Chapter 9
The Instruments
of Trade Policy
Introduction
•
Every model we developed in class shows that trade can increase
economic welfare.
Is free trade the optimal policy or is it possible
for the government to increase welfare
by influencing the amount of trade?
•
A trade policy is a government action meant to influence the amount
of trade. The most common are:
– Tariff: tax on imported products
– Quotas: Limits the quantity of a given product that can be imported
– Export subsidy: a payment to a firm that ships a product abroad
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9-2
Introduction
• Free trade is not the norm
Source :World Bank WDI 2012
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9-3
Introduction
• Why do countries impose restrictions?
1. Easy way to raise revenue
2. A large country can tilt the terms of trade in its favor
3. Distortions: infant industry protection
4. Political economy: redistribute income across different
groups in society
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9-4
Introduction
• It turns out that the impact of a trade policy depends on the
(relative) size of the country and the structure of the
industry
• Country size matters because:
– Small countries take the world price as given
– Large countries can influence the world price
• Market structure matters because:
– Under imperfect competition, trade policies can affect
market power (i.e., markups and prices)
– This is not the case under perfect competition
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9-5
Introduction
Road Map
1. Develop a measure of welfare to evaluate the impact of
different trade policies
2. Import Tariff
3. Import Quota
4. Export subsidy
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9-6
Welfare
• Welfare can be evaluated using two concepts:
– The consumer surplus (CS) is the difference between
what the consumers are willing to pay and the actual
price of the good.
– The producer surplus (PS) is the difference between
the price and the marginal cost.
• We can represent these surpluses in a simple demand and
supply graph.
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9-7
Welfare
•
CS is the area below the demand curve and above the price
•
PS is the area above the supply curve and below the price
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9-8
Welfare
• Welfare is the sum of the
CS and PS:
W = CS + PS.
• The greater the total
surplus, the greater the
total home welfare –the
better off the country is.
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9-9
Welfare
• How can we evaluate the impact of trade policies?
– We can compare welfare under different policies (e.g.,
closed economy vs. free trade).
– The policy that leads to the highest surplus is preferred
(e.g., if the total surplus is higher under free trade, we
conclude that there is no economic motive to stay in a
closed economy).
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9-10
Welfare
•
Consider a small country under
closed economy.
•
Suppose that the world price, PW,
is lower than the autarky price,
PA. (Why?)
•
Because the country is small, it
can buy or sell any amount it
desire in world markets without
affecting the world price.
•
What happens if we open the
country to free trade?
PW
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9-11
Welfare
•
The decrease in price has two
impacts:
1. the (domestic) demand goes
up to D1.
2. the (domestic) supply goes
down to S1.
•
The difference between demand
and supply is imported
IM = D1 – S1
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9-12
Welfare
•
What is the impact on welfare?
1. The CS increases from a to
a+b+d. Prices are lower, so
consumers are better off.
2. The PS decreases from (b+c) to
c. Prices are lower, so producers
are worse off.
3. The overall impact on welfare is
given by:
DW = DCS + DPS
= ( b + d ) + ( - b)
=d>0
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9-13
Welfare
•
We can provide a precise
estimate for the effect of trade on
welfare using simple geometry.
•
The change in welfare is equal to
the area of triangle d, which
implies that:
1
DW = M1 × (P A - P W )
2
•
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Gains from trade are increasing
in the quantity imported and the
price difference.
9-14
Import Tariffs - Small Country
•
The import demand curve (M) shows the relationship between the
world price of a good an the quantity of imports demanded by
consumers.
– Imports are inversely related to world price and equal to zero when
world price is equal to autarky price.
•
The export supply curve (X*) shows the relationship between the
world price of a good an the quantity of export foreign firms are willing
to supply to (domestic) consumers.
– Because Home is small, the export curve is flat at PW
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9-15
Import Tariffs - Small Country
Export supply curve, X*
•
•
Imports are inversely related to world price
Because Home is small, the export curve is flat at PW
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9-16
Import Tariffs - Small Country
What is the impact of imposing a tariff (t)
on a small open economy?
•
Because the economy is small, its decisions have on impact on world
markets.
– In particular, the world price remains the same.
– Therefore, the price of imported goods will be equal to the world
price plus the tariff: P = PW + t
•
Because Home is small, the export curve is still flat but now it is at P =
PW + t.
– The export supply curve (X*) shifts up
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9-17
Import Tariffs - Small Country
•
•
From the point of view of domestic consumers and firms, a tariff increases the
price of goods.
In the new equilibrium:
– the quantity demanded goes down (from D1 to D2)
– the quantity supplied by domestic firms goes up (from S1 to S2)
– Imports go down (from M1 to M2)
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9-18
Import Tariffs - Small Country
Welfare impact
•
Recall that CS is the area below
the demand curve (D) and above
the price.
•
An increase in price decreases
CS:
PA
ΔCS = -(a+b+c+d)
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9-19
Import Tariffs - Small Country
•
Recall that PS is the area above
the supply curve (S) and below
the price.
•
An increase in price increases
PS
ΔPS = a
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9-20
Import Tariffs - Small Country
•
The gain in government revenue
due to the tariff is equal to the
tariff, t, times the quantity of
imports, M2
G = t × M2
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•
This is equivalent to the shaded
area c
•
This revenue is a gain and
increases welfare.
9-21
Import Tariffs - Small Country
•
The overall impact of the tariff in the small country can be summarized
as follows:
Fall in consumer surplus
Rise in producer surplus
Rise in government revenue
Net effect on Home welfare
•
-(a+b+c+d)
+a
+c
.
-(b+d)
The area (b+d) is the deadweight loss of the tariff -- the loss that is not
offset by a corresponding gain.
Tariffs always lead to deadweight losses
for small open countries
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Import Tariffs - Small Country
Decomposition
• a is a transfer from
consumers to producers
• c is a transfer from
consumers to government
• (b+d) is deadweight loss
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Import Tariffs - Small Country
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Import Tariffs - Small Country
ΔM=ΔD-ΔS
DWL = ½ ΔD Ÿ t – ½ ΔS Ÿ t
= ½ (ΔD-ΔS) t
= ½ ΔM Ÿ t
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U.S. Tariffs on Steel
•
During the 2000 presidential campaign, President Bush promised he
would consider the implementation of a tariff on imports of steel.
•
President Bush requested that the U.S. International Trade
Commission (ITC) initiate a Section 201 investigation into the steel
industry.
•
The ITC determined that the conditions were met and recommended
that tariffs be put in place to protect the U.S. steel industry.
•
President Bush took the recommendation of the ITC but applied even
higher tariffs, ranging from 8% to 30%.
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U.S. Tariffs on Steel
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9-27
U.S. Tariffs on Steel
• We can use our model to obtain an estimate of how costly
these tariffs were in terms of welfare.
1
DWL = t × DM
2
• It is convenient to measure the deadweight loss relative to
the value of imports, which is PWM.
DWL 1 t × DM 1 t DM
= × W = × W×
W
P M 2 P M 2 P
M
• Note that t is a change in price, so that t/PW is the
percentage change in price – in other words, the tariff in
percentage.
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9-28
U.S. Tariffs on Steel
• We are going to use the most common tariff from the table:
30%
• Imports fell by about 30% over the first year.
• Using these values in our equation, we obtain:
DWL 1 t DM
= × W×
= (0.5)(0.3)(0.3) = 0.045
W
P M 2 P
M
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9-29
U.S. Tariffs on Steel
• We can obtain a dollar equivalent of the DWL by
multiplying our result by the value of import.
• The average import value over that period is $4.1 billion per
year.
DWL = (0.045) × P W M = (0.045) $4.1 billion = $185 million
– This deadweight loss reflects the net annual loss to the
U.S. from applying the tariff.
– Protecting jobs may be worth it, but it is not cheap.
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9-30
Import Tariffs - Large Country
What is the impact of a tariff
on a large open economy?
• When the country is large it can influence the world price:
– Potential gains to the economy (favorable changes in
the terms of trade)
– Imposes a loss on other countries
• If a tariff can raise welfare then:
What is the optimal tariff?
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9-31
Import Tariffs - Large Country
• The economy is large if a change in imports or tariff affects
the price of the good in world markets
• This means that the Foreign export curve (X*) is no longer
flat at the world price.
• To obtain the new export curve we use the foreign demand
(D*) and supply (S*) curves.
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Import Tariffs - Large Country
•
•
When the world price is higher then Foreign’s autarky price, Foreign exports
An increase in world price increases the volume of export (i.e., X* is upward
sloping).
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Import Tariffs - Large Country
•
The tariff increases the price
domestic consumers pay for
foreign goods.
•
X* shifts to X*+t.
•
The import demand curve (M) is not
affected by tariffs.
•
The tariff drives a wedge between
what Home consumers pay (P*+t)
and what foreign producers receive
(P*). The difference (t) goes to the
Home government
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P*+t
P*
9-34
Import Tariffs - Large Country
(a) Home market
Price
(b) Foreign market
Price
No-trade
equilibrium
X*+t
S
A
X*
t
C
P*+t
t
PW
B*
P*
D
C*
M
S1 S2
D2 D1
Quantity
M2
M1
Imports
M2
M1
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Import Tariffs - Large Country
•
The price Home pays for its imports P*+t rises by less than the amount
of the tariff, t, as compared to the initial world price, PW.
•
This is because the price received by foreign exporters, P*, has fallen
compared to the initial world price, PW.
•
Foreign producers are essentially “absorbing” a part of the tariff by
lowering their price from PW to P*.
•
The effect of the tariff on the terms of trade may be enough to increase
welfare.
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Import Tariffs - Large Country
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Import Tariffs - Large Country
•
Recall that the terms of trade is
the ratio of export prices to
import prices.
•
Since the tariff decreases the
(net of tariff) import price (P* <
PW), it follows that the terms of
trade at Home increases.
•
The terms-of-trade gain for Home
is given by:
e = (P W - P * )× (D 2 - S2 )
= DP × IM
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9-38
Import Tariffs - Large Country
•
Home may gain due to the
application of a tariff.
•
However, Foreign definitely loses
ΔW* = −(e + f)
– e is the terms of trade loss
– f is the loss associate with
lower export
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9-39
Import Tariffs - Large Country
• What is the effect of a tariff on world welfare?
– Home may gain from a tariff if the terms of trade effect is
strong enough
– Foreign always loses
– Aggregate world welfare always goes down
ΔW +ΔW* = e − (b+d) − (e + f) = − (b+d+f)
– Beggar thy neighbor tariff: A country can be better off
by making the other one worst off by more than the gain.
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9-40
Optimal Tariff
(a) Small tariff
(b) Large tariff
Price
Price
X*+t
X*+t
P*+t
P*+t
PW
P*
B
X
A
B
X
A
PW
M
P*
M
The welfare effect depends on the size of the tariff
– The ToT gains (e) are in green and the DWL (b+d) in red.
– When t is small e > DWL, but when t is large e < DWL
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9-41
Optimal Tariff
•
•
When t is small the terms of trade effect exceeds the DWL.
What is the optimal tariff -- maximizes welfare ?
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9-42
Optimal Tariff
•
The importing country can influence the export decision of exporting
firms by changing the tariff rate
•
As t changes, the Terms of Trade effect and DWL vary.
•
This implies that the tariff can be chosen to maximize the welfare gain:
W = e – (b+d).
•
One way to find the optimal tariff is to derive a formula for welfare using
demand and supply equation and computing the area e – (b+d).
– Requires strong assumption on demand and supply
– Lots of algebra
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9-43
Optimal Tariff
•
Instead, we use an indirect method.
•
We choose t such that the foreign country behaves optimally from the
point of view of domestic consumers (set MR* equal to MC) – This will
give the same answer.
•
Suppose that the (inverse) export supply curve can be written as:
P = P(X)
•
In which case the total revenue from export is: RX = P(X)X
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9-44
Optimal Tariff
TCM = RX = P X
MC M =
eX =
¶TC M
¶P
X ¶P ö
1 ö
æ
= P+X
= P + Pæç
=
P
1
+
ç
÷
÷
¶X
¶X
è P ¶X ø
è eX ø
¶X P
× >0
¶P X
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9-45
Optimal Tariff
•
Think of MC as the “efficient” supply
curve.
•
The “true” cost of importing is higher
than the price (PW) – because
importing an additional unit raises the
price of all imported units.
•
•
1 ö
æ
X* º P(X) < P(X) × ç1 + ÷ º MC M
è eX ø
P
The MCM curve lies above the export
supply curve X*
W
Without tariff, MCM > PW = MR: Home P
imports “too much”.
– Should be at point C not A
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MCM
B
X*
C
A
M
Q
9-46
Optimal Tariff
• Therefore, to maximize
welfare the importing country
will want to chose the tariff
such that:
P
MCM
1 ö
æ
MC M = P × ç1 + ÷ = P* + t opt
è eX ø
X*+topt
*
X*
P* + topt
• We can solve for the
optimal tariff:
t opt
P*
1
t opt =
or topt = * =
eX
P
eX
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M
Q
9-47
Optimal Tariff
•
The optimal tariff depends only the elasticity of Foreign export supply,
ex:
– When ex is low (differentiated goods with inelastic demand curve –
the curve is very steep) the optimal tariff is high.
– When ex is high (homogenous goods with elastic – the curve is flat)
the optimal tariff is low.
•
When the supply is inelastic, the Foreign country absorbs more of the
tariff. This leads to a large Terms of Trade gain.
•
For a small importing country, the elasticity of Foreign export supply is
infinite, and so the optimal tariff is zero.
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9-48
U.S. Tariffs on Steel Redux
•
If we apply this formula to the U.S. steel tariffs, we can see how the
tariffs applied compare to the theoretical optimal tariff.
•
Tariffs are lower than the predicted optimal level – potential gain from
increasing tariffs
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9-49
Import Quotas – Small Country
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9-50
Import Quotas – Small Country
P2
•
We assume that the quota is
binding – imports would be
higher in the absence of the
quota (M2 < M1, the free
trade level of imports)
•
We now have a vertical
export supply curve
•
The equilibrium price in the
Import Market is
P2 > Pw
Pw
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Import Quotas – Small Country
•
•
The Import Market price establishes the Home Market price (P2) .
At that price domestic supply is S2 and demand is D2
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Import Quotas – Small Country
• For consumers and producer, the impact of the quota is the
same as the equivalent import tariff: t = P2 − Pw.
• The big difference is that the government does not collect
revenue from tariff.
• The difference between the world price and the domestic
price creates quota rents
– Suppose you buy a unit in the world market and sell it at
home, you make profits.
– Those profits are called rents because they do not arise
from production
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9-53
Import Quotas – Small Country
• Who gets the rent?
• Quota licenses are permits to import the quantity allowed
under the quota system.
• The Home government has many options:
– Give licenses to domestic firms
– Give licenses to foreign firms
– Auction the licenses
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9-54
Import Quotas – Small Country
1. Home Firms get quota licenses
– The net effect on Home welfare due to the quota is then:
Fall in consumer surplus
-(a+b+c+d)
Rise in producer surplus
+a
Quota rents earned at Home
+c
Net effect on Home welfare:
-(b+d)
– This is the same DWL as with a tariff
– Revenue is collected by firms instead of the government.
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Import Quotas – Small Country
2.
Rent Seeking
– Because of the gains associated with owning a quota license, firms
have an incentive to engage in rent seeking – inefficient activities
(e.g., bribery or lobbying) – in order to obtain them.
– If we assume that rent seeking does not produce any useful output
(i.e., that it destroys resources), the loss is larger than a tariff.
Fall in consumer surplus
Rise in producer surplus
Net effect on Home welfare:
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-(a+b+c+d)
+a
-(b+c+d)
9-56
Import Quotas – Small Country
3. Auctioning the Quota
– The government of the importing country auction off the quota
licenses.
– In a well-organized, competitive auction, the revenue collected
should exactly equal the value of the rents.
Fall in consumer surplus
-(a+b+c+d)
Rise in producer surplus
+a
Auction revenue earned at Home
+c
Net effect on Home welfare:
-(b+d)
– This is the same loss as DWL as with a tariff.
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Import Quotas – Small Country
4. “Voluntary” Export Restraint
– The importing country gives authority for implementing the quota to
the exporting government.
• In May 1981, with the American auto industry mired in
recession, Japanese car makers agreed to limit exports of
passenger cars to the United States.
– With VERs, quota rents are earned by foreign producers:
Fall in consumer surplus
-(a+b+c+d)
Rise in producer surplus
+a
Net effect on Home welfare:
-(b+c+d)
– This is a higher net loss than with a tariff.
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9-58
Export Subsidy – Large Country
• An export subsidy, S, is a payment to firms per unit
exported. It is an “inverse tariff.”
• Suppose the exporter price is P* then:
– Foreign consumers pay P*
– Domestic firms receive P*+S
• In equilibrium, import demand is equal to export supply
which requires
M(P*) = X(P*+S)
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9-59
Export Subsidy – Large Country
To study export, we need
relabel the graph
World Price
Home exports
supply, X
Pw
Foreign import
demand, M*
Exports
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• X is the supply of exports
by Home: it gives optimal
export for each world price
• M* is the demand for
imports by foreign
consumers: it gives optimal
import for each world price.
9-60
Export Subsidy – Large Country
World Price
Home exports
supply, X
X-S
Pw
S
P*
Foreign import
demand, M*
Exports
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• Suppose that the
equilibrium export price
under the export subsidy is
Pw, then:
Pw = P* + S
• Foreign consumers pay P*
and the domestic
government pays S.
• From the point of view of
foreign consumers, X shifts
down by the amount of the
subsidy, S.
9-61
Export Subsidy – Large Country
(a) Home Market
(b) World Market
Home
Price
World
Price
D
!
Home exports
supply, X
S
X2
P*+s
s
X1
s
X–s
PW
P*
Foreign
import
demand, M*
D2 D1
S1 S2
Quantity
X1
X2
Exports
36 of
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9-62
Export Subsidy – Large Country
• The export subsidy leads to a reduction in world price (from
Pw to P*)
• However, the export subsidy raises the price in the
exporting country from Pw to P* + S
– To prevent (re)import at world price (Pw), import tariffs
are usually in place
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9-63
Export Subsidy – Large Country
Home
Price
D
b
d
P*+s
a
s
c
PW
S
Consumer surplus falls by
- (a+b)
Producer surplus increases by
+ (a+b+c)
Subsidy costs to government
- (b+c+d+e)
Net deadweight loss of
-(b+d+e)
e
P*
An export subsidy leads to costs that
D2 D1
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S1 S2
Quantity
exceed its (economic) benefits.
9-64
Imperfect Competition
• The results for the perfect competition case are useful
benchmark.
• However, many industries are characterized by imperfect
competition and a small number of producers.
What is the impact of trade policy
under imperfect competition?
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9-65
Tariff and Quota with Domestic Monopoly
Monopoly Model
• Suppose there is a single firm in the domestic market
– The demand, P(Q), is downward sloping – must lower
the price to sell more.
– Monopolist profits are maximized by choosing Q such
that MR = MC:
MR = P(Q) + P’(Q)Q = MC
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Tariff and Quota with Domestic Monopoly
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•
The MR curve is below the
demand curve
MR = P(Q) + P’(Q)Q < P(Q)
•
MC is increasing in Q –
decreasing returns to scale
•
Monopolist charges prices
above marginal costs
PM > MC
•
The monopolist charges more
and produce less than
perfectly competitive firms (PC,
QC)
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Tariff and Quota with Domestic Monopoly
International trade
• Assume that:
– Home is a small economy. Foreign firms will supply any
quantity to the domestic market at the world price: the
export supply curve is flat at Pw.
– The world price is lower than the monopoly price: Home
is an importer.
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9-68
Tariff and Quota with Domestic Monopoly
• The monopolist
– can supply any quantity at the world price
– but cannot charge more than the world price –
consumer would switch to foreign goods.
• The monopolist now faces a perfectly elastic demand curve
at the world price.
– Cannot affect the MR by changing Q (or equivalently P)
– This implies that MR = PW for any quantity sold.
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9-69
Tariff and Quota with Domestic Monopoly
• As before, the monopolist maximizes profit by choosing Q
such that MR = MC.
• Because MR = PW under free trade, this implies that:
MC = PW
Free trade eliminates the monopolist’s ability
to charge a price greater than its MC.
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9-70
Tariff and Quota with Domestic Monopoly
• Profits are maximized at Q
such that MR = MC.
– Under autarky (point A):
PM > MC
– Under free trade (point
B): PW = MC
• The monopoly price is lower
and output higher under
free-trade than in the closed
economy
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9-71
Tariff and Quota with Domestic Monopoly
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•
There is a difference between
domestic demand and supply
•
At the world price:
– The monopoly supplies S1 to
the market
– Consumers demand D1
•
The increase in demand is greater
than the increase in supply
•
The difference is imported from
Foreign (M1)
9-72
Tariff and Quota with Domestic Monopoly
Trade Policy: Tariff
• Suppose Home imposes a tariff, t, on imports:
– Price at Home increases from PW to PW + t
– The foreign export supply curve shifts up to X* + t
– The Monopolist still faces a flat demand curve at PW + t
– To maximize profits, it will set MC = PW + t
– The import demand curve is not affected by the tariff
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9-73
Tariff and Quota with Domestic Monopoly
•
The tariff increases the price paid
by domestic consumers.
– There is a decrease in
demand from D1 to D2.
– Monopolist increases its
supply from S1 to S2
– Imports go down because
supply goes up and demand
goes down (M1 to M2).
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9-74
Tariff and Quota with Domestic Monopoly
•
What is the impact on welfare?
•
The net effect on Home welfare is:
ΔCS
ΔPS
ΔG
ΔW
•
ECON40710 – University of Notre Dame
= -(a+b+c+d)
= +a
= +c
= -(b+d)
.
As with perfect competition, a tariff
leads to a DWL for small countries.
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Tariff and Quota with Domestic Monopoly
Trade Policy: Quota
• Now we look at the effect of a quota
• We choose a quota that will give us the same level of
imports as the tariff – equivalent quota .
• Under a quota, the monopolist retains the ability to
influence price
– The monopolist will never charge a price lower than the
world price.
– Consumers buy from foreign firms first
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Tariff and Quota with Domestic Monopoly
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•
The effective demand curve
facing the Home monopolist
under the quota is therefore the
old demand curve minus the
quota.
– D’ = D – M2
– The demand curve shifts left
•
As usual profits are maximized by
setting MR = MC (Point E)
•
The monopolist charges P3 and
produces S3.
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Tariff and Quota with Domestic Monopoly
ECON40710 – University of Notre Dame
•
By definition of equivalent quota
the import is the same as before
(D2 – S2 = D3 – S3).
•
However, the monopoly price is
higher and the quantity lower
with the quota (point E) then
under the equivalent tariff (point
C).
– Quantity consumed is lower
and average price higher
•
Under imperfect competition, a
quota is not equivalent to a tariff
even though the level of import
is the same under both policies.
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Tariff and Quota with Domestic Monopoly
ECON40710 – University of Notre Dame
•
We can also compare with free
trade (point B).
•
In our example, the monopoly
price is higher and the quantity
lower with the quota then under
free trade (point B).
– This does not have to be the
case (it depends on the
slopes of the curves), but it
is a possibility.
•
Why is this finding important?
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Tariff and Quota with Domestic Monopoly
•
Trade policies are often implemented to protect an industry.
– The quantity produced at Home (and as a result employment) under
the quota is lower than under free trade.
– The quota does not protect the industry.
•
What is the impact on welfare?
– We don’t compute it in details because it is difficult
– However, the DWL is higher then with a tariff because:
• Imports and world price are the same
• The monopolist charges a higher price and produce less
ECON40710 – University of Notre Dame
9-80
Tariff and Quota with Domestic Monopoly
U.S Import of Japanese Automobiles
•
The Japanese government announced that it would “voluntarily”
limit Japan’s export of cars to the US (this is a case of Voluntary
Export Restraints).
•
The quota restriction changed over time
– From 1.8 millions in 1981 to 2.5 millions in 1985
– By 1988 the quota was no longer binding – Japanese
companies began assembling cars in the US.
•
An potential response to a quota is that a firm may upgrade the
quality of the exported product.
– Ship fewer units but higher value per unit
ECON40710 – University of Notre Dame
9-81
Tariff and Quota with Domestic Monopoly
•
We decompose the price changes intro 3 parts:
1. Quota: change due to trade restriction
2. Quality upgrading: increase in price due to changes in product
characteristics
3. Trend: changes that would have occurred anyway
•
Source: Feenstra, Robert C. "Quality change under trade
restraints in Japanese autos." The Quarterly Journal of
Economics 103.1 (1988): 131-146.
ECON40710 – University of Notre Dame
9-82
Tariff and Quota with Domestic Monopoly
•
The figure shows the impact of the VER on the price of Japanese cars
•
The price rose from $5,150 to $8,050 between 1980 and 1985:
1. $1,100 is a result of the quota
2. $1,650 is quality improvement
3. $150 is trend
ECON40710 – University of Notre Dame
9-83
Tariff and Quota with Domestic Monopoly
•
What happened to the price of US cars during that period?
– Price goes up from $4,200 to $6,000 in just 2 years
– Most of it is simply exercise of market power by U.S producer
ECON40710 – University of Notre Dame
9-84
Tariff and Quota with Domestic Monopoly
•
By limiting the supply of cars from Japan, the export restraints
raised the prices of Japanese and US cars.
•
This increased car sales by U.S. firms, thereby hiking their profits.
•
This comes at the expense of American auto consumers.
– After accounting for the higher profits of American
automakers, the U.S. economy as a whole thus suffered
welfare losses totaling some $3 billion.
•
One key long-run consequence
– Provision: any Japanese cars produced in the U.S. were
excluded from the limits.
– Japanese makers responded to this provision by investing
heavily in U.S. production facilities.
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9-85
Tariff with Foreign Monopoly
•
Suppose that the Foreign exporting firm is a monopoly.
•
For simplicity, we assume no competing Home firm – Home demand is
supplied entirely by the foreign monopolist.
•
The monopolist maximizes profits by setting MR = MC
•
For simplicity, assume that the MC of production is constant
•
A tariff is equivalent to an increase in the marginal cost for the exporter
in the Home market
MC’ = MC + t.
ECON40710 – University of Notre Dame
9-86
Tariff with Foreign Monopoly
•
•
A tariff increases the MC
In the new equilibrium, the quantity is lower and the price higher.
ECON40710 – University of Notre Dame
9-87
Tariff with Foreign Monopoly
•
The consumer price increases by less than the tariff:
P2 < P1 + t
•
This happens because the MR curve is steeper than the demand curve:
A given change in Q has a smaller impact on P(Q) than on MR(Q)
•
This implies that the price received by the monopolist is now lower than
before:
P3 = P2 – t < (P1 + t) – t = P1
ECON40710 – University of Notre Dame
9-88
Tariffs with Foreign Monopoly
•
The Foreign firm is making a strategic decision to absorb part of the
tariff itself in order to maximize its profits.
•
Since the Home country is paying a lower net-of-tariff price for its
imports, it has experienced a terms-of-trade gain as a result of the
tariff.
•
Welfare will be higher with the tariff if the terms of trade effect is larger
than the DWL.
– Home welfare is higher for a small tariff but then decreases as the
tariff becomes large.
– This is similar to the impact of an import tariff for a large perfectly
competitive economy.
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Tariffs with Foreign Monopoly
ECON40710 – University of Notre Dame
•
ΔCS = – (c+d)
•
ΔPS = 0, there is no producer at
Home
•
ΔG = t X2 = c + e
•
ΔW = ΔCS + ΔPS + ΔG
=e–d
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Tariffs with Foreign Monopoly
Import of Japanese Trucks
•
To what extent do Foreign exporters absorb tariffs?
•
In the 1980s, the United Automobile Workers applied to the ITC for
protection -- It was determined that the recession was the primary
cause of contraction in the auto industry so the case was rejected.
•
At the time, most of the trucks were imported as cab/chassis with some
final assembly needed.
– The category “parts of trucks” carried a 4% tariff rate
– Another category “complete or unfinished trucks” faced a tariff of
25%
ECON40710 – University of Notre Dame
9-91
Tariffs with Foreign Monopoly
•
The U.S. Customs Service reclassified some products in “parts of
trucks” to “complete or unfinished trucks” to get the higher tariff.
– This reclassification raised the tariff rates on all Japanese trucks by
21%.
– By how much did the price rise?
•
Of the 21% increase, only 12% was passed through to U.S. consumer
prices
•
9% was absorbed by Japanese producers – increase in US terms of
trade.
ECON40710 – University of Notre Dame
9-92
Infant Industry Protection
•
Despite losses, nearly all countries use tariffs in the early stages of
economic development.
•
The infant industry case for protection:
– If given time to grow, the industry will be able to compete with
foreign firms in the future.
– Some short-term protection from imports is needed.
•
When should the Home government intervene with protection?
– Only if the costs today are smaller than the future gains
ECON40710 – University of Notre Dame
9-93
Infant Industry Protection
1. Learning
• Protection today increases output, this helps the firm to
learn better production techniques and reduce costs in the
future.
• For infant industry protection to be justified:
– Firm profit are negative at the world price
– And the firm cannot cover losses by borrowing against
future profits.
ECON40710 – University of Notre Dame
9-94
Infant Industry Protection
2. Externality
– Knowledge spillover: An innovation in one area helps
lower costs in other areas.
– This is an externality, it is not taken into account by the
firm when it maximizes its profit.
• A tariff can increase investment in technology that benefit
other industries.
ECON40710 – University of Notre Dame
9-95
Infant Industry Protection
•
In both of these cases, there is a market failure: The market does not
operate efficiently on its own.
•
The government can implement a policy (e.g. a tariff) to correct the
market failure.
– Can the government distinguish the industries that deserve infantindustry protection from those that do not?
– Is the policy going to create other distortions?
– Even if it eliminates the market failure it is still costly to implement
such a policy – increase in price.
ECON40710 – University of Notre Dame
9-96
Infant Industry Protection
1. Chinese Car Industry
• China joined the WTO on December 1, 2001
• Before that:
– Tariffs (260% in 1980 and fell to about 80% in 1996
– Quota restriction
• By 2006 tariffs were much lower: 25% in 2006
• China is now the largest car market in the world
• Is the Chinese automobile industry a successful case of
infant industry protection?
ECON40710 – University of Notre Dame
9-97
Infant Industry Protection
AUTOINDUSTRY--2009PRODUCTIONSTATISTICS
# Country
Cars
Share
SumShare
1 China
10,383,831 22%
22%
2 Japan
6,862,161
14%
36%
3 Germany
4,964,523
10%
46%
4 SouthKorea 3,158,417
7%
53%
5 Brazil
2,576,628
5%
58%
6 USA
2,246,470
5%
63%
7 India
2,166,238
5%
67%
8 France
1,819,462
4%
71%
9 Spain
1,812,688
4%
75%
10 Iran
1,359,520
3%
78%
Total
47,952,995
Source:InternationalOrganizationofMotorVehicleManufacturers
ECON40710 – University of Notre Dame
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Infant Industry Protection
Year
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Production
0.6
0.6
0.7
1.1
2.0
2.5
3.1
5.2
6.3
6.7
13.8
China
World
39.8
41.2
39.8
41.4
42.0
44.6
46.9
49.9
53.2
52.7
61.7
worldshare
2%
1%
2%
3%
5%
6%
7%
10%
12%
13%
22%
Source:InternationalOrganizationofMotorVehicleManufacturers
ECON40710 – University of Notre Dame
9-99
Infant Industry Protection
Production in China
• Begin in the 1980s China allowed joint ventures between
foreign firms (e.g. Jeep, Volkswagen, Peugeot)and local
Chinese partners.
– Foreign ownership was limited to 50%
– Chinese controlled the distribution network
– Why do they impose those restrictions?
• Some joint ventures achieved success (Most notably
Volkswagen)
• Jeep and Peugeot did not do very well
ECON40710 – University of Notre Dame
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Infant Industry Protection
Cost to Consumers
•
Trade policies kept imports very low throughout the 1980s
•
In addition some joint ventures enjoy local monopoly (Volkswagen).
•
What happens to prices when firms have lots of market power?
•
An increase in market power has little effect on production costs but a
huge impact on markups – the difference between price and production
costs.
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Infant Industry Protection
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9-102
Infant Industry Protection
Gains to Producers
• China currently exports some cars.
• This implies that the production costs are low enough to
compete on world markets.
• Is this the result of protection?
• Yes, trade policies and ownership restrictions for joint
ventures has led to a great deal of learning
ECON40710 – University of Notre Dame
9-103
Infant Industry Protection
2. Computers in Brazil
•
In the late 1970s, the Brazilian government thought that achieving
national autonomy in the computer industry was essential for strategic
military reasons.
•
In 1977, it began a program to protect domestic computer firms:
– Imports of PC’s were banned
– Domestic firms had to buy from local suppliers
– Foreign producers were not allowed to operate in Brazil
– The ban lasted until the early 1990s.
ECON40710 – University of Notre Dame
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Infant Industry Protection
•
The impact of the laws differ across market segments
– Large business and public sector buyers could not evade the trade
barriers.
– However, up to 65% of individual buyers bought technically
superior illegal imports.
•
Domestic firms do not produce for export, therefore they produced
mostly for large firms and public sector buyers.
•
10 major producers dominated the industry in the 1980s by supplying
around 80% of total (legally-supplied) sales.
ECON40710 – University of Notre Dame
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Infant Industry Protection
•
The 1980s was a period of rapid innovation in the computer industry
worldwide with large drops in the cost of computing power.
•
Brazilian firms were very good at reverse engineering the IBM PC’s
sold from the U.S.
•
But this took time and since Brazilian firms had to use local suppliers
for many parts, it added to the costs of production.
•
Brazil was never able to produce computers at competitive prices
without tariff protection.
ECON40710 – University of Notre Dame
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Infant Industry Protection
•
•
•
The growth rate is similar
But Brazil never achieved the same low prices as the U.S. – there is a 3
to 5 year lag
In that sense, the infant industry protection “failed”.
ECON40710 – University of Notre Dame
9-107
Infant Industry Protection
•
The price in Brazil is higher than in the US. Therefore:
– CS is lower than it would be under free trade
– PS is higher because would not be able to produce under FT
– The increase in PS does not cover the loss in CS
•
The higher prices in Brazil imposed costs on industries that relied on
computers
ECON40710 – University of Notre Dame
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Infant Industry Protection
• A number of reasons have been given for the failure of this policy:
– Imported materials (silicon chips) were expensive to obtain
– Regulations limited the entry of new firms in the industry
•
15 years of costly policy failed to develop an industry with competitive
prices.
•
President Fernando Collor de Mello abolished the infant industry
protection immediately after he was elected.
ECON40710 – University of Notre Dame
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Conclusions
•
A tariff on imports is the most commonly used trade policy.
•
The impact of a tariff depends on the size of the country
– When the country is small, a tariff always leads to a DWL
– If a country is large enough, a small tariff may lead to a terms of
trade effect high enough to increase welfare – world welfare is
always lower, however.
•
In a large economy, we can compute an optimal tariff which maximizes
welfare.
– It depends on the elasticity of demand. When the supply is not
responsive to changes in price the optimal tariff is low.
ECON40710 – University of Notre Dame
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Conclusions
•
Countries also may choose quotas, which restrict the quantity of imports into a
country.
•
Under perfect competition:
– Welfare effects are same as tariffs but generates quota rents instead of
guaranteed government revenues.
– Quotas are more difficult to use efficiently because of rent seeking
behavior.
•
With imperfect competition Tariff and Quota are no longer equivalent policies:
– With a tariff, a Home monopolist cannot exercise its monopoly power.
– With a quota, the Home firm is able to charge a higher price because it
enjoys a “sheltered” market.
ECON40710 – University of Notre Dame
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Conclusions
•
Countries sometimes use export subsidies, a payment to a firm that export.
– Welfare is always lower
•
Why not free trade?
– Easy way for governments to raise revenue
– Infant industry protection
– The government might care more about protecting firms than avoiding
loses for consumers (redistribution)
ECON40710 – University of Notre Dame
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