1. Trade Policy: Arguments
Appleyard & Field (& Cobb): 14 and 15
Krugman & 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, 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 doesn’t 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
(1+τ)Pint
(1+τ)Pint
increase of
producer
surplus
tariff to the
government
Loss of consumer surplus
deadweight
loss
deadweight
loss
Pint
Pint DD DD Q
imports after tariff 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 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 welfare
Objectives
increase the ratio PX/PM ( = to make imports cheaper)
increase country’s aggregate welfare
Consistency & Implementation
IF the country is large enough, imposing a tariff may result enough decrease in world price and thus improvement in country’s 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), country’s welfare increases
optimum tariff = a tariff structure that maximizes country’s 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 e a D b
tariff
PFT
price decrease in country B C PB Q Q
Country 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
tariff e a D b
PFT
price decrease in country B 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 country’s import-competing producers
Home country’s government
Foreign country’s consumers
Losers
Foreign country’s exporters
Home country’s 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 MC
The monopolists maximizes profits by selling QD at home for price PD and QT-QD abroad for Pint 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 Predatory 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
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 country’s 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 R&D 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 world’s only supplier
Objective
to increase home country’s 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
MC+t=AC+t
Government
revenue
tariff
MC=AC 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 firm’s 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 other’s 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. 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 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
firm’s 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 firm’s reaction curve rightwards and the threat becomes credible H H’ F
QF*(QH*) E E’
QF*(QH’*) F H H’
QH*(QF*)
QH’*(QF*)
Home firm’s 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
Airbus
Boeing
Produces
Does not produce
Airbus: -5
Airbus: 0
Boieng: -5
Boieng: 100
Airbus: 100
Boieng: 0
Airbus
Boe i ng
Produces
Does not produce
Airbus: 5
Airbus: 0
Boieng: -5
Boieng: 100
Airbus: 110
Boieng: 0
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 > 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 tariff>0
→ Free trade is not an equilibrium
T2(T1)
Country 1’s tariff rate
T2*(T1*)
T1(T2)
T1*(T2*)
Country 2’s tariff rate

50. Tariff Game (2) Country 1 Country
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
Country 1
Country 2
Free Trade
Protection
Counry 1: 100
Counry 1: 120
Country 2: 100
Country 2: 50
Counry 1: 50
Counry 1: 60
Country 2: 120
Country 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 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