW DH S0 D0 Quantity, Q

3.C. Domestic Prod’n Subsidy Price to Consumer, P PW+ s Ssub 1. Domestic subsidy, s, raises price received by producers to PW + s. Price to consumer unchanged at PW . s SHsub Home Market 2. Consumer surplus unchanged. 3. Producer surplus rises by area: a SH 4. Government subsidy (cost) is area: a+b 5. Deadweight loss (cost of policy): b (= pro’dn loss) b a PW 6. Domestic prod’n rises, domestic demand stays unchanged, level of imports falls. DH S0 D0 Quantity, Q