2 management - School of International Business and ...

Günter S. Heiduk
market. The unit cost at this output equalizes the price, thus implying zero profit. With free trade
domestic consumers will shift a part of their demand to foreign varieties and foreign consumers to
domestic varieties. Domestic demand by domestic consumers will fall while domestic demand by
foreign consumers will rise. Similarly foreign demand by foreign consumers will fall while foreign
demand by domestic consumers will rise. Each country is an exporter and importer of differenti-
ated goods that are classified in the same industry. Trade has become intra-industry trade. The
higher number of varieties leads to higher price sensitivity of the consumers. Small changes in
prices motivate consumers to switch from one variety to another one, probably resulting in a larg-
er decrease of the demand for the original variety. Free entry and exit of firms ensure the zero
profit equilibrium for all remaining firms. The effects of intra-industry trade within this analytical
framework are firstly the increase in the number of varieties of products for consumers to choose
from, secondly the reduced price of every variety and thirdly the more efficient usage of resourc-
es. Potential negative effects are firstly the costs of adjusting to the long-term equilibrium and
secondly the transaction costs for consumers (e.g. to achieve complete market transparency). It
is to be expected that the net welfare effect is positive.
Helpman-Krugman model (Annex, figure 6) showed that inter-industry trade as well as in-
tra-industry trade with varieties of a product occurs at the same time. The former follows the
Heckscher-Ohlin result. Empirical studies of trade between the OECD countries using the gravity
equation confirmed the prediction that intra-industry has a regional bias.
3.2.4 THEORY OF TRADE POLICY: PROTECTION BY TARIFFS
The effects of tariffs as the most traditional policy measures that disturb free trade are analysed
by using a partial equilibrium model with perfect competitive markets (Annex, figure 7). If the pro-
tectionist country is large, then its trade policy can influence the world market price of its import
goods. In contrast, producers and consumers in a small country have to take the world market
price as given. The effects of tariffs are different in each case. The small country case implies
that the fully elastic world market price will not change if the small country imposes a tariff on
imports from the world market. The domestic price will rise by the amount of the tariff (Box 2a).
This leads to decreasing demand and increasing domestic production resulting in lower imports
compared to the free trade situation. The expansion of the domestic production can be called
»protection«. In contrast to the free trade situation there exists no world market price; further-
more, the volume of trade has decreased. From welfare point of view the tariff has worsened the
efficiency of the resource allocation. The producers who entered the market after imposing the
tariff achieve a producer surplus (quantity of their production multiplied by the tariff) whereas con-
sumers lose (decreasing quantity of their consumption multiplied by the tariff). The government
realizes revenues (import quantity multiplied by the tariff). The net welfare effect results from
the difference between the government’s revenues and the sum of the loss of production and
consumption efficiency. The tariff rate and the welfare loss are positively correlated. The loss is
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