Monday, 29 August 2016

Why restricting natural gas exports is not a good idea

This week in ECON110 we are covering international trade (and globalisation). The arguments against free trade often focus on the harms to workers (and firms) in import-competing industries - that is, those firms where jobs would be lost by having to compete with lower-cost foreign producers. The counter-argument is that consumers are made better off in these markets by being able to buy the imported products at much lower prices (increasing their consumer surplus).

Much less attention is focused on the impacts of trade restrictions on exporting industries. Consider for example, this 2013 New York Times story about the exporting of natural gas in the U.S.:
As Dow Chemical’s chief executive, Andrew N. Liveris has made himself into something of an outcast among his fellow business leaders.
The reason? He is spearheading a public campaign against increased exports of natural gas, which he sees as a threat to a manufacturing renaissance in the United States, not to mention his own company’s bottom line. But many others say such exports would provide far more benefits to the country than drawbacks, all part of a transformation that promises to increase the nation’s weight in the global economy...
By 2020, new oil and gas production could increase the country’s economic output by 2 to 4 percent beyond what it otherwise would be, add as many as 1.7 million jobs and perhaps reduce the bill for energy imports to zero, according to a report by the McKinsey Global Institute.
“This is a giant turnaround,” said Daniel Yergin, a longtime energy expert and author of a recent book, “The Quest: Energy, Security and the Remaking of the Modern World.” “This is fundamentally improving the competitive position of the United States in the world economy.”
But that windfall is at risk if the government permits natural gas exports to increase quickly, Mr. Liveris warns.
Natural gas is valuable, and on the surface the argument to restrict exports of natural gas in order to keep the value in the U.S. economy makes some intuitive sense. But it would also be quite wrong, and actually make the U.S. worse off.

To see why, let's take a step back and compare an exporting country with trade and without trade. Consider the diagram below, and we'll assume that the U.S. has a comparative advantage in producing natural gas - that means that the domestic price of natural gas (PD) would be below the price of natural gas on the world market (PW). This indicates that U.S. natural gas producers can produce and sell natural gas at a lower cost than foreign producers. Because the domestic price is lower than the world price, if the country is open to trade there are opportunities for traders to buy natural gas in the domestic market (at the price PD), and sell it on the world market (at the price PW) and make a profit (or maybe the suppliers themselves sell directly to the world market for the price PW). In other words, there are incentives to export natural gas. The domestic consumers would end up having to pay the price PW for natural gas as well, since they would be competing with the world price (and who would sell at the lower price PD when they could sell on the world market for PW instead?). At this higher price, the domestic consumers choose to purchase Qd0 natural gas, while the domestic suppliers sell Qs0 natural gas (assuming that the world market could absorb any quantity of natural gas that was produced). The difference (Qs0 - Qd0) is the quantity of natural gas that is exported. Essentially the demand curve with exports follows the red line in the diagram.

We can also use the diagram to demonstrate the gains from trade for an exporting country. Without trade, the market would operate at the domestic equilibrium, with price PD and quantity Q0. Consumer surplus (the gains to domestic natural gas consumers) would be the area AEPD, the producer surplus (the gains to domestic natural gas producers) would be the area PDEF, and total welfare (the sum of consumer surplus and producer surplus, or the gains to society overall) would be the area AEF. With trade, the consumer surplus decreases to ABPW, the producer surplus increases to PWCF, and total welfare increases to ABCF. Since total welfare is larger (by the area BCE), this represents the gains from trade. So, the U.S. is better off with trade, because the total welfare is larger than it is without trade.

Now consider an intermediate case. Instead of having no trade, or having unlimited trade, what would happen if the government allows trade up to some limit? In other words, what happens when there is an export quota? This is demonstrated in the diagram below. Whereas previously, we assumed that the world market could absorb any quantity of exports of natural gas, now the quantity of exports is limited to the agreed quota amount. Let's say that the export quota is limited to the amount between B and G (about half the amount of unrestricted exports). Importantly, the export quota is implemented using licenses - only holders of export licenses are allowed to export natural gas.

Now that there is a quota on exports, consider what happens to the demand curve (including exports). The upper part represents the domestic consumers with high willingness-to-pay for natural gas. Then there is a limited quantity of export demand, at the world price PW. After that, there are still profit opportunities for domestic suppliers (that is, there are still some domestic consumers who are willing to pay more than what it costs the suppliers to produce natural gas). So, the demand curve (including the export quota) pivots at the point G, and follows a parallel path to the original demand curve (i.e. the demand curve including exports follows the red line in the diagram). The domestic price is the price where supply is equal to demand (P1). Export license holders can purchase natural gas at this price, and then sell it on the world market and receive the higher world price (PW), and pocket a profit. The domestic consumers choose to purchase Qd1 natural gas at the price P1, while the domestic suppliers sell Qs1 natural gas at that price. The difference (Qs1 - Qd1) is the quantity of exports (which is also the quantity of the quota).

Now the consumer surplus is larger than it was without the export quota (it is now the area AJP1), the producer surplus is smaller than it was without the export quota (it is now the area P1HF). The export license holders now receive a surplus (profit), equal to the area KLHJ. Total welfare (which is now made up of the consumer surplus, producer surplus, and license holder surplus) is smaller than without the export quota (it is now the area AJHF+KLHJ). There is a deadweight loss (a loss of total welfare arising from the export quota) equal to the area [BKJ + LCH] - these areas were part of total welfare with trade and no export quota, but have now been lost.

Importantly though, note that the total welfare area is larger with the export quota (AJHF+KLHJ) than with no trade at all (AEF). So, the argument that restricting exports of natural gas makes the U.S. better off and will "fundamentally improve the competitive position of the U.S. economy" is simply untrue. Up to the point where the market-determined quantity of natural gas is exported, there are gains to be had from additional exports. That doesn't mean that more exports are always better. For instance, export subsidies that increase exports beyond the quantity shown in the first diagram above are also bad. And, you might want to restrict natural gas production for environmental reasons (which haven't been accounted for in the diagrams above). But those are stories for another day.

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