GLOBE

Trade Policy with a Foreign Monopoly

by Steven Suranovic ©1997-2004

Trade 100-5  

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Consider a domestic market supplied by a foreign monopoly firm. The domestic market consists of many consumers who demand the product but has no domestic producers of the product. All supply of the product comes from a single foreign firm.

Although this situation is not very realistic, it is instructive as an application of the theory of the second-best. In this case the market imperfection is that there are not a multitude of firms supplying the market. Rather we have assumed the extreme opposite case of a monopoly supplier. To make this an international trade story we simply assume the monopoly happens to be a foreign firm.

Consider the market described in the adjoining diagram. Domestic consumer demand is represented by a linear demand curve D. When demand is linear it follows that the marginal revenue curve will have twice the slope and will equal demand when the quantity is zero. Let the flat MC line represent a constant marginal cost in production for the foreign monopolist.

Assuming the monopolist maximizes profit, the profit maximizing output level is found by setting marginal cost equal to marginal revenue. Why? Profit maximizing output occurs at the quantity level QFT. At that quantity the monopolist would set the price at PFT , the only price that equalizes demand with its supply.

The monopolist's profit is the difference between total revenue and total cost. Total revenue is given by the product (PFTQFT), the yellow area in the graph. Total cost is equal to average cost (AC) times output (QFT), given by the striped area. The monopolist's profit is represented as the dotted rectangle in the diagram.

Strategic Trade Policy

Generally, strategic trade policy refers to cases of advantageous protection when there are imperfectly competitive markets. The case of a foreign monopolist represents one such case.

More specifically though, the presence of imperfect competition implies that firms can make positive economic profit. Strategic trade policies typically involve the shifting of profits from foreign firms to domestic firms. In this way national welfare can be improved although it is often at the expense of foreign countries.

In this example we shall consider the welfare effects of a specific tariff set equal to t. The tariff will raise the cost of supplying the product to the domestic market by exactly the amount of the tariff. We can represent this in the adjoining diagram by shifting the marginal cost curve upward by the amount of the tariff to MC + t. The monopolist will reduce its profit maximizing output to QT and raise its price to PT. Note that the price rises by less than the amount of the tariff.

The following Table provides a summary of the direction and magnitude of the welfare effects to producers, consumers and the government in the importing country as a result of the import tariff. The aggregate national welfare effects are also shown. Positive welfare effects are shown in black, negative effects are shown in red.

Welfare Effects of a Tariff

Importing Country
Consumer Surplus - (a + b + c)
Producer Surplus 0
Govt. Revenue + d
National Welfare d - (a + b + c)

Import Tariff Effects on:

Importing Country Consumers - Consumers of the product in the importing country suffer a reduction in surplus because of the higher price that prevails. Refer to the Table and Figure to see how the magnitude of the change in producer surplus is represented.

Importing Country Producers - It is assumed that there are no domestic producers of the goods, thus, there are no producer effects from the tariff.

Importing Country Government - The government receives tariff revenue given by the perunit tax (t) times the quantity of imports (QT). Who gains from the tariff revenue depends on how the government spends the money. Presumably these revenues help support the provision of public goods or help to sustain transfer payments. In either case someone in the economy ultimately benefits from the revenue. Refer to the Table and Figure to see how the magnitude of the subsidy payments is represented.

Importing Country - The aggregate welfare effect for the country is found by summing the gains and losses to consumers, producers, and the government. The net effect consists of two components: a positive effect on the recipients of the government tariff revenue (d) and a negative effect on consumers, (a + b + c), who lose welfare due to higher prices.

If demand is linear, it is straightforward to show that the gains to the country will always exceed the losses for some positive non-prohibitive tariff. In other words there will exist a positive optimal tariff. Thus, a tariff can raise national welfare when the market is supplied by a foreign monopolist.

One reason for this positive effect is that the tariff essentially shifts profits away from the foreign monopolist to the domestic government. Note that the original profit level is given by the large blue rectangle shown in the diagram above. When the tariff is implemented the monopolists profit falls to a level given by the red rectangle. Thus, in this case, the tariff raises aggregate domestic welfare as it reduces the foreign firm's profit.

First-Best Policy

Although a tariff can raise national welfare in this case, it is not the first-best policy to correct the market imperfection. A first-best policy must attack the imperfection more directly. In this case the imperfection is the monopolistic supply of the product to the market. A monopoly maximizes profit by choosing an output level such that marginal revenue is equal to marginal cost. This rule deviates from what a perfectly competitive firm would do, i.e. set price equal to marginal cost. When a firm is one among many it must take the price as given. It cannot influence the price by changing its output level. In this case the price is its marginal revenue. However, for a monopolist, which can influence the market price, price exceeds marginal revenue. Thus when the monopolist maximizes profit it sets a price greater than marginal cost. It is this deviation, i.e. P > MC, that is at the core of the market imperfection.

The standard way of correcting this type of imperfection in a domestic context is to regulate the industry. For example electric utilities are regulated monopolies in the US. Power can generally be purchased from only one company in any geographical area. To assure that these firms do not set exorbitant prices, the government issues a set of pricing rules that the firms must follow. These rules set the allowable prices that the firms can charge. The purpose is to force the firms to set prices closer, if not equal to, the marginal cost of production.

Now in the case of utilities, determining the marginal cost of production is a rather difficult exercise, so the pricing rules needed to optimally regulate the industry are relatively complicated. In the case of a foreign monopolist with constant marginal cost supplying a domestic market, however, the optimal policy is simple. The domestic government could merely set a price ceiling equal to the firm's marginal cost in production.

To see why a price ceiling is superior to a tariff consider the adjoining diagram. A second-best policy is the tariff. It would raise national welfare by the area (h - a - b - c), which as mentioned above will be positive for some tariff and for a linear demand curve. The first-best policy is a price ceiling set equal to marginal cost at PC. The price ceiling would force the monopolist to set price equal to marginal cost and induce an increase in supply to QC. Consumers would experience an increase in consumer surplus given by area (d + e + f + g + h + i + j + k) because of the decline in price. Clearly in this example, the consumer surplus gain with the price ceiling exceeds the national welfare gain from a tariff.

This shows that although a tariff can improve national welfare, it is not the best policy to correct this market imperfection. Instead a purely domestic policy, a price ceiling in this case, is superior.


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International Trade Theory and Policy Lecture Notes: ©1997-2004 Steven M. Suranovic
Last Updated on 10/3/97