Chapter 6: Strategic Trade policy

Question 1

What is the topic about

Answer 1

Analysing the national welfare effects when there is imperfect competition
􏰀 Compare import quota and tariff when the domestic industry is a monopoly
􏰀 Strategic trade policy when the world industry is a duopoly
⋆ The Brander-Spencer model

Question 2

How does the monopolist profit maximise normally

Answer 2

In autarky, the domestic monopolist profit maximizes by choosing the quantity QM where MR = MC which corresponds to setting price PM .

Bring up to demand curve

Question 3

What happens to the monoplist now when the country starts to import this good

Answer 3

Under free trade the monopolist faces competition from the rest of the world. The monopolist therefore acts as if there is perfect competition.

Monopolist is a price taker and must set world price Pw

Monopolist then sells Qf which corresponds to P=MC (on MC)

Import demand is Df-Qf at world price

Question 4

How are monopolists protected by tariffs?

Answer 4

All foreign firms in the industry sell their good for PW + t. The domestic monopolist is still a price taker and keeps acting as if there is perfect competition.

Monopolist will produce along P=MC curve and produce quantity Qt, which corresponds to Pw+T = MC

At a higher price, consumers consume less demand and import demand decreases
Dt-Qt

Question 5

How are monopolists protected by quotas

Answer 5

If the import quota denoted by Q bar

Residual domestic Demand D(q) = D - Q bar

The monopolist maximizes profits by setting MRq = MC i.e. selling Qq units at monopoly price Pq.

The importer obtains a rent Pq − PW on each unit it sells.

Question 6

Recap: What is a tariff-equivalent quota

Answer 6

an import quota that limits the amount of imports by exactly the same amount as a particular tariff.

Question 7

How to create a tariff equivalent quota for the monopoly

Answer 7

Essentially the Dt-Qt (import demand) should equal the Q bar number of import

Question 8

Why does it make sense for the WTO to promote tarifffs over quota

Answer 8

In the case of a domestic import-competing monopoly, the welfare-worsening effects of a quota are stronger than those of a tariff. Therefore, the WTO policy to promote tariffs over quota makes sense.

Question 9

Explain a monopoly, oligopoly, duopoly

Answer 9

Monopoly: industry with only one firm
Oligopoly: industry with a few firms
duopoly: special case of oligopoly with two firms

Note that the key assumption when analyzing the oligopoly is that the firms do not cooperate

Question 10

Differentiate Cournot and Bertrand Competition

Answer 10

In Cournot competition, the duopolists compete in quantities

-producing same good
- Each firm sets its own profit-maximizing quantity taking the quantity produced by its
rival as given.

• Output in cournot equilibrium larger if firms form cartel and produce joint profit maximising quantity. Firm profits are so less if they didnt share the joint monopoly profits

In Bertrand competition, duopolists compete in prices.
- each firm set own profit maximising price taking price set by rival
- if two firms selling (Homogenous good**) price of each firm will be competitive
- but if goods are differentiated, resulting market price will be above competitive price but below joint profit maximising

Question 11

What constitutes as an international duopoly

Answer 11

Two firms in world industry

Profits obtained by the home duopolist enter into home country’s national income

Government has incentive to help home firm increase its profits and reduce foreign firm’s profits

Question 12

How to solve cournot competititon

Answer 12

Firms face inverse market demand
P(Q+Q*)

Total industry output is (Q+Q*)

The firms have cost functions C(Q) and C(Q).

Firms profits for home:
P in terms of (Q+Q*)xQ- C(Q)

Cournot Equilibrium point is where the two reaction curves cross where R=R*

In cournot equilibrium, each firm is producing their profit maximizing quantity, where profits are maximized while taking the output of the rival firm as given

Question 13

What are the impacts of cournot equilibrium

Answer 13

The total Cournot equilibrium output is smaller than the competitive equilibrium output. Both firms make positive profits.

At the same time, cournot equilibrium is larger than the world monopoly output.

The sum of the two duopolists profits less than world monopolists profits. If two firms colluded, be better off by jointly producing world monopoly output

Question 14

How do Isoprofit curves come into play?

Answer 14

The highest possible profits that H can obtain is where Q∗ = 0 and Q = QM. At
that point H takes the entire industry monopoly profit. That isoprofit curve is just
one single point. The further away from this point an isoprofit curve for H lies, the
lower H profits does it correspond to.

Question 15

What is Home optimal quantity point denoted as

Answer 15

Q (Best Response) = (a-c-b(Q*))/ 2b

Question 16

If F produces more than the competitive quantity Q(c), H will produce nothing. Therefore, if Q> Qc*, Q(BR) =0

Thus what is the monopoly quantity in this case

Answer 16

Set P=MC

Q(monopoly) = (A-c)/(2b

Question 17

How To find reaction function of home and foreign

Answer 17

Find MR (H) = MC
will get Q = some form of Q*

Obtain 2 simulatenous eqn and solve for Q and Q*

Find profit per firm subsequently

Question 18

Explain first mover advantage of the stackelberg equilibrium

Answer 18

If H somehow achieves a first-mover advantage and credibly commits to producing quantity S, F’s best response (it takes the output by H as given!) is to produce less.

In such an equilibrium, H is the leader and F is the follower.

In such an equilibrium, H’s profits are higher than in cournot equilibrium, and F’s profits are lower than in cournot

Question 19

What is an imperfect competitive industry

Answer 19

Imperfectly competitive industries are typically dominated by a few firms that generate monopoly profits or excess profits.

􏰀 Excess profits are revenues that exceed all opportunity costs: profits higher than what equally risky investments elsewhere in the economy earn.

In an imperfectly competitive industry, government subsidies can shift excess profits from a foreign firm to a domestic firm.

Question 20

What is the Brander and Spencer model

Answer 20

That a shift in subsidies can alter the outcome to make it profitable for companies like Airbus to produce regardless of Boeing’s action

Make producing a dominant strategy for airbus
–> result in boeing choosing not to produce

Question 21

Explain the Brander-Spencer model using home and foreign govt. What are some of assumptions too

Answer 21

We assume that the Home government is fully informed about the industry and that both firms sell to a third market (the rest of the world) and do not consume any of the output in the industry.

Home government offers a per unit subsidy s to H such that H profits are Π = QP(Q + Q∗) − C(Q) + sQ. Foreign’s profit function is still
Π∗ = Q∗P∗(Q + Q∗) − C∗(Q∗).

When the Home government announces its subsidy s to the domestic firm H, it creates a first mover advantage for H firm.

With a subsidy–> Home reaction function now higher, cut at a higher Quantity for home and lower quantity for Q*

In the new equilibrium, F’s best response is to produce less than what they produce in Cournot equilibrium.

Question 22

What is a strategic trade policy

Answer 22

A government policy to give a domestic firm a strategic advantage in an international industry is called a strategic trade policy.

Question 23

What are some criticisms of this analysis?

Answer 23

􏰀 1. Practical use of strategic trade policy requires more information about firms than is likely available.
⋆ The predictions from the simple Boeing-Airbus example differ if the numbers are slightly different.
⋆ What if governments or economists are not exactly right when predicting the profits of firms?
⋆ For example, what if Boeing has a better technology that only it can recognize, so that even
if Airbus produces, Boeing still finds it profitable to produce?

􏰀 2. Foreign retaliation also could result:
⋆ If the European Union subsidizes Airbus, the U.S. could subsidize Boeing, which would deter neither firm from producing, start a trade war, and waste taxpayer funds.

􏰀 3. Strategic trade policy, like any trade policy, could be manipulated by politically powerful groups.