Transcript Trade Policy & Imperfect Competition

LECTURE 12
Controversies in Trade Policy
• Strategic trade policy (Gasiorek)
• Trade and…labor, environment
Trade Policy & Imperfect Competition
(Michael Gasiorek - U of Sussex)
• Review of the gains from trade
– more efficient allocation of resources (Ricardo, HOS)
– economies of scale (internal eg. under monopolistic
competition, or external
– increase competition (reciprocal dumping)
– increase variety (in models with differentiated products)
– promote economic growth (especially with respect to
endogeneous growth theory)
• Conclusion from perfectly competitive models is:
– free trade is best
– under perfect competition tariffs and quotas can be seen to be
equivalent
• In what way does imperfect competition impact upon the
traditional policy conclusions?
1) Models that explore the relationship between trade policy
and imperfect competition, but which do not consider the
nature of strategic interaction between firms
– eg. the impact of trade policy on the domestic market in the
presence of monopoly power. Is a tariff then equivalent to a
quota?
– The extent to which trade policy can be used to extract any of
the foreign monopolists profits
– trade policy enabling firms to take advantage of economies of
scale
2) Models that explore the ways in which governments /
policy can impact upon the nature of strategic interaction
between firms  strategic trade policy
1.1) Trade policy and the domestic market
(Bhagwati, 1965)
• Focusses on (a) the pro-competitive impact of trade
liberalisation; (b) shows how different trade policy
instruments can have a different impact on competition
MC
Pm
• If tariff world price (Pw) is
sufficiently low to allow for
imports than the monopolist
cannot charge a price above Pw
and hence supplies Qm’
Pw
MR
Qm
Qm’
D
• If tariff inclusive world price (Pw) is
sufficiently low to allow for imports
than the monopolist cannot charge a
price above Pw and hence supplies Qm’
MC
Pm
Pw(1+t)
MR
• Even if tariff is set higher, the
monopolist is constrained. It cannot
set a price which is higher than the
tariff inclusive price because of the
threat of imports.
• therefore effect of tariff on domestic
production can be seen by red line (as
tariff )
Qm
D
Qm’
MC
Pm
Pw(1+t)
MR
Qm
Qm’
D
• a monopolist protected by a tariff,
cannot raise its price above the tariff
inclusive price without losing the
domestic market to imports.
MC
Pm
Pw(1+t)
• Suppose you set a quota to the
same level of imports as above
(red line)
D
MR
Qm
Qm’
• once the quota has been filled,
D-q D
the effective demand curve facing
the domestic monopolist is given
Pquota
by “D-q”
• Setting MC=MR means charging
a price of Pquota.
Pw(1+t)
Pw
• a quota creates more domestic
monopoly power than a tariff
MC
MR
Qm
Qm’
1.2) Extracting a foreign monopolist’s profits
(Brander & Spencer 1984)
• assume a linear demand curve,
constant MC
• specific tariff is imposed therefore
MC curve  by the amount of the tax
• Since the demand curve is 1/2 as
steep as the MR curve, the price goes
up by 1/2 the amount of the tax
 W:
pT
pft
a
b
 CS = -(a+b)
 GR = c
but,
c = 2a

c>a+b
• so the tariff generates more revenue
than the cost to the consumer of
higher prices
MC+t
c
MC
MR
qT qft
D
1.3) Import Protection as export promotion
(Krugman, 1984)
• Protecting the domestic market enables an expansion of
domestic production
• As a result of that expansion costs decline (either because
of economies of scale, or through a more dynamic
process of learning by doing, or through increased
investment in R&D)
• The decline in costs makes the industry more competitive
in world markets, therefore exports increase
• Note the similarities (and differences) between this, and
the infant industry argument
2) Strategic Trade Policy
• An STP is a policy which impacts upon the nature of
competitive interaction between firms, and hence impacts
upons firms’ strategies in a game-theoretic sense.
• Firms recognise the interdependencies between them in
making their decisions and then government policy
impacts upon their equilibrium decisions.
• Main insights from Brander & Spencer (1985) “rent
shifting / profit shifting”.
– Assume firms act as Cournot competitors and produce a
homogeneous product
– Domestic and foreign firms compete in a third market (ie no
domestic consumption of the good)
– “game” is played in two stages (1) government(s) set
tax/subsidy level; (2) firms simultaneously decide output
(export) levels.
• Firms compete in quantities
(Cournot competition) which gives
the Nash equilibrium at the
intersection of the reaction function
at “e”.
Q*
R
e
• Now assume that the government
of the home firm offers a
production subsidy.
• The effect of the subsidy is to
lower the firms costs (MC), and
therefore increases the firms’
output level
R’
e’
R*
Q
P
MC
MC’
• This is true for all output levels
of the competitor therefore is
represented by an outward shift of
the home firms’ reaction function,
to a new equilibrium at e’
Q
• The new equilibrium involves the home firm producing more, and
getting more profits, the foreign firm producing less and getting
less profits  profit shifting.
• Formally the equilibrium with the subsidy puts the domestic firm
in the same position as being a “Stackelberg” leader
• Note also that domestic welfare has risen ie that the rise in
domestic profits is greater than the amount paid out by the
government in subsidy
– the subsidy is effectively a transfer from the taxpayers to the owners of the
firm
– the profits of the firm rise, but by more than the value of the subsidy because
the subsidy induces the firm to act more aggressively towards its rival - this
is the “strategic effect”
• Note also that the rise in welfare is also at the expense of the
foreign rival
• but note also that there have been various extensions and
generalisations of the basic model
– to incorporate domestic consumption,
– to allow for competition in R&D subsidies
– to consider retaliation
Strategic trade policy more broadly interpreted:
• A “strategic industry” is one which is considered to be
important to the economy:
– industries that promote significant externalities to the economy
– high growth industries (which may therefore generate higher
rates of economic growth for the economy) perhaps
characterised by economies of time (learning curves) which
implies that first movers may have a significant and continuing
advantage
– industries which may simply be important in terms of their
contribution to GDP
• with regard to the first two, the general perception is that
these are likely to be high R&D, high technology
industries probably characterised by imperfect
competition  strategic trade policy
It may be therefore tempting to argue...
 Governments should pursue policies that maximise
growth and competitiveness
 comparative advantage is not static, but is dynamic ie
changes over time. Governments have a legitimate role in
trying to shape that comparative advantage
 government intervention is also justified where there is
market failure (eg. externalities and spillovers)
 spillovers are prevalent in high tech, R&D intensive
industries
 High tech R&D industries will lead to higher rates of
productivity growth + give rise to spillovers hence result
in higher rates of economic growth
 R&D intensive industries (aerospace, pharmaceuticals,
telecommunications) tend to be highly imperfectly
competitive (and have high economies of scale)
 trade theory suggests that appropriate policy can increase
domestic output, profits and welfare in imperfectly
competitive industries
 in addition firms can take advantage of economies of
scale, and increase domestic competitiveness (cf. Import
protection as export promotion)
 therefore strategic trade and industrial policy should be
undertaken by governments
However...
• if both governments grant a subsidy, then welfare ends up
being lower in each country (prisoner’s dilemma)
• if:
– raising revenue involves incurring distortionary costs than the
opportunity cost of a unit of public funds is greater than 1 
gains from the policy are reduced
– if the government attaches less weight to shareholders welfare
than to tax payer’s welfare; or if some of the domestic firm’s
shareholders are foreign  gains from the policy are reduced
• suppose we allow for n firms in each country as opposed
to a duopoly:
– with free entry there may be no profits to be shifted as the initial
equilibrium is one of zero profits
– even with positive domestic profits, competition for subsidies
could result in output levels being too high domestically&
prices too low. An export tax , rather than a subsidy, would then
restrict output hence increasing output levels.
In summary...
– fragility of the results
– The analysis has assumed that governments made their
announcements first, and then firms made their decisions. How
realistic is this?
– The analysis ignored general equilibrium interactions
– rent seeking
– is the relevant information available to governments?
– retaliation
– beggar-thy-neighbour
• Hence, while the literature suggests that in the presence
of distortions there is scope for government intervention
but this is not necessarily the same as advocating
government intervention