Trade Policy: Arguments
Appleyard & Field (& Cobb): 14 and 15
Krugman & Obstfeld: Chapters 9 and 11
1
Today’s Lecture
1. Traditional Arguments for Protection
o
Infant-Industry, Terms-of-Trade, Anti-Dumping, Offsetting a
foreign subsidy, Aggregate unemployment, Promoting a particular
industry, National security, Externalities
2. Strategic Trade Policy
o
o
o
Tariff to Extract Foreign Monopoly Profit
Economies of scale & Duopoly
Export Subsidy & Duopoly
2
Analysing a Policy Proposal:
Questions to Ask
When you hear an argument about any policy, you
should ask:
1.
2.
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?
3.
4.
5.
Who gains, who losses?
What is the net effect?
Does a more efficient way(s) to achieve the
objectives exist?
3
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
4
Analysing the Infant Industry Argument
• Objective
o to realize a potential comparative advantage
• Consistency
o 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?
o Implementation
 Problem with identifying the right industries
 Time consistency: will the protection eventually
become permanent?
5
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
P
consumer
surplus
producer
surplus
D
Quantity (Q)
6
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
P
SD
P
increase of
producer
surplus
Loss of consumer surplus
Pint
tariff to the
government
(1+τ)Pint
(1+τ)Pint
Pint
DD
imports after tariff
Q
DD
imports after tariff
Q
7
imports in free trade
imports in free trade
Analysing the Infant Industry Argument
• Winners and losers
o
o
o
Protected producers win
Government gets tariff revenue
Consumers lose in the short-run, but win in thelong run IF protection leads to higher efficiency
and thus lower prices
• Net impact
o IF efficiency improves the net effect for the
country and the world is positive
8
The Impact of Subsidy to ImportCompeting Industry (Small Country Case)
SD
P
P
Cost to the
government
P
P
SD
increase of
producer
surplus
DD
DD
imports after the subsidy
imports in free trade
Q
imports after the subsidy
Q
imports in free trade
9
Analysing the Infant Industry Argument
• Alternative policy
o Subsidising the infant industry would deliver the same
result with less cost, i.e. a more efficient policy exists
• Conclusion
o
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 Self10
Discovery. NBER Working Paper 8952. The “Economics Focus” section of the Economist in Feb
27th 2003 introduces the main points of this paper.
Terms-of-Trade Argument
Restrictive trade policy can improve country’s terms-oftrade and thus increase its welfare
Objectives
•
o
o
increase the ratio PX/PM ( = to make imports cheaper)
increase country’s aggregate welfare
Consistency & Implementation
•
o
o
o
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
11
welfare
Single Market, Two Countries, Free Trade
P
Country A
Country B
P
SA
SB
DB
DA
Q
Q
12
Single Market, Two Countries, Free Trade
P
Country A
Country B
P
SA
SB
DB
DA
Q
Q
Countries A and B have different supply curves (cost of production) and demand curves
13 the
(preferences). In free trade equilibrium the world price is such that country B is willing to export
same quantity as country A is willing to import.
Single Market, Two Countries, Tariff
P
Country A
Country B
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
14
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)
Effect of a Tariff in a Single Market
and Two-Countries
Country A
P
DA
Country B
P
SA
DB
SB
PA
PFT
e
a
D
b
tariff
C
price decrease
in country B
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
15
before tariff).
Impact of Elasticises
Country A
P
DA
P
SA
PA
PFT
Country B
SB
DB
e
tariff
a D b
PB
C
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
price decrease
in country B
Q
16
Analysing the Terms-of-Trade Argument
• Winners
o
o
o
Home country’s import-competing producers
Home country’s government
Foreign country’s consumers
• Losers
o
o
Foreign country’s exporters
Home country’s consumers
• Net Impact
o
o
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
17
Analysing the Terms-of-Trade Argument
• Alternative policy
o
if the objective is just to improve terms of
trade, tariff is the most effective instrument
• Other considerations: retaliation
• Conclusion
o
a case for terms-of-trade argument exists for
large countries. However, this requires that
a) suitable conditions exist and
b) no retaliation
18
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
o to stop an unfair trading practice (dumping)
• Consistency: Depends on the type of dumping
o 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

o
19
Rationale for Persistent Dumping:
Domestic Monopoly
Price
Domestic monopoly is able to get
Pint from the world market 
Pint = minimum marginal revenue
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
QDQA QT
exports
Quantity
20
Rationales for Temporary Dumping
• Predatory
o
A foreign firm sells at low price in order to
eliminate competition and eventually to reap
monopolist profits
• Sporadic / Cyclical
o
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)
21
Impact of Dumping
• Persistent dumping
o
o
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)
o
Positive net welfare effect (compared to a tariff regime)
• Predatory dumping
o
o
o
Losers: impost-competing home firms, home and foreign consumers
Winner: foreign (dumping) firm
Negative net welfare effect (compared to a tariff regime)
• Sporadic dumping
o
o
o
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
22
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?
o
o
To prevent predatory dumping: yes
To prevent persistent dumping : no
• Alternative policy
o
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?
23
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
o
to offset a distortion due to a foreign subsidy
• Consistency
o
The subsidy moves foreign supply curve
downwards, a tariff moves it upwards → a tariff
can be used to offset the impact of a subsidy
24
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
o
o
o
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
25
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.
26
Analysing the Impact of a Tariff to
Aggregate Unemployment
Objective
•
o
to decrease aggregate unemployment
Consistency
•
o
in the models presented in this course, we have assumed full
employment (thus the discussion here is quite informal)
o
a tariff/quota will increase the domestic
production of the protected good (and hence
demand for labour in this sector)
o
o
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
27
Analysing the Impact of a Tariff to
Aggregate Unemployment
• Winners (home country)
o producers of the import-competing good
o previously unemployed, who get a job in the import-competing
industry
o government (tariff revenue)
• Losers (home country)
o consumers
o producers of the export good
o previously employed, who lose their jobs in the export good industry
• Net Impact
o depends on the (possible) net decrease of unemployment rate and the
efficiency cost of the tariff
28
Analysing the Impact of a Tariff to
Aggregate Unemployment
• Alternative policy
o expansionary fiscal and/or monetary policies would
increase employment more directly
• Conclusion
o While tariff might decrease unemployment under some
circumstances, macroeconomic policies would do the
job more efficiently and with higher chance of success
29
Tariff to Increase Employment in a
Particular Industry
Tariff on imports will increase the domestic production of the importcompeting 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
o
to increase the production of and reallocate labour to the importcompeting industry
• Consistency
o setting a tariff will lead to the objective
• Negative net impact due to efficiency loss
• Alternative policy
o again, subsidising the import-competing industry would result the
same outcome with less cost
30
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
31
The Externality Argument for Tariffs
1. There is a negative externality in consumption of
imports OR
2. There a positive externality in producing importcompeting products
→ Setting a tariff on imports is a way to increase
social welfare
32
Analysing the Externality Argument
•
Objectives
1.
2.
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
33
Analysing the Externality Argument
•
Critical questions
1.
2.
•
How to measure the size of the externality?
Why restrict only consumption of imports, but not
that of the domestic produced good?
Alternative policy
1.
2.
Negative externality: impose a tax on consuming the
product, regardless of the location of manufacturing
Positive externality: Subsidise the domestic industry
34
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.
35
Strategic Trade Policy Models
• Introduces the theory of industrial organization (IO)
to the context of international trade
o
First papers published in early 1980s
• A variety of models that share common features:
o
o
o
Imperfect competition
Recognized interdependence
Economies of scale (often, not always)
36
Case 1: Tariff to Extract Foreign
Monopoly Profit
• Market Structure
o Home country faces a foreign monopoly that is the
world’s only supplier
• Objective
o to increase home country’s welfare
• Consistency
o theoretically sound argument exists (next slide)
• Welfare Impact
o Home country wins, foreign monopoly loses
o 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
37
Tariff to Extract Foreign Monopoly Profit

Q2
MC+t=AC+t
tariff

Imposition of a tariff
increases prices and
decreases quantity →
loss of consumer
P2
surplus
Loss of consumer
surplus
However, part of the
1
monopolists profits are P
transferred to the
Government
government
revenue
If government revenue
is larger than the loss
of consumer surplus,
the country gains
Price

MC=AC
D
MRA
Q1
Quantity
38
For simplicity, we assume a horizontal marginal cost curve (just to make the graph easier to draw, the model
does not depend on it).
Case 2: Economies of Scale in a Duopoly
Framework
• Market Structure
o Duopoly = two firms (home and foreign)
• Objective
o increase production and exports of the home firm
• Consistency requires:
1. economies of scale
2. firms behave strategically (=take each others actions into account)
• Welfare Impact
o 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 Presence39
of Oligopoly and Economies of Scale. In Kierzkowski (ed.) Monopolistic Competition in International Trade
Reaction Curves
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
Foreign firm sales
• Reaction curve plots the profit
H
F
The HH curve plots the
optimal production of the
home firm given the
production of the foreign
firm (FF curve, vice versa)
F
H
Home firm sales
40
The Interdependence of Marginal
Costs and Output
• MM curve: given a level of
assume economies of scale)
• QQ curve: given a marginal
cost, what is the profit
maximizing output? (downward
Marginal cost
output, what is the marginal
cost? (downward sloping, since we
Q
Q’
M
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.
M
Q
Q’
Output
41
The Impact of a Protection to
Reaction Curves
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
Foreign firm sales
• The home country imposes a
H
F
E
E’ F
H
Home firm sales
42
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
43
Case 3a: Export Subsidy in Duopoly
•
•
•
•
Market Structure
o Two firms (home and foreign) competing in a third
market (no sales in home or foreign market)
Objective
o To increase the sales of the home firm
Consistency (key assumptions)
1. firms behave strategically (take each others actions into account)
2. both know each others reaction curves
Note that we are not assuming economies of scale here
Welfare Impact
o Home firm wins, foreign firm loses, net impact is not
evident
44
The Impact of a Export Subsidy to
Reaction Curves
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
F
QF*(QH*)
E’ and announces that it will
produce QH’*
• The foreign firm does not believe
the threat (if foreign firm continues to
H
H’
E
QF*(QH’*)
• The home firm wants to move
Foreign
to firm’s sales
E’
F
H H’
QH*(QF*)
QH’*(QF*)
Home firm’s sales
45
Case 3b: Export Subsidy in Duopoly
• Market Structure
Two firms (home and foreign)
o Such economies of scale that if both produce, both lose
• Objective
o To get home firm to produce and foreign firm not to
produce
• Consistency (key assumptions)
1. Sufficient economies of scale (for a natural monopoly to exits)
2. Firms behave strategically
• Welfare Impact
o Home firm and home country wins, foreign firm and foreign
country loses, net impact not evident
o
46
Hypothetical Example:
Airbus and Boeing
Without subsidy
Airbus
B
o
e Produces
i
n Does not
g produce
Produces
Does not
produce
Airbus: -5
Airbus: 0
Boieng: -5
Boieng: 100
Airbus: 100
Airbus: 0
Boieng: 0
Boieng: 0
Airbus gets 10 as subsidy if it
produces
Airbus
B
o
e Produces
i
n Does not
g produce
Produces
Does not
produce
Airbus: 5
Airbus: 0
Boieng: -5
Boieng: 100
Airbus: 110
Airbus: 0
Boieng: 0
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].
47
Strategic Government Interaction
• Setting
o Governments choose trade policy given the trade policy
of other governments
• Objective
o To maximize national welfare
• Key Assumptions
o large countries (terms-of-trade effect exists → optimum
tariff > 0)
• Welfare Impact
o When countries individually choose optimum tariff
suboptimal trade equilibrium follows
48
• In a two-country case, both
countries can use the
terms-of-trade effect →
optimum tariff>0
→ Free trade is not an
equilibrium
Country 1’s tariff rate
Tariff Game (1)
T2(T1)
T2*(T1*)
T1(T2)
T1*(T2*)
Country 2’s tariff rate
49
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
Country 1
Free
Trade
C
o
u
n Free Trade
t
r
y
2
Protection
Protection
Counry 1:
Counry 1:
100
120
Country 2:
Country 2: 50
100
Counry 1:
50
Country 2:
120
Counry 1: 60
Country 2: 60
50
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
51