Chapter 4 Estimating the Impact of Policy Actions Affecting Trade on Industry Revenues, Costs, and Profits

In the last chapter we explored how policy actions change trade flows by affecting the cost and price of traded goods, or affect prices by changing trade flows directly. Information on the impact on trade flows still does not tell us, however, how the economic interests of stakeholders are affected.  The focus of this chapter is the subset of stakeholders participating in the profits of firms producing goods and services domestically. To estimate these effects, we must calculate how a change in prices and trade flows translates into changes in the domestic production of goods and services, and thus on industry revenues, costs and profits.[1]

An increase in exports will increase domestic production by an equal amount, provided the industry has unutilized production capacity or large inventories of final goods.[2] In some cases, we assume that the industry has the capacity to increase output. We want to estimate the change in domestic output in the industry after producers have adjusted their output to accommodate the increased export demand. We can simply add the projected increase in exports to the projected level of domestic consumption (abstracting from imports) to obtain the new, higher level of output. The argument in policy debates can be simplified still more.  It is not unreasonable to de-link foreign and domestic demand, and say that the increase in output attributable to a trade policy that increases exports is simply the increase in exports.  Remember that our goal is generally not to predict future sales and profits, but to isolate the impact of a proposed trade policy on sales and profits. Economists sometimes express these numbers as changes from a “baseline” or “status quo” scenario.

To calculate the impact on growth in the industry, we divide the increase in exports by the current level of output. The result tells us how much additional growth has been or will be created by the trade policy action. We can also measure the significance of the trade policy action by calculating how the growth generated by the increase in exports compares to the current growth in domestic demand or the underlying growth trend in exports.

One problem in making these calculations is the discrepancy between the commodity classification system used for trade data and the industry classification system used for production data.  As discussed in Chapter 2, we either must find a concordance that allows us to map data in the trade data series to the production data series, or we simply must utilize trade and production data that provide the closest fit.  One must be particularly careful not to mix levels of aggregation.  Suppose a proposed trade deal will lower tariffs facing US exporters of newsprint. That will clearly boost exports and output of US pulp and paper manufacturers, but we cannot apply the estimated percent increase in newsprint exports to the entire pulp and paper sector, which includes cardboard, printer paper, etc., as well as newsprint.

We need also consider the effect of time. In the very short term, producers may not be able to increase production because they don’t have sufficient parts or raw materials on hand.  Or they may not want to increase production because they first want to reduce inventory of finished products before paying overtime, hiring new workers, or installing new machines, particularly if they feel that the increase in demand may be temporary. An increase in sales satisfied through a reduction in inventories increases revenues and profits, but does not increase the level of output (and employment, the topic of the next chapter). At some later stage producers may adjust the supply chain, with inventories fallen enough to demand replenishing. At this stage the increased demand for products is translated into increased production, up to a level that can be accommodated by the production capacity. We will explore next what happens when producers reach full capacity utilization. Given enough time they can increase production capacity through more investment in plants and equipment. New firms may enter the industry, adding to total production. Over time, we should witness a sequence of three events—in the very short run a reduction in inventories, in the intermediate run an increase in output (by using existing capital and labor more intensively), and in the long run an increase in production capacity (through new capital investment, hiring and training at existing firms, and new firms entering the market).[3]

We now need to explore what happens when producers reach production capacity limits. At this stage, producers start charging more money for their product, and if they can sell their products abroad for a higher price than in the domestic market, they may also divert sales from the domestic market to the foreign market. This chain of events increases their revenues. How much they will increase prices depends on the interaction between demand and supply in the market.  How much a producer increases prices as compared to increasing production depends on the producer’s cost structure and competitiveness, and the culture of the industry.  Industries may be quicker to expand output where economies of scale exist (increasing production capacity allows costs to decline). Competitive pressures discourage price increases, and corporate culture (the main bank and Keiretsu system of Japan , for instance) encourage expansion.  To estimate how the market would respond we would need to examine the past relationship between price changes and production decisions in the industry, information that is contained in the previously discussed price elasticity of supply. To determine the new equilibrium price and production level, the supply responses must then be compared to the responses of consumers (usually both industrial users and households) to changes in price using the price elasticity of demand we reviewed in the last chapter.  

There is no simple way to make these calculations. They are complex calculations with simultaneous equations that are often best left to economists.[4] However, we can approximate the long-run equilibrium if we assume the industries are perfectly competitive.  For non-competitive industries dominated by a few firms, or characterized by large fixed costs or high barriers to entry, the methodology introduced in the next section will understate the additional profits the industry enjoys from an increase in demand for its exports (and correspondingly underestimate the decrease in profits for an import-competing industry faced with increased imports).

In political discourse, the tendency of trade advocates is to jump immediately to the long-run change in production that is generated by trade liberalization. On the other hand, opponents emphasize short-term adjustment costs. When will these benefits to domestic industry show up in the economic data?  The actual length of time that corresponds to the short, intermediate and long run varies from industry to industry, according to the cyclical position of the industry at any one period of time. The inventory and capacity management practices adopted by the industry also matter.  As a rule of thumb, the short run as no more than a year, and the long run at least 3 years in the future. 

This brings us to a discussion of profits.  All other things being equal, we can expect industry profits to increase proportionately with the increase in sales (if profit margins are constant per unit of output) or revenues (if gross profit margins on sales are constant).[5] Other things may not stay the same, however. Profits are the difference between costs and revenues, and both might be affected by circumstances. We saw earlier that when producers near their capacity limits they are likely to increase their prices. An increase in the prices of goods sold will boost profits. On the other hand, costs may increase as well because the suppliers of the inputs may also reach capacity limitations, which will reduce the profits. Making these calculations is a fairly complex undertaking and not necessary for most policy discussions. It is sufficient to observe that under certain conditions favorable to the industry firms are likely to experience a surge in profits. Policy makers should be able to take advantage of those conditions in exploring policy options.  
 

Calculating Changes in Production and Profits

The remainder of this chapter introduces the standard graphic methodology for analyzing the impact of trade policy changes on producers.  The same methodology also allows us to see and calculate the benefits and costs to consumers and the government.  The benefits of this methodology are that it is well known and generally accepted by economists, and is relatively simple to learn and use.  If you understand supply and demand diagrams, you are halfway there.

This methodology has several drawbacks, however, making it unsuitable for some trade policy analysis questions.  The underlying assumption is that domestic and foreign products in this market are perfect substitutes.  Consumers will purchase the cheaper product, without regard for its national origins.  Thus, there can be no real or perceived quality difference between products.  The model is perfectly appropriate for homogeneous goods, like commodities (appropriately categorized by quality, such as “light, sweet Brent crude” instead of just oil, Durum wheat, Arabica coffee, etc.).[6] In an appendix, we discuss the more complex case in which the domestic product and the import are different varieties of the same product, such as Honda Accords and Ford Taurus’.[7] A second problem with this methodology is that it doesn’t lend itself to generalizations about the overall impact on the country (what we call “the national welfare”), since it focuses on a single industry.  We would expect there to be “upstream” and “downstream” effects on industries that sell and buy with the industry in question.  We will discuss these effects later, in the context of effective rates of protection, input-output tables, and computable general equilibrium models (Chapter 9). 

As indicated above, we must know both the change in output and the change in price before  estimating a change in profits for the industry.  We also must know the change in output before we can estimate the likely change in employment, which we will do in the next chapter.  What we typically know with respect to our exports is how much the cost of our product will change in the foreign market(s) as a result of a policy action. How we know this is covered in the introduction to Chapter 3. We then use the estimated change in trade flows as a first guess for the long-run increase in production of the export.

If capacity in the industry is limited, however, we must modify our estimate. If capacity utilization is high in the export industry, and the additional production for export would push it near or over 100 percent, prices and profits will rise, and output will rise less than our first guess would indicate.  A rule of thumb is to use an 85–90% capacity utilization level as the turning point, with increases in demand below that level translating primarily into increased production and increases above that level resulting primarily in higher prices.[8] In the language of economists, we can say that elasticities of supply, like those of demand, change as one moves along the supply curve. Once again, we must be careful in applying a single price elasticity to a large change in price and clearly state the time frame of the analysis.

Table 4 – 1   Capacity Utilization in Different Sectors.

  
Let’s turn to what happens to the output of domestic producers when the price of a competing imported product falls. We must consider how a fall in the price of imports will affect the price of the competing domestic products and consequently the demand for the domestic product. One might initially expect that an increase in imports would lead to a reduction in the price of competing domestic products, as domestic producers seek to preserve sales. However, an increase in imports is less likely to be met by a cut in the price of the domestic substitute if domestic capacity utilization rates are high than if substantial excess capacity already exists.  Consider also the possibility of domestic complements, which face increased demand as the price of imports falls. 

Thus we see the complexity of decomposing a given change in projected trade flows into a price and production impact for domestic producers.  But once we have those estimates, with just a few more assumptions, we can calculate changes in profits.  The supply curve shown in Figure 4–1 provides a graphic illustration of the impact of increased foreign demand for a country’s exports on the profits of the export industry. The diagram shows the impact of the mutual elimination of tariffs between the US and Costa Rica on export opportunities for Costa Rican garment producers.  In Figure 4–1, increased demand results in both higher prices and greater output.

To estimate the potential impact of an action on profits, we must address what economists call producer surplus .

The shaded triangle in Figure 4–1 represents producer surplus prior to the trade agreement.  See also the more detailed discussion of producer surplus in Chapter 6. 

Figure 4 – 1 Producer Surplus Resulting from the Elimination of Foreign Tariffs

Producer surplus clearly increases for the Costa Rican exporter, and with numbers for the Qs and Ps, we can calculate the increase.  Suppose Q increases from 6,000 to 8,000 units, and P increases from $15 to $20 per unit.[9] In this simple model, production costs increase only for the increased output. Since the exporter can charge a higher price for all goods sold, profits will rise by the price increase times the old quantity of sales [$5 * 6,000] plus the triangular area of profits on new sales [1/2 * $5 * 2,000], or $35,000.[10] Total revenues increase from $15 * 6,000 = $90,000 to $20 * 8,000 = $160,000.  The “other” $35,000 (the difference between the increase in revenues and the increase in profits) represents increases in costs of production (wages, electricity, etc.).

The simplifying assumptions in this calculation are repeated here to emphasize their importance:

• Decreasing returns to scale (new production is more costly than average).

• Industry output can be aggregated (added together) because products produced by different firms in the industry are nearly identical.

• An appropriate price elasticity of supply separates the impact on the domestic industry into output and price components.

• The market is competitive, with many sellers and many buyers.

Consider now the case of an increase in imports.  Suppose a 10 percent fall in the price of imports results in a 10 percent increase in the demand for imports.  What happens to the production of domestic substitutes? 

It depends.  Are the domestic and imported products close substitutes?  Even in the case of perfect substitutes, domestic production will not fall by as much as the increased demand for imports, since total demand increases at the lower price.  If the two products are perfect substitutes, then domestic producers must lower their prices to match the lower import price.  At this lower price, there is greater demand for both the domestic and the imported product. The domestic producer loses from the price cut, but gains from the increased domestic demand.

If the products are imperfect substitutes, we use the cross-price elasticity of demand to find the impact of the fall in import prices on demand for the domestic product, all else being equal.[11]  In this case, we assume domestic producers make some reductions in price, but do not fully match the cut in import prices. Now some of the increased demand for imports comes at the expense of domestic producers, but the rest is new demand, generated by lower consumer prices.  The exact split depends on the elasticities of supply and demand.  Profits will fall, but there is convincing evidence that competition encourages cost-cutting measures by firms in the long run, mitigating the fall. 

Once you estimate the new price and quantity for the domestic product, you can calculate the change in profits, as above.  Suppose a US garment producer lowers price from $25 to $24 and lowers production from 50 million to 48 million units, as a result of increased competition from all CBI (Caribbean Basin Initiative) and NAFTA countries combined.  How might profits change?

In the short run, we can repeat the calculations above.  Profits fall by one dollar per unit on the 48 million units still viable at the $24 price, plus the smaller margin on the higher-cost production that was phased out.  The total area of profits lost is thus $49 million [$1 * 48 million + ½ * $1 * 2 million]. 

To summarize, changes in trade flows can affect domestic industry in different ways, depending on:

Capacity utilization in domestic industry—At high rates of capacity utilization, additional demand is likely met by price increases, while lower demand may be met by production cuts.  At low rates of capacity utilization, the reverse is likely.

Degree of substitutability between foreign and domestic products—For extremely close substitutes, a fall in the price of imports will force domestic producers to match the lower price, lowering profits and production levels.  For less close substitutes, we would expect the same changes, but of lesser magnitude.  Demand for complementary products will increase when the price of imports falls. 

Production technologies (increasing returns, constant returns or decreasing returns)—In increasing returns industries, firms are more likely to expand production than to raise prices, and more likely to cut prices than contract production.

Corporate culture—US firms are considered more sensitive to quarterly profits, while Japanese firms are considered more concerned with market share and long-term growth.  The price versus quantity adjustments above may reflect these different concerns. 

Time frame—Are we are considering the short run, when economic decision makers are in the process of adjusting to changes, or the long run, when everyone makes the necessary adjustments?

Industry competitiveness—Is the industry competitive, or does a single firm or group of firms have the power to set prices?   Does a change in domestic trade policy (making the domestic market more or less open to imports) affect the degree of competitiveness in the market?

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