Tariffs and Quotas

INTERNATIONAL TRADE

As noted in Chapter 6, international trade is based on mutually beneficial specialization among countries, that is, on comparative advantage. The final section of this chapter underscores two additional points. First, when free trade is the norm, patterns of trade follow the rules of worldwide supply and demand. If a country’s demand outstrips its available supply, it will make up the difference via imports from the rest of the world. Second, the proposition that competitive markets are efficient applies not only to individual markets within a nation but also to all global markets. Free trade is the basis for worldwide efficient production. When nations erect trade barriers, economic welfare is diminished.

To see why perfectly competitive global markets are efficient, we use exactly the same arguments as before. Under free trade, firms from all over the world compete for sales to consumers of different nations. Free competition means that the good in question will sell at a single world price (net of transport costs). Only the most efficient lowest-cost firms will supply the good. Only consumers willing and able to pay the world price will purchase the good. Finally, exactly the right amount of the good will be supplied and consumed worldwide. In competitive equilibrium, global output occurs at a quantity such that P MB MC. The quantity of output is efficient. In a nutshell, this is the efficiency argument for free trade.

Tariffs and Quotas

In reality, worldwide trade is far from free. Traditionally, nations have erected trade barriers to limit the quantities of imports from other countries. Most commonly, these import restrictions have taken the form of tariffs, that is, taxes on foreign goods, or direct quotas. The usual rationale for this is to protect particular industries and their workers from foreign competition. Since World War II, the industrialized nations of the world have pushed for reductions in all kinds of trade barriers. Under the General Agreement on Tariffs and Trade (GATT), member nations meet periodically to negotiate reciprocal cuts in tariffs. In the last decade, there has been a rise in protectionist sentiment in the United States, aimed in part at insulating domestic industries from competition and, in part, as retaliation against alleged protectionist policies by Japan and Europe.

Although there are a number of strategic reasons why a country might hope to profit from trade barriers, the larger problem is the efficiency harm imposed by these restrictions. To illustrate this point, we return to the digital watch example introduced in Chapter 6.

RESTRICTED TRADE IN WATCHES Figure 7.8a depicts hypothetical U.S. demand and supply curves for digital watches. Suppose that the world price is $12.50 per watch (shown in the figure by the horizontal price line at P $12.50).

With free trade, the United States can import an unlimited number of watches at this price. At P $12.50, domestic demand is 25 million watches, which outstrips the domestic supply of 15 million watches. Therefore, the United States imports 10 million watches. In Figure 7.8a, the length of the line segment CD measures this volume of imports, the difference between U.S. consumption and U.S. production.

Now suppose the United States enacts trade restrictions prohibiting the import of watches altogether. Then, the no-trade equilibrium price would occur at the intersection of domestic supply and demand. In the figure, this price is $15, and total output is 20 million watches.

What is the net effect of prohibiting watch imports? Domestic watch producers benefit, while domestic consumers are harmed. We now show that the cost to consumers exceeds the benefit to producers, thus causing a net loss in the aggregate. To see this, note that the extra profits earned by domestic producers due to the price increase (from $12.50 to $15) are given by the area of trapezoid ABCE. (The extra profit lies between the old and new price lines and above the industry supply curve.) However, the increase in price has sliced into the total surplus of consumers. The reduction in consumer surplus is measured by trapezoid ABDE. (This is simply the area between the two price lines and under the demand curve.) When we compare trapezoids ABDE and ABCE, we see that consumer losses exceed producer gains by the shaded triangle ECD. This triangle measures the harm done to society, or the so-called deadweight loss attributable to the trade prohibition.15

Figure 7.8b depicts the effect of a less dramatic trade restriction. In this instance, U.S. trade authorities have imposed a 12 percent tariff on Japanese imports, raising the price of watches to (1.12)($12.50) $14. As shown in the figure, the tariff reduces total U.S. consumption to 22 million watches, while increasing domestic production to 18 million watches. Thus, U.S. imports are 22 18 4 million watches. Although less extreme, the impact of the tariff is qualitatively similar to that of a complete trade prohibition. Compared to free trade, consumer surplus is reduced by trapezoid FBDI (the area between the two price lines). Producer profits are increased by trapezoid FBCJ. The trade authority also collects tariff revenue, given by rectangle JGHI, on the 4 million watches imported. Comparing the loss in consumer surplus to these twin gains, we see that the nation as a whole suffers a net loss measured by the areas of the two shaded deadweight loss triangles.

We make two final observations. First, a tariff is superior to the alternative of a quota that achieves an equivalent reduction in imports. A quota of 4 million units would have exactly the same result as the 12 percent tariff, except that it would raise no revenue. After eliminating the revenue rectangle JGHI, we find the total deadweight loss of the quota to be trapezoid CDIJ. Second, moves

15For more on deadweight loss, see the discussion of market failure in Chapter 11.

Figure (a) shows a complete restriction on trade. Figure (b) shows a tariff.

308

(a) Price

U.S. demand

$15.00 A E U.S. supply

12.50 B C

U.S. imports D

(b) Price 15 20

25 Quantity of Digital Watches

U.S. demand U.S. supply

$15.00

14.00 F

12.50 B C J I

HG D

22201815

25 Quantity of Digital Watches

to higher and higher tariffs steadily diminish imports, increase deadweight losses, and ultimately raise little revenue. In the present example, as the tariff is raised toward 20 percent, the price of watches approaches $15, and imports fall closer and closer to zero. Obviously, tariff rates that eliminate nearly all imports generate very little revenue.

Simon’s bet rested on the simple economics of supply and demand. If ecologists were correct in their assertion that the world was running out of essential resources, then the prices of these scarce resources should rise. Basing his opinion on his own research, Simon was confident that the ecologists were wrong and that resources would be more abundant tomorrow than today so that their prices would fall.

Who was right? When the bet was settled in 1991, the prices of all five metals had declined over the decade. The same quantities of the metals that were worth $1,000 in 1981 had a total market value of only $618 in 1991. The explanations? Increases in supply kept up with increases in demand; mining companies found new deposits and used more efficient methods to recover and refine ores; the metals often were replaced by cheaper substitutes; and the tin cartel collapsed and tin prices collapsed with it. Ehrlich wrote Simon a check for the difference between the prices then and now—$382 plus accumulated interest over the decade. Using price as the market test, the “boomster” had won his bet with the “doomster.”

Of course, the result of such a bet hardly settles the larger debate about the depletion of resources.16 Although supplies of many resources are more abundant now than in the past, this does not mean that resource supplies will outstrip demand indefinitely. Indeed, dramatic economic growth in the developing world has greatly raised demand for essential resources. The emergence of high-consuming middle classes in China and India means exponential increases in food consumption, automobile purchases, and energy use per capita. Higher living standards per capita constitute a greater demand on resources than population growth per se.

Are we entering an era of markedly higher resource prices and greater scarcity? The last few years have seen significant price increases for oil, food, and many commodities. Financial expert Paul Kedrosky points out that had the same bet been made in any year from 1994 on, Ehrlich—not Simon—would have been the winner. In no small part, the surge in commodity demand by China, India, and other fast-growing emerging nations contributed to commodity price increases. (This effect reflects the increased value of commodities as engines of growth, rather than a sign of increased scarcity.)

16For discussions of the resource debate, see J. Lahart, P. Barta, and A. Batson, “New Limits to Growth Revive Malthusian Fears,” The Wall Street Journal, March 24, 2008, p. A1; J. Diamond, “What’s Your Consumption Factor?” The Wall Street Journal, March 24, 2008, p. A19; K. Arrow et al, “Are We Consuming Too Much?” Journal of Economic Perspectives (Summer 2004): 147–172; and P. Kedrosky, “Re-litigating the Simon/Ehrlich Bet,” Infectious Greed Blog (February 18, 2010).

Betting the Planet Revisited

In the longer term, much will depend on (1) technological innovations that enable the extraction of greater output from limited resources, (2) success in finding substitutes for today’s most important scarce resources, and (3) better management and conservation. No doubt some combination of alternative fuels, wind, solar, and nuclear power will take the place of oil and coal in global energy supplies. A greater concern is the increasing scarcity of water (often wasted because it is priced much too low) and arable land and the long-term risks posed by global warming. Thus, the resource debate continues.

SUMMARY

Decision-Making Principles

1.Whatever the market environment, the firm maximizes profit by establishing a level of output such that marginal revenue equals marginal cost. 2.In perfect competition, the firm faces infinitely elastic demand: Marginal revenue equals the market price. Thus, the firm follows the optimal output rule P MC. In long-run equilibrium, the firm’s output is marked by the equalities P MR MC ACmin, and the firm earns zero profit. 3.Economic transactions are voluntary. Buyers and sellers participate in them if and only if the transactions are mutually beneficial. 4.Competitive markets provide the efficient amounts of goods and services at minimum cost to the consumers who are most willing (and able) to pay for them. Worldwide competition and free trade promote global efficiency.

Nuts and Bolts

1.In a perfectly competitive market, a large number of firms sell identical products, and there are no barriers to entry by new suppliers. Price tends toward a level where the market demand curve intersects the market supply curve. In the long run, price coincides with minimum average cost, and all firms earn zero economic profits. 2.The total value associated with an economic transaction is the sum of consumer and producer surplus. Consumer surplus is the difference between what the individual is willing to pay and what she or he actually pays. 3.For any market, the height of the demand curve shows the monetary value that consumers are willing to pay for each unit. Consumer surplus

in the market is given by the area under the demand curve and above the market price line. 4.In equilibrium, a competitive market generates maximum net benefits.

The optimal level of output is determined by the intersection of demand and supply, that is, where marginal benefit exactly equals marginal cost.

Questions and Problems

1.The renowned Spaniard, Pablo Picasso, was a prolific artist. He created hundreds of paintings and sculptures as well as drawings and sketches numbering in the thousands. (He is said to have settled restaurant bills by producing sketches on the spot.) a.What effect does the existence of this large body of work have on the monetary value of individual pieces of his art? b.Might his heirs suffer from being bequeathed too many of his works?

As the heirs’ financial adviser, what strategy would you advise them to pursue in selling pieces of his work? 2.Consider the regional supply curve of farmers who produce a particular crop. a.What does the supply curve look like at the time the crop is harvested? (Show a plausible graph.) b.Depict the crop’s supply curve at the beginning of the growing season (when farmers must decide how many acres to cultivate). c.Depict the crop’s supply curve in the long run (when farmers can enter or exit the market). 3.Potato farming (like farming of most agricultural products) is highly competitive. Price is determined by demand and supply. Based on U.S.

Department of Agriculture statistics, U.S. demand for potatoes is estimated to be QD 184 20P, where P is the farmer’s wholesale price (per 100 pounds) and QD is consumption of potatoes per capita (in pounds). In turn, industry supply is QS 124 4P. a.Find the competitive market price and output. b.Potato farmers in Montana raise about 7 percent of total output. If these farmers enjoy bumper crops (10 percent greater harvests than normal), is this likely to have much effect on price? On Montana farmers’ incomes? c.Suppose that, due to favorable weather conditions, U.S. potato farmers as a whole have bumper crops. The total amount delivered to market is 10 percent higher than that calculated in part (a). Find the new market price. What has happened to total farm revenue? Is industry demand elastic or inelastic? In what sense do natural year-to-year changes in growing conditions make farming a boom-or-bust industry?

4.a.In 2009, the Japanese beer industry was affected by two economic events: (1) Japan’s government imposed on producers a tax on all beer sold, and (2) consumer income fell due to the continuing economic recession. How would each factor affect (i.e., shift) demand or supply? What impact do you predict on industry output and price? b.In 2011, the U.S. trucking industry faced the following economic conditions: (1) At last, the US economy was recovering from a prolonged slump (during which trucking had shrunk its capacity by 14%), (2) the government instituted new regulations imposing more frequent equipment inspections and restricting operators’ daily driving hours, and (3) year over year, diesel fuel prices were up by 9 percent. For each separate effect, show whether and how it would shift the industry demand curve or supply curve. What overall impact do you predict on industry output (measured in total volume and miles of goods transported) and trucking rates? 5.The Green Company produces chemicals in a perfectly competitive market.

The current market price is $40; the firm’s total cost is C 100 4Q Q2 . a.Determine the firm’s profit-maximizing output. More generally, write down the equation for the firm’s supply curve in terms of price P. b.Complying with more stringent environmental regulations increases the firm’s fixed cost from 100 to 144. Would this affect the firm’s output? Its supply curve? c.How would the increase in fixed costs affect the market’s long-run equilibrium price? The number of firms? (Assume that Green’s costs are typical in the market.) 6.In a competitive market, the industry demand and supply curves are P 200 .2Qd and P 100 .3Qs, respectively. a.Find the market’s equilibrium price and output. b.Suppose the government imposes a tax of $20 per unit of output on all firms in the industry. What effect does this have on the industry supply curve? Find the new competitive price and output. What portion of the tax has been passed on to consumers via a higher price? c.Suppose a $20-per-unit sales tax is imposed on consumers. What effect does this have on the industry demand curve? Find the new competitive price and output. Compare this answer to your findings in part (b). 7.In a perfectly competitive market, industry demand is given by Q 1,000 20P. The typical firm’s average cost is AC 300/Q Q/3. a.Confirm that Qmin 30. (Hint: Set AC equal to MC.) What is ACmin? b.Suppose 10 firms serve the market. Find the individual firm’s supply curve. Find the market supply curve. Set market supply equal to market demand to determine the competitive price and output. What is the typical firm’s profit?

c.Determine the long-run, zero-profit equilibrium. How many firms will serve the market? 8.Firm Z, operating in a perfectly competitive market, can sell as much or as little as it wants of a good at a price of $16 per unit. Its cost function is

C 50 4Q 2Q2. The associated marginal cost is MC 4 4Q and the point of minimum average cost is Qmin 5. a.Determine the firm’s profit-maximizing level of output. Compute its profit. b.The industry demand curve is Q 200 5P. What is the total market demand at the current $16 price? If all firms in the industry have cost structures identical to that of firm Z, how many firms will supply the market? c.The outcomes in part (a) and (b) cannot persist in the long run. Explain why. Find the market’s price, total output, number of firms, and output per firm in the long run. d.Comparing the short-run and long-run results, explain the changes in the price and in the number of firms. 9.Demand for microprocessors is given by P 35 5Q, where Q is the quantity of microchips (in millions). The typical firm’s total cost of producing a chip is Ci 5qi, where qi is the output of firm i. a.Under perfect competition, what are the equilibrium price and quantity? b.Does the typical microchip firm display increasing, constant, or decreasing returns to scale? What would you expect about the real microchip industry? In general, what must be true about the underlying technology of production for competition to be viable? c.Under perfect competition, find total industry profit and consumer surplus. 10.In 2007, dairy farmers faced an (equilibrium) wholesale price for their milk of about 1 cent per ounce. Because of changes in consumer preferences, the demand for milk has been declining steadily since then. a.In the short run, what effect would this have on the price of milk? On the number of dairy farmers (and the size of dairy herds)? Explain. b.What long-term prediction would you make for the price of milk? 11.In a competitive market, the industry demand and supply curves are P 70 QD and P 40 2QS, respectively. a.Find the market’s equilibrium price and output. b.Suppose that the government provides a subsidy to producers of $15 per unit of the good. Since the subsidy reduces each supplier’s marginal cost by 15, the new supply curve is P 25 2QS. Find the market’s new equilibrium price and output. Provide an explanation for the change in price and quantity.

c.A public-interest group supports the subsidy, arguing that it helps consumers and producers alike. Economists oppose the subsidy, declaring that it leads to an inefficient level of output. In your opinion, which side is correct? Explain carefully. 12.The market for rice in an East Asian country has demand and supply given by QD 28 4P and QS 12 6P, where quantities denote millions of bushels per day. a.If the domestic market is perfectly competitive, find the equilibrium price and quantity of rice. Compute the triangular areas of consumer surplus and producer surplus. b.Now suppose that there are no trade barriers and the world price of rice is $3. Confirm that the country will import rice. Find QD, QS, and the level of imports, QD QS. Show that the country is better off than in part (a), by again computing consumer surplus and producer surplus. c.The government authority believes strongly in free trade but feels political pressure to help domestic rice growers. Accordingly, it decides to provide a $1 per bushel subsidy to domestic growers. Show that this subsidy induces the same domestic output as in part (a). Including the cost of the subsidy, is the country better off now than in part (b)? Explain.

Discussion Question Over the last 30 years in the United States, the real price of a college education (i.e., after adjusting for inflation) has increased by almost 80 percent. Over the same period, an increasing number of high school graduates have sought a college education. (Nationwide college enrollments almost doubled over this period.) While faculty salaries have barely kept pace with inflation, administrative staffing (and expenditures) and capital costs have increased significantly. In addition, government support to universities (particularly research funding) has been cut. a.College enrollments increased at the same time that average tuition rose dramatically. Does this contradict the law of downward-sloping demand?

Explain briefly. b.Use supply and demand curves (or shifts therein) to explain the dramatic rise in the price of a college education.

Spreadsheet Problems

S1.In a perfectly competitive market, the cost structure of the typical firm is given by C 25 Q2 4Q, and industry demand is given by Q 400 20P. Currently, 24 firms serve the market. a.Create a spreadsheet (similar to the given example) to model the short-run and long-run dynamics of this market. (Hint: Enter

numerical values for the Price, # Firms, and QF cells; all other cells should be linked by formulas to these three cells.) b.What equilibrium price will prevail in the short run? (Hint: Use the spreadsheet’s optimizer and specify cell F8, the difference between demand and supply, as the target cell. However, instead of maximizing this cell, instruct the optimizer to set it equal to zero. In addition, include the constraint that P MC in cell F14 must equal zero.)

A B C D E F G H

1 2 3

Equilibrium in a Perfectly Competitive Market

4

5 The Industry 6 Price# Firms Supply Demand D S Tot. Profit

7

8 10 24 192 200 8 552

9 10

11 The Typical Firm 12 QF MC Cost AC P MCFirm Profit

13

14 8 12 57 7.13 2 23

15 16

17 SR: (1) D S 0 and (2) P MC; Adjust: P & QF 18 LR: (1) and (2) and (3) P AC; Adjust: P & QF & # Firms

19

c.What equilibrium price will prevail in the long run? (Hint: Include cell C8, the number of firms, as an adjustable cell, in addition to cells B8 and B14, and add the constraint that total profit in cell G8 must equal zero.) S2.The industry demand curve in a perfectly competitive market is given by the equation P 160 2Q, and the supply curve is given by the equation P 40 Q. The upward-sloping supply curve represents the increasing marginal cost of expanding industry output. The total industry cost of producing Q units of output is C 800 40Q .5Q2. (Note that taking the derivative of this equation produces the preceding industry

MC equation.) In turn, the total benefit associated with consuming Q units of output is given by the equation B 160Q Q2. (Total benefit represents the trapezoidal area under the demand curve. It is also the sum of consumer surplus and revenue. Note that taking the derivative of the benefit equation produces the original industry demand curve MB 160 2Q.) a.Create a spreadsheet similar to the given example. Only the quantity cell (C5) contains a numerical value. All other cells are linked by formulas to the quantity cell. b.Find the intersection of competitive supply and demand by equating the demand and supply equations or by varying quantity in the spreadsheet until MB equals MC. c.Alternatively, find the optimal level of industry output by maximizing net benefits (cell F9) or, equivalently, the sum of consumer and producer gains (cell F10). Confirm that the perfectly competitive equilibrium of part (b) is efficient.

1 2 3 A B C D E F G

EFFICIENCY OF

PERFECT COMPETITION

4

5 Quantity 32 Price 96

6

7 Benefit 4,096 Con Surplus 1,024 8 P MB 96 9 B C 1,504 10 Revenue 3,072 CS Profit 1,504 11 MR 32 12 Profit 480 13 Cost 2,592 14 MC 72

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Suggested References

Brock, J. R. (Ed.). The Structure of American Industry. New York: Prentice-Hall, 2008, especially Chapter 1. This volume devotes separate chapters to describing the market structures of the major sectors in the American economy—from agriculture to banking, from cigarettes to beer, from automobiles to computers.

The following readings discuss Internet and e-commerce competition: Borenstein, S., and G. Saloner. “Economics and Electronic Commerce.” Journal of Economic Perspectives (Winter 2001): 3–12. Brynjolfsson, E., Y. Hu, and M. D. Smith. “From Niches to Riches: Anatomy of the Long Tail.” Sloan Management Review (Summer 2006): 67–71. Levin, J. D. “The Economics of Internet Markets.” National Bureau of Economic Research, Working Paper 16852, March 2011. The following volume assesses the effects of airline deregulation in promoting competition and lowering prices. It also estimates the increase in consumer surplus resulting from airline deregulation. Morrison, S. A., and C. Winston. The Evolution of the Airline Industry. Washington, DC: Brookings Press, 1995. More on the debate about diminishing resources can be found at Kedrosky, P. “Re-litigating the Simon/Ehrlich Bet.” Infectious Greed Blog (February 18, 2010), available online at paul.kedrosky.com/archives/2010/02/. The following provide readable treatments of competitiveness, free trade, and protectionism. Baldwin, R. E. “Are Economists’ Traditional Trade Policy Views Still Valid?” Journal of Economic Literature (June 1992): 804–829. Bhagwati, J. “Free Trade: Old and New Challenges.” The Economic Journal 104 (March 1994): 231–246. “Research on Free Trade.” The American Economic Review 83, Papers and Proceedings (May 1993): 362–376. Bhagwati, J. In Defense of Globalization. Oxford, UK: Oxford University Press, 2004. Samuelson, P. A. “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization.” Journal of Economic Perspectives 18 (Summer 2004): 135–146. “A Special Report on the World Economy.” The Economist (October 9, 2010). “A Special Report on Globalization.” The Economist (September 20, 2008). The best Internet sources for analyzing free trade are the writings of Professor Jagdish Bhagwati of Columbia University: http://www.columbia.edu/~jb38/.

1. Equating QD 15 10P and QS 3 14P implies 18 24P, or P 18/24 $.75 per pound. Given the drop in demand, we equate 12 8P 3 14P, implying the new price P $.68. Although demand has fallen 20 percent, price has declined by just some 10 percent. 2. Setting P MC implies P 2QF 4, or QF (P 4)/2. With 40 firms, the supply curve is QS 40(P 4)/2 20P 80. 3. To find the point of minimum average cost, we set AC MC. This implies 25/Q Q 4 2Q 4, or 25/Q Q. After multiplying both sides by Q, we have Q2 25 or Qmin 5. Thus, each firm will produce 5 thousand units. In turn, ACmin 6. Thus, the long-run price is also

P $6. At this price, QD 320 (20)(6) 200 thousand units. The requisite number of firms to supply this demand is 200/5 40. (This exactly matches the number of current firms.) 4. From Check Station 2, the short-run supply curve is QS 20P 80.

Setting QD equal to QS implies 400 20P 20P 80. Therefore, we have P $8. In turn, QF (8 4)/2 6 thousand units and

CHECK STATION ANSWERS

QS (40)(6) 240 thousand units. With price greater than average cost, each firm is making a positive economic profit. In the long run,

P ACmin $6, implying QD 400 (20)(6) 280 thousand units, supplied by 280/5 56 firms. 5. If day care is free (P $0), the outcome will be inefficient: Too much day care will be demanded and consumed. The marginal benefit of the last hours consumed will be nearly zero, that is, much less than the hours’ marginal cost, MB MC. (However, there may be beneficial distributional consequences.)