Import Tariffs and Quotas under Imperfect Competition

1. Figure 9-1 shows the Home no-trade equilibrium under perfect competition (withthe price PC), and under monopoly (with the price PM). In this question, we com-pare the welfare of Home consumers in these two situations.

a. Under perfect competition, with the price PC, label the triangle of consumersurplus and the triangle of producer surplus. Outline the area of total Home sur-plus (the sum of consumer surplus and producer surplus).

Answer: Refer to Figure 9-1: Consumer surplus is the area under the demandcurve D and above the market price, and producer surplus is the area above themarginal cost curve MC and below the market price. Under perfect competi-tion, consumer surplus is PCBPD, where PD is the intersection of the demandcurve with the vertical axis. Producer surplus is PCBPMC, where PMC is the in-tersection of the marginal cost curve with the vertical axis. Total surplus is thusrepresented 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 measurethis, 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 eachunit sold. Label the difference between the price and the MC curve as producersurplus, or profits.

Answer: Refer to the following figure: Producer surplus is represented by thetrapezoid PMABPMC.

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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 thetrapezoid PDABPMC.

e. Compare your answer with parts (a) and (d) and outline the difference betweenthese two areas. What is this difference called and why?

Answer: Refer to the figure from part (c): This is called the deadweight loss dueto monopoly, and is represented by the triangle ABB. It is called a deadweightloss 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 undermonopoly (both with the price PW). In this problem, we compare the welfare ofHome consumers in the no-trade situation and under free trade.

a. Under perfect competition, with the price PW, label the triangle of consumersurplus and the triangle of producer surplus. Outline the area of total Home sur-plus (the sum of consumer surplus and producer surplus).

Answer: Refer to the following figure: The free-trade equilibrium under per-fect competition has a Home consumer surplus of PDBPW, and a producer sur-plus of PWBPMC.

S-80 Solutions Chapter 9 Import Tariffs and Quotas under Imperfect Competition

Price

PD

PM

PMC

PC

QC QuantityQM

A

B

MC

MR D

B

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 bythe shaded triangle.

c. Under monopoly, still with the price PW, again label the triangle of consumersurplus and the triangle of producer surplus.

Answer: Refer to the figure from part (a): The free-trade equilibrium under mo-nopoly has a Home consumer surplus of PDBPW, and a producer surplus ofPWBPMC. 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 prob-lem, outline the area of gains from free trade under Home monopoly.

Answer: Refer to the following figure: Gains from trade are represented by theshaded area.

e. Compare your answer with parts (b) and (d). That is, which area of gains fromtrade 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 themonopolists ability to charge a price higher than the perfectly competitive price.

Solutions Chapter 9 Import Tariffs and Quotas under Imperfect Competition S-81

Price

Quantity

Gains fromtrade

MC

MR

B

A

PD

PM

PW

PMC

QM S1 D1

D

B X* = MR*

Price

Gains fromtrade

MC

D

X* = MR*

MR

B

A

B

PD

PM

PW

QM S1 D1

PMC

Quantity

As such, trade additionally eliminates the deadweight loss associated with mo-nopoly, making gains from trade higher.

3. Rank the following in ascending order of Home welfare and justify your answers. Iftwo 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 hasequivalent levels of welfare under either perfect competition or monopoly. Adding atariff in either case reduces welfare due to the deadweight loss associated with the tar-iff, 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 themonopolist, and the deadweight loss due to monopoly is additive to the deadweightloss due to the quota, such that: c a b. Finally, a tariff with a Foreign monopolycan actually increase welfare if the terms-of-trade gain is greater than the deadweightloss, and if so, a b d.

4. Refer to the prices of Japanese automobile imports under the VER (Figures 9-5 and9-6) and answer:

a. What component of the price of imported automobiles from Japan rose the mostduring the period 1980 to 1985?

Answer: Quality improvements increased the price of Japanese cars by the mostduring that period.

b. Sketch how Figures 9-5 and 9-6 might have looked if the U. S. had applied atariff to Japanese auto imports instead of the VER (with the same level of im-ports). In words, discuss how the import prices and U.S. prices might havecompared under a tariff and the VER.

Answer: Under a percentagte (i. e. , ad valorem) tariff, the relative price of high-quality automobiles is unchanged relative to low-quality automobiles. Therefore,you would not expect the average quality level of imports to change as a resultof the tariff. Therefore, Figure 9-5 would not show the large increase in qualityof Japanese imports. For U. S. producers, the tariff would not enable them toraise their prices as much as they did. Therefore, Figure 9-6 would not show thelarge increase in the price of American small cars.

c. Which policya tariff or the VERwould have been least costly to U. S. consumers?

Answer: Because the tariff would lead to a smaller increase in the prices of smallAmerican 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 fac-ing a Foreign monopolist. In Figure 9-7, suppose that the Home country applies animport quota of X2, meaning that the Foreign firm cannot sell any more than thatamount.

a. To achieve exports sales of X2, what is the highest price that the Foreign firmcan charge?

Answer: Refer to the following figure: To achieve export sales of exactly X2, theForeign monopolist would charge P2.

S-82 Solutions Chapter 9 Import Tariffs and Quotas under Imperfect Competition

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 representedby the shaded triangle with area b.

c. Compare the consumer surplus you identified in part (b) with the consumer sur-plus under free trade. Therefore, outline in Figure 9-7 the Home losses due tothe quota. Hint: Remember that there is no Home firm, so you do not need totake into account Home producer surplus or tariff revenue. Assume that quotarents go to Foreign firms.

Answer: Refer to the figure in part (a): Consumer surplus under free trade is atriangle 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: atariff 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, wel-fare 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.

Solutions Chapter 9 Import Tariffs and Quotas under Imperfect Competition S-83

Price

Foreign Exports

MR

P2

X2 X1

P1

MC*A

d

b

c

Quantity Price Total Revenue Marginal Revenue

0 10 0 NA1 9 9 92 8 16 73 7 21 54 6 24 35 5 25 16 4 24 17 3 21 38 2 16 59 1 9 7

10 0 0 9

a. Draw a graph containing both the demand curve and marginal revenue curve.

Answer:

b. Is the marginal revenue curve a straight line as well? What is the slope of the mar-ginal revenue curve? How does that slope compare with that of the demandcurve?

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 curveis -1.Thus, the slope of the marginal revenue curve is twice as steep as the de-mand curve.

c. Does the marginal revenue curve contain negative values over the specified rangeof quantities? Explain why or why not.

Answer: Over the specified range of quantities, the marginal revenue curvedoes contain negative values. After the fifth unit sold, to sell a sixth, the fall inprice on every unit sold causes revenue to decrease, yielding a negative marginalrevenue.

7. Consider the case of a Foreign monopoly with no Home production, shown in Fig-ure 9-7. Starting from free trade at point A, consider a $10 tariff applied by theHome government.

a. If the demand curve is linear, as in problem 6, what is the shape of the marginalrevenue curve?

Answer: The shape of the marginal revenue curve is also linear, but twice assteep.

b. Therefore, how much does the tariff-inclusive Home price increase because ofthe tariff, and how much does the net-of-tariff price received by the Foreign firmfall?

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 curveof $10, reflecting the tariff, is twice as much as the corresponding vertical increasealong the demand curve. Thus, the Home tariff-inclusive price increases by $5and the net-of-tariff Foreign price decreases by $5.

c. Discuss the welfare effects of implementing the tariff. Use a graph to illustrateunder what conditions, if any, there are increases in Home welfare.

S-84 Solutions Chapter 9 Import Tariffs and Quotas under Imperfect Competition

Quantity

Pric

e

Demand

Marginal Revenue

10

8

6

4

2

0-2

-4

-6

-8-10

1 2 3 4 5 6 7 8 9 10

Answer: Refer to the following figure: The tariff decreases Home consumer sur-plus by the area c d, increases government revenue by the area c, and improvesHomes terms of trade by the area e. Thus if e exceeds d, there is an overall wel-fare gain from the tariff.

8. Suppose the home firm is considering whether to enter the foreign market. Assumethat 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 firms total costs from selling only in the local market.

Answer:

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

b. What is the firms average cost from selling only in the local market?

Answer:

$340/20 = $17

c. Calculate the firms profit from selling only in the local market.

Answer:

$25 20 $340 = $160

d. Should the home firm enter the foreign market? Briefly explain why.

Answer: The firm should enter the Foreign market because it would be earn-ing an additional $50. The firm is able to earn the extra profit because the ex-porting price, $15, although lower than the average costs, $17, is higher than themarginal cost of $10.

Solutions Chapter 9 Import Tariffs and Quotas under Imperfect Competition S-85

Price

Foreign ExportsX2

P2P1

P3 = P2 t

X1

B

e

c d

c

t

d

MC*+ t

MC*A

MR{ {

VariableCosts

FixedCosts

{ {

TotalCosts

AverageCosts

{ {

Revenue TotalCosts

{

Profits

S-86 Solutions Chapter 9 Import Tariffs and Quotas under Imperfect Competition

e. Calculate the firms profit from selling to both markets.

Answer:

($25 20 + $15 10) $10 30 $140 = $210

f. Is the home firm dumping? Briefly explain.

Answer: The firm is dumping because its export price ($15) is lower than its lo-cal price ($25).

9. Suppose that in response to a threatened antidumping duty of t, the Foreign monop-oly 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 dutycauses the Foreign firm to increase its price by t P2 P1. Consumer surplusdecreases by the area a b.

b. How do these losses compare with the losses from a safeguard tariff of theamount t, applied by the Home country against the Foreign monopolist?

Answer: A safeguard tariff would differ in two ways: (1) The Home governmentwould collect revenue on imports and (2) there would be a terms-of-trade gainfor the Home country because the incidence of the tariff would be shared by theForeign monopolist. Both differences reduce the amount of Home welfare lossunder 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 higherlikelihood of being implemented under U. S. trade law than safeguard tariffs.Because Home producers benefit due to higher prices when there is even athreat of an antidumping duty, they have an incentive to apply for this kind ofprotection.

10. Why is it necessary to use a market failure to justify the use of infant industry pro-tection?

Answer: If all markets are working perfectly, there is no reason why a potentially suc-cessful fledgling industry cannot survive without government intervention. Let usconsider the two justifications for using an infant industry tariff. The first is that theindustry will learn over time, which will drive down its average costs to the pointwhere it is competitive; if credit markets were working perfectly, that industry couldborrow against future profitability to keep it in business until that time. The second

Price

Quantity

D

b

a

D2

P2

P1

D1

{

Revenue VariableCosts

{

FixedCosts

{ {

Profits

Solutions Chapter 9 Import Tariffs and Quotas under Imperfect Competition S-87

justification explicitly assumes a market imperfection: A positive externality in pro-duction implies that the socially optimal level of infant industry output is above thatdetermined by the market equilibrium.

11. What is a positive externality? Explain the argument of knowledge spillovers as a po-tential reason for infant industry protection.

Answer: Positive externality exists when the increase in production by one firm gen-erates benefits to other firms by lowering industry costs. By imposing the tariff, thegovernment could nurture the infant industry because the increase in output allowsthe firms to reduce their future costs by learning from each other. Without the pro-tection, each firm on its own would lack the incentive to invest in learning throughincreasing its current production.

12. If infant industry protection is justified, is it better for the Home country to use a tar-iff or a quota, and why?

Answer: To the extent that the Home infant industry has market power, it is betterto use a tariff rather than a quota. The infant industry calculus weighs the benefits offuture producer surplus against current deadweight losses due to protection. Becausedeadweight 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 andOther Types of Contingent Protection, by Chad Bown (World Bank, PREM NotesNo. 144, October 21, 2009).

a. Figure A shows the number of newly initiated trade remedy investigations, in-cluding safeguard (SF), China safeguard (CSF), antidumping (AD), and counter-vailing duty (CVD) (a countervailing duty is used when foreign firms receive asubsidy from their government, and then the CVD prevents them from charginglower prices in the importing country). Each bar shows the number of new casesin each quarter of the year (Q1, Q2, etc. ) for 20072009. The number of casesis graphed separately for developing countries and developed countries. Whatdoes this graph tell us about what has happened to the number of such casessince 2007? What might have caused this pattern?

Answer: From the second quarter of 2007 onward the number of newly initi-ated trade remedy investigations increased in nearly every quarter. One of manypossible explanations is that the global recession, which started in late 2007, hasled to greater protectionism, as we have discussed in this chapter.

S-88 Solutions Chapter 9 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 mightexplain these increases? (Hint: consider the U.S. business cycle over these years)

Answer: The three years that saw the largest number of safeguard tariff initia-tions by WTO members were 2000, 2002, and 2009. One possible explanationof the spikes in safeguard tariff initiations in 2002 and 2009 is that the UnitedStates 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 WTOmembers. How many actions were started that year, and what U. S. safeguardcase that year was discussed in this chapter?

Answer: In 2002, a total of thirty-five safeguard actions were initiated by WTOmembers. That year President Bush imposed safeguard tariffs on steel importsunder Section 201 of the U. S. Trade Act of 1974 (as was discussed in Chapter8). As we can see from Figure B, 10 of the thirty-five tariffs imposed in 2002were related to steel products.

d. Figure C shows the number of newly initiated antidumping (AD) investigations, forquarters of the year from 20072009. Compare the number of cases in this graphwith Figure A, which included safeguard (SF), China safeguard (CSF), antidumping(AD), and countervailing duty (CVD). What can you conclude about the totalnumber 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 safeguardinvestigations are antidumping investigations. In the third quarter of 2009 therewere forty-four newly initiated trade remedy investigations, of which thirty-sevenwere antidumping investigations. The trend is similar for all quarters reported. Thistrend makes sense given that in the U.S. antidumping duties require a lower bur-den of proof, and are more often imposed as a result (as in Table 9-1).