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Unformatted text preview: Econ 424 – Winter 2010/2011 Interpreting Welfare for: Closed Economy, Free‐Trade, Tariff, Quota, Voluntary Export Restraint, and Subsidy Closed Economy In a closed economy, price (P) is determined by the intersection of supply and demand and the quantity sold and purchased on the market is determined by the quantity demanded and the quantity willing to be supplied at that price (Q). In a closed economy, consumer surplus (CS) and producer surplus (PS) are determined as shown below. CS = area below demand curve, above price consumers pay. PS = area above supply curve below price producers receive for their good. A Note About Surplus Consumer surplus exists for the very same reason markets function at all (in fact, you could say that markets work because of the existence of consumer and producer surplus). Nobody would buy anything ever if they didn’t value the good they are buying more than they value whatever it is they must sacrifice in order to obtain the good (usually they sacrifice money in the amount of the “price” of the good). The 1 excess value to the consumer above the market price is defined as the consumer’s surplus. 1 Similarly, producers are able to sell the good at a market price above the marginal cost of production (which you can read directly from the supply curve). The difference between the price they sell the good for and the marginal cost of producing that good is the producer surplus. Important: Consumer surplus and Producer surplus are both measured in dollars (or whatever currency the good is priced in). Open Economy with Completely Free Trade – Home is an Importer of this good Suppose that for whatever reason, home is an importer of this good (perhaps their comparative advantage of production lies elsewhere). Introducing international trade lowers the price in the home market to Pw. Notice that the quantity demanded at this price (Qw,d) is greater than the quantity demanded in a closed economy (Q). Why? Because the price the consumers have to pay is now lower. Also notice that the quantity supplied by domestic producers at this price (Qw,s) is lower than the quantity supplied in a closed economy (Q). Why? Because the price producers receive has been lowered by foreign competition. Since the quantity demanded exceeds the quantity the home market will supply on its own, the economy must import the good to compensate for the excess demand in the home market. 1 For example, if I purchase a soda for $1, you can deduce that I must value the soda at least as much as I valued the dollar I traded for it (why else would I make the trade?). This can be said for any purchase. Usually you’d be willing to pay more than the price you actually have to pay (the market price), but fortunately you don’t have to since all consumers face the same price (whatever’s on the tag).* The difference between your absolute maximum willingness to pay and the market price is your surplus. In reality, finding your maximum willingness to pay is pretty difficult (especially if you’re being honest with yourself), since I could always ask, “really, not a penny more?” and you’d say, “yeah, well, okay, one more penny,” and we could keep repeating that for dimes and maybe even dollars. Turns out there are some clevermechanisms for eliciting maximum willingness to pay, but this is not a behavioral economics course. * You might say, “what about countries where you haggle over all the prices?” You’re right, in these countries consumers are all charged different prices. Haggling, to an economist, is simply a bargaining procedure to determine who gets your consumer surplus. You try to obtain a lower price in order to earn more consumer surplus, they try to obtain a higher price in order to earn more producer surplus. If you’re interested in talking about bargaining behavior feel free to visit me in office hours or after class sometime. PS: You just read the post‐ script of a footnote inside a footnote, you must really be interested in this stuff. 2 To observe the effect on welfare let’s put the closed economy price (P) back on the graph and define some areas using letters for names. We see that the introduction of international trade greatly increases Consumer Surplus to the area (A+B+D) and does so at the expense of Producer Surplus which is now given by area (C). Notice that the area denoted by B once belonged to producers, but now to consumers. Also notice that, before international trade, neither producers nor consumers were capturing the surplus inside of the triangle marked D. This means that total social welfare at home has increased by the value of area D. Producers are therefore the clear losers of international trade when trade occurs in an industry that the economy will be a net importer. As an exercise, show that an economy that will export the good when opening up to international trade will experience a gain in producer surplus, a loss in consumer surplus, and an increase in total welfare (Hint: it’ll look just like this graph except with Pw > P instead of Pw < P). Tariffs To regain some of their lost surplus, firms often lobby governments to introduce trade protections. The classical example is a tariff which places a tax on the good in question, but only when it is imported. This means that the good produced domestically is not taxed in this way but the import is. This is the equivalent of raising the costs of foreign firms for producing the good. Let t represent the amount of the tariff. This increase in cost associated with the goods they export will cause the foreign firm to produce less for the export sector. This decrease in the amount being exported by foreign means that foreign will have more of the good to supply to its own people. This increase in supply in foreign’s domestic market will lower the price that foreigners pay for this good. This lower price in foreign resulting from this tariff is shown by Pt*. Of course, the tariff will serve to raise prices paid by consumers in home. The good they were importing cheaply had a tax levied upon it. This will decrease the amount imported, and more of home’s supply will be produced by firms at home. This higher price in home resulting from this tariff is shown by Pt. 3 So, the price for the good paid by consumers in home increases by some amount and the price for the good paid by consumers in foreign decreases by some amount. The difference in the two new prices (Pt and Pt*) is exactly the size of the tariff (t). So Pt – Pt* = t. The size of these changes is determined by the relative size of the countries. If home is large relative to foreign, than its price won’t change much (so it won’t go up much). Since the difference between Pt and Pt* is always equal to t, if Pt doesn’t go up much for a given t, then Pt* must go down by a lot. On the other hand, if home is small relative to foreign, than Pt will increase a lot due to the tariff and Pt* will not change much. The incidence of a tariff is shown below. Qs,t represents the new quantity supplied by home’s producers to the home market. Qd,t represents the new quantity demanded by home consumers. Again, any excess demand must be imported. Again we can throw a bunch of letters onto this graph to represent welfare values. The imposition of a tariff results in a decrease of consumer surplus. In the new graph with letters A‐H on it, old CS would have been represented by A+B+c+D+e+F. AFTER the tariff, however, it is only A+B. Pre‐tariff, PS would have been represented entirely by G. AFTER the tariff it increases to G+F. A tariff is a tax, which means it generates revenue. How much? Well, the size of the tax per unit (which is given by t, the value of the tariff) times the number of units that are taxed. Since only imports are taxed, this means that the quantity of units taxed are given exactly by the quantity of the good imported (shown in the graph with “Imports”). The value of this product (t x imports) is clearly given by the area of the rectangle of height t and width “imports,” shown on the graph as the area D+H. 4 Clearly there are two areas unaccounted for, c and e. These little triangles represent the deadweight loss associated with the market distorting tariff. The size of (c+e) relative to H determines whether or not social welfare will increase or decrease due to the imposition of the tariff. Recall that small countries have their price affected more by the tariff than large countries. Therefore, if a small country levies a tariff, Pt will increase by much more than Pt* decreases. This will mean a smaller value for H and a larger value for (c+e). What does this mean? That small countries are more likely to decrease their own welfare by imposing a tariff. A large country will have a larger H and smaller (c+e) meaning that large countries are more likely to increase their own welfare by imposing a tariff. Should we let the welfare effect determine our trade policies? Depends on your point of view. If all you care about is increasing total social welfare, than yes. However, if you value transfers from consumers to producers, then a tariff is a good idea regardless of the total social welfare effect. Conversely, if you value transfers to consumers from producers, then you should let international trade persist uninhibited. 5 Summary of Tariff: Consumer Surplus Change = – F – c – D – e Producer Surplus Change = +F Government Revenue Change = +D + H Total Welfare Change = H – c – e Quotas Quotas can be interpreted similarly to tariffs. The idea of a quota is that a country, for whatever reason, feels as though it is importing too much of a good and wishes to decrease imports in the most unimaginative of ways: by saying that they cannot import more than Qx number of units of the good. In this case, Qx would represent the size of the quota. Suppose a country is currently importing at the world price (Pw) as shown in the graph below. Consumer and producer surplus is determined in the usual way and can be illustrated using the graph below (you’ve already seen this graph, it’s simply reproduced here for convenience): Now suppose that the home country wants to decrease imports. To do so it will impose a quota of size Qx which had better be less that “Imports” in the graph above. (If Qx > imports the quota will have no 6 effect. If an economy wants to import 100,000 units of a good and the government says, “you can’t import more than 200,000 units,” absolutely nothing will change). The imposition of this quota will decrease the amount imported to Qx, which we can represent on the graph by where the distance between Quantity Demanded and Quantity Supplied = Qx. If it helps, think of the quota as a horizontal “bar” of size Qx that will be placed between the supply and demand curves, below their intersection, and wherever that bar just fits is going to determine the new price level in the market resulting from the quota. Note that, when only Qx units are being imported, the good is relatively more scarce. This allows those who sell the good in the home market to sell it for a higher price shown by Pq. Domestic suppliers now supply Qs,q and at the higher price domestic consumers demand only Qd,q. Important: The price charged by firms under the quota (Pq) is charged not only by home firms, but also by foreign firms lucky enough to still be exporting this good to home. Obviously, since the amount imported decreased to Qx, some foreign firms are no longer doing any exporting to home. Those that are still exporting to home are fortunate because they get to charge a higher price (Pq). So, who decides who gets to keep exporting to home when there’s a quota? The owner of the quota licenses makes this decision. How valuable are these licenses? Foreign firms get to sell at a price Pq > Pw and they get to sell Qx units at this higher price. This means that the total value of these licenses is given by the rectangle of height (Pq – Pw) and width Qx. This is given by area D in the welfare calculation graph below. The value of these quota licenses is called quota rents. So quota rents = $D. 7 Notice that a quota, like a tariff, decreases consumer surplus relative to free trade. Similarly, like a tariff, a quota increases producer surplus at home relative to free trade. It also generates some revenue in the form of quota rents, equal to the amount given by area D. Also, just like tariffs, deadweight loss in the amount of (c+e) is created by this market distortion. Unlike tariffs, however, there is no offsetting area of size H (compare with the tariff graph). This means that, unlike tariffs, quotas always result in a decrease in social welfare. Does this mean that quotas aren’t “worth it?” Again, that depends upon your viewpoint. If you value producers having surplus transferred to them from consumers, then you might like the idea of a quota. Though, given the fact that tariffs accomplish the same thing while still possibly increasing social welfare, it is hard to imagine a scenario where a quota would be preferable to a tariff. Summary of Quota: Consumer Surplus Change = – F – c – D – e Producer Surplus Change = +F Government Revenue Change = +D (if government sells quota licenses for full value) Total Welfare Change = – c – e Voluntary Export Restraints Voluntary Export Restraints (VERs) are exactly like quotas in that they directly limit the extent of imports by picking a precise number and saying “this will be the amount imported.” VERs accomplish this by having the country that does all the exporting voluntarily limit the amount that it exports entirely on its own without any legislation ever being passed by the importing country. In the case of VERs we will denote the size of the VER (the amount the exporting country limits its exports to) to be given by “VER,” the quantity supplied at home in the presence of the VER as Qs,v, and the quantity demanded at home in the presence of the VER as Qd,v. The price resulting will be given by Pv. The graph is exactly like the quota graph except with these different labels. It is provided below: 8 Due to this similarity, the welfare analysis of VERs is identical to that of quotas except for where the ownership of the rights to export end up (i.e. the VER equivalent of quota rents). In the case of quotas, it is usually at the discretion of the home government (who issued the quota) where the quota licenses end up. This allows the home government to sell these licenses and capture the value of the quota rents (area D in the quota welfare graph). In the case of VERs, the licenses to export end up in the hands of the foreign country (who issued the VER). This allows the foreign government to sell these licenses and capture the value of the VER rents. The resulting effect on welfare is shown below. This looks pretty similar to the quota welfare graph, eh? However, in the case of VERs the area D is not captured by the home government, but rather the foreign government. This makes VERs a strictly worse idea (in terms of welfare effects on the home country) than the equivalently sized quota. So why would a country ever agree to a VER when they could instead issue a quota and gain the value of the rents for themselves? Politics. I’m sure you can imagine many scenarios in which the home country would be happy to say that they looked out for domestic producers and did so without passing any laws. It’s fairly easy to see why foreign would like VERs more than quotas: VERs are their own choice and can 9 be removed at their own discretion. Once a country issues a quota against a good they import from you it becomes up to them to remove that quota. If you volunteer to restrict your exports, now no such foreign law exists limiting your situation. Also, your ability to in an instant remove a VER is a bargaining chip. Their ability to remove a quota is their bargaining chip. So from a strategic standpoint it’s advantageous as well. If politics, rents, and strategic maneuvering weren’t enough, the existence of WTO regulations against trade barriers makes VERs a more attractive option as well. As I’m sure you know from your mini‐reports, when a country raises trade barriers against another country, the wounded country is allowed to retaliate with certain trade restrictions of their own. VERs are voluntary and a nice work‐around for these retaliation provisions. Summary of Voluntary Export Restraints: Consumer Surplus Change = – F – c – D – e Producer Surplus Change = +F Government Revenue Change = 0 (Foreign government holds licenses) Total Welfare Change = – c – e – D Subsidy ‐ For this section, Home is an EXPORTER of the good The greatest confusion that has arose in this course so far (to my knowledge) surrounds subsidies, particularly, why the subsidizing of home’s exports would result in an increase in prices consumers pay for those goods at home. Let’s clear that up. Recall that a supply curve represents the marginal cost of producing a certain level of production for an industry. You can directly read the marginal cost of producing Q units of output directly off of the supply curve. Supply curves are upwards sloping because marginal cost curves are upwards sloping. Upwards sloping marginal cost curves reflect an increase in the cost of producing one more unit when a firm is producing more units. Do not think of firms as setting a price and then determining what quantity to produce. Think of it as occurring in the opposite order. Specifically, firms decide what quantity to produce and then, given their costs, determine a price equivalent to marginal‐cost of production given quantity of output. 2 Below, the closed‐economy graph is reproduced for convenience, followed by the open‐free‐trade economy graph representing the situation in which Home is an exporter of the good (you have seen the first graph, but not the second). 2 This is not just a “trick” to help you think of this process, this is in fact how firm behavior is modeled in classical theory of the perfectly competitive firm. 10 Notice how free trade actually increases the price paid at home for consumers relative to the closed economy. This is because more of this good is demanded by foreigners, so firms increase the quantity they supply to meet this foreign demand, but at these higher production levels, they must increase their price to Pw. The result is a gain in producer surplus and a decrease in consumer surplus relative to the closed economy situation (shown below). Note that total surplus increases. 11 Imposing a Subsidy on Exports When exports are subsidized at a rate of $S per unit, the government of Home literally pays for $S of the price of each unit sold. It is a gift to foreign consumers. This decreases the price that foreigners have to pay for the good by $S beneath the world price. Since more of the good is demanded by foreigners due to the lower price, the quantity supplied by home increases. Since marginal cost (supply) is upward sloping, the cost per unit of producing these additional units goes up, so world price goes up. Consumers at home pay the world price, so the price home consumers pay goes up. Consumers abroad pay the world price MINUS the $S subsidy, so the price they pay goes down (world price increases by some amount less than $S and this price is decreased for them by the full $S, meaning a net decrease in price for foreigners). Producers receive the world price, which has increased. These effects are illustrated in the graph below, where Pw,s represents the world price in the presence of the subsidy, Pw,s* represents the price that foreigners pay for the good (Pw,s* = Pw,s ‐ $S). Qs,s represents the quantity supplied by home firms under the subsidy and Qd,s represents the quantity demanded by home consumers under the subsidy. The amount of exports under the subsidy increases. Producer surplus increases and consumer surplus decreases. Government expenditures increase. A quick look at the new surpluses and government expenditure is shown below with green representing CS, blue representing PS, and red representing government expenditures on the subsidy. 12 The exact amounts by which these surpluses change are shown in the graph below covered in letters. Comparing the before and after of the subsidy we see that consumer surplus is now A. Consumers LOSE B+C because of the subsidy. On the other hand, producers GAIN B+C+D because of the subsidy. Government spending on the subsidy is C+D+F+G+H+I+J. This is all a loss to the government (since, pre‐ subsidy they spent nothing). Why does this rectangle represent government spending? Because each unit exported is subsidized $S (the height of the rectangle) and “Exports w/ subsidy” units are exported (the width of the rectangle). So the total cost of the subsidy is the area of that rectangle. For example, if the subsidy was $2 per unit and 1,000,000 units were exported, the cost to the government would be $2,000,000. Summary of Subsidies: Consumer Surplus Change = – B – C Producer Surplus Change = +B+C+D Government Revenue Change = – C – D – F – G – H – I ‐ J Total Welfare Change = – C – F – G – H – I – J 13 ...
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