Transcript Principles of Macroeconomics

BA 187 – International Trade
Krugman & Obstfeld, Chapter 11
Strategic Trade Policy
1
Problems with Achieving Free Trade
Strategic Interaction and Trade Wars
2
Strategy & Trade Warfare

Two Countries with two
policy choices.
– Free Trade or Protection.

U.S.
Free Trade
Protection
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20
Free Trade
Payoff Table at right.
– Payoffs to each given
strategy choice of other.
– Assume particular structure.

Japan
10
Protection
-10
-10
20
-5
-5
Assumptions:
– Each nation chooses protection if other’s policy is taken as given.
– Each nation better off if both acted jointly to choose free trade.

Example of the “Prisoner’s Dilemma” Game
– Each acting unilaterally chooses to protect, together get worst payoff.
– If each could credibly commit to free trade, both better off.
– International agreements one way to enforce cooperation for free trade.
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International Trade Agreements

General Agreement on Trade and Tariffs, GATT (1947)

Multi-lateral commitment to reducing trade barriers, sponsored
– Kennedy Round (1962 – 67)

Tariffs reduced average 35% on 2/3 of manufactured goods.
– Tokyo Round (1974 – 79)
Tariffs fall 1/3 on manufactures, restrict NTB’s,
 Non-reciprocity principle for developing countries.

– Uruguay Round (1986 – 93)



Tariffs fall 34% on manufactures, agricultural subsidies cut
36%, textile quotas (MFA) phased out, nat’l treatment for
services under GATS, establish WTO to replace GATT.
Omnibus Trade & Competitiveness Act (1988)
Strategic Impediments Initiative, SII (1990)
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Strategic Trade Policy I
Tariffs in the face of a
Foreign Monopolist
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Tariff to Gain Foreign Monopoly Profit
p1
1. Foreign monopolist sells q0 in Home market,
at price p0 earns excess profits, Profit0.
2. Home gov’t imposes tariff t, monopolist sets
quantity q1 < q0, earns less profit, Profit1.
3. Loss of consumer surplus from higher price.
p0
4. Gov’t tariff revenue captures part of previous
excess monopoly profits.
Cost, C and
Price, P
Profit1
MC+t =AC+t
Profit
Tariff 0
MR
Q1
Q0
MC=AC
5. Net result to Home is
Gain from 4. less Loss in 3.
D
6. Net efficiency loss to world
as quantity falls from tariff.
Quantity, Q
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Strategic Trade Policy II
Subsidies and
Imperfect Competition
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Strategy in a Duopoly Model


Airbus
Two firms, one industry,
new aircraft decision.
Boeing
– Produce or Not Produce.
Produce
Payoff Table at right.
– Payoffs to each given
No Prod’n
strategy choice of other.
– Assume particular structure.

Produce
No Prod’n
-5
-5
0
100
100
0
0
0
Features:
– If both firms choose to produce new aircraft, both suffer losses.
– If either firm is sole producer, then they make substantial profits.

Equilibrium:
– Advantage to firm that moves first. First-mover captures entire market,
no incentive for other firm to enter. No unique equilibrium.
– A firm could guarantee market if had a credible commitment to enter.
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Effects of a Subsidy to Airbus

Targeted Gov’t subsidy can
Boeing
provide a credible entry
commitment.
– Assume EU guarantees
Airbus a $25 mill. Subsidy
to produce new aircraft.

New Payoff Table at right.
– Payoffs to Airbus change.

Airbus
Produce
Produce
No Prod’n
20
-5
No Prod’n
0
100
125
0
0
0
Features:
– Profitable for Airbus to enter regardless of Boeing strategy.
– Boeing knows Airbus will enter, so Boeing will not to avoid loss.

Equilibrium with Subsidy
– Subsidy ensures Airbus produces new aircraft & Boeing does not enter.
– EU Subsidy acts as deterrent to U.S. firm, allows EU industry to
capture industry.
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Strategic Trade Policy III
What Types of Industries
might be subsidized?
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Strategic Trade Policy Targets

Domestic gain from a targeted gov’t export subsidy depends on
how gov’t intervention affects strategic interaction between
domestic & foreign firms.
– Argument requires imperfect competition in targeted industry.
– Depends on form of strategic competition.

Credible commitment to large expenditures on capital and R&D
can play central role in strategic interaction.
– If this strategic game occurs early in product lifecycle, it will have major
impacts on profitability in mature product phase.

Avoid industries where Foreign Gov’t providing subsidies.
– Matching subsidies “levels the playing field” for domestic firms
– Industry as a whole likely to face lower prices, and profits.

Why export subsidies rather than subsidy to domestic prod’n?
– Export targeting based on raising profits of domestic firms at expense of
foreign rivals. Ignores consumer benefits/costs from policy.
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Preferred Industry Characteristics

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Substantial Barriers to Entry
– Additional returns expected to exceed cost of subsidy.
Serious Foreign Competition or Potential Competition
– Subsidy should force foreign rivals to cut back capacity.
High Concentration in Domestic Industry
– Domestic industry at least as concentrated as foreign rival.
Factor Prices increase little in face of subsidy
– Lack of strong union, profit-sharing, no key input in fixed supply.
Subsidy Targeting most effective when:
– Domestic industry has cost advantage over foreign firms.
– Substantial scale/learning economies from increased production.
R&D subsidies most effective when:
– Minimum spillovers to rivals/subsidies aid transfer rival tech.
Domestic Industry an especially good candidate if:
– R&D & capital are major costs or winning product in early development.
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Strategic Trade Policy IV
Micro-level problems with
Strategic Trade Policy.
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Problems with Strategic Policies

Optimal Policy depends on specific strategic interaction.
– Firm has beliefs about rival’s actions, each pair of beliefs has different
equilibrium outcome and so optimal gov’t policy.
– If price competition, then optimal policy is an export tax, not subsidy.

If more than one domestic firm then different optimal policy.
– Competition among firms leads to prefer export tax over subsidy.

Barriers to entry necessary for policy to secure excess profits.
– Subsidy brings excess domestic entry, competition, inefficient scale.
– Difficult to identify excess profit industries from ex post returns.


Barriers determined in earlier round of capacity, R&D or advertising.
Effect on Domestic Consumers of strategic trade policies.
– Ignores effects of normally higher prices from strategic policy on
consumer surplus.
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Problems with Strategic Policies

Which Oligopoly to Choose to Promote?
– If common pool of resources, subsidy to one industry hurts all others.

Theoretical result is that indirect losses generally outweigh direct gains.
– Do not choose industry with highest returns, rather industry that shifts
highest profit from foreign rival.


How to determine this in real world? Information requirements excessive.
Threat of Foreign Retaliation
– Strategic trade policies are “Beggar thy Neighbor” policies that
transfer profits from foreign rivals to domestic producers.
– Foreign retaliation highly likely, net result is loss to both countries.

Capture of Strategic Trade Policies
– Trade policy susceptible to pressure by special interest groups.
– Choice of industry not optimal, fewer benefits but same potential loss.
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Duopoly Model Revisited


Boeing
– Produce or Not Produce.
Produce
New Payoff Table at right.
– Assume Boeing has cost
advantage in prod’n over
Airbus of $25 million.

Airbus
Two firms, one industry
with new good.
Produce
No Prod’n
-20
5
No Prod’n
0
125
100
0
0
0
Features:
– Boeing will produce regardless of decision by Airbus due to advantage.
– Airbus loses with certainty, so will not enter industry.

Equilibrium:
– Boeing is the single low-cost producer that captures entire market.
– No need for first-mover advantage, no uncertainty about market
structure.
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Effects of a Subsidy Revisited

Effects of same targeted
Gov’t subsidy as before.
– EU guarantees Airbus a
$25 million Subsidy to
produce new aircraft.

New Payoff Table
Airbus
Boeing
Produce
5
5
No Prod’n
– Payoffs to Airbus change.

No Prod’n
Produce
0
125
125
0
0
0
Features:
– Each firm would be better off if the other chose not to produce.
– Both firms will choose to produce the aircraft as their best strategy.

Another Example of Prisoner’s Dilemma.
– Both firms will produce the aircraft, both firms get low payoff.
– EU subsidy is worst possible policy here as both firms lose.
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Strategic Trade Policy V
Philosophical problems with
Strategic Trade Policy.
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Goals of Strategic Policy?

The Rhetoric of Competition and Industrial Policy
– Popular counterpart of strategic trade policy is industrial policy.
– Asserts that nations compete for desirable industries.

Encourage High Value Added Industries?
– Industries with high value added per worker tend to be capitalintensive, i.e. low value-added per unit of capital.
– Capital is also a scarce factor, so no guarantee max. nat’l income.

Encourage High Wage Industries?
– Wage differential argument that manufactures better than services.
– Deindustrialization from tech. change, not international trade.

Encourage High Technology Industries?
– Effects of trade on jobs & high wages of this sector fairly small.
– Increase tech. progress in economy through tech. Spillovers.
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