University of Cassino Economics and Business Academic Year 2018/2019 International Economics International Trade (Industrial and Commercial policies lecture 7) Maurizio Pugno University of Cassino 1
Industrial Policy Industrial policy (definition): A government s policy designed to create new industries or support existing industries. Industrial policies are controversial because: they may help backward countries to exit from the trap due to unexploited economies of scale they may fail to achieve the world standard of efficiency. 2
Industrial Policies and Market Failure Market failure is a major justification for industrial policies. Market failure Failure by the market economy to deliver an optimal quantity of goods and services. The value of a good to private consumers (private returns) and to society (social returns) fails to equal to its cost of production There is a divergence between private returns and social returns. Too little or too much of a good is a market failure. 3
Positive and negative externalities Positive externalities: social returns are greater than private returns, a free-market economy produces less than the optimal amount. - This occurs because some of the benefits are captured by individuals or firms other than those that produce the benefits. Negative externalities: social returns are smaller than private returns, a free-market economy produces more than the optimal amount. - Economic agents do not take into account the costs that spill over onto others. 4
The case of Positive Externalities 5
When externality arises Some costs or benefits of an activity are externalized outside the area of concern of the economic agents engaged in the activity. Examples: - Knowledge spillover - Coordination problems - Capital market imperfections 6
Industrial Policy Tools - Providing information about foreign markets to domestic firms, - lobbying foreign governments to adopt home country standards, - provide government loans to private firms at below-market interest rates, - governments purchases to develop an industry, - governments direct funding of industrial research - relaxation of antitrust laws. 7
Limits to Industrial Policy WTO as part of the Uruguay Round limit the ability of countries to employ industrial policies that were once relatively common. In fact, many of the practices described are considered harmful to the interests of foreign firms. 8
Problems with Industrial Policies A basic problem is that it is difficult to obtain the information necessary to measure the extent of market failure. Second problem is determining which industry to target. Industrial policies encourage rent seeking. Rent seeking (definition): An activity, such as lobbying, by individuals, firms, or special interests to alter the distribution of income in their favor. 9
Commercial Policy Policy of tariffs and quotas is called commercial policy. There are numerous barriers to trade, some are obvious (transparent), others are not (nontransparent). Two common barriers are Tariffs and Quotas. Tariffs: indirect limit on imports: impose a tax on imports. Quotas: direct limit on imports: regulate the quantity of imports 10
Analysis of a Tariffs and Quotas Tariffs and quotas encourage Consumers to switch to relatively cheaper domestic goods. Domestic producers to increase their output as demand switches from foreign to domestic goods. We will present a partial equilibrium analysis of the effects of tariffs and quotas: it considers only their impact on the industry on which they are imposed, rather than their economy-wide effects. 11
Consumer and Producer Surplus There are two key concepts in the analysis of the impact of tariffs Consumer surplus: value received by consumers in excess of the price they pay (can be measured only if the demand curve is known) Producer surplus: value received by producers in excess of the minimum price at which they are willing to produce (can be measured only if the supply curve is known) 12
Diagram of Consumer and Producer Surplus Price Supply P* CS PS Demand 0 Q* Quantity 13
Introducing International Trade Assume: 1. There is only one price for a good (world price P w ) 2. Foreign producers are willing to supply us with all of the units of the good we want at that price 14
Bigger surplus with International Price Trade Supply P* CS Pw PS Imports Demand 0 Domestic production Q1 Q2 Quantity 15
Introducing a Tariff Now assume: Government imposes a tariff of amount t. Importers will still be able to buy the good from foreign producers for P w, but they will have to pay the import tax of t. The tax is a mark-up onto the price to domestic consumers. The price to them is P w + t=p t The consumption of the imported good subsequently decreases 16
Smaller surplus with the Tariff Pw+t Pw 0 Price PS CS Efficiency loss Domestic production Revenues Imports Q*1 Domestic consumption Q*2 Supply Consumption loss Q2 Demand Quantity 17
Results of Tariff Policy In Summary, tariffs cause the domestic price to rise by the amount of the tariff (consumer cost), domestic consumption falls (consumer cost), domestic production rises (producer benefit), imports fall (government benfit), public revenue increase (government benfit) But total surplus falls. 18
The problem of Tariffs Developed countries often impose tariffs (and other barriers) that discourage exports of many developing countries (mainly products of agriculture, clothing, and textile industries). The Doha Development Agenda of the World Trade Organization (WTO) is focused on the trade problems of developing countries. Nevertheless, developing countries have higher tariffs than developed countries. 19
Average Tariff Rates, 1986-2010 20
Why tariffs? The higher a country s income, the lower its tariffs are likely to be. This confirms that trade is beneficial for growth. But why do developing countries tend to have higher tariff rates? Because: - tariffs are a relatively easy tax to administer, - instead, on income, sales, and property require more complex accounting systems, - the informal economy is larger in developing countries, - taxes often form an important part of government revenue. 21
Other Potential Costs A tariff may have effects that are less predictable and harder to quantify Retaliation by other countries: adds to the net loss of a tariff by hurting export markets of other industries; can escalate rapidly Innovation: tariffs reduce competitive pressures on domestic firms and thus their incentives to innovate and improve the quality of existing products 22
Other Potential Costs of a Tariff (cont.) Rent seeking: any activity that uses resources in order to capture more income without actually producing a good (e.g., firms hire lobbyists to maintain tariff protection) - Political systems that do not easily provide tariffs are more likely to avoid rent seeking 23
The Large Country Case Economists distinguish between small and large countries in analyzing tariffs: Large country: one that imports enough of a particular product so that if it imposes a tariff, the exporting country will reduce its price of the good in order to keep its share of the large country's market. In theory, large countries can improve their national welfare by imposing a tariff as long as their trading partners do not retaliate. 24
Diagram of tariffs in the Large Country Case 25
Effective versus Nominal Rates of Protection The amount of protection given to any one product depends not only on the tariff rate but also on tariffs on the inputs used to produce the good. Nominal rate of protection: tariff rate levied on a given product Effective rate of protection: nominal rate + tariffs on intermediate inputs Value added: price of a good minus the costs of intermediate goods used to produce it (the contributions of labor and capital at a given stage of production) 26
Formula of the Effective Rate of Protection Effective rate of protection = (VA* - VA) / VA VA = amount of domestic value added under free trade; VA* = domestic value added after taking into account all tariffs (on both final goods and intermediate inputs) 27
Example of Nominal and Effective Rates of Protection 28
Uruguay Round (1986-1995)WTO 29