II. Efficient policymaking in global markets
A. First-best policy making

    Last time: examined taxes in a closed (Econ101) economy:
    result: only the size of the tax matters:
    It doesn't matter if you impose the tax on the consumer or the producer, supply and demand determine how the tax gets divided up into a higher price paid by buyers (Pbt) and a lower price received by sellers (Pst).

    Now let's see how taxes differ in a global economy.

Key difference in Econ311:     For a small open economy, taxes and subsidies affect only the targeted party, which makes them more effective     The other side of the market remains free to buy or sell at the global price     So all you have to do is just adjust Pf by the size of the tax or subsidy     $1 consumption tax on cigarettes: PB rises to $1 above Pf, and Qd falls     PSt remains = Pf, so QP remains the same.

    Examples:  first-best policymaking handout
    Consider a small-country importer

    Example 1: an infant industry
    Goal: expand domestic production
    Which policies increase domestic production?

Results vs. free trade   1 Tariff 2 Prod.sub. DCS -abcd 0 DPS +a +a DGovtRev +c -ab DNW -bd -b If social benefit of domestic steel production >b, then NW rises overall tariff = "infant industry protection"
	Domestic steel market

    Result 1: Trade policy is a second-best policy for promoting production because it is less direct and causes unintended side effects.
    Stern: "Trade policy is like doing acupuncture with a fork: no matter how carefully you insert one prong, the other is likely to do damage."
    a production subsidy is a first-best policy for increasing domestic production

    Why do you think the government might choose trade protection anyway?
    Result 2: Politicians might choose trade protection for budgetary and political reasons
    Tariff: +c vs. Production Subsidy: -ab
    But it's misleading, since it ignores that taxpayers gain back abcd as consumers with the subsidy, enough to pay ab for the subsidy and replace the lost tariff revenue (c) and still come out ahead.
    Subsidies also make the cost more transparent--so economists prefer subsidies.

    Example 2: solar power
    Goal: expand domestic consumption
    Why? external benefits from consumption (XMB)

    Policy recommendation? a consumption subsidy

Results vs. free trade   Consumption subsidy DCS +abcd DPS 0 DGovtRev -abcde DNW w/o XMB -e If social benefit of more solar power use >e, then NW rises overall
	Domestic solar energy market

    What would have happened to domestic consumption with a production subsidy instead? nothing--a production subsidy would not affect the price buyer's pay
    A price ceiling causes a greater shortage in an open economy because Qs falls to zero without export restrictions

    China uses production subsidies for its solar industry
    The US uses consumption subsidies (tax rebates for installing solar)
    China's is not a first-policy and may therefore violate WTO provisions

    Example 3: oil
    Goal: reduce dependence on imports
    Why? external costs from imports (XMCtrade)

    Policy recommendation? a trade restriction

Results vs. free trade   Trade restriction DCS -abcd DPS +b DGovtRev or quota rents +c DNW w/o XMCtrade -bd If social benefit of lower oil imports >bd, then NW rises overall
	Domestic oil market

    What would you recommend if the goal is to reduce overall consumption of oil?
    A consumption tax--ex: higher gasoline taxes

    Worksheet key

    General principles for first-best policymaking
    Clearly specify your goal: change (1) consumption, (2) production or (3) trade.
    Choose a policy that precisely targets your goal: (1) tax or (2) subsidize exactly what you want to change.

    Since most social objectives concern production and consumption, a trade policy is rarely a country's first-best policy