Lecture 5 - Strategic Trade Policy and Trade Blocs
from last time
strategic trade policy
From Last Time
- Anything a tariff can do to encourage domestic production a subsidy can do at a smaller net national loss because, unlike the tariff, a subsidy does not raise the price to domestic consumers.
- The world price is set by the supply and demand for imports. With an optimal tariff, the world price falls because the higher domestic price due to the tariff causes consumers to purchase less. So, even though consumers are paying a higher price
because of the tariff, the nation gains because it is able to purchase the product from other countries at a lower world price.
- Import quotas would cut imports first. The decrease in supply would raise the price causing domestic firms to increase production.
- We are going to discuss the politics of trade after the exam. Political influence determines which industries receive trade protection.
- The spillover argument for trade protection is based on the idea that an industry generates benefits for other industries for which the industry is not compensated. Maybe certain industries are not fully compensated for their research and development
expenditures. The argument is typically made for technologically progressive industries where firms can capture the results of other firms' research by simply taking apart a product to see how it works. Trade protection can both compensate this
industry for the spillover benefits it generates and encourage more production and more spillover benefits.
- Indifference Curve Analysis of a Tariff
|Under free trade, the country produces at point A and consumes at point B on indifference curve I1. A tariff raises the domestic price of the import good. The slope of the price ratio
line is the price of the export good divided by the price of the import good. So, the tariff flattens out the price ratio line. The economy now produces at point C and consumes at point D on a lower indifference curve, I 2. The level
of imports falls as domestic production of the import good rises. The fall in welfare is due to the distorting effects of the tariff on consumption.|
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.
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.
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
- government must estimate the potential payoff of each course of action
- the behavior of rival governments must be anticipated
- many interest groups will compete for the governmental assistance although only a small number of industries can be considered potentially strategic
- subsidizing one domestic industry takes resources away from others
|An 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
is a net national loss equal to areas B+F.|
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.
|The export subsidy increases the supply of imports to S2imports. The subsidy lowers the price in the
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.
|with export subsidy||gain X+Y||lose X+Y+Z||lose Z|
duty||lose Y||gain Y+Z||gain Z|
|both together||gain X||lose X||0|
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.
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.
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.
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
- 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.
- customes union
Members of a customs union adopt common tariff policies towards non-members.
- common market
Members allow full freedom of labor and capital migration among themselves in addition to having a customs union.
- economic union
Members unify all their economic policies as well as policies toward trade and factor migration.
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.
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.
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