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Import Tariffs and Quotas under Imperfect Competition

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Import Tariffs and Quotas under Imperfect Competition

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    1. Import Tariffs and Quotas under Imperfect Competition

    2. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Chapter Outline Introduction Tariffs and Quotas with Home Monopoly No-Trade Equilibrium Comparison with Perfect Competition Free Trade Equilibrium Comparison with Perfect Competition Effect of Home Tariff Comparison with Perfect Competition Home Loss due to the Tariff Effect of a Home Quota Home Loss due to the Quota

    3. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Chapter Outline Infant Industry Protection Free Trade Equilibrium Equilibrium Today Tariff Equilibrium Equilibrium Today Equilibrium in the Future Effect of the Tariff on Welfare Protecting the Automobile Industry in China Protection in China Cost to Consumers Gain to Producers

    4. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Chapter Outline Computers in Brazil Prices in Brazil Consumer and Producer Surplus Other Losses US Tariff on Heavyweight Motorcycles Calculation of Deadweight Loss Future Gain in Producer Surplus Was Protection Successful? Tariffs with Foreign Monopoly Foreign Monopoly Free Trade equilibrium Effect of a Tariff on Home Price Effect of the Tariff on Home Welfare

    5. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Chapter Outline Policy Response to Dumping Antidumping Duty Countervailing Duty Comparison with Safeguard Tariff Calculation of Antidumping Duty Conclusions

    6. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Learning Objectives Understand the implications of import tariffs and quotas in markets with imperfect competition Understand the different effect trade policies have on Home prices in imperfectly competitive markets compared to perfectly competitive markets Understand the “non-equivalence” between the effects of tariffs and the effects of quotas in imperfectly competitive markets

    7. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Learning Objectives Know what an infant industry is Understand the implications in using trade policies in the case of infant industries Know what a discriminating monopoly is and its role in dumping Know what an anti-dumping duty is Know how to calculate the antidumping duty Understand the effects when a tariff is applied against a Foreign discriminating monopoly

    8. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Introduction In 2005, China overtook Japan as the second largest automobile market in the world Strong competition between foreign firms located in China, local producers, and import sales have resulted in new models and a fall in prices China’s middle class can now afford cars Of 2.5 million cars sold in China in 2005, 5.76 million were produced domestically In 1985, only 5200 were produced

    9. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Introduction When China joined the WTO, they lowered tariffs on autos down to 25%, which had been as high as 80-100%. Quotas were revisited as well To fully understand the effects of the import tariffs and quotas on the automobile market, we have to drop our perfect competition assumption In allowing for imperfect competition, we will assume here the extreme case of a single producer to see how trade policies affect welfare

    10. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Introduction We will first assume a Home monopoly and will show how quotas and tariffs have different effects on Home prices The choice therefore matters and this “non-equivalence” among tariffs and quotas must be taken into account. We will then consider an infant industry An industry too young to have achieved its lowest costs Again assume one firm By increasing its output today, the firm will learn how to produce more efficiently and have lower costs in the future

    11. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Introduction Our question is then, should a government impose a temporary tariff or quota today, to protect an infant industry from competition, keeping it in business long enough to learn how to achieve lower costs in the future? We then consider a Foreign monopoly and the effect of an import tariff applied by the Home country We will show it is similar to the large country case in Chapter 8

    12. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Introduction A specific example of a foreign monopolist is the Foreign discriminating monopoly Charges a lower price at Home than in its local market Dumping its product into the Home market In this case, we might see an anti-dumping duty A tariff applied against a Foreign discriminating monopoly We will show these are unlikely to result in gains for the Home country

    13. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly We will assume a Home monopolist A single firm selling a homogeneous good Firm has influence over price charged—charge prices above marginal costs Free trade introduced many new firms into the market, which eliminate the monopolist’s ability to change a price greater than MC Free trade results in perfectly competitive Home market Because the firm has market power however, tariffs and quotas affect the trade equilibrium differently

    14. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly With a tariff, the Home monopolist still competes against a large number of importers limiting its market power With a quota, though, once the quota is reached, the monopolist is the only producer able to sell in the Home market The monopolist is again able to exercise its market power This section looks at Home equilibrium with and without trade, and explains the difference between tariffs and quotas

    15. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly No-Trade Equilibrium We can see this in Figure 9.1 We see a standard monopoly graph with upward sloping marginal costs Remember that because the demand the monopolist faces is downward sloping, they must lower price to sell more This means that the marginal revenue, the revenue received from selling the next unit, will always be lower than the price. Monopolist maximize profits at the quantity where MR = MC Price is then determined from the demand curve

    16. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Comparison with Perfect Competition If we suppose there are many firms in the industry and they all have the same cost conditions as the monopolist, we can show where this market would produce if it were perfectly competitive The no trade equilibrium with perfect competition occurs where supply (MC) equals demand We can see in Figure 9.1 that the competitive price, PC is lower than the monopoly price, PM Also the competitive quantity, QC, is higher than the monopoly quantity, QM

    17. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Figure 9.1 No-Trade Equilibrium In the absence of international trade, the monopoly equilibrium at Home occurs at the quantity QM, where marginal revenue equals marginal cost. From that quantity, we trace up to the demand curve at point A, and the price charged is PM. Under perfect competition, the industry supply curve is MC, so the no-trade equilibrium would occur where demand equals supply (point B), at the quantity QC and the price PC. Figure 9.1 No-Trade Equilibrium In the absence of international trade, the monopoly equilibrium at Home occurs at the quantity QM, where marginal revenue equals marginal cost. From that quantity, we trace up to the demand curve at point A, and the price charged is PM. Under perfect competition, the industry supply curve is MC, so the no-trade equilibrium would occur where demand equals supply (point B), at the quantity QC and the price PC.

    18. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Free Trade Equilibrium Assume Home is a small country, facing a fixed world price of PW Figure 9.2 shows the horizontal world price line, X*, the Foreign export supply curve The is also the new demand curve facing the Home monopolist, the original home demand, D no longer applies Home’s new MR is the same as the new demand curve, so X* = MR* MR* = MC at point B, supplying S1 Home consumers demand D1 leading to Home imports of M1 = D1 - S1

    19. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Comparison with Perfect Competition Remember we assume the cost conditions facing the competitive firms are the same A perfectly competitive industry will take PW and supply where that price intersects the marginal cost curve, at S1 with consumers demanding D1 Under free trade for a small country then, a Home monopolist produces the same quantity and charges the same price as a perfectly competitive industry would The monopolist loses its control over price and behaves just as a perfectly competitive industry with the same marginal costs would

    20. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Figure 9.2 Home Monopoly’s Free-Trade Equilibrium Under free trade at the fixed world price PW, Home faces Foreign export supply of X * at that price. Because the Home firm cannot raise its price above PW without losing all of its customers to imports, X* is now also the demand curve faced by the Home monopolist. Because the price is fixed, the marginal revenue MR* is the same as the demand curve. Profits are maximized at point B, where marginal revenue equals marginal costs. The Home firm supplies S1, and Home consumers demand D1. The difference between these is imports, M1 = D1 - S1. Because the Home monopoly now sets its price at marginal cost, the same free-trade equilibrium holds under perfect competition.Figure 9.2 Home Monopoly’s Free-Trade Equilibrium Under free trade at the fixed world price PW, Home faces Foreign export supply of X * at that price. Because the Home firm cannot raise its price above PW without losing all of its customers to imports, X* is now also the demand curve faced by the Home monopolist. Because the price is fixed, the marginal revenue MR* is the same as the demand curve. Profits are maximized at point B, where marginal revenue equals marginal costs. The Home firm supplies S1, and Home consumers demand D1. The difference between these is imports, M1 = D1 - S1. Because the Home monopoly now sets its price at marginal cost, the same free-trade equilibrium holds under perfect competition.

    21. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Suppose Home imposes a tariff, t, on imports Price at Home increase from PW to PW+t The foreign export supply curve shifts up to X*+t Again this is the new demand curve and marginal revenue curve for the monopolist Maximizing profits where MR=MC at point C gives Home supply of S2 and a Home demand of D2 Since Home production increases and Home demand falls, imports fall to M2 = D2 – S2

    22. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Figure 9.3 Tariff with Home Monopoly Initially, under free trade at the fixed world price PW, the monopolist faces the horizontal demand curve (and marginal revenue curve) X*, and profits are maximized at point B. When a tariff t is imposed, the export supply curve shifts up since Foreign firms must charge PW + t in the Home market to earn PW. This allows the Home monopolist to increase its domestic price to PW + t, but no higher, since otherwise it would lose all of its customers to imports. The result is fewer imports, M2, because Home supply S increases and Home demand D decreases. Figure 9.3 Tariff with Home Monopoly Initially, under free trade at the fixed world price PW, the monopolist faces the horizontal demand curve (and marginal revenue curve) X*, and profits are maximized at point B. When a tariff t is imposed, the export supply curve shifts up since Foreign firms must charge PW + t in the Home market to earn PW. This allows the Home monopolist to increase its domestic price to PW + t, but no higher, since otherwise it would lose all of its customers to imports. The result is fewer imports, M2, because Home supply S increases and Home demand D decreases.

    23. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Comparison with Perfect Competition Again assuming S=MC, the competitive equilibrium will be where P=MC which gives the quantity Q2 at PW+t So, with a tariff, a Home monopolist will produce the same quantity at the same price as a perfectly competitive industry would Home Loss due to the Tariff Since the equilibrium outcomes are the same for a Monopolist and a Perfect Competitor under a tariff, we would expect that the losses would be the same as well

    24. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Home Loss due to the Tariff As before, we look at the changes in surplus to both producers and consumers, and the gain to government in the form of tax revenue With a higher price, consumer surplus falls by the amount (a+b+c+d) and producer surplus rises by (a) The government gains revenue equal to the tariff, t, times the amount of imports, M2 giving the area (c) As before that leads to a deadweight loss of (b+d) We can see this again looking at Figure 9.3

    25. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Figure 9.3 Tariff with Home Monopoly Initially, under free trade at the fixed world price PW, the monopolist faces the horizontal demand curve (and marginal revenue curve) X*, and profits are maximized at point B. When a tariff t is imposed, the export supply curve shifts up since Foreign firms must charge PW + t in the Home market to earn PW. This allows the Home monopolist to increase its domestic price to PW + t, but no higher, since otherwise it would lose all of its customers to imports. The result is fewer imports, M2, because Home supply S increases and Home demand D decreases. The deadweight loss of the tariff is measured by the area (b + d). This result is the same as would have been obtained under perfect competition because the Home monopolist is still charging a price equal to its marginal cost. Figure 9.3 Tariff with Home Monopoly Initially, under free trade at the fixed world price PW, the monopolist faces the horizontal demand curve (and marginal revenue curve) X*, and profits are maximized at point B. When a tariff t is imposed, the export supply curve shifts up since Foreign firms must charge PW + t in the Home market to earn PW. This allows the Home monopolist to increase its domestic price to PW + t, but no higher, since otherwise it would lose all of its customers to imports. The result is fewer imports, M2, because Home supply S increases and Home demand D decreases. The deadweight loss of the tariff is measured by the area (b + d). This result is the same as would have been obtained under perfect competition because the Home monopolist is still charging a price equal to its marginal cost.

    26. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Effect of Home Quota Now we can look at the effect of a quota and compare it to the effect of a tariff The quote will end up with higher prices for Home consumers since it allows the monopolist to keep its market power, which we know leads to higher prices This is another reason why the WTO has encouraged countries to replace quotas with tariffs

    27. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Effect of a Quota In Figure 9.4 we begin with the free trade equilibrium at B and the tariff equilibrium at C We choose a quota that will give us the same import as the tariff, M2 The effective demand curve facing the Home monopolist under the quota is now the old demand curve, D, minus the quota, M2 The monopolist still retains the ability to influence price and will choose its profit maximizing price along D-M2

    28. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Effect of a Quota Adding the MR curve for the effective demand curve D-M2, allows us to find the profit maximizing price and quantity for the Monopolist MR=MC at point E with S3 and a price of P3 Comparing the tariff equilibrium at C with the quota equilibrium at E shows us the differences The price is higher: P3>PW+t This reflects the ability of the monopolist to raise its price once the quota amount has been imported This occurs even though the quota allows in the same amount of imports that were brought in under that tariff They are no longer equivalent

    29. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Effect of a Quota Since the price is higher under the quota, the monopolist will definitely produce a lower quantity under the quota, S3<S2 In fact, it is even possible for the quantity under the quota to fall below the no-trade quantity. This will depend on the demand and therefore the MR curve If S3<S1 is possible, then workers would not even be protected under a quota, which is typically one of the expectations of a trade restriction Employment would actually fall under this type of quota

    30. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Figure 9.4 Effect of Quota with Home Monopoly Under free trade, the Home monopolist produces at point B and charges the world price of PW. With a tariff of t, the monopolist produces at point C and charges the price of PW + t. Imports under the tariff are M2 = D2 - S2. Under a quota of M2, the demand curve shifts to the left by that amount, resulting in the demand D - M2 faced by the Home monopolist. That is, after M2 units are imported, the monopolist is the only firm able to sell at Home, and so it can choose a price anywhere along the demand curve D – M2. The marginal revenue curve corresponding to D - M2 is MR, and so with a quota, the Home monopolist produces at point E, where MR equals MC. The price charged at point E is P3 > PW + t, so the quota leads to a higher Home price than the tariff.Figure 9.4 Effect of Quota with Home Monopoly Under free trade, the Home monopolist produces at point B and charges the world price of PW. With a tariff of t, the monopolist produces at point C and charges the price of PW + t. Imports under the tariff are M2 = D2 - S2. Under a quota of M2, the demand curve shifts to the left by that amount, resulting in the demand D - M2 faced by the Home monopolist. That is, after M2 units are imported, the monopolist is the only firm able to sell at Home, and so it can choose a price anywhere along the demand curve D – M2. The marginal revenue curve corresponding to D - M2 is MR, and so with a quota, the Home monopolist produces at point E, where MR equals MC. The price charged at point E is P3 > PW + t, so the quota leads to a higher Home price than the tariff.

    31. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Home Loss due to the Quota Since price rises more with a quota than a tariff, it is clear that consumers will lose more surplus under a quota than they would under a tariff Although we will not make a detailed calculation, you can expect that the deadweight loss will always be higher for a quota than for a tariff The higher price benefits the monopolist but harms the Home consumers and creates an extra deadweight loss due to the exercise of its monopoly power

    32. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs and Quotas with Home Monopoly Home Loss due to the Quota Given that the monopolist is charging a higher price, quota rents will increase as well Quota rents are measured by the difference between P3 and PW times the number of imports, M2 In the case of a Home monopoly, quota rents are higher than tax revenue would be under a tariff Also remember that quota rents often go to the Foreign producers or are just wasted on rent seeking activities The next application looks at an example in detail

    33. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor U.S. Imports of Japanese Automobiles A well known VER occurred in the 1980’s when the US limited the imports of cars from Japan In the early 1980’s, the US suffered a deep recession and unemployment in the auto industry rise sharply In 1980 the United Automobile Workers and Ford Motor Comp. applied to the International Trade Commission (ITC) for protection under Article XIX of GATT and Section 201 of US trade laws

    34. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor U.S. Imports of Japanese Automobiles The ITC determined that the US recession was a more important cause of injury to the auto industry than increased imports It did not recommend that the auto industry receive protection In response, several congressmen from states with auto plants pursued other means A bill was introduced in the US Senate to restrict imports Aware of this, the Japanese government announced it would “voluntarily” limit Japan’s export of autos to the US

    35. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor U.S. Imports of Japanese Automobiles By 1988, Japanese exports were below the VER because Japanese firms were producing their cars in the US Price and Quality of Imports Under the VER, the average price rose $2900 from 1980 and 1985 Of that, $1100 was due to quota rents earned by Japanese producers $1650 was due to quality improvements in Japanese cars $150 is what prices would have risen under free trade.

    36. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor U.S. Imports of Japanese Automobiles Quota Rents If we take the quota rents per car and multiply it by the number of imports, we can estimate the total rents to be about $2.2 billion This is the lower estimate of the annual cost of quota rents for autos we saw in Table 8.4 The Japanese firms’ stock prices rose during the VER period after it was clear that the Japanese government would administer the quotas to each producer Japanese firms had a strong incentive to export the more expensive models—quality upgrading

    37. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor U.S. Imports of Japanese Automobiles Price of US Cars Under the VER, the average price of US cars rose very rapidly—43% increase from 1979 to 1981 This was due to the exercise of market power by the US producers, who were sheltered by the quota The quality of US cars did not rise by as much as the quality of Japanese imports seen in Figure 9.5 The fact that the US and Japanese firms were both able to raise prices substantially indicates the policy was VERY costly to US consumers

    38. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor U.S. Imports of Japanese Automobiles Figure 9.5 Prices of Japanese Car Imports Under the “voluntary” export restraint (VER) on Japanese car imports, the average price rose from $5,150 to $8,050 between 1980 and 1985. Of that $2,900 increase, $1,100 was the result of quota rent increases earned by Japanese producers. Another $1,650 was the result of quality improvements in the Japanese cars, which became heavier and wider, with improved horsepower, transmissions, and so on. The remaining $150 is the amount that import prices would have risen under free trade.Figure 9.5 Prices of Japanese Car Imports Under the “voluntary” export restraint (VER) on Japanese car imports, the average price rose from $5,150 to $8,050 between 1980 and 1985. Of that $2,900 increase, $1,100 was the result of quota rent increases earned by Japanese producers. Another $1,650 was the result of quality improvements in the Japanese cars, which became heavier and wider, with improved horsepower, transmissions, and so on. The remaining $150 is the amount that import prices would have risen under free trade.

    39. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor U.S. Imports of Japanese Automobiles Figure 9.6 Prices of American Small Cars Under the VER on Japanese car imports, the average price of U.S. cars rose very rapidly when the quota was first imposed: from $4,200 in 1979 to $6,000 in 1981, or a 43% increase over two years. Only a very small part of that increase was explained by quality improvements, and in the later years of the quota, U.S. quality did not rise by as much as for the Japanese imports.Figure 9.6 Prices of American Small Cars Under the VER on Japanese car imports, the average price of U.S. cars rose very rapidly when the quota was first imposed: from $4,200 in 1979 to $6,000 in 1981, or a 43% increase over two years. Only a very small part of that increase was explained by quality improvements, and in the later years of the quota, U.S. quality did not rise by as much as for the Japanese imports.

    40. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor U.S. Imports of Japanese Automobiles The GATT and WTO Because the export restraint was enforced by the Japanese instead of the US, it did not necessarily violate Article XI of GATT Countries should not use quotas to restrict imports, but this was not a quota This loophole was closed when the WTO was established As a result of this rule, VER’s can no longer be used unless they are a part of some other agreement in the WTO

    41. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection Despite losses, nearly all countries use tariffs in the early stages of economic development, often in industries composed of a small number of firms This means they are more often acting under conditions of imperfect competition Why? They argue because their industries are too young to withstand foreign competition If given time to grow, the industries will be able to compete in the future Some short term protection from imports is needed

    42. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection This is called the infant industry case for protection We will assume only one Home firm Increasing output today will lead to lower costs in the future through learning Should the Home government intervene with protection? We will consider two cases where it is potentially justified A tariff today increases Home production and lowers future costs A tariff today increase output and reductions in future costs for other firms in the industry or other industries

    43. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection Let’s assume that if a firm is protected today, we will get an increase in Home output This will then help the firm to learn better production techniques and reduce costs in the future For infant industry protection to be justified, the firm’s learning just shifts down the entire average cost curve to the point where it is competitive at world prices, even without a tariff

    44. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection But, if the firm’s costs are going to fall in the future, why doesn’t it just borrow today to against future profits later? An essential piece of the infant industry argument is that the firm needs to earn non-negative profits each period to avoid bankruptcy There must be some reason the firm cannot cover losses by borrowing against future profits In this case, the trade protection is just offsetting an imperfection in the capital market

    45. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection Now what about the case where a tariff in one period will lead to an increase in output and reductions in future costs for other firms in the industry, or even for firms in other industries? This is a type of externality that exists when firms learn from others’ successes An innovation in one area helps lower costs in other areas We call this knowledge spillover—firms mimic the successful innovations of other firms

    46. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection When there are spillovers, the tariff is promoting a positive externality Because firms learn from each other, each firm on its own does not have much incentive to invest in learning through increasing production today A tariff is needed to offset this externality by increasing production, allowing for these spillovers to occur between firms leading to cost reductions

    47. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection In both of these cases, the infant industry argument supporting trade restrictions depends on the existence of some form of market failure These market failures create a potential role for government policy However, if the capital market will not provide a loan to the firm, it must not believe it will be profitable in the future If that is true, why would the government have better information about that firm’s future prospects?

    48. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection Similarly, can we expect the government to know the extent of spillovers and determine if they are enough to justify trade protection? We should be skeptical about the ability of government to distinguish the industries that deserve infant-industry protection from those that don’t Furthermore, these market failures do not guarantee that the protection is worthwhile We still need to compare the costs of protection today with the benefits of protection in the future

    49. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection Free Trade Equilibrium Figure 9.7 shows a Home firm with its current and proposed future situation We will assume Home is a small country and therefore faces fixed world prices for its imports We will also assume that increasing output today will lead to a reduction in costs in the future Equilibrium today With free trade the Home firm faces PW = MR producing where PW crosses its MC, supplying S1 Given that at S1, average costs are higher than PW, we know the firm is suffering losses and would shut down today instead of producing S1

    50. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection Tariff Equilibrium To prevent the firm from shutting down, the Home government could apply a tariff or quota to raise Home price We assume this increased output allows the firm to learn better production techniques so its future costs are reduced From before we know the Home government should choose the tariff since under the quota the home firm will produce less and raise prices more Remember we assume that the firm’s learning depends on increasing its production

    51. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection Equilibrium Today If a tariff, t, is applied then Home price rises to PW+t as before Assume that PW+t just covers the firms average costs The firm produces S2 and since PW+t equals AC at that quantity, the firm makes zero profits Equilibrium in the Future At S2, the firm can lower its costs in the future The effect of learning on production costs is shown by a downward shift in the AC curve to AC’ This means the firm can produce S3 without tariff protection at PW and still cover its AC

    52. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection Effect of the Tariff on Welfare As would be expected, the tariff leads to a deadweight loss measured by (b+d) In order to determine welfare in this case, we also have to consider the gain from having the firm operating in the future We do this by measuring the producer surplus measure in panel b, area (e) This is the present value of the firm’s future producer surplus Amount that would be forgone if the firm shut down today

    53. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection Figure 9.7 Infant Industry Protection In the situation today (panel a), the industry would produce S1, the quantity at which MC = PW. Because PW is less than average costs at S1, the industry would incur losses at the world price of PW and would be forced to shut down. A tariff increases the price from PW to PW + t, allowing the industry to produce at S2 (and survive) with the net loss in welfare of (b + d). In panel (b), producing today allows the average cost curve to fall through learning to AC ’. In the future, the firm can produce the quantity S3 at the price PW without tariff protection and earn producer surplus of e.Figure 9.7 Infant Industry Protection In the situation today (panel a), the industry would produce S1, the quantity at which MC = PW. Because PW is less than average costs at S1, the industry would incur losses at the world price of PW and would be forced to shut down. A tariff increases the price from PW to PW + t, allowing the industry to produce at S2 (and survive) with the net loss in welfare of (b + d). In panel (b), producing today allows the average cost curve to fall through learning to AC ’. In the future, the firm can produce the quantity S3 at the price PW without tariff protection and earn producer surplus of e.

    54. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Infant Industry Protection Effect of the Tariff on Welfare To evaluate whether the tariff has been successful, we need to compare the future gain with the present losses We need to compare (e) with (b+d) If (e) is greater than (b+d) then it was worthwhile If (e) is less than (b+d), then the costs of protection today do not justify the future benefits The challenge for government policy is to try and distinguish worthwhile cases from cases that are not We follow with three examples

    55. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection We will consider three examples of infant industry protection that have occurred The automobile industry in China The computer industry in Brazil Harley-Davidson motorcycles in the US Although we normally think of developing countries using the infant industry argument, it is not necessarily always the case as you can see from the examples

    56. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Harley-Davidson does not really fit the infant industry description as it had been in operation for about 80 years before it was in trouble By including this case, we are able to make a precise calculation of the effect of the tariff on consumers and producers, to determine if the infant industry protection was in fact successful

    57. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Protecting the Automobile Industry in China Until China joined the WTO in 2001, China had protected many of its industries with strict tariffs and quotas Tariffs on autos were as high as 260% in the early 1980’s, and fell to 80–100% by 1996. By 2006, tariff on autos had been reduced to 25% and import quotas had been eliminated Is China’s success in the automobile industry a case of infant industry protection success?

    58. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Protecting the Auto Industry in China In the 1980’s, China permitted a number of joint ventures between foreign firms and local Chinese partners This provided a window for foreign manufacturers to tap the China market, but there were limits on their participation Foreign manufacturers could not own majority stake in a manufacturing plant Chinese kept control of distribution networks for the jointly-produced autos

    59. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Protecting the Auto Industry in China These regulations combined with the high tariffs helped achieve success for some of the new joint ventures Volkswagen’s Shanghai plant was the far winner under these rules It produced over 200,000 vehicles per year—more than twice as much as any other plant Other local restrictions on engine size also helped ensure that only Volkswagen's models could be sold in the Shanghai market

    60. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Protecting the Auto Industry in China Volkswagen’s competitors did not fare as well Beijing Jeep never produced more than 20,000 Peugeot ended up withdrawing However, Volkswagen open a new plant and other factories reached agreements with Honda and Daihatsu Today Toyota, General Motors, and Ford are either producing or planning on producing in China

    61. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Costs to Consumers Tariffs and quotas used in China kept imports fairly low throughout the 1990’s ranging from a high of 222,000 to a low of 27,500 autos Given the high tariffs, import prices were nearly doubled But the quotas imposed had at least as great an impact on prices of imports and domestically produced cars Remember our analysis of quotas and local monopolies and then remember that Volkswagen enjoyed a local monopoly in Shanghai

    62. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Costs to Consumers This caused prices in the Shanghai market increased substantially Figure 9.8 shows the estimated markups of price over average costs for autos sold in China from 1995 to 2001. The ones for Shanghai Volkswagen were the highest It is clear the monopoly power allowed them to substantially raise prices This is what our theory told us would happen

    63. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Figure 9.8 Automobile Markups by Firms in China, 1995–2001 This diagram shows the percentage markups (price over marginal cost) applied to automobiles sold in China from 1995 to 2001, by various producers. The highest markup was charged by Shanghai Volkswagen, which had a local monopoly in Shanghai. Source: Haiyan Deng, 2006, “Market Structure and Pricing Strategy of China’s Automobile Industry.”Figure 9.8 Automobile Markups by Firms in China, 1995–2001 This diagram shows the percentage markups (price over marginal cost) applied to automobiles sold in China from 1995 to 2001, by various producers. The highest markup was charged by Shanghai Volkswagen, which had a local monopoly in Shanghai. Source: Haiyan Deng, 2006, “Market Structure and Pricing Strategy of China’s Automobile Industry.”

    64. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Costs to Consumers Also, some of the models produced by Shanghai Volkswagen during the 1990’s were outdated models That plant had the highest production through 2001, despite high prices and outdated models A large number of consumers in the Shanghai area bore the costs of that local protection Clearly the Home monopoly benefited from the protection, but at the expense of consumers Additionally we see how protection creates disincentives for innovation

    65. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Gains to Producers In order to justify all the protective measures in the auto industry, they should lead to a large enough drop in future production costs that protection is no longer needed There is some evidence that these measures did help: Tariffs are now only at 25% Some producers are making plans to export cars from China It must be true that average costs have fallen enough to reach world prices

    66. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Gains to Producers Now, did the fall in average costs occur due to protection or did it happen for some other reason? The early firms entered China because that was the only way to sell in China since the protection levels were so high Local costs did fall as the Chinese partners learned from the technology transferred from their foreign partners Shanghai Automotive, the previous partner of Volkswagen and General Motors, will soon begin building and selling its own brand of car in China

    67. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Gains to Producers This clearly shows that the technology transfer helped the local firms and the foreign firms might not have come into China but for the high protection levels Some of the current firms are purchasing ready-made plants from other countries in their first mass production and export of cars This shows that the first exports from China will not come from firms that benefited from the technology transfer

    68. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Gains to Producers Clearly there are other reasons that China is doing so well in the auto industry At least as important as the tariffs is the rapid growth in China’s income level This has increased domestic sales and therefore to more firms entering the market Consumers are not the ones demanding the newest models built with the most efficient techniques In the end, we cannot really answer whether the trade restrictions were responsible for China’s current successes

    69. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Thanks to Detroit, China is Poised to Lead Volkswagen and other producers used to send outdated equipment to China and produce models that were no longer demanded in the West Competition in China now has become so fierce that auto manufacturers are having to introduce their newest models as quickly here as they would in other markets

    70. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Thanks to Detroit, China is Poised to Lead When Ford opened a factory in China three years ago, it just copied an older factory it had been using in Philippines This year Ford opened a new factory identical to one of its most advanced factories The Chinese managers are not even happy with that—the automotive industry is expanding and modernizing so quickly that some current firms are having difficulty keeping up

    71. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Thanks to Detroit, China is Poised to Lead One requirement to export autos is to develop a highly competitive and efficient domestic market that demands excellent quality, and China has managed to do that Many foreign car companies are introducing their best technology in their plants in China This is not just to compete with each other but also with purely local companies These foreign firms have always been wary of transferring proprietary technology to make hybrid engines in China for fear it will be copied

    72. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Thanks to Detroit, China is Poised to Lead Although Toyota is still quite cautious, China is still the only place besides Japan where they are assembling the Prius, arguably its most important car in a decade Volkswagen said it would jointly develop a hybrid minivan for the Chinese market with Shanghai Automotive This will clearly give the Chinese a good look at the technology

    73. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Thanks to Detroit, China is Poised to Lead Shanghai Automotive also announced it was going to begin selling its own brand of cars while keeping its joint ventures It is expected other Chinese companies will follow suit Chinese automakers are also buying modern technology and design themselves When MG-Rover Group of Britain entered bankruptcy proceedings last year, a Chinese company was the high bidder to take control of Rover and its fairly modern engine-producing subsidiary and move it to China

    74. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Computers in Brazil One case where infant industry protection has not been successful is the computer industry in Brazil In 1977, the Brazilian government began a program to protect domestic computer firms It was thought that achieving national autonomy in the computer industry was essential for strategic military reasons Imports of PC’s were banned Domestic firms had to buy from local suppliers whenever possible Foreign producers of PCs were not allowed to operate in Brazil

    75. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Computers in Brazil The ban lasted until the early 1990s This was a period of rapid innovation in the computer industry worldwide with large drops in the cost of computing power Figure 9.9 shows the effective price of computing power in the US and Brazil from 1982 to 1992 which fell rapidly in both countries This is the effective price because it reflects the improvements over time in the PC’s speed, etc.

    76. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Figure 9.9 Computer Prices in the United States and Brazil, 1982–1992 This diagram shows the effective price of computer power in the United States and Brazil. Both prices fell very rapidly due to technological improvements, but the drop in the U.S. price exceeded that of the Brazilian price. The difference between the two prices is a measure of the technology gap between Brazil and the United States in the production of personal computers. Source: Eduardo Luzio and Shane Greenstein, 1995, “Measuring the Performance of a Protected Infant Industry: The Case of Brazilian Microcomputers,” Review of Economics and Statistics, 77(4), November, 622–633.Figure 9.9 Computer Prices in the United States and Brazil, 1982–1992 This diagram shows the effective price of computer power in the United States and Brazil. Both prices fell very rapidly due to technological improvements, but the drop in the U.S. price exceeded that of the Brazilian price. The difference between the two prices is a measure of the technology gap between Brazil and the United States in the production of personal computers. Source: Eduardo Luzio and Shane Greenstein, 1995, “Measuring the Performance of a Protected Infant Industry: The Case of Brazilian Microcomputers,” Review of Economics and Statistics, 77(4), November, 622–633.

    77. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Prices in Brazil Brazilian firms were very good at reverse engineering the IBM PC’s sold from the US But this took time and since Brazilian firms had to use local suppliers for many parts, it added to the costs of production Figure 9.9 shows that Brazil never achieved the same low prices as the US Brazil was never able to produce computers at competitive prices without tariff protection That alone tells us the infant industry protection failed

    78. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Consumer and Producer Surplus Table 9.1 shows the welfare calculation for Brazil and other details of the PC industry From the table you can see that in 1984 Brazil’s price was almost twice that of the US price Although this lead to increased producer surplus, the loss in consumer surplus led to a net loss of about $51 million The industry was never able to produce in the absence of tariffs so there are no future gains (like area e) that we can use to counter the losses.

    79. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Table 9.1 Brazilian Computer Industry This table shows the effects of the government ban on imports of personal computers into Brazil. Source: Eduardo Luzio and Shane Greenstein, 1995, “Measuring the Performance of a Protected Infant Industry: The Case of Brazilian Microcomputers,” Review of Economics and Statistics, 77(4), November, 622–633.Table 9.1 Brazilian Computer Industry This table shows the effects of the government ban on imports of personal computers into Brazil. Source: Eduardo Luzio and Shane Greenstein, 1995, “Measuring the Performance of a Protected Infant Industry: The Case of Brazilian Microcomputers,” Review of Economics and Statistics, 77(4), November, 622–633.

    80. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Other Losses The higher prices in Brazil imposed costs on industries that relied on computers and they become increasingly dissatisfied with the government policies President Fernando Collor de Mello abolished the infant industry protection immediately after he was elected

    81. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Other Losses A number of reasons have been given for the failure of this policy to develop an efficient industry in Brazil Imported materials such as silicon chips were expensive to obtain This was also true of domestically-produced parts that local firms were required to use Local regulations limited the entry of new firms in the industry Clearly it is difficult to successfully nurture an infant industry using tariffs

    82. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection US Tariff on Heavyweight Motorcycles In 1983, Harley-Davidson was suffering losses due to a long period of lagging productivity and intense competition from Japanese producers In the early 1980’s foreign firms were engaged in a global price war that spilled over into the US market Inventories of imported heavyweight cycles rose dramatically Harley-Davidson applied to the ITC for Section 201 protection

    83. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection US Tariff on Heavyweight Motorcycles The ITC determined that there were over 9 months worth of inventory of Japanese motorcycles already in the US and recommended to President Reagan that import protection be placed on heavyweight motorcycles This is one of the few times that threat of injury by imports has been used as justification for tariffs under Section 201 of the US trade law President Reagan approved the tariffs beginning high to decline over 5 years

    84. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection US Tariff on Heavyweight Motorcycles The tariff was scheduled to end in April of 1988 Harley-Davidson petitioned the ITC to end the tariff one year early By that time they had cut costs and introduced new and very popular products so profitability had been restored In a great fanfare, President Reagan declared that the tariff had been a successful case of protection

    85. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Calculation of Deadweight Loss Was the tariff on heavyweight motorcycles a success? We need to compare the deadweight loss of the tariff with the future gain in producer surplus We will use the formula we derived in Chapter 8, measuring deadweight loss relative to the import value

    86. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Table 9.2 gives information on imports of heavyweight cycles The percentage drop in import quantity between 1982 and 1983 was about 17% with a tariff of 45% The deadweight loss relative to input value is measured as :

    87. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Figure 9.2 U.S. Imports of Heavyweight Motorcycles This table shows the effects of the tariff on imports of heavyweight motorcycles in the United States. Source: Heavy Weight Motorcycles. Report to the President on Investigation No. TA-203-17, under Section 203 of the Trade Act of 1974. U.S. International Trade Commission, June 1987, and author’s calculations.Figure 9.2 U.S. Imports of Heavyweight Motorcycles This table shows the effects of the tariff on imports of heavyweight motorcycles in the United States. Source: Heavy Weight Motorcycles. Report to the President on Investigation No. TA-203-17, under Section 203 of the Trade Act of 1974. U.S. International Trade Commission, June 1987, and author’s calculations.

    88. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Average import sales over that time was $431. Multiplying the percentage loss by average imports, we get the deadweight loss in 1983 of $16.3 million Adding up all the DWLs, we obtain a total loss of $112.5 million over the 4 years of the tariff

    89. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Future Gains in Producer Surplus We can evaluate the future gains in producer surplus by examining the stock market value of the firm around the time that the tariff was removed. During the time of the tariff, the management of Harley-Davidson reduced costs through several methods, many of which were copied from the Japanese firms These changes allowed Harley-Davidson to transform losses in 1981–1982 in to profits for 1983 and the following years

    90. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Future Gains in Producer Surplus In July 1986, Harley-Davidson became a public corporation and issued stock on the American Stock Exchange 2 million shares at $11 per share totaling $22 million The sum of these stock and debt issues is $112.3 million, which we can interpret as the present discounted value of the producer surplus of the firm This estimate of area (e) is nearly equal to the consumer surplus loss of $112.5 million

    91. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Future Gains in Producer Surplus A month after a second stock was offered, it rose from $19 per share Using that price for outstanding stock plus $70 in repaid debt, we bet $131 million as the future producer surplus By this calculation, the future gain in producer surplus from tariff protection to Harley-Davidson exceeds the deadweight loss of the tariff. Harley-Davidson has grown every year since and now the Japanese copy from them

    92. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Was Protection Successful? When we made the criteria that protection is successful if the producer surplus outweighs the deadweight loss, we assume the company would not have survived otherwise It is well documented that Harley-Davidson was on the brink of bankruptcy before the tariff Citibank had decided that it would not extent more loans to cover Harley’s losses However, if Harley-Davidson had filed for bankruptcy, it might still have emerged to prosper again

    93. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Examples of Infant Industry Protection Was Protection Successful? Bankruptcy does not mean the company must stop producing If they had gone bankrupt without the tariff, some of all of the future gains in producer surplus might have been realized We cannot be certain whether the turn around of Harley-Davidson required the use of the tariff or not In general we agree that the harm caused by the tariff was small compared with the potential benefits of avoiding bankruptcy, which allowed Harley to become a very successful company

    94. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs with Foreign Monopoly Now let’s consider what happens when a Foreign exporting firm as a monopoly We will show that applying a tariff under a Foreign monopoly leads to an outcome similar to the large country case in Chapter 8 The tariff will lower the price charged by the Foreign exporter A tariff may now benefit the Home country

    95. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs with Foreign Monopoly Foreign Monopoly Assume no competing Home firm Home demand, D in Figure 9.10, is supplied entirely by the foreign monopolist This is not very realistic, since normally a tariff is considered when there is also a Home firm, but this makes the analysis simpler Free Trade Equilibrium The Foreign monopolist maximizes profits in its export market where Home MR = Foreign MC* This is point A in Figure 9.10 showing exports of X1 charging a price of P1

    96. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs with Foreign Monopoly Effect of a Tariff on Home Price If a tariff, t, is implemented, then marginal cost for the exporter in the Home market increases to MC*+t The new profit maximizing level of output is at point B with import prices now at P2 The increase in price from P1 to P2 is less than the amount of the tariff, t In this case, the net-of-tariff price received by the foreign exporter, P3 = P2 – t, has fallen from its previous level of P1 since price rises by less than the tariff

    97. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs with Foreign Monopoly Figure 9.10 Tariff with a Foreign Monopoly Under free trade, the Foreign monopolist charges prices P1 and exports X1, where marginal revenue MR equals marginal cost MC*. When an antidumping duty of t is applied, the firm’s marginal cost rises to MC* + t, so the exports fall to X2 and the Home price rises to P2. The decrease in consumer surplus is shown by the area c + d, of which c is collected as a portion of tax revenues. The net-of-tariff price that the Foreign exporter receives falls to P3 = P2 - t. Because the net-of-tariff price has fallen, the Home country has a terms-of-trade gain, area e. Thus, the total welfare change depends on the size of the terms-of-trade gain e relative to the deadweight loss d.Figure 9.10 Tariff with a Foreign Monopoly Under free trade, the Foreign monopolist charges prices P1 and exports X1, where marginal revenue MR equals marginal cost MC*. When an antidumping duty of t is applied, the firm’s marginal cost rises to MC* + t, so the exports fall to X2 and the Home price rises to P2. The decrease in consumer surplus is shown by the area c + d, of which c is collected as a portion of tax revenues. The net-of-tariff price that the Foreign exporter receives falls to P3 = P2 - t. Because the net-of-tariff price has fallen, the Home country has a terms-of-trade gain, area e. Thus, the total welfare change depends on the size of the terms-of-trade gain e relative to the deadweight loss d.

    98. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs with Foreign Monopoly Effect of a Tariff on Home Price 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 Since the Foreign firm is facing a downward sloping demand curve, as price increases, the quantity demanded falls, so price will not increase by the full amount of the tariff The Foreign firm is making a strategic decision to absorb part of the tariff itself and pass only a portion of it onto the Home market in order to maximize its profits

    99. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs with Foreign Monopoly Effect of the Tariff on Home Welfare With the increase in price, consumers are worse off and consumer surplus falls by (c+d) The increase in price will benefit Home firms, but we have assumed there are no Home firms Tariff revenue equals the tariff, t, times the amount of imports X2, which is area (c+e) Fall in Home consumer surplus (c+d) Rise in Home government revenue (c+e) Net change in Home welfare (e-d)

    100. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Tariffs with Foreign Monopoly Effect of a Tariff on Home Welfare We can interpret area (e) as the terms of trade gain for the Home country The area d is the deadweight loss due to the tariff Again if the terms of train gain exceed the deadweight loss, then Home is better of due to the tariff As we saw in the large country case, Home welfare initially rises for small tariffs We can use the again use the automobile industry and show how a tariff can affect prices charged by a Foreign monopolist

    101. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Import Tariffs on Japanese Trucks We just learned that a tariff on a Foreign monopolist can have a positive terms of trade effect for the Home country To what extent do Foreign exporters actually behave that way? We can look at the effects of the 25% tariff on imported Japanese compact trucks imposed by the US in the early 1980’s and still in place today For cars, the VER with Japan was pursued, but for compact trucks, it turned out another form of protection was possible

    102. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Import Tariffs on Japanese Trucks At the time, most of the trucks were imported as cab/chassis with some final assembly needed They were classified as “parts of trucks” which carried a 4% tariff rate Another category of truck, “complete or unfinished trucks”, faced a tariff of 25% This created an irresistible opportunity to reclassify the trucks to get the higher tariff and that is exactly what the US Customs Service did

    103. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Import Tariffs on Japanese Trucks This reclassification raised the tariff rates on all Japanese trucks According to one estimate, the tariff on trucks was only partially reflected in US prices Of the 21% increase, only 12% was passed through to US consumer prices. 9% was absorbed by Japanese producers Therefore this tariff lead to the terms of trade gain for the US predicted by our theory

    104. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Policy Response to Dumping Our discussion of a Foreign monopolist brings us back to the topic of dumping we discussed in Chapter 6 Dumping occurs when a firm is exporting goods at a price that is below the price in its local market, or below its average cost of production We now want to understand the policy response in the Home importing country Under the WTO, an importing country is entitled to apply an antidumping tariff anytime that a foreign firm is dumping its product

    105. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Policy Response to Dumping An imported product is being dumped if its price is below the price that the exporter charges in its own local market If the exporter’s local price is not available, then dumping is determined by comparing the import price to A price charged for the product in a third market, or The exporter’s average costs of production

    106. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Policy Response to Dumping Anti-dumping Duty The amount of the antidumping duty is calculated as the difference between the exporter’s local price and the “dumped” price in the importing country The purpose of the duty is to raise the price of the dumped good and protect domestic producers The fact that the higher price also raises prices for domestic consumers and causes a deadweight loss for the importing country is not taken into account with deciding on whether or not to apply the tariff

    107. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Policy Response to Dumping Countervailing Duty Used when the Foreign government subsidizes its own exporting firms so that they can charge lower prices for the exports All you need to know about export subsidies for now is that they tend to lower the prices charged by exporters Under WTO rules, the importing country can then respond to export subsidies with a countervailing duty Again the purpose of which is to raise prices of imports back up to what it would have been without the subsidy

    108. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Policy Response to Dumping Comparison with Safeguard Tariff It is important to recognize that the tariff on compact trucks was not an antidumping duty It was actually a safeguard tariff Given that the tariff was set over 20 years ago and still holds, it confirms our assumption that Foreign firms treat the tariff as fixed This assumption does not hold for anti-dumping duties Evidence shows that Foreign firms often do change their prices, and increase the price charged in the importing country even before an antidumping tariff is applied

    109. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Policy Response to Dumping Calculation of Antidumping Duty To see why firms increase prices before an antidumping duty is applied we need to see how the duty is calculated The duty is based on the Foreign firm’s local price For example, if the local price is $10 and the export price to Home is $6, the antidumping duty is $4—the difference in the local price and the export price This method creates an incentive for the Foreign firm to raise its export price even before the tariff is applied so the duty will be lower

    110. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Policy Response to Dumping Calculation of Antidumping Duty So using our same example, if they charge an export price of $8 instead of $6 but keep the local price at $10, the duty is now only $2 A price of $10, would avoid the duty all together This increase in the import price results in a terms of trade loss for the Home country We illustrate this in Figure 9.11 As price rises from P1 to P2 gives a gain to Home firms of (a), but a loss to Home consumers of (a+b+c+d) If no duty, then no revenue to the Home government (b+c+d) is now the deadweight loss which is higher than the tariff

    111. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Policy Response to Dumping Figure 9.11 Home Loss Due to Threat of Duty A charge of dumping can sometimes lead Foreign firms to increase their prices, even without an antidumping duty being applied. In that case, there is a loss for Home consumers (a + b + c + d) and a gain for Home producers (a). The net loss for the Home country is area (b + c + d).Figure 9.11 Home Loss Due to Threat of Duty A charge of dumping can sometimes lead Foreign firms to increase their prices, even without an antidumping duty being applied. In that case, there is a loss for Home consumers (a + b + c + d) and a gain for Home producers (a). The net loss for the Home country is area (b + c + d).

    112. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Policy Response to Dumping The loss of (c) is the extra costs associated with the threat of an antidumping duty The fact that Foreign firms will raise their prices to reduce the potential duty gives Home firms an incentive to charge Foreign firms with dumping, even if none is occurring Just the threat of dumping is often enough for Foreign firms to raise prices and therefore reduce competition in the market for that good These incentives lead to excessive filings of antidumping and countervailing duty cases

    113. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Antidumping/Countervailing duties versus Safeguard Tariffs In Chapter 8 we discussed the “safeguard” provision of GATT and Section 201 of US trade law This provision, which permits temporary tariffs to be applied, is used infrequently Table 9.3 shows only 19 safeguard or “escape clause” cases were filed in the US Of the 19 cases filed, the ITC made a negative recommendation in 12 cases One of which was for the Japanese compact trucks The remaining 7 cases went to the President for a final ruling who recommended import protection in only 5 cases

    114. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Antidumping/Countervailing duties versus Safeguard Tariffs Table 9.3 Import Protection Cases in the United States, 1980–1994 This table shows the use of safeguard tariffs as compared with antidumping duties and countervailing duties in the United States. Safeguard tariffs are used much less often. Sources: Wendy Hansen and Thomas J. Prusa, 1995, “The Road Most Taken: The Rise of Title VII Protection,” The World Economy, 295–313. Update for 1989 to 1994 from I. M. Destler, 2005, American Trade Politics, Washington, D.C.: Peterson Institute for International Economics, pp. 149, 165.Table 9.3 Import Protection Cases in the United States, 1980–1994 This table shows the use of safeguard tariffs as compared with antidumping duties and countervailing duties in the United States. Safeguard tariffs are used much less often. Sources: Wendy Hansen and Thomas J. Prusa, 1995, “The Road Most Taken: The Rise of Title VII Protection,” The World Economy, 295–313. Update for 1989 to 1994 from I. M. Destler, 2005, American Trade Politics, Washington, D.C.: Peterson Institute for International Economics, pp. 149, 165.

    115. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Antidumping/Countervailing duties versus Safeguard Tariffs The infrequent use of the safeguard provision can be contrasted with the many cases of antidumping and countervailing duties, also listed in Table 9.3 Over 1980–1988, there were more than 400 antidumping cases filed in the US and over 300 countervailing duty cases To have antidumping duties applied, a case must first go the US Department of Commerce, which rules on whether imports are selling domestically at “less than fair value”

    116. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Antidumping/Countervailing duties versus Safeguard Tariffs The rulings were positive in 94% of cases during this period The case is then brought before the ITC, which must rule on whether imports have caused “material injury” to the domestic industry This criterion is much easier to meet than that for a safeguard tariff, and therefore, the ITC more frequently rules in favor of antidumping duties

    117. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Antidumping/Countervailing duties versus Safeguard Tariffs Furthermore, the application of duties does not require the additional approval of the President Of the 400 antidumping cases, about 150 were rejected and another 150 had duties levied The remaining cases fall into a third category—those that are withdrawn prior to a ruling by the ITC

    118. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Antidumping/Countervailing duties versus Safeguard Tariffs The US antidumping law permits US firms to withdraw their case and, acting through an intermediary at the Department of Commerce, agree with the foreign firm on the level of prices and market shares As we should expect, these withdrawn and settled cases result in significant increases in market prices for the importing country Since it seems most of the cases are either ruled favorably or are settled with the exporting firm, it is clear why firms make claims of dumping so often

    119. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor U.S to Impose new Duties on Chinese Goods The US Commerce Department is imposing tariffs on Chinese imports of coated paper There has been a long standing policy to not apply duties to subsidized goods from non-market economies The current trade deficit with China, which reached $233 billion last year, has angered some leading to demands for a tougher response to Chinese export subsidies

    120. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor U.S to Impose new Duties on Chinese Goods Home producers feel they have an unfair disadvantage competing with Foreign firms who have been subsidized Many believe the Chinese government subsidies are what are fueling the country’s exports The Commerce Department’s long standing position was it was too difficult to determine levels of subsidies in non-market economies, which China is considered under US trade laws However, many argue this no longer makes sense when it comes to China

    121. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Conclusions We can contrast the results we saw in Chapter 8 under perfect competition with the results here assuming imperfect competition With a tariff, a Home monopolist can increase its price by the amount of the tariff, but cannot exercise its monopoly power With a quota, the Home firm is able to charge a higher price than it could with a tariff, because it enjoys a “sheltered” market Import quota leads to higher costs for Home consumers than tariff Tariff and Quota are no longer “equivalent” policies

    122. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Conclusions With a Foreign monopoly, results are similar to the large country case in Chapter 8 A tariff leads to a fall in price received by the Foreign monopolist Price paid at Home rises by less than the tariff Home importer obtains a terms of trade gain For small tariffs, Home can gain as deadweight loss is lower than terms of trade gain A specific example of a tariff on a Foreign monopoly was on a discriminating monopoly

    123. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Conclusions The WTO allows countries to respond with tariffs if dumping in occurring in their countries An anti-dumping duty However, the potential for Home gains are unlikely to arise, due to the way the duties are applied The typical outcome are that Foreign exporters raise prices even when the duty is not applied, leading to Home losses

    124. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Conclusions Finally we considered the infant industry argument for the implementation of trade policy Examples studied were automobiles in China, computers in Brazil, and Harley-Davidson motorcycles in the US There were mixed results in how useful the trade policy is and whether or not the losses justify the gains. It is likely there are other options with less deadweight loss

    125. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Key Points Free trade will lead a Home monopoly in a small country to act in the same way as a perfectly competitive industry. Quotas are not equivalent to tariffs when the Home firm is a monopolist An infant industry is a firm that requires protection in order to compete at world prices today When a tariff is applied against a Foreign monopolist, the results are similar to the large country case analyzed in Chapter 8

    126. © 2007 Worth Publishers ? International Economics ? Feenstra/Taylor Key Points Dumping is a practice of selling goods abroad at a price that is below a firm’s domestic price, or below its average cost of production. Countries respond with anti-dumping duties Antidumping duties are calculated as the difference between a Foreign monopolist’ local price and its export price. Foreign firms often raise their export prices In the US and other countries, the use of antidumping tariffs far exceeds the use of safeguard tariffs

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