7. Infant industry agreement

Step 1-What is the Infant Industry Argument?

The infant industry argument, a classic theory in international trade, states that new industries require protection from international competitors until they become mature, stable, and are able to be competitive. The infant industry argument is commonly used to justify domestic trade protectionism.

The infant industry argument was initiated by Alexander Hamilton in 1791 when he argued for the protection of industries in the United States from imports from Great Britain. Later on, Friedrich List published his book, National System of Political Economy, in 1841, which helped refine, formulate, and provide a comprehensive overview of the infant industry argument.

Step 2-What is an Infant Industry?

An infant industry is a term used in economics to describe an industry that is in its early stages of development. In other words, an infant industry is a newly established industry. Therefore, infant industries lack the experience and size to compete effectively against established competitors abroad. An infant industry is characterized by a lack of efficiency, competitiveness, and a high vulnerability to sudden market changes.

Consider a country that traditionally imports cars from overseas and has no domestic production of cars. The creation of a domestic automotive industry would be an example of an infant industry.

Step 3-Rationale Behind the Infant Industry Argument

The main rationale behind the infant industry argument is that new industries require protection because they lack the economies of scale that competitors possess. Infant industries lack the capabilities to leverage their existing production and require protection until they can acquire similar economies of scale.

In addition, there are various other reasons behind the infant industry argument:

1. To encourage and stimulate domestic production
2. To promote national security and reduce reliance on production from abroad
3. To be a source of government revenue once the infant industry reaches maturity
4. To attract foreign investment
5. To create employment and develop the domestic market
6. To encourage the consumption of domestically produced goods
7. To prevent trade dumping

Step 4-Arguments Against Infant Industry Protectionism

There are several criticisms of the infant industry argument:

1. Infant industry protectionism may encourage industries to be inefficient. Developing industries that have protection may lack the incentive to be efficient and competitive.
2. Infant industry protectionism may result in retaliation from other countries.
3. Once an industry gains government protection, it may be politically difficult to remove the protective measures later on due to vested interests.
4. It is difficult for a government to choose industries to protect – what is the rationale behind protecting one industry over the other?
5. Infant industry protectionism decreases consumer surplus as it results in consumers having to pay higher prices for goods that would have otherwise been cheaper if imported.

Step 5-How is an Infant Industry Protected?

There are a number of ways to protect an infant industry. The three most common methods are:

1. Tariffs
An infant industry can be protected by imposing tariffs on imports. A tariff is a tax or duty on the volume of imports. Tariffs can either be (1) a fixed dollar charge for each unit imported or (2) a percentage tax levied on the value of the imported good. The Smoot-Hawley Tariff of 1930 is a famous example of tariffs aimed at protecting the U.S. agriculture industry from European agricultural imports.

2. Production subsidies
An infant industry can be protected by imposing a production subsidy for domestic production. A production subsidy is a payment made by the government to producers; production is subsidized by the government. Similar to tariffs, production subsidies can either be (1) a fixed dollar subsidy for each unit produced or (2) a percentage subsidy on the value of the produced good.

3. Quotas on imported goods
An infant industry can be protected by imposing a quota on imports. A quota is a limit on the number of goods that can be imported within a specific time period.

8. What are the important reasons for advocating strategic trade policy

Step 1- Introduction

Strategic trade policy refers to trade policy that affects the outcome of strategic interactions between firms in an actual or potential international oligopoly. A main idea is that trade policies can raise domestic welfare by shifting profits from foreign to domestic firms. A well-known application is the strategic use of export subsidies, but import tariffs as well as subsidies to R&D or investment for firms facing global competition can also have strategic effects. Since intervention by more than one government can lead to a Prisoner’s Dilemma, the theory emphasizes the importance of trade agreements that restrict such interventions.

International trade policy is one of the oldest subject areas in economics, having generated serious academic debate at least as far back as the classical period of ancient Greece, well over two thousand years ago. A very informative description of classical Greek and Roman thought on international trade and trade policy is provided by Irwin (1996, ch. 1). Interestingly, for example, both Plato and Aristotle were at best ambivalent about the virtues of open trade. Our modern understanding of international trade policy is based largely on the principle of comparative advantage as developed by David Ricardo (1807) and has been the focus of much political as well as academic debate in the two centuries since Ricardo.

Consideration of strategic trade policy is a relatively recent addition to the trade policy debate, having started in the early 1980s. Although definitions of the term differ slightly, we believe the following definition captures the important concepts:

Step 2-Definition

Strategic trade policy refers to trade policy that affects the outcome of strategic interactions between firms in an actual or potential international oligopoly.

As the definition suggests, the term ‘strategic’ in this context arises from consideration of the strategic interaction between firms. It does not refer to military objectives or the importance of an industry. Strategic interaction requires that firms recognize that their payoffs in terms of profit or other objectives are directly affected by the decisions of rivals or potential rivals. As a result, firms recognize that their own choices concerning such variables as output, price and investment depend on the decisions of other firms. The existence of strategic interaction is the defining characteristic of oligopoly.

The term ‘trade policy’ is interpreted broadly here as any policy directed primarily at the level or pattern of trade. In particular, policies that change the incentives for investment or research and development (R&D) in the context of international oligopoly represent an important application in the literature.

The requirement that the oligopoly be ‘international’ implies that production is actually or potentially carried out in two or more countries. Trade policy instruments set by one country then tend to affect the strategic choices of firms located in that country differently from firms located abroad. Strategic trade policy typically exploits these differential effects so as to achieve a domestic objective at the expense of welfare in other countries. In much of the literature the domestic objective is to maximize aggregate domestic welfare, but there is nothing that rules out political economy objectives, such as the use of trade policy to reward special interest groups that provide large donations to the government.

Most applications of strategic trade policy assume that firms differ by ownership as well as country of location. This assumption focuses attention on the importance of the policy in shifting profits from foreign to domestic firms. Indeed, strategic profit-shifting is often viewed as the hallmark of strategic trade policy. According to our definition, however, strategic trade policy can apply even if all firms in the industry are owned by residents of just one country. For example, a country might be interested in fostering exports by foreign multinationals that compete with firms located abroad. Potential sources of domestic gain would include rents such as above-normal wages, captured by domestic employees of the multinational, and taxes on the multinational’s profits.

Step 3-A Brief History of the Origins of Strategic Trade Policy

Strategic trade policy was one of the early applications of oligopoly theory in international economics. Formal treatment of oligopoly (and monopolistic competition) in international trade theory did not become well-established until the 1980s. Perhaps the first formal application was by Brander (1981), who explained intra-industry trade in identical commodities. Prior to the 1980s, most trade theory relied on the assumption of perfect competition, although monopoly also received some attention. There was an early ‘distortions literature’ that concerned second-best policies in imperfectly competitive markets, but strategic interaction between firms was not modelled.

In the light of the empirical importance of competition between large firms in world markets, the introduction of oligopoly into international trade was a significant step forward in improving the relevance of international trade theory. Oligopoly turned out to be central for understanding and explaining a number of important phenomena that could not be understood in a perfectly competitive framework. In addition to strategic trade policy, these included intra-industry trade, intra-firm trade, multinational corporations, and the role of economies of scale, R&D and technology transfer in international trade.

In applying strategic trade policy, one key difference between oligopoly and other market structures is the existence of profits (or ‘rents’) that can be shifted from one firm to another in a given industry by altering the strategic interactions between firms. Under monopoly, profit-shifting between firms does not arise as there is only one firm. In standard models of perfect competition and monopolistic competition, long-run profits are zero so there are no profits to shift. There are variations of the basic models of perfect competition or monopolistic competition in which firms are heterogeneous, only marginal firms earn zero profits, and infra-marginal firms can earn positive profits. However, such firms are not explicitly engaged in strategic interactions or ‘games’ with one another, so altering the outcome of strategic interactions is not an issue.

As the previous paragraph suggests, application of basic game theory is a feature of strategic trade policy that distinguishes it from much of the previous work in international economics. In addition to considering games between firms, strategic trade policy places particular emphasis on the sequential structure of decision-making, making it one of the first areas of application of game theory where the implications of sequential rationality were clearly understood.

Step 4-Numerical Examples

We first illustrate the idea that governments can use trade policy instruments to shift profits from foreign to domestically owned firms, thereby raising national economic welfare at the expense of other countries.

Suppose that only two firms, Boeing, an American firm, and Airbus, a European firm, are capable of producing a certain type of passenger aircraft. To focus on profit-shifting, we abstract from effects on consumer welfare in Europe and America by assuming that the aircraft are all exported to a third country. The profit earned by each country’s firm minus the cost of any subsidy is then the appropriate measure of each country’s national benefit. Consider an initial situation where the third-country market is profitable if there is only one producer, but both firms would make losses if they both enter and must share the market. The European government is considering whether to subsidize the entry of Airbus.

Figure 1 shows the profits of each firm depending on whether or not each firm enters. The game tree on the left illustrates profits if there is no intervention or ‘free trade’, while the game tree on the right illustrates profits if Europe commits to pay a subsidy of 6 to Airbus in the event that it enters. The box diagrams show Boeing’s profit as the first number in each cell, while the second number is the profit of Airbus.

Fig.1- Intervention by Europe

The outcome of the game in Fig. 1 is indeterminate under non-intervention. If either firm enters, the other firm loses from entry. Thus, if Boeing enters while Airbus does not, then Boeing earns 50, but both Boeing and Airbus lose 5 if Airbus enters. By contrast, if Airbus is given a subsidy of 6 when it enters, the outcome is a Nash equilibrium in which Airbus enters and Boeing does not. The subsidy makes entering a dominant strategy for Airbus. If Boeing enters, Airbus earns 1 from entry, which is better than the zero it gets if it does not enter. If Boeing does not enter, then Airbus gains 56 by entering. Given that Airbus enters, Boeing will not enter, for it will lose 5.

To move back one stage to Europe’s subsidy decision, it is clear that Europe is made better off by the subsidy. If Boeing would have entered under no intervention, Europe gains 50 by preventing the entry of Boeing: Airbus earns 56, but Europe’s payoff is reduced by 6 due to the cost of the subsidy to taxpayers. If there is a 50 per cent chance that Airbus would have captured the market in the absence of intervention, the expected gain to Europe is 25 from intervention. It is notable that a small subsidy can give rise to a large payoff as a result of the effect of the subsidy in changing the outcome of the strategic interaction between firms.

As this example illustrates, strategic trade policy requires that governments have the ability to commit to policy: that is, government policy must be ‘credible’. This requirement is captured in the game-theoretic structure by the order in which parties make decisions. Credibility of policy requires that the government move first by committing to its policy, prior to the decisions by firms. Commitment means that the government cannot subsequently change its policy. If Boeing did not believe that Europe would follow through on its subsidy, then the subsidy would not have any effect.

Having established the advantage to Europe from a subsidy, the obvious next question is whether the US government would also have an incentive to subsidize the entry of Boeing. In this example, the outcome of the policy game is indeterminate. Both countries lose if both countries subsidize leading to the entry of both firms, but each country has an incentive to subsidize if the other does not. Consequently, to gain a richer insight, we slightly change the example so that each government is considering an export subsidy in a situation where, without intervention, both firms earn profits from exports to the third-country market.

Figure 2 illustrates the payoffs to each country in a symmetric game in which both Airbus and Boeing earn 25 in the absence of intervention (bottom-right cell). If Europe subsidizes exports, say by 6, and the US does not, the profits of Airbus are assumed to increase by 16, so that, net of the subsidy, Europe earns 35 (bottom-left cell). The subsidy makes it credible that Airbus expands its sales at the expense of Boeing, which then earns 5. Due to the overall expansion in sales, the buyers of aircraft enjoy lower prices and the net industry profit (after the European subsidy is subtracted) falls from 50 to 40. Consequently, for the subsidy to benefit Europe, the shift in sales from Boeing to Airbus must be sufficient to offset the fall in price. The same situation applies to the United States if it subsidizes exports but Europe does not. If both countries subsidize exports, the expansion of sales by both firms reduces net industry profit to 20, with each country gaining 10 (top-left cell).

Fig.2- Intervention by both Europe and the united states

This policy game involves a Prisoner’s Dilemma. In a non-cooperative one-shot game in which countries move simultaneously, the dominant strategy is for each country to subsidize its exports. Consequently, at the Nash equilibrium, both countries use strategic trade policy with a payoff of 10 each (upper-left cell). However, both countries would be better off if they could cooperate so as to achieve the higher payoff of 25 (bottom-right cell). As pointed out by Spencer and Brander (1983), one means of cooperation would be to negotiate a trade agreement that binds the countries to free trade. Also, if the game is repeated through time, a government might hope that current cooperation (that is, choosing not to intervene) might induce future cooperation from the other government.

The analysis of strategic trade policy provides a helpful framework for understanding the incentives facing governments in trade policy negotiations. In particular, strategic trade policy provides a rationale for the Prisoner’s Dilemma mentality that pervades real-world trade policy negotiations. Under perfect competition, countries would not use export subsidies since they would simply benefit foreign consumers. In a world of strategic trade policy it makes sense that each government might reasonably view reducing or eliminating its own subsidies or tariffs as ‘giving up’ something, but might be willing to do so if other countries do the same. Each country faces a unilateral incentive to use activist trade policy but all can benefit if they can collectively agree to abandon such policies.

Step 5-A Formal Model of the Role of Export Subsidies

In the examples given so far, payoffs to firms and countries have been specified as convenient numbers. For a convincing analysis, it is important to model the underlying structure that gives rise to these payoffs. In this section we provide an algebraic demonstration of the argument for the profit-shifting effects of an export subsidy.

As in Brander and Spencer (1985), a domestic and a foreign firm are assumed to act as Cournot competitors in exporting to a third-country market. Entry barriers, such as high fixed costs, prevent entry. Let x and y represent the exports of the domestic and foreign firm, c and c* their respective marginal costs, and p = p(x + y) the price of the homogeneous product. If an export subsidy, s, is applied per unit of domestic exports, the profit functions of the domestic and foreign firm are:

π(x,y;s)=xp(x+y)−cx+sx and π∗(x,y;s)=yp(x+y)−c∗y.

At the Cournot–Nash equilibrium, each firm sets output to maximize its profit given the output level of its rival. The first order conditions are π _x  = 0 and π∗y=0πy∗=0, where subscripts denote partial derivatives. From total differentiation of the first order conditions with respect to x, y and s, and use of Cramer’s rule, it follows that a domestic subsidy always raises domestic exports: that is,

dx/ds=π∗yy/D>0dx/ds=πyy∗/D>0 where π∗yy<0πyy∗<0 and D/πxxπ∗yy−πxxπ∗yx>0D/πxxπyy∗−πxxπyx∗>0 from the second order and stability conditions. To ensure that a domestic export subsidy reduces the output of the foreign firm (that is, dy/ds=π∗yx/D<0dy/ds=πyx∗/D<0), an important assumption identified by Brander and Spencer (1985) is π∗yx=p′+yp′′<0 andπxy=p′+xp′′<0

where prime and double prime represent first and second derivatives. Condition (2) is now known as the requirement that x and y be ‘strategic substitutes’: an increase in x reduces the rival firm’s marginal profit from an increase in y and vice versa. Given Cournot competition, this holds for linear demand (since p″ = 0) and, more generally, if the inverse demand curve is not too convex.

The effect of the export subsidy is illustrated in Fig. 3 showing the best response or reaction functions of each firm. Since domestic marginal cost falls, the subsidy increases domestic exports for any given level of the rival’s exports, as shown by the outward shift in the best-response function of the domestic firm. As a result, the subsidy moves the Cournot–Nash equilibrium from point N to point S, reducing the output of the foreign firm.

The effect of the export subsidy is illustrated in Fig. 3 showing the best response or reaction functions of each firm. Since domestic marginal cost falls, the subsidy increases domestic exports for any given level of the rival’s exports, as shown by the outward shift in the best-response function of the domestic firm. As a result, the subsidy moves the Cournot–Nash equilibrium from point N to point S, reducing the output of the foreign firm.

A domestic export subsidy

The optimal subsidy is determined by maximizing domestic welfare with respect to s. As there is no domestic consumption, welfare, denoted W, consists only of the profit of the domestic firm minus the cost of the subsidy:

W(s)=π(x(s), y(s);s)−sx(s)=xp(x+y)−cx.

Setting dW/ds=πydy/ds--sdx/ds=0dW/ds=πydy/ds--sdx/ds=0 yields s=−πyπ∗yx/π∗yy>0s=−πyπyx∗/πyy∗>0. Consequently, an export subsidy increases domestic profits by more than the subsidy payment leading to a rise in domestic welfare. But why is it that we need government intervention to do this?

At the initial Cournot–Nash equilibrium, domestic profits are lower than they would be if the domestic firm were able to somehow act first as a Stackelberg leader so as to take into account the reaction of the foreign firm. Government commitment to an export subsidy makes it credible for the domestic firm to expand within the confines of a Cournot–Nash equilibrium in which no one firm has the ability to act first. Indeed, if only one government intervenes, the optimal export subsidy increases domestic exports to the (unsubsidized) Stackelberg-leader level. As illustrated in Fig. 3, the profits of a domestic leader-firm (and domestic welfare) are maximized at S, which is the point of tangency between the domestic firm’s iso-profit curve and the foreign firm’s reaction function.

Further analysis of this case shows that both governments have a unilateral incentive to subsidize exports. There is a domestic profit-shifting gain even if the foreign government also subsidizes exports. The outcome is a Prisoner’s Dilemma in which both are made worse off than if they could agree not to use export subsidies. Thus, as previously discussed, an understanding of strategic trade policy helps us make sense of international trade agreements that disallow export subsidies.

9. Discuss the role of World Trade Organisation (WTO)

step 1 -

In brief, the World Trade Organization (WTO) is the only international organization dealing with the global rules of trade. Its main function is to ensure that trade flows as smoothly, predictably and freely as possible.

The World Trade Organization (WTO) is one of the three international organisations (the other two are the International Monetary Fund and the World Bank Group) which by and large formulate and co-ordinate world economic policy.

It can be argued that the WTO plays a particularly significant role in the promotion of free international trade. The organisation acts as an umbrella institution, that is an organisation covering the agreements concluded at the Uruguay Round. The Uruguay Round was the preparatory stage for the launch of the WTO. The Round was based on the General Agreement on Tariffs and Trade (GATT).

The crucial role of the WTO is to provide a common institutional framework for the implementation of those agreements. The organisation is the result of the Uruguay Round of negotiations (1986-1994) and was formally created in 1995.

step 2- Progressive opening and regulation of markets

The WTO's mission is to open markets gradually while ensuring that rules are respected. The origin of the organization dates back to the end of World War II when the idea of peaceful cooperation among peoples was emerging. In 1947, a number of countries decided to open up their markets on the basis of common principles, and founded the WTO's predecessor, the General Agreement on Tariffs and Trade (GATT). In the current round of trade negotiations, the WTO is seeking to make further advances in equitable trade.

Step 3- Roles of WTO

The WTO acts as conductor, tribunal, monitor and trainer

Orchestra conductor
International trade is governed by very precise rules developed by the WTO's members. Countries must apply these rules when trading with one another. The WTO acts as the orchestra conductor, ensuring that rules are respected. The WTO was founded in 1995, but its origins date back to 1947 and the creation of the GATT. Since then, WTO members have adapted these rules to keep up with new developments. For example, services have developed considerably since the 1980s, and have now become one of the most important economic sectors. As a result, WTO members established rules governing international trade in services. Adapting or changing the principles of international trade means reaching consensus among WTO members through a round of negotiations. The latest round the ninth since 1947 was launched in 2001.

How do trade negotiations work?

Before defining the principles of international trade, WTO members have to negotiate them. Every eight to ten years or so, they launch a new round of trade negotiations. They begin by defining the subjects to be included. For example, the current round, known as the Doha Round, has 20 dishes on the negotiation menu, including agriculture, the environment, fisheries, development, etc. The meal is prepared by 157 chefs (the 157 WTO members). Given the number of dishes and chefs involved, producing the meal is a lengthy and difficult process, and it is not surprising that it can be a long time before the family can sit down to enjoy it.

Tribunal
One of the main roles of the WTO is to settle disputes between its members. The WTO plays the role of trade tribunal, where members may file complaints against other members who fail to abide by the principles of international trade. There are three stages to dispute settlement. To begin with, the disputing countries try to settle their differences by themselves. If that fails, the case is decided by a panel made up of three experts, which issues a ruling. That ruling may be appealed. Once a definitive ruling has been issued, the losing party must comply. If it does not, it is liable to sanctions. Since 1995, over 400 complaints have been filed by WTO members.

Monitor
The WTO regularly reviews the trade policies of its members. These reviews assess whether WTO members are abiding by WTO rules and measure the impact of their domestic policies on international trade. The purpose of these reviews is not so much to solve problems as to prevent them from occurring in the first place.

Trainer
The WTO provides training programmes for government officials from developing countries for example, ministry staff or customs officials. The WTO currently spends about 35 million Swiss francs annually on these programmes. Africa is the main beneficiary, followed by Asia and Latin America. In 2011, approximately 26 per cent of training activities took place in Africa.