International Trade - Chapt 9 Imports Tariff/ Quotas for Imperfect Markets

Import Tariffs and Quotas under Imperfect Competition

9

1. Figure 9-1 shows the Home no-trade equilibrium under perfect competition (with the price PC ), and under monopoly (with the price PM ). In this question, we compare the welfare of Home consumers in these two situations. a. Under perfect competition, with the price PC, label the triangle of consumer surplus and the triangle of producer surplus. Outline the area of total Home surplus (the sum of consumer surplus and producer surplus). Answer: Refer to Figure 9-1: Consumer surplus is the area under the demand curve D and above the market price, and producer surplus is the area above the marginal cost curve MC and below the market price. Under perfect competition, consumer surplus is PCBPD, where PD is the intersection of the demand curve with the vertical axis. Producer surplus is PCBPMC, where PMC is the intersection of the marginal cost curve with the vertical axis. Total surplus is thus represented by the triangle PMCBPD. b. Under monopoly, with the price PM, label the consumer surplus triangle. Answer: Refer to Figure 9-1: Consumer surplus is the triangle PMAPD. c. Producer surplus is the same as the profits earned by the monopolist. To measure this, label the point in Figure 9-1 where the MR curve intersects MC at point B⬘. For selling the units between zero and QM, marginal costs rise along the MC curve, up to B⬘. The monopolist earns the difference between the price PM and MC for each unit sold. Label the difference between the price and the MC curve as producer surplus, or profits. Answer: Refer to the following figure: Producer surplus is represented by the trapezoid PMAB⬘PMC.

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Chapter 9

Import Tariffs and Quotas under Imperfect Competition

Price

PD

PM

A MC B

PC

B⬘

MR

D

P MC

QM

QC

Quantity

d. Outline the area of total Home surplus with a Home monopoly. Answer: Refer to the figure from part (c): Total surplus is represented by the trapezoid PDAB⬘PMC. e. Compare your answer with parts (a) and (d) and outline the difference between these two areas. What is this difference called and why? Answer: Refer to the figure from part (c): This is called the deadweight loss due to monopoly, and is represented by the triangle ABB⬘. It is called a deadweight loss because it is a loss that is not gained by any other party. 2. Figure 9-2 shows the free-trade equilibrium under perfect competition and under monopoly (both with the price PW ). In this problem, we compare the welfare of Home consumers in the no-trade situation and under free trade. a. Under perfect competition, with the price PW, label the triangle of consumer surplus and the triangle of producer surplus. Outline the area of total Home surplus (the sum of consumer surplus and producer surplus). Answer: Refer to the following figure: The free-trade equilibrium under perfect competition has a Home consumer surplus of PDB⬘PW, and a producer surplus of PWBPMC.

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Chapter 9 Import Tariffs and Quotas under Imperfect Competition

Price PD

PM

A

MC

Gains from trade

B⬘

PW

X* = MR*

B MR

D

P MC Q M S1

Quantity

D1

b. Based on your answer to part (a) in this problem and part (a) of the last problem, outline the area of gains from free trade under perfect competition. Answer: Refer to the figure from part (a): Gains from trade are represented by the shaded triangle. c. Under monopoly, still with the price PW, again label the triangle of consumer surplus and the triangle of producer surplus. Answer: Refer to the figure from part (a):The free-trade equilibrium under monopoly has a Home consumer surplus of PDB⬘PW, and a producer surplus of PWBPMC. This is identical to the free-trade surplus under perfect competition. d. Based on your answer to part (c) in this problem and part (d) of the last problem, outline the area of gains from free trade under Home monopoly. Answer: Refer to the following figure: Gains from trade are represented by the shaded area. Price PD

PM

Gains from trade MC

A

B⬘

PW

X* = MR*

B MR

D

P MC Q M S1

D1

Quantity

e. Compare your answer with parts (b) and (d). That is, which area of gains from trade is higher and why? Answer: The area representing gains from trade is larger in part (d) than in part (b). This is because the opening of trade in the monopoly case eliminates the monopolist’s ability to charge a price higher than the perfectly competitive price.

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As such, trade additionally eliminates the deadweight loss associated with monopoly, making gains from trade higher. 3. Rank the following in ascending order of Home welfare and justify your answers. If two items are equivalent, indicate this accordingly. a. Tariff t in a small country with perfect competition. b. Tariff t in a small country with a Home monopoly. c. Quota with the same imports M in a small country, with a Home monopoly. d. Tariff t in a country facing a Foreign monopoly. Answer: c ⬍ a ⫽ b ⬍ d. As shown in problem 2, a small country with free trade has equivalent levels of welfare under either perfect competition or monopoly. Adding a tariff in either case reduces welfare due to the deadweight loss associated with the tariff, but does not reintroduce any additional deadweight losses due to monopoly. Thus, a ⫽ b. A quota in a country with a monopoly maintains the market power of the monopolist, and the deadweight loss due to monopoly is additive to the deadweight loss due to the quota, such that: c ⬍ a ⫽ b. Finally, a tariff with a Foreign monopoly can actually increase welfare if the terms-of-trade gain is greater than the deadweight loss, and if so, a ⫽ b ⬍ d. 4. Refer to the prices of Japanese automobile imports under the VER (Figures 9-5 and 9-6) and answer: a. What component of the price of imported automobiles from Japan rose the most during the period 1980 to 1985? Answer: Quality improvements increased the price of Japanese cars by the most during that period. b. Sketch how Figures 9-5 and 9-6 might have looked if the U. S. had applied a tariff to Japanese auto imports instead of the VER (with the same level of imports). In words, discuss how the import prices and U. S. prices might have compared under a tariff and the VER. Answer: Under a percentagte (i. e. , ad valorem) tariff, the relative price of highquality automobiles is unchanged relative to low-quality automobiles. Therefore, you would not expect the average quality level of imports to change as a result of the tariff. Therefore, Figure 9-5 would not show the large increase in quality of Japanese imports. For U. S. producers, the tariff would not enable them to raise their prices as much as they did. Therefore, Figure 9-6 would not show the large increase in the price of American small cars. c. Which policy—a tariff or the VER—would have been least costly to U. S. consumers? Answer: Because the tariff would lead to a smaller increase in the prices of small American cars, it would be less costly than the VER. 5. In this problem, we analyze the effects of an import quota applied by a country facing a Foreign monopolist. In Figure 9-7, suppose that the Home country applies an import quota of X2, meaning that the Foreign firm cannot sell any more than that amount. a. To achieve exports sales of X2, what is the highest price that the Foreign firm can charge? Answer: Refer to the following figure: To achieve export sales of exactly X2, the Foreign monopolist would charge P2.

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Chapter 9 Import Tariffs and Quotas under Imperfect Competition

Price b d P2 P1 c

MC* A MR Foreign Exports

X2 X1

b. At the price you have identified in part (a), what is the Home consumer surplus? Answer: Refer to the figure in part (a): Home consumer surplus is represented by the shaded triangle with area b. c. Compare the consumer surplus you identified in part (b) with the consumer surplus under free trade. Therefore, outline in Figure 9-7 the Home losses due to the quota. Hint: Remember that there is no Home firm, so you do not need to take into account Home producer surplus or tariff revenue. Assume that quota rents go to Foreign firms. Answer: Refer to the figure in part (a): Consumer surplus under free trade is a triangle with area b ⫹ c ⫹ d. Under a quota, consumer surplus decreases by c ⫹ d. The Home welfare loss due to the quota is thus area c ⫹ d. d. Based on your answer to (c), which has the greater loss to the Home country: a tariff or a quota, leading to the same level of sales X2 by the Foreign firm? Answer: Because there is no terms-of-trade gain associated with the quota, welfare is lower under a quota regime relative to a tariff regime. 6. Suppose that the demand curve for a good is represented by the straight line P = 10 – Q. Answer: In italics in the following chart. Quantity 0 1 2 3 4 5 6 7 8 9 10

Price

Total Revenue

Marginal Revenue

10 9 8 7 6 5 4 3 2 1 0

0 9 16 21 24 25 24 21 16 9 0

NA 9 7 5 3 1 –1 –3 –5 –7 –9

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a. Draw a graph containing both the demand curve and marginal revenue curve. Answer: 10 8

Demand

6 4 2 Price

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0 -2 Marginal Revenue

-4 -6 -8 -10 1

2

3

4

5

6

7

8

9

10

Quantity

b. Is the marginal revenue curve a straight line as well? What is the slope of the marginal revenue curve? How does that slope compare with that of the demand curve? Answer: Like the demand curve, the marginal revenue curve is a straight line. The slope of the marginal revenue curve is -2 and the slope of the demand curve is -1. Thus, the slope of the marginal revenue curve is twice as steep as the demand curve. c. Does the marginal revenue curve contain negative values over the specified range of quantities? Explain why or why not. Answer: Over the specified range of quantities, the marginal revenue curve does contain negative values. After the fifth unit sold, to sell a sixth, the fall in price on every unit sold causes revenue to decrease, yielding a negative marginal revenue. 7. Consider the case of a Foreign monopoly with no Home production, shown in Figure 9-7. Starting from free trade at point A, consider a $10 tariff applied by the Home government. a. If the demand curve is linear, as in problem 6, what is the shape of the marginal revenue curve? Answer: The shape of the marginal revenue curve is also linear, but twice as steep. b. Therefore, how much does the tariff-inclusive Home price increase because of the tariff, and how much does the net-of-tariff price received by the Foreign firm fall? Answer: Because the marginal revenue curve is steeper than the demand curve (twice as steep in this case), the vertical increase along the marginal revenue curve of $10, reflecting the tariff, is twice as much as the corresponding vertical increase along the demand curve. Thus, the Home tariff-inclusive price increases by $5 and the net-of-tariff Foreign price decreases by $5. c. Discuss the welfare effects of implementing the tariff. Use a graph to illustrate under what conditions, if any, there are increases in Home welfare.

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Chapter 9 Import Tariffs and Quotas under Imperfect Competition

Answer: Refer to the following figure:The tariff decreases Home consumer surplus by the area c ⫹ d, increases government revenue by the area c, and improves Home’s terms of trade by the area e. Thus if e exceeds d, there is an overall welfare gain from the tariff. Price c P2 P1 P3 = P2 – t

d

e B

MC*+ t t MC* A c

MR X2 X1

d

Foreign Exports

8. Suppose the home firm is considering whether to enter the foreign market. Assume that the home firm has the following costs and demand: Fixed costs

= $140

Marginal costs

= $10 per unit

Local price

= $25

Local quantity

= 20

Export price

= $15

Export quantity = 10 a. Calculate the firm’s total costs from selling only in the local market. Answer:

{

{

Total Costs = $10 ⴢ 20 + $140 = $340 Variable Costs

Fixed Costs

b. What is the firm’s average cost from selling only in the local market? Answer: Total Costs

{

{

$340/20 = $17

Average Costs

c. Calculate the firm’s profit from selling only in the local market. Answer:

{

{ {

$25 ⴢ 20 – $340 = $160 Revenue

Total Costs

Profits

d. Should the home firm enter the foreign market? Briefly explain why. Answer: The firm should enter the Foreign market because it would be earning an additional $50. The firm is able to earn the extra profit because the exporting price, $15, although lower than the average costs, $17, is higher than the marginal cost of $10.

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e. Calculate the firm’s profit from selling to both markets. Answer: ($25 ⴢ 20 + $15 ⴢ 10) – $10 ⴢ 30 –$140 = $210

f.

Revenue

Variable Costs

{ {

■

{

Solutions

{

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Fixed Costs

Profits

Is the home firm dumping? Briefly explain. Answer: The firm is dumping because its export price ($15) is lower than its local price ($25).

9. Suppose that in response to a threatened antidumping duty of t, the Foreign monopoly raises its price by the amount, t. a. Illustrate the losses for the Home country. Answer: Refer to the following figure: The threat of an antidumping duty causes the Foreign firm to increase its price by t ⫽ P2 ⫺ P1. Consumer surplus decreases by the area a ⫹ b. Price

b P2 a P1

D D2

D1

Quantity

b. How do these losses compare with the losses from a safeguard tariff of the amount t, applied by the Home country against the Foreign monopolist? Answer: A safeguard tariff would differ in two ways: (1) The Home government would collect revenue on imports and (2) there would be a terms-of-trade gain for the Home country because the incidence of the tariff would be shared by the Foreign monopolist. Both differences reduce the amount of Home welfare loss under a tariff relative to a threatened antidumping duty. c. In view of your answers to (a) and (b), why are antidumping cases filed so often? Answer: Despite their higher welfare costs, antidumping tariffs have a higher likelihood of being implemented under U. S. trade law than safeguard tariffs. Because Home producers benefit due to higher prices when there is even a threat of an antidumping duty, they have an incentive to apply for this kind of protection. 10. Why is it necessary to use a market failure to justify the use of infant industry protection? Answer: If all markets are working perfectly, there is no reason why a potentially successful fledgling industry cannot survive without government intervention. Let us consider the two justifications for using an infant industry tariff. The first is that the industry will learn over time, which will drive down its average costs to the point where it is competitive; if credit markets were working perfectly, that industry could borrow against future profitability to keep it in business until that time. The second

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Chapter 9 Import Tariffs and Quotas under Imperfect Competition

justification explicitly assumes a market imperfection: A positive externality in production implies that the socially optimal level of infant industry output is above that determined by the market equilibrium. 11. What is a positive externality? Explain the argument of knowledge spillovers as a potential reason for infant industry protection. Answer: Positive externality exists when the increase in production by one firm generates benefits to other firms by lowering industry costs. By imposing the tariff, the government could nurture the infant industry because the increase in output allows the firms to reduce their future costs by learning from each other. Without the protection, each firm on its own would lack the incentive to invest in learning through increasing its current production. 12. If infant industry protection is justified, is it better for the Home country to use a tariff or a quota, and why? Answer: To the extent that the Home infant industry has market power, it is better to use a tariff rather than a quota. The infant industry calculus weighs the benefits of future producer surplus against current deadweight losses due to protection. Because deadweight losses are greater under a quota due to maintaining Home market power, infant industry protection has a better chance of being worthwhile by using a tariff. 13. Figures A, B, and C are taken from the paper, “The Pattern of Antidumping and Other Types of Contingent Protection,” by Chad Bown (World Bank, PREM Notes No. 144, October 21, 2009).

a. Figure A shows the number of newly initiated trade remedy investigations, including safeguard (SF), China safeguard (CSF), antidumping (AD), and countervailing duty (CVD) (a countervailing duty is used when foreign firms receive a subsidy from their government, and then the CVD prevents them from charging lower prices in the importing country). Each bar shows the number of new cases in each quarter of the year (Q1, Q2, etc. ) for 2007–2009. The number of cases is graphed separately for developing countries and developed countries. What does this graph tell us about what has happened to the number of such cases since 2007? What might have caused this pattern? Answer: From the second quarter of 2007 onward the number of newly initiated trade remedy investigations increased in nearly every quarter. One of many possible explanations is that the global recession, which started in late 2007, has led to greater protectionism, as we have discussed in this chapter.

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Import Tariffs and Quotas under Imperfect Competition

b. Figure B shows the number of safeguard (SF) tariff initiations by WTO members. Since 1995, what three years saw the largest numbers of safeguards? What might explain these increases? (Hint: consider the U. S. business cycle over these years) Answer: The three years that saw the largest number of safeguard tariff initiations by WTO members were 2000, 2002, and 2009. One possible explanation of the spikes in safeguard tariff initiations in 2002 and 2009 is that the United States was in a recession in both the early 2000s and again in 2009. c. According to Figure B, year 2002 had the most safeguards actions by WTO members. How many actions were started that year, and what U. S. safeguard case that year was discussed in this chapter? Answer: In 2002, a total of thirty-five safeguard actions were initiated by WTO members. That year President Bush imposed safeguard tariffs on steel imports under Section 201 of the U. S. Trade Act of 1974 (as was discussed in Chapter 8). As we can see from Figure B, 10 of the thirty-five tariffs imposed in 2002 were related to steel products.

d. Figure C shows the number of newly initiated antidumping (AD) investigations, for quarters of the year from 2007–2009. Compare the number of cases in this graph with Figure A, which included safeguard (SF), China safeguard (CSF), antidumping (AD), and countervailing duty (CVD). What can you conclude about the total number of SF, CSF, and CVD cases as compared to the number of AD cases? Answer: As we can see by looking at Figures A and C, the majority of all safeguard investigations are antidumping investigations. In the third quarter of 2009 there were forty-four newly initiated trade remedy investigations, of which thirty-seven were antidumping investigations. The trend is similar for all quarters reported. This trend makes sense given that in the U. S. antidumping duties require a lower burden of proof, and are more often imposed as a result (as in Table 9-1).