Question

Suppose that you are tasked with negotiating an international trade agreement. Assume that your counterpart is from a large nation and that the overseas industry in question is a State-run monopoly. You seek to ensure that domestic consumers and producer receive the maximum benefit from any possible trade. Discuss the tactics you will use. Support your claims with models and diagrams.

Answer 1

In Economics, all models, including the Ricardian Model, Mutually Beneficial & Efficient Trade Model, and Exchange Model have a restriction of zero production disintergration. This makes it particularly difficult for countries to negotiate with a monopoly, from a theoretical perspective. However, we can use the the assumptions of the Gravity Model of Trade to design a model for this agreement.

Now, the Gravity Model of Trade predicts the two way flow of economic products based on the GDP of the country and the distance. This model was used to design NAFTA, and is still used by WTO; making it suitable for our purpose. In mathematical terms, the model can be described as:

Xij= C (Yi*Yj/Tij)

ij= The two countries (i and j)

C= Constant

Y= Size of the GDP

T= Trade Costs (primarily transport costs, which depends on distance between countries)

Now, the constant is kept aside. We know that countries that are not far away from each other tend to trade more. A small country tends to be a price taker, since the global price of the commodity will not be affected by a change in the quantity demanded by the smaller country (demand and supply equilibrium).

Moving on, we have to find a way, that the consumers of the smaller country do not get charged too heavily for that product. The best way to go about that is by either investing in the Research and Development of the larger country's product, or by reducing trade barriers. Assuming that the smaller country does not have enough resources to invest in the R&D, it is left with no option but to reduce the taxes.

Let's take the two countries to be USA and Paraguay. The product in question is electric cars.

If I were Paraguay, this would the policy I'd follow:

1) Subsidy for import of car parts,

2) Reducing trade restrictions to enter in Joint Venture Agreements with Paraguayan car manufacturers

3) Allocation of Special Economic Zone

Now the reasons:

1) According to the Gravity Model, reducing trade costs will automaticaly lead to higher trade (as observed in the EU). But given the distance, it would be next to impossible to reduce transport costs, since it is out of our hands. What we can reduce is the cost of importing the raw car parts, which can be then assembled by a local manufacturer. Hence, we reduce the import tax of 10% (average import tax in Paraguay) to around 4.5%. This would drastically cut down on the amount the US producer would have to spend on exporting their raw material, leading to lower costs for the producer, and a better price for the consumer.

2) By reducing restrictions on entering into a Joint Venture with a Paraguayan company, we are not only benefitting the producers & consumers, but also the nation. This would lead to higher investment by US companies in the foreign market. Leading to creation of jobs, and the need for importing car parts would be drastically reduced, since the company can get access to the raw materials in Paraguay. Also, the producers stand to benefit from the extra investment, which would automatically imply reduction in prices for the consumers. The foreign company could also explore the avenue of opening electric charging pumps, with a local producer in that sector.

3) Lastly, the Special Economic Zone (SEZ) status. Now, this is something which is widely practiced in China and India, to promote economic development. By giving SEZ status to the US company, you are allowing them to set up factories and production units, with lesser tax impositions (land tax, turnover tax, etc). Using this to your advantage, not only are you inviting Foreign Direct Investment (FDI), but also reducing the price at which the producers would be willing to supply the product. In turn, Paraguayan producers and consumers will no longer be price takers. The supply-demand equilibrium would determine the price, as it should. Thus, benefitting both the producer and the consumer.

What does the US company gain?

    Market expansion
    They become a giant in the car manufacturing business in Paraguay
    Unlimited access to the Paraguyan labour market

Downsides:

    Might become a monopoly in Paraguay, hurting local competition
    Exploitation of labour
    Increased dependence of the Paraguayan economy on a foreign company