1. Go to: http://www.wto.org/english/thewto_e/whatis_e/tif_e/org6_e.htm , and find out how many countries belong to the WTO. Which countries joined most recently?
2. Which of the following actions would be legal under GATT, and which would not?
A U.S. tariff of 20 percent against any country that exports more than twice as much to the United States as it imports in return.
While tariffs are legal, the United States is obliged to offer compensation for any unilateral tariff increase by reducing other tariffs to compensate the affected exporting country.
A subsidy to U.S. wheat exports, aimed at recapturing some of the markets lost to the European Union.
Export subsidies on agricultural products are legal under GATT.
A U.S. tariff on Canadian lumber exports, not matched by equivalent reductions on other tariffs.
This is not legal under GATT because the United States is not offering compensating reductions in other tariffs on Canadian goods. Interestingly, in the late 1980s, U.S. efforts to protect the shakes and shingles industry were met with an outcry and Canadian threats of a trade war. These protectionist efforts by the United States were rescinded.
A Canadian tax on lumber exports , agreed to at the demand of the United States to placate U.S. lumber produces.
This is legal under GATT since the action is taken by Canada on its own exports.
A program of subsidized research and development in areas related to high-technology goods such as electronics and semiconductors.
This is legal under GATT since it does not involve any direct export subsidies.
Special government assistance for workers who lose their jobs because of imports competition.
This is legal under GATT and, in fact, may help increase the benefits from trade.
Problem Set 2: Trade Policy 1: Tariffs and Quota
a. Suppose that the country decides to reduce its tariff to t’. Draw the graphs for the Home (with domestic supply and demand) and import markets (derived import demand curve) to illustrate this change. What happens to the quantity of goods produced at Home and their price? What happens to the quantity of imports?
Answer: The reduction of the tariff, and corresponding decrease in domestic price in the small country, leads to a reduction in domestic production (to S3) and an increase in domestic quantity demanded (to D3). The result is an increase in imports (to M3). See the following figure.
b. Are there gains or losses to domestic consumer surplus due to the reduction in tariff? Are there gains or losses to domestic producer surplus due to the reduction in tariff? How is government revenue affected by the policy change? Illustrate these on your graphs.
Answer: Consumer surplus increases because consumers now buy a greater quantity of products at a lower price. Domestic producer surplus, on the other hand, decreases because producers sell a smaller quantity of products at a lower price. Government revenue changes from the rectangle S2D2PWPW + t to the rectangle S3D3PWPW+ t’. Notice that the area of the rectangle does not necessarily decrease when the tariff is lowered because, although the tax per import is less, the amount of imports has increased.
c. What is the overall gain or loss in welfare due to the policy change?
Answer: The overall welfare gain from the reduction in the tariff is illustrated by the decrease in total deadweight loss. On our graphs this is the reduction in the size of the striped triangles; after the reduction in the tariff, total deadweight loss is represented by the smaller solid triangles.
2. Consider a large country applying a tariff, t, to imports of a good.
a. How does the export supply curve in panel (b) compare with that in the small country case? Explain why these are different.
Answer: The export supply curve is upward-sloping in the large-country case (it was horizontal in the small-country case). In the small-country case, a horizontal export supply curve means that the supply of exports from the rest of the world is infinitely elastic. This corresponds to the price taking assumption in perfect competition. In contrast, an upward-sloping export supply curve means that the price of exports from the rest of the world responds when the large country changes its import demand. For instance, if the large-country importer applies a tariff that decreases its demand for imports, the price charged by foreign exporters falls.
b. Explain how the tariff affects the price paid by consumers in the importing country, and the price received by producers in the exporting country. Use graphs to illustrate how the prices are affected if (i) the export supply curve is very elastic (flat), or (ii) the export supply curve is inelastic (steep).
Answer: In the small-country case (flat export supply curve), a tariff increases the amount that consumers pay by exactly the amount of the tariff and foreign exporters are paid the original world price, P*; the difference is collected by the domestic government as tax revenue. Refer to Figure 8-7: With an upward-sloping export supply curve (in the large-country case) foreign exporters reduce their price due to a tariff; that is, foreign exporters receive less than they did prior to the tariff. Domestic consumers pay more than before, but by less than the full amount of the tariff. Again, the difference between what consumers pay and what Foreign exporters receive is the amount of the tariff, t, collected by the domestic government. In the large-country case, the incidence of the tariff is shared by domestic consumers and foreign producers. Moreover, a steeper foreign export supply curve implies that foreign exporters absorb more of the price increase due to the tariff.
3. Consider a large country applying a tariff, t, to imports of a good. How does the size of the terms-of-trade gain compare with the size of the deadweight loss when (i) the tariff is very small, and (ii) the tariff is very large?
Use graphs to illustrate your answer.
Answer: As the size of the tariff increases, the export supply curve shifts upward by more, M2decreases by more (relative to M1), and the size of the triangle with area b+d increases relative to rectangle e. That is, consumer deadweight losses get larger relative to terms-of-trade gains due to the tariff. We can interpret this as meaning that for small tariffs the welfare gains from terms of-trade improvements outweigh consumer deadweight losses, but the opposite is true for tariffs that are sufficiently large.
4. Consider the following scenarios:
a. If the foreign export supply is perfectly elastic, what is the optimal tariff Home should apply to increase welfare? Explain.
Answer: This is the small-country case. Because the incidence of the tariff is shouldered completely by consumers and there is no terms-of-trade gain to applying a tariff, the optimal tariff is zero.
b. If the foreign export supply is less than perfectly elastic, what is the formula for the optimal tariff Home should apply to increase welfare?
Answer: This is the large-country case. The optimal tariff is determined as: t=1/E*X, where E*X is the Foreign export supply elasticity.
c. What happens to Home welfare if it applies a tariff higher than the optimal tariff?
Answer: For a tariff higher than the optimal tariff, welfare declines because deadweight losses increasingly outweigh terms-of-trade gains. For a sufficiently high tariff, welfare can go as low as the autarky level.
5. Rank the following in ascending order of Home welfare and justify your answers. If two items are equivalent, indicate this accordingly.
a. Tariff of t in a small country corresponding to the quantity of imports M.
b. Tariff of t in a large country corresponding to the same quantity of imports M.
c. Tariff of t’ in a large country corresponding to the quantity of imports M’>M.
Answer: a < c < b. For the same quantity of imports, M, Home welfare is greater in the large-country case relative to the small-country case because (assuming an optimal tariff) the terms-of-trade gain partially offsets the deadweight losses due to the tariff; thus, a< b. A larger quantity of imports implies that t’< t. Therefore, in the large-country case with optimal tariff t, the welfare associated with a tariff of t’ is somewhere in between the small-country case and the large country case; thus, a < c < b.
6. Rank the following in ascending order of Home welfare and justify your answers. If two items are equivalent, indicate this accordingly.
a. Tariff of t in a small country corresponding to the quantity of imports M.
b. Quota with the same imports M in a small country, with quota licenses distributed to Home firms and no rent seeking.
c. Quota of M in a small country with quota licenses auctioned to Home firms.
d. Quota of M in a small country with the quota given to the exporting firms.
e. Quota of M in a small country with quota licenses distributed to rent-seeking Home firms.
Answer: d = e < a = b = c. A tariff t corresponding to imports M, and a quota on M units of import corresponding to tariff t are equivalent in terms of welfare so long as proceeds from quota rents remain in the Home country and are not squandered by rent-seeking activities: a = b = c. When quota rents are either given away to Foreign firms or are squandered completely by Home firms seeking access to rents, Home welfare diminishes by an equal amount (the amount of the quota rents): d = e < a = b = c.
7. Suppose Home is a small country. Use the graphs below to answer the questions.
a. Calculate Home consumer surplus and producer surplus in the absence of trade.
Answer: Total surplus in the absence of trade is 35.
Consumer surplus without tariff: Producer surplus without tariff:
CS = 0.5 . 5 .(18 - 9) PS = 0.5 . 5 . (9 - 4)
CS = 22.5 PS = 12.5
b. Now suppose that Home engages in trade and faces the world price, P*= $6. Determine the consumer and producer surplus under free trade. Does Home benefit from trade? Explain.
Answer: Home is better off with trade because total surplus increases by 15 (i.e., total surplus under trade is 50).
Consumer surplus under free trade: Producer surplus under free trade:
CS = 0.5 . 8 .(18 - 6) PS = 0.5 . 2 . (6 - 4)
CS = 48 PS = 2
c. Concerned about the welfare of the local producers, the Home government imposes a tariff in the amount of $2 (i.e., t = $2). Determine the net effect of the tariff on the Home economy.
Answer: The net effect on Home welfare is -8.
Consumer surplus with tariff: Producer surplus with tariff:
CS = 0.5 . 6 . (18 - 8) PS =0.5 . 4 . (8 - 4)
CS = 30 PS = 8
Government with tariff:
Government = (6 - 4) . (8 - 6)
Government = 4
Fall in consumer surplus: -18
Rise in producer surplus: +6
Rise in government revenue: +4
Net effect on Home welfare: -8 8. Refer to the graphs in problem 8. Suppose that instead of a tariff, Home applies an import quota limiting the amount foreign can sell to 2 units.
a. Determine the net effect of import quota on the Home economy if the quota licenses are allocated to local producers.
Answer: An import quota of 2 units has the same net effect on Home welfare as an equivalent tariff of $2 when the quota licenses are allocated to local producers as long as the firms do not participate in rent-seeking activities.
Fall in consumer surplus: -18
Rise in producer surplus: +6
Rise in government revenue: +4
Net effect on Home welfare: -8 b. Calculate the net effect of the import quota on Home’s welfare if the quota rents are earned by foreign exporters.
Fall in consumer surplus: -18
Rise in producer surplus: +6
Net effect on Home welfare: -12
c. How do your answers to parts (a) and (b) compare with part (c) of problem 8?
Answer: With an import quota of 2 units the net effect on Home welfare is equivalent to that of a tariff of $2 (i.e., the net effect on Home welfare is -8) when the quota licenses are allocated to local producers. If the quota rents are earned by foreign exporters, Home welfare falls further so that the net effect is -12.
Questions from Ch 9
1. Figure 9-1 shows the Home no-trade equilibrium under perfect competition (with the price PC), and under monopoly (with the price PM). In this question, we compare the welfare of Home consumers in these two situations.
a. Under perfect competition, with the price PC, label the triangle of consumer surplus and the triangle of producer surplus. Outline the area of total Home surplus (the sum of consumer surplus and producer surplus).
Answer: Refer to Figure 9-1: Consumer surplus is the area under the demand curve D and above the market price, and producer surplus is the area above the marginal cost curve MC and below the market price. Under perfect competition, consumer surplus is PCBPD, where PDis the intersection of the demand curve with the vertical axis. Producer surplus is PCBPMC, where PMC is the intersection of the marginal cost curve with the vertical axis. Total surplus is thus represented by the triangle PMCBPD. b. Under monopoly, with the price PM, label the consumer surplus triangle.
Answer: Refer to Figure 9-1: Consumer surplus is the triangle PMAPD. c. Producer surplus is the same as the profits earned by the monopolist. To measure this, label the point in Figure 9-1 where the MR curve intersects MC at point B’. For selling the units between zero and QM, marginal costs rise along the MC curve, up to B’. The monopolist earns the difference between the price PMand MC for each unit sold. Label the difference between the price and the MC curve as producer surplus, or profits.
Answer: Refer to the following figure: Producer surplus is represented by the trapezoid PMAB’PMC.
d. Outline the area of total Home surplus with a Home monopoly.
Answer: Refer to the figure from part (c): Total surplus is represented by the trapezoid PDAB’PMC.
e. Compare your answer with parts (a) and (d) and outline the difference between these two areas. That difference is called the deadweight loss due to monopoly.
Answer: Refer to the figure from part (c): The deadweight loss due to monopoly is represented by the triangle ABB’.
2. Figure 9-2 shows the free-trade equilibrium under perfect competition and under monopoly (both with the price PW). In this problem, we compare the welfare of Home consumers in the no-trade situation and under free trade.
a. Under perfect competition, with the price PW, label the triangle of consumer surplus and the triangle of producer surplus. Outline the area of total Home surplus (the sum of consumer surplus and producer surplus).
Answer: Refer to the following figure: The free-trade equilibrium under perfect competition has a Home consumer surplus of PDB’PW, and a producer surplus of PWBPMC.
b. Based on your answer to part (a) in this problem and part (a) of the last problem, outline the area of gains from free trade under perfect competition.
Answer: Refer to the figure from part (a): Gains from trade are represented by the shaded triangle.
c. Under monopoly, still with the price PW, again label the triangle of consumer surplus and the triangle of producer surplus.
Answer: Refer to the figure from part (a): The free-trade equilibrium under monopoly has a Home consumer surplus of PDB’PW, and a producer surplus of PWBPMC . This is identical to the free-trade surplus under perfect competition.
d. Based on your answer to part (c) in this problem and part (d) the last problem, outline the area of gains from free trade under Home monopoly.
Answer: Refer to the following figure: Gains from trade are represented by the shaded area.
e. Compare your answer with parts (b) and (d). That is, which area of gains from trade is higher and why?
Answer: The area representing gains from trade is larger in part (d) than in part (b). This is because the opening of trade in the monopoly case eliminates the monopolist’s ability to charge a price higher than the perfectly competitive price. As such, trade additionally eliminates the deadweight loss associated with monopoly, making gains from trade higher.
3. Rank the following in ascending order of Home welfare and justify your answers. If two items are equivalent, indicate this accordingly.
a. Tariff, t, in a small country with perfect competition.
b. Tariff, t, in a small country with a Home monopoly.
c. Quota with the same imports M in a small country, with a Home monopoly.
d. Tariff, t, in a country facing a Foreign monopoly.
Answer: c < a = b < d. As shown in problem 2, a small country with free trade has equivalent levels of welfare under either perfect competition or monopoly. Adding a tariff in either case reduces welfare due to the deadweight loss associated with the tariff, but does not reintroduce any additional deadweight losses due to monopoly. Thus, a = b. A quota in a country with a monopoly maintains the market power of the monopolist, and the deadweight loss due to monopoly is additive to the deadweight loss due to the quota, such that: c < a = b. Finally, a tariff with a Foreign monopoly can actually increase welfare because it generates a terms-of-trade gain, and hence: a = b < d.
5. Why is it necessary to use a market failure to justify the use of infant industry protection?
Answer: If all markets are working perfectly, there is no reason why a potentially successful fledgling industry cannot survive without government intervention. Let us consider the two justifications for using an infant industry tariff. The first is that the industry will learn over time, which will drive down its average costs to the point where it is competitive; if credit markets were working perfectly, that industry could borrow against future profitability to keep it in business until that time. The second justification explicitly assumes a market imperfection: A positive externality in production implies that the socially optimal level of infant industry output is above that determined by the market equilibrium.
6. What is a positive externality? Explain the argument of knowledge spillovers as a potential reason for infant industry protection.
Answer: Positive externality exists when the increase in production by one firm generates benefits to other firms by lowering industry costs. By imposing the tariff, the government could nurture the infant industry because the increase in output allows the firms to reduce their future costs by learning from each other. Without the protection, each firm on its own would lack the incentive to invest in learning through increasing its current production.
7. If infant industry protection is justified, is it better for the Home country to use a tariff or a quota, and why?
Answer: To the extent that the Home infant industry has market power, it is better to use a tariff rather than a quota. The infant industry calculus weighs the benefits of future producer surplus against current deadweight losses due to protection. Because deadweight losses are greater under a quota due to maintaining Home market power, infant industry protection has a better chance of being worthwhile by using a tariff.
8. In this problem, we analyze the effects of an import quota applied by a country facing a Foreign monopolist. In Figure 9-10, suppose that the Home country applies an import quota of X2, meaning that the Foreign firm cannot sell any more than that amount.
a. To achieve exports sales of X2, what is the highest price that the Foreign firm can charge?
Answer: Refer to the following figure: To achieve export sales of exactly X2, the Foreign monopolist would charge P2.
b. At the price you have identified in part (a), what is the Home consumer surplus?
c. Compare the consumer surplus you identified in part (b) with the consumer surplus under free trade. Therefore, outline in Figure 9-10 the Home losses due to the quota. Hint: Remember that there is no Home firm, so you do not need to take into account Home producer surplus or tariff revenue. Assume that quota rents go to Foreign firms.
Answer: Refer to the figure in part (a): Consumer surplus under free trade is a triangle with area b +c +d. Under a quota, consumer surplus decreases by c + d. The Home welfare loss due to the quota is thus area c +d.
d. Based on your answer to (c), which has the greater loss to the Home country: a tariff or a quota, leading to the same level of sales X2 by the Foreign firm?
Answer: Because there is no terms-of-trade gain associated with the quota, welfare is lower under a quota regime relative to a tariff regime.
9. Consider the case of a Foreign monopoly with no Home production, shown in Figure 9-10. Starting from free trade at point A, consider a $10 tariff applied by the Home government.
a. Assuming that the demand curve is linear, as in problem 10 of Chapter 6, what is the shape of the marginal revenue curve?
Answer: The shape of the marginal revenue curve is also linear, but twice as steep.
b. Therefore, how much does the tariff-inclusive Home price increase because of the tariff, and how much does the net-of-tariff price received by the Foreign firm fall?
Answer: Because the marginal revenue curve is steeper than the demand curve (twice as steep in this case), the vertical increase along the marginal revenue curve of $10, reflecting the tariff, is twice as much as the corresponding vertical increase along the demand curve. Thus, the Home tariff-inclusive price increases by $5 and the net-of-tariff Foreign price decreases by $5.
c. Discuss the welfare effects of implementing the tariff. Use a graph to illustrate under what conditions, if any, there are increases in Home welfare.
Answer: Refer to the following figure: The tariff decreases Home consumer surplus by the area c _ d, increases government revenue by the area c, and improves Home’s terms of trade by the area e. Thus if e exceeds d, there is an overall welfare gain from the tariff.
Problem Set 3: Trade Policy 2:Export Subsidies and other policy tools
Which of the following are potentially valid arguments for tariffs or export subsidies, and which are not (explain your answers)?
a. “The more oil the United States imports, the higher the price of oil will go in the next world shortage.”
This could make a valid argument for import tax. This works like tax on foreign monopoly.
b. “The growing exports of off-season fruit from Chile, which now accounts for 80 percent of the U.S. supply of such produce as winter grapes, are contributing to sharply falling prices of these former luxury goods.”
This does not make a good case for import tariff. Winter grapes are no competing Home Summer grapes and thy don’t have any negative externalities.
c. “U.S. farm exports don’t just mean higher incomes for farmers – they mean higher income for everyone who sells goods and services to the U.S. farm sector.”
This argument can be made more or less about any industry. This doe not make a good argument for protection.
d. “Semiconductors are the crude oil to technology; if we don’t produce our own chips, the flow of information that is crucial to every industry that uses microelectronics will be impaired.”
This could make a good case for infant industry and thus some sort of protection including import tariff.
e. “The real price of timber has fallen 40 percent, and thousands of timber workers have been forced to look for other jobs.”
This is not a good argument for protection. There is no particular externality associated with the timber industry. And protection is not a good policy for keeping jobs.
On the following page of this problem set there is a three panel graph. In the left hand panel are the demand and supply curves in the Home country for some good Q. In the right hand panel are the demand and supply curves for the Foreign country for the same good. Both Home and Foreign are "large" countries.
A. (a) In the middle panel, draw the import demand (MD) and export supply (XS*) curves for Home and Foreign, respectively. Be sure to label the curves.
(b) Label the equilibrium world price in free trade as PoW, and indicate quantities consumed (QD) and produced (QS) in each country, as well as the quantity of good Q traded (label this Mo).
B. Suppose that Foreign imposes a specific export tax of $t.
(a) Show the new equilibrium price in Home and in Foreign, plus the new level of good
Q traded (label this M1). Also indicate the new quantities produced and consumed in each country.
(b) Label the areas in the right hand panel. Relative to free trade, what is the
i) change in Foreign consumer surplus?
CS* = b + c ii) change in Foreign producer surplus?
PS* = -[ b + c + d + e + f ] iii) change in the Foreign government’s revenue?
Gov R* = a + e
iv) total change in Foreign’s welfare. Explain why/whether Foreign’s export tax makes Foreign better off.
.W* = a – d - f The total effect of an export tax imposed by foreign is ambiguous. It depends on the size of the government revenue and the dead weight losses that results from over consumption and under production in the foreign country.
(c) Label the areas in the left hand panel. Relative to free trade, what is the
i) change in Home consumer surplus?
CS = -[ a + b + c + d ]
ii) change in Home producer surplus?
PS = a
iii) change in Home government’s revenue?
Gov R = 0
iv) total change in Home welfare? Explain why/whether Foreign’s export tax makes Home worse off.
W = -[ b + c + d ] (d) Define global welfare as the sum of consumer surpluses, producer surpluses, and government revenues for each country. Using the labeled areas from the graph, what is the effect of the export tax on global welfare?
Does the export tax raise/lower/have an ambiguous effect on global welfare?
Wg = a - [ b + c + d + d + f ] = - [ b + d + d + f ] for a = c. Does the export tax raise/lower/have an ambiguous effect on global welfare?
The export tax has a negative effect on global welfare for a = c.
C. Indicate on the graph above the VER that would be equivalent to Foreign’s export tax t.
(a) Would Home be better off/worse off/indifferent if Foreign used a VER instead of an export tax? Explain.
Home is indifferent to foreign using a VER or an export tax to restrict trade. Home faces the same import price as before. The difference is now that the foreign producers now receive the government revenue, previously collected by the foreign government from the tax, as rents derived from their restricted production.
(b) Would Foreign producers be better off/worse off/indifferent if Foreign used a VER instead of an export tax.? Explain.
Foreign producers will definitely better off with a VER than an export tax. With the tax they have to pay areas a & e to the government while with the VER they would receive this money in the form of rents (This is assuming that the foreign producers get the VER rents. The government may allocate them in a different way).
Problem Set 4: Trade Creation and Diversion, Strategic trade
As a result of political and economic liberalization in Eastern Europe, it seems increasingly likely that Eastern European nations such as Poland and Hungary may join the European Union in the near future. Discuss the potential economic costs of such an expansion of the European Union, from the point of view of (1) Western Europe; (2) Eastern Europe; and (3) other nations (like the U.S.).
The potential economic costs associated with the entrance of Poland and Hungary into an expanded EU depend largely on whether their membership results in trade creation or trade diversion.
(1) The Western nations should also be concerned on the trade creation versus trade diversion aspects of the entry of Poland and Hungary. For distributional and political reasons, they may be concerned about whether the prices of their own products will be driven down by competition or whether the entrants will simply bring to the Western markets an expanded variety of products and scope for additional scale economies of production. Workers in Western markets may be concerned that inflows of foreign labor drive down wages, although, as we have observed in previous chapters, the nominal wage shifts should be considered in light of changes in the prices of consumption goods.
(2) In particular, Poland and Hungary will gain if they engage in new trade with
Western Europe although they might lose if trade within the European Union simply replaces trad,e which had been occurring with Eastern bloc countries. Furthermore, both of these nations will face at least higher structural unemployment during the transition period. Some of the negative effects on workers might be lessened if labor mobility is permitted across borders.
(3) Countries outside of the EU, such as the United States and Japan, would express concern if the supplies of products to the EU by Poland and Hungary substitute for goods previously supplied by the United States and Japan. The large outsiders, however, could reap substantial positive gains from having expanded access to the consumers of Poland and Hungary.
The U.S. Commerce Department has urged that the United States provide special support for high-technology industries. It argues that these industries have the prospects of rapid future growth, provide inputs to many other industries, and generate technology that benefits the whole economy. Furthermore, some U.S. high-technology industries such as aircraft and microelectronics face challenges by government-supported foreign competitors. Which of these arguments might be valid reasons for the United States to have a policy targeting these industries?
A valid reason for supporting high-technology industries would be that they generate technologies which benefit the whole economy. The value to the whole economy of this aspect of the high-technology firms' existence exceeds the benefits to the firms themselves, and there will be too little expansion of these firms from a social point of view. Other stated benefits are not valid reasons for industrial policy since the market provides incentives for the realization of these benefits. The protection from foreign competition is also a spurious argument since, as has been shown in previous chapters, the economy as a whole benefits from cheap foreign high-technology goods. The exception being if the industry provides monopoly rents and the foreign government is trying to capture these rents for its home economy.
Does the U.S. military budget help or hurt the strategic position of U.S. high-technology industries? Make the case for either point of view.
The potential gains for the high technology industries depend on the extent to which a great deal of government sponsored research and development is filtered through the military budget. This is especially relevant when military expenditures on research and development have spillover effects and produce a marginal social gain of knowledge which benefits other firms in U.S. industry. However, there are several caveats to this argument. To the extent that military industry is particularly concentrated and oligopolistic, there may be a serious market failure. More importantly, there remains the issue of how relevant and applicable will be any knowledge spillovers from military research and development to the high technology sectors. Moreover, the military fields may be siphoning off many highly talented researchers from civilian high-technology industries. Much of it may not be well-suited. In this case, the goal of developing a broad application to high technology through military research would not be a well-targeted program.
Suppose that the European Commission asked you to develop a brief on behalf of subsidizing European software development –bearing in mind that the software industry is currently dominated by U.S. firms, notably Microsoft. What arguments would you use? What are the weaknesses in those arguments?
A primary argument must be that there is some sort of market failure that voids the standard logic of free trade. One might argue that Microsoft’s’ monopoly position allows it to capture excessive profits, and that its market power dissuades entry. A state-sponsored firm might be able to over-come these entry costs. Furthermore, the software industry may have numerous knowledge spillovers with other industries and high-tech applications that make it desirable to have some local presence even if the local industry loses money. On the other hand, Microsoft may be a natural monopoly. It is much easier for the world to have one computer standard. Furthermore, state direction of an industry where innovation is so important is unlikely to be successful. Finally, in software, physical location may be of minor importance as ancillary industries could develop anywhere and use modern telecommunications technology to interact with U.S. based software firms.