EC 340

Lecture 5 - Strategic Trade Policy and Trade Blocs

from last time
strategic trade policy
export subsidies
countervailing duties
manufacturing leadership
trade blocs
trade embargoes

From Last Time

Strategic Trade Policy

Strategic trade policy refers to the aggressive support by a nation's government of the international competitive position of home firms.

Imagine that a new technology will soon be available to produce a new kind of passenger aircraft and that there are two firms (Boeing and Airbus) in a position to develop that technology. The economics are such that only one firm can enter the market profitably: profits are 100 if only one firm enters; if both enter, they each lose 10.

payoff table
What will happen? Suppose Boeing enters first, Airbus will stay out and Boeing reaps the profits.

Suppose that a group of European governments promise Airbus a subsidy of 20 if it enters the market, regardless of what Boeing does.

payoff table
Whatever Boeing does, Airbus finds it profitable to enter. But, this means that if Boeing enters it will lose money. So, Boeing doesn't enter and Airbus does.

problems with strategic trade policy

Export Subsidies

export subsidyAn export subsidy raises the domestic price above the world price by the amount of the subsidy because domestic firms would be unwilling to sell at home for less than they would receive if the product was exported. As a result, consumers lose areas A and B. Producer surplus rises by areas A+B+C+D+E. The cost of the subsidy to the government equals areas B+C+D+E+F. Overall, th ere is a net national loss equal to areas B+F.

Countervailing Duties

GATT's rules hold that export subsidies on manufactured goods are illegal for developed countries and an importing country can retaliate by imposing countervailing import duties.

countervailing dutyThe export subsidy increases the supply of imports to S2imports. The subsidy lowers the price in the importing country.
with export subsidygain X+Ylose X+Y+Zlose Z
with countervailing dutylose Ygain Y+Zgain Z
both togethergain Xlose X0
A countervailing duty big enough to offset the export subsidy shifts the supply curve back to S1imports. The countervailing duty hurts the importing country while it is beneficial for the world as a whole.


Dumping is a form of price discrimination. It occurs when an exporting firm sells at a lower price in a foreign market than it charges in its home-country market. Predatory dumping has the purpose of eliminating competitors so as to later raise prices.

A firm will maximize profits by charging a lower price to foreign buyers if it has greater monopoly power in its home market than abroad and if buyers in the home market cannot import the good cheaply.

A price discriminating monopolist maximizes profits by setting marginal revenue in each market equal to marginal cost. The price will be higher in the market with the less elastic demand.

U.S. firms may bring dumping charges against foreign competitors. If the Commerce Department finds that dumping has occurred and the U.S. International Trade Commission finds that U.S. firms have been injured, an extra import tax equal to the proven price discrepancy is levied.

Manufacturing Leadership

The purpose of strategic trade policy is to gain international leadership. Manufacturing is the usual focus because manufacturing has more potential for external benefits and economies of scale. We can look at relative prices to determine leadership.

Japan caught up to the U.S. in the steel industry by the 1970's because of differences in wages rates, productivity, and the costs of raw materials. Government policies played no role.

In automobiles, high union wages and lagging productivity were the reasons why U.S. auto makers fell behind. Japanese government policies played a secondary role.

The Japanese government targeted electronics for rapid export growth by underwriting research and development spending and by protecting the home market.

Trade Blocs

An economic bloc consists of two or more countries joined together into a closer economic union than each has with the rest of the world.


  1. free trade area

    NAFTA is an example of a free trade area. In a free trade area member countries trade freely among themselves but have different policies towards non-members.

  2. customes union

    Members of a customs union adopt common tariff policies towards non-members.

  3. common market

    Members allow full freedom of labor and capital migration among themselves in addition to having a customs union.

  4. economic union

    Members unify all their economic policies as well as policies toward trade and factor migration.

trade creation versus trade diversion
Are preferential trade agreements beneficial? Since they represent a move towards free trade, preferential trade agreements create trade (which is good). However, since preferential trade agreements discriminate against non-members, they may divert trade away from the low cost supplier (which is bad). The above diagram represents the U.S. market for some product on which a tariff is levied. Since China is the low cost supplier, we import the product from China and pay the Chinese price plus the tariff. NAFTA eliminate tariffs on Mexican imports but leaves the tariff on imports from China. We now import the product from Mexico. The level of imports rises but trade has been diverted away from the low cost supplier, China.


NAFTA provides for the elimination of tariff and most non-tariff barriers to trade and investment on trade between the U.S., Canada, and Mexico. Opponents point to the fact that average hourly compensation in Mexican manufacturing is only 14% of the U.S. figure and argue that low Mexican wages and poor enforcement of Mexican labor standards will deprive U.S. workers of jobs and drive down U.S. wages.

But, high U.S. labor productivity pays for high U.S. wages. And, opponents ignore the jobs created by increased trade with Mexico. NAFTA should stimulate Mexican income growth, so there will be more U.S. exports to Mexico. Exports to Mexico support 122,000 more jobs today than in 1993. Only a couple of thousand Americans have been certified as having lost their jobs due to NAFTA.

NAFTA opponents also argue that Mexico has lower environmental standards and that this causes U.S. factories to move to Mexico. Also, NAFTA gives Mexico the right to challenge the strict U.S. environmental regulations.

In reality, Mexican standards are similar to those of the U.S. and rising Mexican incomes will lead to demand for more environmental protection. And, any challenge to U.S. environmental standards must be based on the absence of scientific evidence justifying a trade barrier. In the end, NAFTA will probably cause Mexico to produce less chemicals, rubber, and plastics (all dirty items) and more agricultural and labor-intensive products (both relatively cleaner).

U.S. exports to Mexico grew by 36.5 percent (or $15.2 billion) from 1993 to a record high in 1996, despite a 3.3 percent contraction in Mexican domestic demand over the same period.

Trade Embargoes

A trade embargo is a complete ban on trade. The majority of embargoes fail to alter the policies of the target nations.

Consider a total embargo on exports to Iraq.

trade embargo
Haiti: fall in consumer surplus = B+C
Embargoing countries: loss of profits on exports = A
Non-embargoing countries: gain of producer surplus = B

world as a whole loses A+C

David A. Latzko
318 COB
Department of Business and Economics
Wilkes University
Wilkes-Barre, PA 18766
phone: (717) 408-4718
fax: (717) 408-4917