Sorry US tomato growers, consumers will be worse off from of the anti-dumping duty on Mexican tomatoes

The Financial Times reported last week (paywalled):

In July, President Donald Trump sided with Florida farmers, imposing a 17 per cent anti-dumping duty on Mexican tomatoes and accusing producers of selling at less than the cost of production. US growers see the levy, which took effect in July and is separate from broader trade tariff negotiations, as a lifeline for their declining industry...

Mexico supplies more than 60 per cent of the fresh tomatoes consumed in the US, a stark example of how the country has won market share across sectors to become the US’s top trading partner since the North American Free Trade Agreement came into effect in 1994.

That has also made it a prime target for Trump since his first presidential campaign. The duty is part of a glut of allegations of trade violations he has thrown at Mexico, alongside broader pressure on security and migration.

The tomato duty, which uses a different legal instrument to regular tariffs, is the first Trump trade levy to directly target a fresh food staple...

Price data has not been released for the period after the new duties were imposed. US growers say farm-level prices could rise, which would eat into retailers’ and distributors’ profits but would not necessarily affect regular Americans. But Mexico’s National Agricultural Council said the consumer would pay, predicting prices would go up 11.5 per cent.

Gándara said if US companies want to produce more, it would require large investments in expensive land and technology, which inevitably would lead to higher prices.

The US growers are not correct here. Regular Americans will be paying more as a result of this anti-dumping duty (which has the same effect as a tariff). This is shown in the diagram below, which shows the American market for tomatoes. With no international trade in tomatoes at all, the market would operate at equilibrium, with a price of P0, and Q0 tomatoes would be traded. However, the domestic price of tomatoes (P0) is higher than the world price (PW). This means that the US has a comparative disadvantage in producing tomatoes. In other words, other countries can produce tomatoes at lower cost (specifically, lower opportunity cost) than the US. One of those countries with a comparative advantage in producing tomatoes is Mexico. If the US allows international trade in tomatoes, US consumers will realise that they can buy tomatoes much cheaper from Mexico than from domestic US tomato growers. The price for tomatoes in the US market will drop to be equal to the world price PW. At this lower price, US consumers will buy more tomatoes (QD0). However, US tomato growers will only be willing to supply QS0 tomatoes at this lower price. The difference between QD0 and QS0 is satisfied by imports of tomatoes.

Now consider what happens if an anti-dumping duty (or a tariff) is imposed. If consumers want to buy tomatoes from the international market, they must now pay the world price PW plus the tariff. The price for tomatoes in the US market will increase to PW+T (where T is the per-unit size of the anti-dumping duty). At this higher price, US consumers will buy less tomatoes than without the tariff (QD1), but US tomato growers will be willing to supply more (QS1). The quantity of tomato imports decreases to the difference between QD1 and QS1. This was the purpose of the anti-dumping duty, of course - to keep a lot of Mexican tomatoes out of the US market.

However, who pays the cost of the tariff? We can work this out by thinking about the areas of economic welfare. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, at the equilibrium price and quantity (without trade), consumer surplus is the area AEP0. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, at the equilibrium price and quantity, consumer surplus is the area P0ED. Total welfare is the sum of the two areas (consumer surplus and producer surplus), and is equal to the area AED.

With international trade (but no import tariff), the consumer surplus increases to the area AFPW. Producer surplus decreases to the area PWGD. Total welfare is the combined area AFGD. Notice that US tomato consumers are better off with trade, but US tomato growers are worse off. As a whole, US society is better off, because total welfare is larger (by the area EFG - this is a measure of the gains from trade).

Now consider what happens when the anti-dumping duty is applied. Consumer surplus decreases to the area ABK. Producer surplus increases to the area KCD. The government gains tariff revenue equal to the area CBJH (this is the per-unit amount of the anti-dumping duty, multiplied by the quantity of imports subject to the duty). Total welfare is all three of these areas added together, which is the area ABCD+CBJH. In other words, the anti-dumping duty makes US tomato growers better off (higher producer surplus), and makes the government better off (due to the duty revenue). However, the import tariff makes US tomato consumers worse off (lower consumer surplus), and US society as a whole worse off (lower total welfare). The loss of total welfare is equal to the areas BFJ+CHG - this is the deadweight loss of the import tariff.

So, it turns out that US consumers do end up paying part of the anti-dumping duty. They pay a higher price (PW+T instead of PW), and they lose some consumer surplus (their consumer surplus is smaller by the area KBFPW). US tomato growers may want to claim that tomato consumers will not be made worse off by the anti-dumping duty, but the growers are clearly not right about that.

China's export restrictions on resources for semiconductors

The Financial Times reported last week (paywalled):

Chinese export controls on crucial semiconductor materials are hitting supply chains and stoking fears of shortfalls in western production of advanced chips and military optical hardware.

Beijing’s curbs on shipments of germanium and gallium, which are used for semiconductor applications and military and communications equipment components, have led to an almost twofold increase in the minerals’ prices in Europe over the past year.

China introduced the restrictions, which it says safeguard its “national security and interests”, last year in response to US-led controls on sales of advanced chips and chipmaking equipment.

The FT article focuses on the effect of the export controls on Europe. However, I want to look at the effect of the export controls (an export quota) on the prices of the resources (gallium and germanium) in China. However, let's start by considering why China is an exporter, and the gains from trade for China. This is demonstrated in the diagram below. China has a comparative advantage producing these resources. That means that China can produce gallium (or germanium) at a lower opportunity cost than other countries. On a supply-and-demand diagram like the one below, it means that the domestic market equilibrium price of gallium (PD) would be below the price of gallium on the world market (PW). Because the domestic price is lower than the world price, if China is open to trade there are opportunities for traders to buy gallium 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 gallium. The domestic consumers would end up having to pay the price PW for gallium 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 gallium, while the domestic suppliers sell Qs0 gallium (assuming that the world market could absorb any quantity of gallium that was produced). The difference (Qs0 - Qd0) is the quantity of gallium that is exported. Essentially the demand curve with exports follows the red line in the diagram.

In terms of economic welfare, if there was no international trade in gallium, the market would operate at the domestic equilibrium, with price PD and quantity Q0. Consumer surplus (the gains to domestic gallium consumers) would be the area AEPD, the producer surplus (the gains to domestic gallium 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.

Now consider what would happen if there is an export quota limiting the quantity of gallium exports below (Qs0 - Qd0). This is shown in the diagram below. Let's say that the quantity of exports is reduced to the amount between B and G on the diagram (about half the amount of exports that were previously occurring). Now consider what happens to the demand curve (including exports). The upper part represents the domestic consumers with high willingness-to-pay for gallium. Then there is a limited quantity of exports that are allowed under the export quota, 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 gallium). 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). The domestic consumers choose to purchase Qd1 gallium at the price P1, while the domestic suppliers sell Qs1 gallium at that price. The difference (Qs1 - Qd1) is the quantity of exports of gallium.

Now consider the areas of economic welfare. The consumer surplus is larger than it was without the restricted exports (it is now the area AJP1), the producer surplus is smaller than it was without the restricted exports (it is now the area P1HF). There is a new area of welfare KLHJ, which is the profit that exporters of gallium would receive from exporting, because they can purchase the gallium at the price P1 domestically, and then sell it to the world market at the price PW. This area KLHJ is the licence-holder surplus. Total welfare is smaller than without the restricted exports (it is now the area AJHF+KLHJ). There is a deadweight loss (a loss of total welfare arising from the restricted exports) equal to the area [BKJ + LCH] - these areas were part of total welfare with trade and no restricted exports, but have now been lost. The reduction in exports makes domestic gallium suppliers worse off, as well as society overall (in terms of economic welfare in total). However, domestic gallium consumers benefit in terms of higher consumer surplus, and the export licence holders are a new group that gains from these restrictions.

Now, the model we used above relies on an assumption that Chinese decisions about gallium (or germanium) exports do not affect the world price. In fact, because China produces 98 percent of the world's gallium, and 60 percent of the world's germanium (according to the FT article), this is unlikely to be true. When China restricts exports through the quota, the world price will increase. That has the effect of increasing the surplus for the export licence holders, but otherwise doesn't affect domestic consumers or producers. However, it will make international consumers worse off, since they would now have to pay a higher price for gallium. And that's what the FT article shows. However, now we know that it isn't just the global consumers of these resources who are worse off, but Chinese mining companies, and Chinese society generally, as well.

Using a Pigovian tax to correct for a negative (consumption) externality

In my previous post, I demonstrated that, if left alone, a market with a negative externality produces too much of a good, and creates a deadweight loss. At the end of that post, I noted that, if we wanted to reduce the quantity that is traded in the market, we could use a tax. Such a tax is called a Pigovian tax (named after 20th Century economist Arthur Pigou), and is the focus of this post.

Consider the same market as that previous post (the market for fireplaces, or fireplace use), as shown in the diagram below. The market operates at the point where supply (S) meets demand (D) - that is, the quantity traded will be QM (and the price of fireplaces, or fireplace use) will be PM. Consumer surplus is the area ACPM, producer surplus is the area PMCF, the welfare cost of the negative externality is the area ACHG, and total welfare (which is the sum of consumer surplus and producer surplus, minus the area of the negative externality) is equal to the area (GEF-ECH).[*]

Now consider what happens when the government imposes an excise tax on fireplaces (or fireplace use). We will assume that the per-unit cost of the tax is exactly equal to the marginal external cost (MEC), and that the tax would be paid to the government by the sellers of fireplaces (or fireplace users). We represent the tax with a new curve, S+tax, which is exactly the same distance above the supply curve as the MSB curve is below the demand curve (that's because the tax is exactly equal to MEC). The price that consumers pay increases to PC. The effective price that producers receive (after paying the tax to the government) decreases to PS. The quantity of fireplaces (or fireplace use) decreases to QS.

What happens to economic welfare? The consumer surplus is the area ABPC, and the producer surplus is the area PSEF. The government receives tax revenue equal to the area PCBEPS (this is part of total welfare, because the government can use that revenue to provide services like schools or hospitals). The area of the negative externality is the area ABEG. Total welfare with the tax is equal to GEF. [**]

In other words, the Pigovian tax not only reduces the quantity of fireplaces (or fireplace use), but leads to an increase in total welfare (in fact, it leads to total welfare being maximised and the deadweight loss being eliminated). Economists aren't often in favour of excise taxes, but this is one case where an excise tax can make society better off.

Read more:

• The welfare impacts of a negative (consumption) externality

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[*] For the explanation of these welfare areas, see my previous post.

[**] Note that this is the same total welfare as occurred at the quantity QS in my previous post. To recap, that's because the area of the negative externality ABEG cancels out some of the total welfare that was in the combined consumer and producer surpluses and government revenue (ABEF), leaving the area GEF.

The welfare impacts of a negative (consumption) externality

As I noted earlier this week, an externality is the uncompensated impact of the actions of one person on the wellbeing of a third party. A positive externality makes the third party better off, while a negative externality makes the third party worse off. They are called externalities because they lie outside the original decision, i.e. some of the costs or benefits are external to the person whose action creates them.

The most common example that economists use to explain negative externalities is pollution. For example, from this New Zealand Herald article from earlier this year:

Two air pollutants are quietly contributing to thousands of premature deaths in New Zealand every year, shows a new analysis that’s prompted fresh calls for tougher regulations.

While New Zealand’s air quality is generally considered good by international standards, Stats NZ’s newly updated indicator has linked pollution from vehicles and fireplaces to around nine times more early deaths than last year’s road toll.

People running vehicles or fireplaces are creating a negative externality for other people - an increased risk of death from poor air quality. Let's focus on fireplaces and show that, left alone, the market will lead to too much use of fireplaces. Consider the market for fireplaces (or fireplace use) as shown in the diagram below. The market will operate at the quantity where supply (S) meets demand (D) - that is, the quantity traded will be QM (and the price of fireplaces, or fireplace use) will be PM.

However, the fireplace users create a negative externality for other people. Since this externality arises from the buyers of fireplaces (or fireplace users), we show this externality on the demand side of the market - we refer to it as a negative consumption externality. [*] This means that the benefits that fireplace users receive themselves from operating their fireplaces are higher than the benefits that society receives from those fireplaces - the difference is the negative benefit that is imposed on other people through air pollution. We show this on the diagram by differentiating between the marginal social benefit (MSB) and the marginal private benefit (MPB). The MPB is the benefit that fireplace users receive for themselves. The MSB is the marginal private benefit, minus the cost of the externality - the marginal external cost (MEC).

Now, society prefers the quantity of fireplaces (or fireplace use) to be the quantity where marginal social benefit (MSB) is equal to marginal social cost (MSC) - I'll explain why a little later in this post. That is the quantity QS, and one way to get to the quantity QS is if the price of fireplaces (or fireplace use) decreased to PS (because then, sellers would not be willing to sell so many fireplaces). Notice that in the diagram, relative to the quantity that society prefers (QS), the market produces too much (QM). There are too many fireplaces (or too much fireplace use).

Why does the market prefer QS (the quantity where MSB = MSC)? It's because that's the quantity that maximises economic welfare. Economic welfare is the sum of all of the net benefits arising from the market. First, the consumers receive some net benefit from participating in the market. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, at the equilibrium price and quantity, consumer surplus is the area ACPM. Second, producers receive some net benefit from participating in the market. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, at the equilibrium price and quantity, producer surplus is the area PMCF. Third, the third parties are negatively affected by the market. The welfare cost of the negative externality is the area in-between marginal social cost and marginal private cost, up to the quantity of fireplaces (or fireplace use) traded (in this case, QM). That is the area ACHG, and it is subtracted from total welfare. Total welfare is the sum of consumer surplus and producer surplus (which is the area ACF), minus the area of the negative externality (ACHG), and is equal to the area (GEF-ECH). [**]

Now consider the market operating at the quantity QS (with the price PS). The consumer surplus is the area ABEPS, the producer surplus is the area PSEF, and the area of the negative externality is the area ABEG. Total welfare at QS is equal to GEF. [***] Notice that this total welfare is larger when the quantity is QS than when the quantity is QM. If the market is left alone, there are too many fireplaces (or too much fireplace use), and this decreases total welfare by the area ECH. That area ECH is the deadweight loss of the externality.

Since the market produces too much, a relevant question is how could we get the market to produce less? A Pigovian tax (named after 20th Century economist Arthur Pigou) is one option, since taxes reduce the quantity of a good that is traded (for more on that, see this post). Requiring permits for fireplaces would be another way to limit the number of fireplaces to QS. Of course, determining the optimal quantity QS is difficult in practice. However, we can be sure that it isn't the quantity that is provided by the market.

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[*] In contrast, when producers produce pollution as a consequence of manufacturing other goods (for example), that is a negative production externality, which we would show on the supply side of the market.

[**] Notice that the area of the negative externality ACHG first cancels out all of the total welfare that was in the area ACEG, leaving the area ECH left over. That's why only GEF is left, while ECH is left subtracting from total welfare.

[***] Notice that the area of the negative externality ABEG cancels out some of the total welfare that was in the combined consumer and producer surpluses (ABEF), leaving the area GEF.

Who pays for Europe's tariffs on Indonesian biodiesel?

My ECONS102 class covered international trade last week, so it was interesting to see import tariffs in the news. As Reuters reported:

Asked about this situation, a European Commission spokesperson told reporters that the EU was confident its duties on Indonesia were in full compliance with WTO rules and that the EU was ready to discuss the matter with Indonesia.

Trade relations between the EU and Indonesia have been strained by the bloc's move to limit imports of commodities linked to deforestation, which is expected to curb EU imports of palm oil from top suppliers Indonesia and Malaysia.

As well as biodiesel, palm oil is used widely in food and cosmetics.

Welcoming the European Commission's investigation, the European Biodiesel Board said it estimated that imports circumventing duties may have cost the EU around 221 million euros ($240.34 million) last year.

The association was also working with EU authorities to address allegations of fraudulent biodiesel imports from China, it added in a statement.

Let's put aside the issue of avoiding the import tariffs (or duties) - we'll come back to those later in the post. Instead, let's focus on the effect of an import tariff on the market for biodiesel in Europe. This is shown in the diagram below. [*] With no international trade in biodiesel at all, the market would operate at equilibrium, with a price of P0, and Q0 biodiesel would be traded. However, the domestic price of biodiesel (P0) is higher than the world price (PW). This means that Europe has a comparative disadvantage in producing biodiesel. In other words, other countries can produce biodiesel at lower cost (specifically, lower opportunity cost) than Europe. One of those countries with a comparative advantage in producing biodiesel is Indonesia. If Europe allows international trade in biodiesel, European consumers will realise that they can buy biodiesel much cheaper from international sources. The price for biodiesel in the European market will drop to be equal to the world price PW. At this lower price, European consumers will buy more biodiesel (QD0). However, European biodiesel producers will only be willing to supply QS0 biodiesel at this lower price. The difference between QD0 and QS0 is satisfied by imports of biodiesel.

Now consider what happens if an import tariff (or import duty) is imposed. If consumers want to buy biodiesel from the international market, they must now pay the world price PW plus the tariff. The price for biodiesel in the European market will increase to PW+T (where T is the per-unit size of the import tariff). At this higher price, European consumers will buy less biodiesel than without the tariff (QD1), but European producers will be willing to supply more (QS1). The quantity of biodiesel imports decreases to the difference between QD1 and QS1. This was the purpose of the tariff, of course - to keep a lot of Indonesian biodiesel out of the European market.

However, who pays the cost of the tariff? We can work this out by thinking about the areas of economic welfare. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, at the equilibrium price and quantity (without trade), consumer surplus is the area AEP0. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, at the equilibrium price and quantity, consumer surplus is the area P0ED. Total welfare is the sum of the two areas (consumer surplus and producer surplus), and is equal to the area AED.

With international trade (but no import tariff), the consumer surplus increases to the area AFPW. Producer surplus decreases to the area PWGD. Total welfare is the combined area AFGD. Notice that European biodiesel consumers are better off with trade, but producers are worse off. As a whole, European society is better off, because total welfare is larger (by the area EFG - this is a measure of the gains from trade).

Now consider what happens when the import tariff is applied. Consumer surplus decreases to the area ABK. Producer surplus increases to the area KCD. The government gains tariff revenue equal to the area CBJH (this is the per-unit amount of the tariff, multiplied by the quantity of imports subject to the tariff). Total welfare is all three of these areas added together, which is the area ABCD+CBJH. In other words, the import tariff makes European biodiesel producers better off (higher producer surplus), and makes the government better off (due to the tariff revenue). However, the import tariff makes European biodiesel consumers worse off (lower consumer surplus), and European society as a whole worse off (lower total welfare). The loss of total welfare is equal to the areas BFJ+CHG - this is the deadweight loss of the import tariff.

So, the import tariff policy has a cost to society (equal to BFJ+CHG). Ideally, you would want there to be an offsetting benefit worth at least as much. The benefits of the tariff are (hopefully) less deforestation in Indonesia, and associated pollution (from burning forests), environmental and public health impacts.

Of course, the import tariff also makes Indonesian producers of biodiesel worse off, because they cannot sell as much into the European market (because their biodiesel is now more expensive due to the tariff. [**] That creates incentives for the Indonesian producers to try to avoid the tariffs. The European Union is alleging that this is what the Indonesian producers have done, by selling their biodiesel to entities in China and Britain (which apply low or no tariffs to imported biodiesel), and then re-exporting the biodiesel from those countries into the European Union (and the EU applies low or no tariffs to biodiesel imported from those countries). This sort of activity is extraordinarily difficult to police, because commodities like biodiesel can be difficult to trace. It will be interesting to see how this case plays out over the coming months.

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[*] I'll discuss this diagram as if it is the whole European market for biodiesel. However, you can easily interpret it instead as the European market for Indonesian biodiesel.

[**] The gains or losses to international producers and consumers are not shown in the market diagram above, which only demonstrates impacts within the European market.

The deadweight loss of free beer

My excellent (and sports-mad) colleague Shaen Corbet shared with me a story about the Nebraska-Northwestern college football game played in Ireland last year. As reported in the Irish Mirror:

But what couldn't be predicted was the events in the Aviva Stadium on Saturday night as technical glitches saw thousands upon thousands take advantage of free food, drink and alcohol.

There was always going to be a party atmosphere for the first Aer Lingus College Football Classic since 2019, a momentous occasion to remind us just how lucky we are to have these events back.

But the Aviva Stadium was rocking like a Harry Styles gig from just a few weeks prior as queues went a dozen deep as match attendees fleeced the concession stand and bar in a one time only offer of everything being free.

A Twitter (ok, X, but it was Twitter then) user posted this video of the queues for beer, where you can see that the entire foyer area in front of the bar is jam-packed with spectators looking for free beer. Usually, if the price is reduced to zero, we would expect to see a shortage. That's because the sellers would want to sell less (because it is less profitable) at the same time that the buyers are wanting to buy more.

However, in this case, the government chose to subsidise the beer (Shaen tells me it was to reduce the chance of unruly fans getting out of control). We can see the effect of this subsidy, reducing the price to zero, using a supply and demand model as shown below. If the beer market was operating in equilibrium, the price would have been P0, and the quantity of beer traded Q0. Instead, the government paid a subsidy to the beer sellers. We demonstrate this on the diagram with a new curve, S-subsidy, which is below the supply curve S by the amount of the subsidy (which was exactly enough to lower the price from P0 to zero). The effective price for the beer sellers increases to PP, which is the zero price they receive from the spectators, plus the per-unit amount of the subsidy. The quantity of beer demanded increases to Q1, and so does the quantity of beer supplied. There is no shortage of beer.

It is worth considering the impacts on economic welfare of this subsidy though. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, at the equilibrium price and quantity, consumer surplus is the triangle AEP0. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, at the equilibrium price and quantity, producer surplus is the triangle P0EB. Total welfare is the sum of the two areas (consumer surplus and producer surplus), and is equal to the triangle AEB.

Once the subsidy is introduced, the consumer surplus increases to AQ1O, while the producer surplus increases to the area BCQ1O. The government loses the area of subsidy, which is the rectangle PPCQ1O (this rectangle is the per-unit amount of the subsidy, multiplied by the quantity of subsidised beer). Total welfare is the sum of consumer surplus and producer surplus, minus the subsidy (the subsidy is subtracted because it has an opportunity cost of lower government spending in other areas), and is equal to the area AEB-ECQ1 [*]. In other words, total welfare is lower by ECQ1 as a result of the subsidy. This is the deadweight loss of the subsidy.

To add insult to injury, even though the price of beer may have been zero, the cost of beer was not free. That's because you have to factor in the cost of the time spent waiting to be served (which will be much higher when the queues are longer), as well as the loss of enjoyment of missing part of the game while waiting for beer. Plus, there are external costs of over-drinking imposed on other fans. Shaen, who was at the game, tells me that there were spectators who vomited all over other spectators after over-indulging in 'free' beer. So, free beer wasn't necessarily a good deal for everyone, least of all for Irish taxpayers and for those who needed a dry-cleaner (and possibly a counselling session) after the game.

[HT: Shaen Corbet]

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[*] The overlapping areas of consumer surplus, producer surplus, and subsidy make this tricky to see. However, there is a shortcut. The area of total welfare is the area that is in-between marginal social benefit (MSB) and marginal social cost (MSC) out to the quantity that is traded (in this case, Q1). When MSB is greater than MSC, this represents positive welfare (the area AEB). But when MSB is less than MSC, this represents negative welfare (the area BCQ1).

When you triple an excise tax, the deadweight loss increases nine-fold

The Financial Times reported a few weeks ago (paywalled):

Turkey has tripled petrol taxes as the government tries to raise money to recoup the cost of huge giveaways ahead of May’s election and fund reconstruction costing up to $100bn after February’s devastating earthquake. 

Taxes on regular petrol were increased about 200 per cent to TL7.53 a litre, with levies on diesel and a series of other petroleum products lifted as well, according to an announcement on Sunday in Turkey’s official gazette. The increase pushed up petrol prices at the pump by about 20 per cent, data from state oil company Turkish Petroleum showed.

My ECONS102 class covered excise taxes (taxes on the sale of goods or services) this week, so it's worth reviewing what happens, first when a tax is introduced, and then when it is tripled in size. Consider the market for petrol, as shown in the diagram below. If the market were left alone, it would operate with a price of P0, and Q0 petrol would be traded. When the excise tax is imposed, we represent that with the new curve S+tax. The price the consumer pays for a petrol increases to PC, but the effective price for the seller decreases to PP (which is the consumer's price PC, minus the amount of the tax paid to the government). The quantity of petrol traded decreases to QT.

However, now think about economic welfare. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, at the equilibrium price and quantity, consumer surplus is the triangle AEP0. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, at the equilibrium price and quantity, consumer surplus is the triangle P0ED. Total welfare is the sum of the two areas (consumer surplus and producer surplus), and is equal to the triangle AED.

Once the tax is imposed, the consumer surplus decreases to ABPC, while the producer surplus decreases to the area PPFD. The government gains the area of tax revenue, which is the rectangle PCBFPP (this rectangle is the per-unit amount of the tax, multiplied by the quantity of taxed petrol). Total welfare is the sum of all three areas (consumer surplus, producer surplus, and government revenue), or ABFD. Notice that total welfare with the tax is lower than it is without the tax, by the area BEF. That is the deadweight loss of the tax - lost economic welfare as a result of the tax reducing the quantity of petrol traded.

Now, with the tax imposed, consider what happens when the tax is tripled in size. So, instead of S+tax, we have a new curve S+3*tax, as shown in the diagram below. Notice that the distance from G to H is about three times larger than the distance from B to F. As a result, the price the consumer pays for a petrol increases even further to P3C, but the effective price for the seller decreases to P3P (which is the consumer's price P3C, minus the now-larger amount of the tax paid to the government). The quantity of petrol traded decreases to Q3T. The consumer surplus decreases further to AGP3C, while the producer surplus decreases further to the area P3PHD. The government now gains the area of tax revenue equal to P3CGHP3P. Total welfare has decreased further to AGHD, and now the deadweight loss is the much larger area GEH.

How much bigger is the deadweight loss? With the size of the tax tripled, it turns out that the deadweight is nine times larger. To see this, the diagram below splits the new deadweight loss area GEH into nine numbered triangles, each of which is about the same size as the original deadweight loss of BEF.

By tripling the petrol excise tax, the Turkish government may have increased tax revenues, but they have massively increased the loss of total welfare arising from the tax. There are likely to be some offsetting benefits in terms of lower vehicle emissions, cleaner air in Turkish cities, and lower traffic congestion, which are not shown in the diagram above. Perhaps overall the higher tax might increase welfare once those benefits are taken into account? No doubt some economists are looking eagerly at this potential natural experiment, to see what the effects are overall.

The effect of timber export restrictions on the domestic market for timber

The housing crisis is causing the government to search frantically for solutions. As the New Zealand Herald reported last week:

The Government was warned its efforts to tackle New Zealand's housing affordability issues could be hampered by wood shortages.

The issue has become so significant, Building and Construction Minister Poto Williams is considering limiting timber exports to ensure there is enough in the country.

What happens if the government limits timber exports, by implementing an export quota? Before we can answer that question, we need to consider the effect of exports on the domestic market, without any restrictions on exports. That situation is shown in the diagram below. New Zealand is an exporting country, which means that New Zealand has a comparative advantage producing timber. That means that New Zealand can produce timber at a lower opportunity cost than other countries. On a supply-and-demand diagram like the one below, it means that the domestic market equilibrium price of timber (PD) would be below the price of timber on the world market (PW). Because the domestic price is lower than the world price, if New Zealand is open to trade there are opportunities for traders to buy timber 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 timber. The domestic consumers would end up having to pay the price PW for timber 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 timber, while the domestic suppliers sell Qs0 timber (assuming that the world market could absorb any quantity of timber that was produced). The difference (Qs0 - Qd0) is the quantity of timber that is exported. Essentially the demand curve with exports follows the red line in the diagram.

In terms of economic welfare, if there was no international trade in timber, the market would operate at the domestic equilibrium, with price PD and quantity Q0. Consumer surplus (the gains to domestic timber consumers) would be the area AEPD, the producer surplus (the gains to domestic timber 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.

Now consider what would happen if there is an export quota limiting the quantity of timber exports below (Qs0 - Qd0). This is shown in the diagram below. Let's say that the quantity of exports is reduced to the amount between B and G on the diagram (about half the amount of exports that were previously occurring). Now consider what happens to the demand curve (including exports). The upper part represents the domestic consumers with high willingness-to-pay for timber. Then there is a limited quantity of exports that are allowed under the export quota, 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 timber). 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). The domestic consumers choose to purchase Qd1 timber at the price P1, while the domestic suppliers sell Qs1 timber at that price. The difference (Qs1 - Qd1) is the quantity of exports. Notice that the price of timber that timber consumers pay has fallen, and more timber is purchased domestically - we'll come back to those points shortly.

Now consider the areas of economic welfare. The consumer surplus is larger than it was without the restricted exports (it is now the area AJP1), the producer surplus is smaller than it was without the restricted exports (it is now the area P1HF plus the area KLHJ. The first area (P1HF) is producer surplus as if the farmers sold all of their products to the domestic market, while the second area (KLHJ) is the extra profits the suppliers get from selling the quota of exports. Total welfare is smaller than without the restricted exports (it is now the area AJHF+KLHJ). There is a deadweight loss (a loss of total welfare arising from the restricted exports) equal to the area [BKJ + LCH] - these areas were part of total welfare with trade and no restricted exports, but have now been lost. The reduction in exports makes timber suppliers worse off, as well as society overall (in terms of economic welfare in total). However, timber consumers benefit in terms of higher consumer surplus.

Now consider the goals of the export quota. If the government is worried that domestic timber prices are too high, the export quota will lower the price (from PW to P1). If the government is worried that not enough timber is available and sold locally, the export quota will increase that quantity (from Qd0 to Qd1). It sounds like the export quota will have all the effects that the government might want. However, there is no free lunch here. Domestic timber producers are made worse off, and by more than the amount that domestic timber consumers gain (we know this because total welfare overall declines).

The negative impact on domestic timber producers is going to create a couple of negative incentives. First, at the margin it will dissuade timber growers from planting forests, because the return on investment will be lower (as timber prices are lower). Of course, that's not going to impact the market until 20-25 years into the future, so the current government might not care. Second, timber growers might prefer to leave their forests uncut, hoping that the export quota is lifted after the next change in government. If prices are low now, but there is an anticipated higher price in the future, then holding back supply might be a good strategy for some timber growers. That will have the opposite effect from what the government intends, because a reduced domestic supply of timber raises the domestic price, and decreases the quantity of domestic timber sold. This effect seems very likely to me.

The government needs to tread carefully, lest they create incentives that actually make the problem worse in the long run. Policy alternatives that encourage timber supply, rather than discouraging it, are likely to be more effective overall.

Reduced exports due to border restrictions and the domestic market for strawberries

Last week, my ECONS102 class covered international trade, including the effects of trade restrictions on economic welfare. Usually, the examples I use involve the government interfering in the market, through the use of quotas or tariffs, and those trade policies invariably lead to a loss of economic welfare (a deadweight loss). However, sometimes other things get in the way of international trade, such as this recent example from HortNews:

Strawberry prices fell 43% in November 2020 as Covid-19 border restrictions reduced exports, Stats NZ said.

Consumer prices manager Katrina Dewbery says that fewer exports have meant there is more supply available for domestic consumption.

Prices averaged $3.45/250g punnet in November, down from $6.04 in October.

“Prices are lower than we typically see for a November month with December generally being when they are cheapest. Some people may be seeing even cheaper prices during the first half of December,” Dewbery said.

There was no government intervention here, but a lack of capacity to export strawberries due to the COVID-19 border restrictions reduced the quantity that could be exported. We could interpret that as being similar to an export quota on strawberries (where the quantity of exports was restricted to less than it would have been with open borders), so let's look at the effect on the market for strawberries.

First, consider the case without any border restrictions. This is shown in the diagram below. New Zealand is an exporting country, which means that New Zealand has a comparative advantage producing strawberries. That means that New Zealand can produce strawberries at a lower opportunity cost than other countries. On a supply-and-demand diagram like the one below, it means that the domestic market equilibrium price of strawberries (PD) would be below the price of strawberries on the world market (PW). Because the domestic price is lower than the world price, if New Zealand is open to trade there are opportunities for traders to buy strawberries 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 strawberries. The domestic consumers would end up having to pay the price PW for strawberries 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 strawberries, while the domestic suppliers sell Qs0 strawberries (assuming that the world market could absorb any quantity of strawberries that was produced). The difference (Qs0 - Qd0) is the quantity of strawberries that is exported. Essentially the demand curve with exports follows the red line in the diagram.

In terms of economic welfare, if there was no international trade in strawberries, the market would operate at the domestic equilibrium, with price PD and quantity Q0. Consumer surplus (the gains to domestic strawberry consumers) would be the area AEPD, the producer surplus (the gains to domestic strawberry 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.

Now consider what would happen if the quantity of strawberry exports was restricted below (Qs0 - Qd0). This is shown in the diagram below as an export quota. Let's say that the quantity of exports is reduced to the amount between B and G on the diagram (about half the amount of unrestricted exports). Now consider what happens to the demand curve (including exports). The upper part represents the domestic consumers with high willingness-to-pay for strawberries. Then there is a limited quantity of exports that can get through the border restrictions, 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 strawberries). 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). The domestic consumers choose to purchase Qd1 strawberries at the price P1, while the domestic suppliers sell Qs1 strawberries at that price. The difference (Qs1 - Qd1) is the quantity of exports. Notice that the price of strawberries that consumers pay has fallen, just as the article linked above noted.

Now consider the areas of economic welfare. The consumer surplus is larger than it was without the restricted exports (it is now the area AJP1), the producer surplus is smaller than it was without the restricted exports (it is now the area P1HF plus the area KLHJ. The first area (P1HF) is producer surplus as if the farmers sold all of their products to the domestic market, while the second area (KLHJ) is the extra profits the farmers get from selling the limited amount of exports that are able to get through the border restrictions. Total welfare is smaller than without the restricted exports (it is now the area AJHF+KLHJ). There is a deadweight loss (a loss of total welfare arising from the restricted exports) equal to the area [BKJ + LCH] - these areas were part of total welfare with trade and no restricted exports, but have now been lost.

The lost exports make strawberry farmers worse off, as well as society overall (in terms of economic welfare in total). However, strawberry consumers are the unwitting recipients of a gain. The interesting thing here is that the government is not responsible for the deadweight loss - this is a deadweight loss caused by a more general disruption in international trade. And it was not just strawberries that were affected - domestic consumers will have been made better off in all exported commodities that cannot be stored for long periods of time.

You can pay a subsidy with a tax, but it won't eliminate the deadweight loss

The government's new plan for incentivising a switch to electric vehicles (EVs) is interesting, as reported in the New Zealand Herald last week:

The Government is signalling its intention to slash the price of imported electric and hybrid vehicles by up to $8000 in a bid to make greener cars cheaper for Kiwis.

But it is also planning to slap a new fee of up to $3000 on the import of vehicles with the highest greenhouse gas emissions.

The Government has today opened a six-week consultation period before it introduces new legislation in Parliament later this year...

The Government is proposing discounts of up to $8000 for zero-emission new imported vehicles, such as electric vehicles (EVs).

That number would be $6800 for plug-in hybrid electric vehicle (PHEVs) and $4800 for hybrids.

The level of the discount depends on the total net emissions of the vehicle...

A used Mazda Axela, which is one of New Zealand's most popular imported vehicles, would cost $7200 after an $800 discount.

But a new Land Rover Sports V8 would be slapped with a $3000 high-emissions fee.

A $22,000 Toyota Hiace would cost an extra $1400 after the fee was applied.

Genter said the policy would be cost neutral – meaning the money gained through the fees from higher emitting vehicles would offset the subsidies provided to the lower emission cars.

A specific excise tax on the sale of a good, such as high-emission vehicles, will raise revenue for the government, but it also creates a deadweight loss - there is some economic welfare from the market for those vehicles that is lost, because fewer of them are being traded. This is illustrated in the diagram below. If the market were left alone, it would operate with a price of P0, and Q0 high-emission vehicles would be traded. When the excise tax is imposed, we represent that with the new curve S+tax. The price the consumer pays for a high-emissions vehicle increases to PC, but the effective price for the seller decreases to PP (which is the consumer's price PC, minus the amount of the tax paid to the government). The quantity of high-emissions vehicles decreases to QT.

However, now think about economic welfare. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, at the equilibrium price and quantity, consumer surplus is the triangle AEP0. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, at the equilibrium price and quantity, consumer surplus is the triangle P0ED.  Total welfare is the sum of the two areas (consumer surplus and producer surplus), and is equal to the triangle AED.

Once the tax is imposed, the consumer surplus decreases to ABPC, while the producer surplus decreases to the area PPCD. The government gains the area of tax revenue, which is the rectangle PCBCPP (this rectangle is the per-unit amount of the tax, multiplied by the quantity of taxed vehicles). Total welfare is the sum of all three areas (consumer surplus, producer surplus, and government revenue), or ABCD. Notice that total welfare with the tax is lower than it is without the tax, by the area BEC. That is the deadweight loss of the tax - lost economic welfare as a result of the tax reducing the quantity of high-emissions vehicles traded.

So, we lose economic welfare in the market that is taxed. Does that mean that we gain welfare in the market that is subsidised? Actually, it doesn't. The diagram below shows the effect of a subsidy on the market for EVs. If the market were left alone, it would operate with a price of PA, and QA EVs would be traded. When the subsidy is introduced (and assuming it is paid to the importers of EVs), we represent that with the new curve S-subsidy. The price the consumer pays for a high-emissions vehicle decreases to PE, but the effective price for the seller increases to PF (which is the consumer's price PG, plus the amount of the subsidy paid to the seller by the government). The quantity of EVs increases to QS.

Now consider the areas of economic welfare. Without the subsidy, consumer surplus is the area FGPA, and producer surplus is the area PAGH. So, total welfare without the subsidy is the area FGH. With the subsidy, the consumer surplus increases to the area FJPG, while the producer surplus increases to the area PFKH. The government subsidy is the rectangle PFKJPG (this rectangle is the per-unit amount of the subsidy, multiplied by the quantity of subsidised vehicles). The subsidy is negative welfare - it reduces total welfare, because the government could instead use that subsidy money to pay for schools, roads, etc. So, it has an opportunity cost (it is not free money). Total welfare with the subsidy is the sum of consumer and producer surplus, minus the area of the subsidy. This is tricky because all the areas overlap, but if you work it out you'll find that total welfare is now FGH-GKJ. So, total welfare with the subsidy is lower than without the subsidy, by the area GKJ - the subsidy also creates a deadweight loss.

Now, combining the two markets, it is clear that the government could use the revenue that it raises from the tax on the high-emissions vehicle market, to pay for the subsidy on the EV market. However, that only pays the subsidy - it does nothing about the deadweight loss in either market. [*] So, while the policy may be cost neutral from a government fiscal standpoint, it clearly isn't cost neutral for society as a whole.

*****

[*] Now, you could argue (rightly) that the high-emissions vehicle market has a negative externality, and so too many high-emissions vehicles are traded relative to the welfare-maximising quantity. So, a tax on that market would actually increase total welfare (once you factor in the externality). However, that still leaves the deadweight loss in the EV market.

You could also argue that the EV market has a positive externality, since EV use reduces the number of high-emissions vehicles, and so too few EVs are traded relative to the welfare-maximising quantity. So, a subsidy on that market would actually increase total welfare (once you factor in the externality).

However, you couldn't argue that both of those things are true, since you would be double-counting the externality. Either there is a negative externality of high-emissions vehicles, or a positive externality of EVs, but there can't simultaneously be welfare increases for both of those things.

Lobbyists, rent seeking and deadweight losses

The rise of lobbying in New Zealand has been in the news recently, as Bryce Edwards explained in his regular Political Roundup column in the New Zealand Herald a couple of weeks ago:

Political lobbying is a growth industry in New Zealand. And lobbyists are going to be particularly busy over the next year.

Edwards charts the rise of 'hyper-partisan' lobby groups Hawker Britton and its right-wing counterpart Barton Deakin. It's an interesting read, along with the many links to other articles embedded within it.

Of course, lobbyists are ultimately being employed by firms that are seeking favourable policy settings. Perhaps they are looking for lighter-handed regulation for themselves, or more regulation of their competitors. Economists refer to this sort of activity as rent-seeking, and in ECON100 and ECON110 I discuss it as one of the key reasons that we might consider monopolies (or firms with market power more generally) to be unfavourable for society. Those firms make large profits, and therefore have a large incentive to use some of those profits to protect their market position through lobbying. If government is seeking to regulate their industry or to open it to more competition (or the firms are worried that the government might contemplate doing so), then those firms will employ lobbyists to dissuade governments from those policies that won't favour the firm.

When I was an undergraduate student, I struggled to see how rent seeking was negative for society. Obviously, it seems ethically problematic. But if you take a general equilibrium framework, then if the firm spends some of its profits on lobbyists, that simply becomes income for the lobbyists, and total welfare remains effectively the same (or maybe it even increases due to the producer surplus in the labour market for lobbyists).

However, that position forgets that the market operates across multiple periods. The firm with market power is generating a deadweight loss (for an explanation of why, see the first part of this earlier post). That deadweight loss arises because the firm with market power is able to price above marginal cost. If the government was to open the market to more competition or to regulate prices, then that would force the price down and increase total welfare in the market. Therefore, if the actions of the lobbyists prevents the regulation or the competition, then it has a cost to society that can be measured by the future deadweight losses that continue to accrue. So, lobbying does potentially have real negative consequences for society, and so as a society we should care about the actions of lobbyists and their interactions with our politicians.

The deadweight loss of a pillow tax

For those of you who have missed the news over the last couple of weeks, Auckland mayor Phil Goff has proposed a targeted rate for accommodation providers in Auckland, to be used to fund Auckland Tourism, Events and Economic Development (ATEED) in its role of promoting the city to tourists. At first glance, this might seem like a useful user-pays charge. After all, the accommodation industry receives benefits from the increased tourism, so why shouldn't they pay the costs rather than the ratepayers at large?

The New Zealand Herald has several stories on this topic, including this one from Tuesday:

As part of its annual budget, Auckland Council wants to shift the funding of Ateed from ratepayers to 330 accommodation providers, ranging from backpackers to camping grounds to big hotels.

Auckland mayor Phil Goff says the accommodation sector has profited from the boom in tourism and increased room rates so it was fair it should pay for Ateed rather than ratepayers.

Money saved could be redeployed to fund infrastructure such as roads, which also benefited the tourism sector.

But the accommodation sector says it has been unfairly singled out and should not be the only sector of businesses to pay for the cost of Ateed.

In its submission it says that it gets 9 per cent of visitor spend in Auckland but is being asked to fund 100 per cent of council efforts through Ateed to increase this spend.

On average rates will increase 150 per cent for the affected accommodation providers and in some cases by more than 300 per cent.

The accommodation sector is right in its criticism of this targeted rate. There are two lines of criticism though, and the sector has struck on only the first: fairness. If a commercial business benefits from the activities of ATEED, they should be paying towards its costs. To be equitable, all businesses would pay proportionally to the benefits received, but that is clearly infeasible. Paying proportional to current property value might be a second-best option. Clearly, some sectors (e.g. finance, law firms) would pay vastly more than necessary due to high property values and low benefits received, while others would pay less relative to benefits received. I would argue that including residential ratepayers in this system would be inequitable (but others might argue the opposite, since the activities of ATEED creates jobs that benefit ratepayers).

The second line of criticism, which is missed by the accommodation sector, is efficiency. If the government has a targeted amount of funding they want to raise (e.g. $27.8 million to fund ATEED), then a small tax (like rates) on a wide number of taxpayers generates a much smaller deadweight loss than a larger tax on a smaller number of taxpayers.

To see why, consider the market diagrams below. There are two sectors (A, on the left; and B, on the right). Without the tax, both markets operate at equilibrium (prices P0 and Pa, quantities Q0 and Qa), and total welfare (a measure of benefits to buyers and sellers in these markets, combined) is the area AED in Sector A, and the area FKJ in Sector B. If the government taxes the firms in both sectors a similar amount, we represent this by a new curve (S+tax) [*]. The per-unit amount of the tax is equal to the vertical distance between the S and S+tax curves (the distance BC in Sector A, or GH in sector B). The quantities traded fall to Q1 and Qb. The prices paid by customers in the two sectors increase to P1 and Pb, while the effective prices for the sellers (the price after paying tax to the government) fall to P2 and Pc. Total welfare falls to ABCD in Sector A (with a deadweight loss, or lost total welfare, equal to the area BEC) and FGHJ in Sector B (with a deadweight loss equal to the area GKH).

Now consider what happens if the government wants to raise the same tax revenue, but by taxing only one sector instead of both sectors. This is shown in the diagrams below. Notice that there is no tax in Sector A, and total welfare is maximised at AED. However, in order to earn double tax revenue from Sector B, the government must more than double the tax rate, to the distance LM. [**] The quantity traded in Sector B falls to Qc (instead of Qb). The total welfare in Sector B falls to FLMJ, and the deadweight loss increases to LKM.

Now compare the size of the deadweight losses in the first pair of diagrams (BEC+GKH) to the deadweight loss in the second pair of diagrams (LKM). It should be clear that the size of the deadweight loss in Sector B is more than four times bigger when it is the only sector that is taxed, than when both sectors are taxed. The combined deadweight loss (when you factor in that there would no longer be any deadweight loss in Sector A in the second pair of diagrams) is more than doubled. Total welfare is therefore much lower if the tax is targeted on only one sector.

So, there are both equity and efficiency arguments against the proposed targeted rate for accommodation providers in Auckland. It probably needs a careful re-think.

*****

[*] Strictly speaking, the targeted rate is different to the specific excise tax that is shown in these diagrams. The difference is that the S+tax curve should be curved in towards the supply curve (but not ever quite touch the supply curve) to represent that the average cost of the targeted rate would reduce, the greater number of accommodation nights provided by the industry. However, I have kept the diagrams simple, as this fact makes no qualitative difference to the discussion.

[**] The government needs to more than double the tax rate, because as the tax increases the quantity sold in the market decreases, so simply doubling the tax would not raise enough tax revenue.

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.

Read more:

• Why export quotas probably failed to help coffee farmers