Oligopoly, Increasing Returns, Tariffs and FD/. Recall from Chapter 3 that one motivation for setting up a branch plant in a foreign country is to avoid transport costs and tariffs, but this has to be weighed against increasing returns, which argues for concentrating production in one location. Here, we can put those ideas together with oligopoly. Consider the model of the auto industry from Section 10.5, using the demand curve and production costs introduced in Section 10.4 but maintaining a Cournot assumption, and introduce transport costs, so that now either automaker must pay a cost of $1,000 per car sold in the other country. Suppose that in addition to the marginal production cost of $5,000 per car, each firm must incur a fixed cost per plant, and under free trade this fixed cost is enough that GM chooses to maintain just its U.S. plant, exporting to Japan, and Toyota maintains just its Japanese plant, exporting to the United States. However, if the U.S. tariff is high enough, Toyota will choose to set up a U.S. plant, from which it can supply the U.S. market without paying transport costs or tariffs. This is called tariff-jumping FD/.
(a) Compute the equilibrium in the U.S. market under free trade, taking the transport costs into account.
(b) Now, do the same under the assumption that the U.S. government imposes a tariff high enough to induce Toyota to set up a U.S. plant.
(c) Taking into account consumer surplus, GM profit, and tariff revenue, what is the effect of the tariff described in part (b) on U.S. welfare?
(d) Usually, a tariff on an imported product raises the domestic price of that product, lowering consumer surplus. Is that true of this tariff? Explain.
(e) Usually, a tariff on an imported product raises the income of domestic producers of that product. Is that true of this tariff? Explain.
(f) Does this example suggest that a tariff to encourage FDI is an attractive strategy? Explain.