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Week 10: Import Tariffs and Quotas Under Imperfect Competition Reading: Chapter 9 • How do the effect of a tariff and the effect of a quota differ in the case where there is a monopoly in the importing country? • What is the effect of a tariff imposed against imports produced by a Foreign monopolist? • What is the effect of imposing anti-dumping duties? • What is the effectiveness of infant industry protection? ECON847 INTERNATIONAL TRADE 1 The Context • In the previous week, we looked at the effects of tariffs and quotas under the setting of perfect competition. That is, we assumed a situation where there are many suppliers both in Home and in Foreign (or the rest of the world). • This week, we consider tariffs and quotas on imperfectly competitive markets. Do the effects of trade policies differ when markets are imperfectly competitive? • This question received a good deal of attention from trade economists in 1980s, in a body of research that became known as strategic trade policy. ECON847 INTERNATIONAL TRADE 2 Introduction • The idea of strategic trade policy is that government trade policies could give a strategic advantage to Home firms in imperfectly competitive markets that would enable them to compete effectively with Foreign firms. – That is, free trade may not be the best policy for the nation. • In looking into strategic trade policies, we consider the following four cases: – Effects of trade policies in the case of Home monopoly (and many Foreign firms). – Effects of trade policies in the case of Foreign monopoly (and no Home firms). – The case of dumping (of a Foreign monopolist) and anti-dumping duties (tariffs). – The case of protecting a Home monopolist in an infant industry. ECON847 INTERNATIONAL TRADE 3 Home Monopoly • Consider a Home monopolist—a single firm selling a homogenous good. • Opening up to free trade introduces many foreign firms selling the same good. This would eliminate the monopolist’s market power (ability to charge a higher price than its marginal cost). • Recall from week 9 that tariffs and quotas are predicted to have an equivalent effect in Home in the setting of perfect competition. • In the case of Home monopoly, tariffs and quotas are predicted to have different effects. ECON847 INTERNATIONAL TRADE 4 Basics of Imperfect Competition: Review • Recall from the introductory econ, the mechanics of profitmaximisation under imperfect competition. • You are expected to understand the followings in conjunction with the diagram below: – A down-sloping demand curve implies a firm’s price-setting power. – A flatter (steeper) demand curve implies that a firm faces more (less) competition in the market. – The marginal revenue lies below the demand curve. – The firm maximises its profit when MR = MC. ECON847 INTERNATIONAL TRADE 5 Home Monopoly: No Trade Equilibrium • With no trade, the firm maximises its profit when MR = MC. • The Home monopolist produces QM and charges PM (point A). • Note that PM < MC. This indicates the monopolist’s market power. • The monopoly quantity is lower and the monopoly price is higher than the perfectly competitive equilibrium (point B). ECON847 INTERNATIONAL TRADE 6 Home Monopoly: Free Trade Equilibrium • Under free trade the world price PW applies. That is, the monopolist faces new marginal revenue (MR* = PW). – The Home market becomes perfectly competitive. – The monopolist (who is not the monopolist anymore) cannot sell any products at a price higher than PW. The monopolist loses its market power. • Given the new MR, the Home firm supplies S1, and Home consumers demand D1. • The amount of imports is M1 = D1 – S1. • Note that free trade equilibrium is same as the case under perfect competition from the last week. ECON847 INTERNATIONAL TRADE 7 Home Monopoly: Effect of a Home Tariff (1) • When a tariff, t per unit, is imposed, the price of imports increases from PW to PW + t. • This allows the Home firm to raise its price to PW + t. – But no higher than PW + t. Why? • The Home firm increases supply from S1 to S2. • Home consumers decrease demand. – Show on the diagram. • The amount of imports decreases. – Show it on the diagram. ECON847 INTERNATIONAL TRADE 8 Home Monopoly: Effect of a Home Tariff (2) • • • • Let us analyse the welfare effect. CS decreases by (a + b + c + d). PS increases by (a). Government’s tariff revenue increases by (c). The net effect of a tariff on Home is then –(b + d). • The triangle (b) represents the production efficiency loss, and (d) represents consumption efficiency loss. • Note that this prediction is the same as the case of perfect competition from the last week. ECON847 INTERNATIONAL TRADE 9 Home Monopoly: Effect of a Home Quota (1) • Now we look at the effect of a quota. • Recall that under free trade the Home monopolist produces at point B, and that with a tariff it produces at point C. • Now assume a quota of M2. – A quota that restricts imports to the same amount that would have been under a tariff t. • Under a quota of M2, the demand curve for the Home monopolist shifts to the left by the amount of a quota. – After the quota is filled up, the Home monopolist is able to exercise its monopoly power. ECON847 INTERNATIONAL TRADE 10 Home Monopoly: Effect of a Home Quota (2) • With the market demand D - M2, the Home monopolist maximises its profit when MR = MC: it produces S3 and charges P3. • The price charged under a quota is higher than the price under a tariff: P3 > PW + t. – This is because the Home monopolist enjoys a ‘sheltered’ market once the quota amount has been imported. • The quantity produced by the monopolist is lower under a quota than that under a tariff: S3 < S2. ECON847 INTERNATIONAL TRADE 11 Home Monopoly: Effect of a Home Quota (3) • Also note that a quota could make the Home monopolist produce less than under free trade: S3 < S1. – This is not a necessary result. It could be S3 > S1 depending the position of MR. – However, this implies that workers in the industry could fail to be protected due to the reduction in output under a quota. – That is, a quota can have undesirable effects as compared to a tariff when the Home industry is a monopoly. ECON847 INTERNATIONAL TRADE 12 Home Monopoly: Effect of a Home Quota (4) • A higher price under a quota implies lower CS compared to the case of a tariff: and the Home monopolist earns higher profit from a quota than from a tariff. – We can say that the deadweight loss would be higher under a quota than under a tariff due to a higher domestic price. – This is another rationale for WTO’s effort to ‘tarrificate’ non-tariff measures. • A higher price also implies a larger amount of quota rents: (P3 - PW) x M2. – This is more than the government revenue under a tariff: t x M2. – Note that quota rents can disappear through rent-seeking or go to the foreign producer in case of VER. ECON847 INTERNATIONAL TRADE 13 Foreign Monopoly: Free Trade Equilibrium • Consider a Foreign firm that is an international monopolist. – That is, Home does not have domestic producers and the Foreign monopolist considers the whole Home demand (D). • Under free trade, the Foreign monopolist maximises its profit when MR = MC (point A). It exports X1 to Home and charges P1. ECON847 INTERNATIONAL TRADE 14 Foreign Monopoly: Effect of a Home Tariff (1) • When a tariff, t per unit, is applied, the Foreign monopolist’s marginal cost rises from MC* to MC* + t. • Foreign monopolist maximises its profit when MC*+t = MR. • The Foreign monopolist’s exports fall from X1 to X2. • The Home’s domestic price rises from P1 to P2. – Note that the price rise is less than the tariff t. – This is because the Foreign monopolist absorb part of the tariff itself by lowering its ‘take-home’ price from P1 to P3 (= P2 – t). ECON847 INTERNATIONAL TRADE 15 Foreign Monopoly: Effect of a Home Tariff (2) • Due to the price rise in Home, CS decreases by (c + d). • Home collects tariffs revenue (c + e). • The net welfare effect of a tariff on imports from the Foreign monopolist is (e – d). • The area (e) is the terms-oftrade gain for Home due to the reduction in the price of imports. – Note that the effect of a tariff applied against a Foreign monopolist is similar to that of a tariff imposed by a large country. ECON847 INTERNATIONAL TRADE 16 Dumping (1) • Dumping is selling exports at a price that is ‘too low’. • An imported product is considered dumped if a foreign firm sells a product abroad at a price that is either i) less than the price it charges in its local market, or ii) less than its average cost to produce the product. • Dumping would benefit consumers but hurt import-competing producers. ECON847 INTERNATIONAL TRADE 17 Dumping (2) • Why foreign firms dump their products at all? 1. A foreign firm may try to drive competitors out of business and secure a market share. This is called predatory dumping. – It is believed that such practice is rare and would be temporary as it is not sustainable for the foreign firm. 2. It can be profitable to sell at low prices abroad, even at prices lower than average cost. This is called price discrimination. ECON847 INTERNATIONAL TRADE 18 Dumping (3) • Recall from the introductory microecon, that firms in imperfect competition (e.g. monopolist) can charge different prices across different groups of people whenever that pricing strategy is profitable. This pricing strategy is called (the third degree) price discrimination (e.g. regular price vs. student price). • This occurs in international trade as well: firms with market power (in multiple countries) may set different prices across countries. – Note that for foreign firms to discriminate in international trade, consumers in the high-price market should not be able to import directly from the low-cost market (e.g. transport costs, tariffs). ECON847 INTERNATIONAL TRADE 19 Dumping (4) • This is an illustration of a price-discriminating Foreign monopolist. • In order to maximise its profits the Foreign monopolist charges a lower price in Home where the demand is more elastic than the Foreign demand. Pugel, T. A. (2014), International Economics, 16th ed., McGraw-Hill ECON847 INTERNATIONAL TRADE 20 Dumping and Anti-dumping Duties (1) • Dumping is common but discouraged by the WTO. • Under the WTO rules, the ‘dumpee’ country is entitled to apply a tariff if dumped products are found to have injured importcompeting industry. This is called an anti-dumping duty. – If the export’s local price is not available, then dumping is determined by comparing the price in question with a price charged in a third market or the exporter’s average cost of production. – Anti-dumping duties are controversial because i) consumers’ welfare is not considered and ii) price discrimination is considered a legitimate business strategy if occurred within the same country. – A recent known example is the US and EU’s duties on Chinese solar panels. ECON847 INTERNATIONAL TRADE 21 Dumping and Anti-dumping Duties (2) • Top initiators of anti-dumping cases: Pugel, T. A. (2014), International Economics, 16th ed., McGraw-Hill • The products most often involved in dumping cases are chemicals, steel, plastics and rubber products, machinery, textiles and apparel. ECON847 INTERNATIONAL TRADE 22 Dumping and Anti-dumping Duties (3) • The amount of anti-dumping duties is calculated based on the Foreign firm’s local price. – For example, if its local price is $10 and its export price is $6, then the anti-dumping duty is calculated as the difference, $4. • To reduce the potential duty, the Foreign firm has an incentive to raise its export price in order to reduce the potential duty. • A raise in its export price increases Home’s PS by (a). – Hence Home firms’ incentives to accuse the Foreign firm of dumping even if there is none occurring: just a ‘threat’ may be enough to reduce competition in Home. – This leads to excessive filings of antidumping cases. ECON847 INTERNATIONAL TRADE 23 Dumping and Anti-dumping Duties (4) • A raise in the Foreign firm’s export price decreases Home’s CS by (a + b + c + d). • The net effect on Home is a loss of –(b + c + d). – This loss can be larger than the effect of imposing an anti-dumping duty. Why? ECON847 INTERNATIONAL TRADE 24 Infant Industry Protection (1) • The infant industry protection argument states that temporary import restrictions are justified until the domestic infant industry learns how to produce at a low enough cost and ready to meet the international competition. • Infant industry protection argument is the oldest and longest-lived argument against free trade, mainly supported by developing countries. – It is older than the argument of strategic trade policy. • It played an important role in the rise of import-substituting industrialisation (ISI) after WW2 until 1970s. – ISI is an economic development strategy: fostering domestic (manufacturing) sectors while limiting imports can lead to economic development. ECON847 INTERNATIONAL TRADE 25 Infant Industry Protection (2) • Here is the illustration of infant industry argument. Assume one Home firm. • A tariff can induce extra domestic production of (S2-S1) but generates deadweight loss (b + d). • After a number of years, the domestic firm find ways to be competitive in the international market by lowing its costs (lower MC and AC). • The government removes the tariff in the future and the domestic producer still generates surplus (e). • If e > (b + d) then Home gains from this protection. ECON847 INTERNATIONAL TRADE 26 Infant Industry Protection (3) • The validity of the argument is still controversial. • First, firms that make losses in the beginning and become eventually profitable is not an unusual story. Why does the government need to intervene? • There are two justifications for government intervention: – Banks may be unwilling to lend due to uncertainty of future profitability of the infant industry firms. Also, a developing country may lack efficient financial institutions (e.g. stock market). – Infant industry firms may help reduce future costs for other firms in the industry or those in other industries through knowledge spillover (positive externality). – Both cases are some form of market failure. • However, it can be also difficult for a government to correct the market failure. ECON847 INTERNATIONAL TRADE 27 Infant Industry Protection (4) • Second, will the infant industry actually grow up? It is cheap to be a firm in an infant industry; it is much harder to become internationally competitive. • There is no consensus among economists on the effectiveness of the infant industry protection. – Some cases are successful (e.g. Japan’s computer industry, China’s automobile industry), but some are not (e.g. Brazil’s computer industry). – East Asian countries’ success led by export-oriented growth (e.g. China, South Korea, Taiwan). • Successful development of manufacturing sectors may require more than production experience. – For example, lack of skilled labour is not an international trade problem, but could be rather a domestic economic/social problem. ECON847 INTERNATIONAL TRADE 28