Lecture 5 - Strategic Trade Policy and Trade Blocs

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

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

Export Subsidies

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 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 duty The export subsidy increases the supply of imports to S^{2imports. The subsidy lowers the price in the
importing country.}

importers exports world
with export subsidy gain X+Y lose X+Y+Z lose Z
with countervailing duty lose Y gain Y+Z gain Z
both together gain X lose X 0
A countervailing duty big enough to offset the export subsidy shifts the supply curve back to S¹_imports. The countervailing duty hurts the importing country while it is beneficial for the world as a whole.

Dumping

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.

types:

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.

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

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.

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
dlatzko@wilkes.edu
wilkes1.wilkes.edu/~dlatzko

	importers	exports	world
with export subsidy	gain X+Y	lose X+Y+Z	lose Z
with countervailing duty	lose Y	gain Y+Z	gain Z
both together	gain X	lose X	0