The United States is a Small Country in World Trade

Christopher S. P. Magee1

Stephen P. Magee2

Abstract Despite being the largest country in world trade and thus presumably having high optimal

tariffs, the United States has been a champion of free trade since the 1930’s, with low and

declining levels of protection. This paradox suggests that the United States is failing to

exploit its monopsony power by levying optimal tariffs. We use data on world output

and trade flows and find that the influence of U.S. tariffs on world prices is negligible in

most industries. In the median manufacturing industry, U.S. tariffs reduce world prices

by only 0.12%. We also find that optimal tariffs are typically small (3.6% in the median

manufacturing industry) and are lower than existing U.S. tariffs in most industries. It is

no puzzle that the United States has long been a champion of free trade – U.S. tariffs

raise domestic prices, but with negligible reductions in world prices.

JEL Codes: F1, D4, L1

1 Department of Economics, Bucknell University, Lewisburg, PA 17837; phone (570) 577-1752; fax (570)

577-3451; email: cmagee@bucknell.edu

2 Department of Finance, University of Texas, Austin, TX 78712; phone (512) 471-5777; fax (512) 471-

5073, email: magee@mail.utexas.edu.

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1. Introduction

Consider the following paradox. The United States is the largest country in the

world with over 21% of world income, 17% of world imports, and 10% of world exports

in 2003.3 According to the standard optimal tariff argument for large countries, then, the

United States should be one of the most protectionist countries in the world. Since the

1934 Reciprocal Trade Agreements Act, however, the United States has been one of the

leading proponents of more open borders and has tariffs that are currently among the

lowest in the world.4 Is the United States a large country in world trade? Is it failing to

exploit its monopsony power in world trade markets by setting tariffs well below their

optimal levels? We show in this paper that by several different measures and for most

industries, the United States is a small country because the impact of its trade barriers on

world prices is negligible.

The results in this paper are contrary to the widespread view that the United

States is a large country in world trade. In their undergraduate textbook International

Economics, for instance, Husted and Melvin (2001, 168) state that the United States,

while it rarely tries to use protection to influence its terms of trade, “certainly has the

market power to do so.” Carbaugh (2000) claims that the case of a country large enough

to influence world prices of imported goods “could apply to the United States … and to

other economic giants, such as Japan and the European Union.” These authors represent

well the views of the profession and our own views before we wrote this paper.

The belief among international economists that the United States is a large

country in world trade is very plausible considering that it is the world’s largest importer

and can reasonably be assumed to influence prices in many world markets in the short

run. But the industrial organization literature has taught for a half century that the United

States has monopsony power only if it can control prices in a given world market for a

3 CIA World Fact Book, 2004. 4 Based on World Bank and WTO data, the United States has the 10th lowest average tariffs (unweighted) among 82 countries in 1998.

2

nontransitory period after a tariff increase by preventing countries from substituting their

exports away from the United States to other markets. Both concentrations measures and

calculations based on elasticity estimates in this paper confirm that the United States is

not a large country because it does not have such monopsony power in world markets.

Even with prohibitive tariffs on all U.S. imports, we find that world prices would only

fall by 4 percent and the United States would receive no economic gains because it would

have eliminated all its imports. In individual products, prohibitive U.S. tariffs would

lower world prices by more than 10% in only two out of 28 industries, accounting for 6%

of U.S. manufacturing imports.

Very few papers have attempted to determine empirically whether U.S. trade

policies influence world prices. Hufbauer and Elliot (1994) calculate the impact of U.S.

tariffs on world prices for a number of different industries, with estimates ranging from a

0.8% fall in the world price of ball bearings to an 8.3% decline in the world price of

orange juice. The authors point out that these estimates are likely to be overstated

however, because they have chosen a conservatively low estimate (3.0) of the world

supply elasticity for exports to the United States. Haynes and Stone (1983) estimate an

elasticity of world supply to the U.S. of 10, which would suggest much smaller world

price effects. Broda, Limao, and Weinstein (2006), on the other hand, estimate much

lower export supply elasticities and conclude that many countries have market power in

world trade. A more extensive discussion of their results appears later in the paper.

Edgeworth (1894), Bickerdike (1907) and Marshall (1923, 213)5 all showed that

large countries in world trade could improve their welfare by raising tariffs and driving

down the world prices of their imports. Thoughtful international economists have since

complicated their models to incorporate large country effects, presumably so that their

models would apply to the United States.6

5 We are indebted to the late Charles P. Kindleberger for the reference to Alfred Marshall’s (1923) paper. 6 A casual examination of papers in international economics over the period 1991-1993 indicated that about half of them made the large-country assumption, either explicitly or implicitly.

3

The hypothesis that the U.S. is a large country has always appeared to contradict

“America’s commitment to a system of open trade” (Irwin, 2002, p. 225) and the fact that

the U.S. was one of the leading advocates of GATT tariff reductions. If the terms of

trade effect is an important consideration driving country tariff levels, we would expect

the United States to have higher protection than everyone else. The apparent irrationality

of the U.S. favoring freer trade than its partners is discussed in Krasner (1976) and

Keohane (1984) in the international relations literature on the U.S. hegemony. In this

literature, the United States chose not to exercise its monopsony power and raise our

protection to optimal tariff levels for political reasons, such as our role as a hegemonic

world leader. Another theory advanced to reconcile the apparent contradiction between

high optimal and low actual tariffs in the United States is provided by Coates and

Ludema (2001). They show that home country liberalization can weaken import-

competing interests in foreign countries and thus raises the likelihood they will approve

trade liberalization measures themselves. Under some conditions large country unilateral

tariffs are lower than small country tariffs.

This paper advances a different hypothesis to explain the contradiction between

the optimal tariff argument and U.S. commitment to open trade. We argue here that for

the vast majority of industries, the United States, like every other nation in the world, is a

small country. We show that if world markets are integrated, then U.S. tariffs have

negligible impacts on world prices. We also estimate that optimal U.S. tariffs are

between 3 and 4 percent in the median industry. Thus, actual U.S. tariff levels are above

optimal levels in most industries, and it is a misconception to see the United States as

surrendering its monopsony power. Only in recent years (during which time the U.S.

commitment to a system of free trade appears to have softened) have tariffs in some

industries dropped below their optimal levels. As a result, U.S. welfare has unilaterally

increased as it cut protection over the past 70 years. Beginning with the Reciprocal

Trade Agreements Act of 1934, the United States has gained even further by inducing

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foreign countries to lower their trade barriers on U.S. goods through bilateral and later

GATT and WTO multilateral negotiations. Thus, our estimates provide a simpler

explanation of the United States’ push for open trade policies than the political-economic

tradeoffs required in the hegemonic literature.

This paper addresses two separate questions. First, in what industries does the

United States have the market power to influence world prices? Second, has the United

States exploited its market power by using tariffs to influence world prices? The next

two sections explore these questions, and section 4 concludes.

2. Does the United States have the market power to influence world prices?

All countries with positive levels of imports can affect world prices to some

degree in the short run by changing their trade policies. For most countries, however, the

nontransitory impact on world prices will be negligible because of exit and substitution to

other markets. The question of an importing country’s market power in international

markets is directly related to the question of monopoly and monopsony power studied by

industrial organization economists.

The vast majority of industrial organization studies have been about monopoly,

but the lessons carry over directly to monopsony. All oligopoly and monopolistically

competitive firms can raise the price of their output but they do not have monopoly

power unless they can maintain the high price for a sustained period of time using

barriers to entry. Absent barriers to entry, existing suppliers and market entrants will

drive elevated prices back to competitive levels. For the case here, the United States

cannot exercise monopsony power using its tariffs unless it can drive down world prices

and then keep them down. Foreign exporters may accept lower prices in the short run to

continue exporting to the United States but if the price in world markets does not decline,

5

then they will eventually shift their exports to alternative destinations unless something

prevents them from doing so.

So what are the standards for monopoly power in U.S. antitrust law and practice?

The U.S. Justice Department Guidelines7 for horizontal mergers defines a product market

as a collection of products within which a firm or group of firms exercising monopoly

power could successfully implement a "small but significant and nontransitory" increase

in price. The Guidelines read: “In attempting to determine objectively the effect of a

‘small but significant and nontransitory’ increase in price, the Agency, in most contexts,

will use a price increase of five percent lasting for the foreseeable future.”8

The Guidelines do not directly specify the length of the “foreseeable future”9 but

on the questions of competitive entry they read: “The Agency generally will consider

timely only those committed entry alternatives that can be achieved within two years

from initial planning to significant market impact.”10 Jorde and Teece11 have argued that

“the DOJ one year and two-year rules are too short for almost any case of serious

technological advance.” For high tech products, they suggest a four-year period as the

length of time that prices would have to be elevated in a monopolized market.

Carlton and Perloff (2005, 679), in their industrial organization text, define

market power as “the ability to set price profitably above the competitive price.” They

7 http://www.ftc.gov/bc/docs/horizmer.htm#N_6_ 8 This is called the “SSNIP test,” which defines a relevant market as one worth monopolizing, that is, one in which a monopolist could increase its profits with a small but significant and nontransitory increase in price. 9 However, there are indications of relevant time periods from the discussions of entry in the guidelines. If prices were to be elevated by monopoly power following a merger, the government is concerned with how fast the anticompetitive prices might be reduced by entry. 10 Even if the entry of new or constrained capacity may require more than two years, however, the Agency still sees new entry as pricing discipline that might deter monopoly pricing: “If entry only can occur outside of the two year period, the Agency will consider entry to be timely so long as it would deter or counteract the competitive effects of concern within the two year period and subsequently.” 11 http://www.ftc.gov/opp/global/jorde2.shtm

6

point out that because the extent of a firm’s market power is difficult to determine,

“courts and economists often use market share as a rough guide to whether a firm has

market power.” Bradburd and Over (1982) report critical values for the four-firm

concentration ratio of 50% to 60%, above which industry prices increase. Further, the

U.S. courts have adopted a 50% market share as a “prerequisite for a finding of

monopoly.” (Cameron and Glick, 1996, p. 193) Carlton and Perloff (2005, 6) indicate

that it is virtually impossible to control prices in contestable markets in which firms can

enter and exit rapidly, even with only one or a few firms present.

Table 1 provides the shares of world imports in 2003 accounted for by the 20

largest importers, with the four-country concentration ratio for world imports and exports

(36%) near the bottom of the table.12 As Table 1 shows, the United States had a 17

percent share of world imports in 2003. This falls far short of 50% standard required in

the United States for monopsony power and the ability to control prices in a market. If

the United States tried to lower world prices by raising its tariffs, foreign suppliers would

substitute into the other 83 percent of the world market. Supplier substitutability

undermines the ability of a buyer with such a small market share to control prices.

In addition to concentration ratios, a second measure of market power is

commonly used by industrial organization economists and the U.S. Federal Trade

Commission in its analysis of mergers -- the Herfindahl-Hirshman Index (HHI). The

HHI is the sum of the squared market shares of suppliers in a market, with theoretical

values ranging from near 0 (tens of thousands of small farmers) to 10,000 (one monopoly

12 The four-country concentration ratio in world imports is only 36%, but that would be relevant only if the United States colluded with the next three largest importers (German, China and the United Kingdom) to drive down world prices using protection. We are unaware that this has ever happened. Exporting countries have coordinated price increases through voluntary export restraint agreements with the United States and other countries, but these agreements have acted to raise the prices received by the those exporters rather

7

seller). Cameron and Glick (1996. p. 194) discuss how the Federal Trade Commission

uses the HHI “as a screening device to filter out cases that require no further competitive

analysis.” The U.S. Justice Department and the U.S. Federal Trade Commission use the

following cutoff points for the values of the HHI in evaluating mergers in markets: 0-

1,000 means a market is not concentrated; 1,000-1,800 means intermediate concentration;

and above 1,800 means it is highly concentrated (Carlton and Perloff, 2005, 645).

The last two rows in Table 1 show that the HHI equals 561 for world imports and

415 for world exports. Both of these values are in the middle of the Justice Department-

FTC's most competitive range of 0 to 1,000. With such low market concentration, it is

clear that world trade is not concentrated.

The conclusion above does not change when we examine trade at an industry

level. Figure 1 summarizes the results of calculating the HHI for 1998 world trade in 434

4-digit SITC industries, again treating each country as a firm. Measuring the HHI by

industry reveals that 320 of the industries (accounting for 71% of world trade flows) are

not concentrated, 94 industries (accounting for 27% of trade flows) had intermediate

levels of market concentration, and only 20 industries (with less than 2% of the total

import value) had highly concentrated market power by country.13

In short, world import markets are not concentrated and the United States share of

world imports is too low for it to have monopsony power. In reality, this 17% share of

world imports dramatically overstates the ability of the United States to influence world

than lowering the prices they receive as would be the case if the United States was exercising its power as a monopsonist. 13 More detailed calculations for some of the results in this paper can be found in Magee, Yoo, Choi and Lee (2008). They examine U.S. shares of world trade for exporters geographically closest to the United States. They found that United States import shares are less than 30% for over 80% of the total trade in that geographic area. For none of the products in that geographic market did the United States import share exceed 50%.

8

prices. World prices are determined by world supply and demand, and the world supply

of goods is many times larger than the existing international trade flows.

As long as producers can move their output between domestic sales and exports,

the U.S. market power in trade policy depends not on the U.S. share of world imports but

on U.S. imports as a share of the total world supply of a good. In 2003, the United States

imported $1.26 TR worth of goods while world goods produced output outside the U.S.

were valued at $17.3 TR.14 The market controlled by U.S. trade policy, then, amounts to

only 7.3% of the supply of potential U.S. imports. The United States market power may

be larger in sectors that are heavily traded because the goods output cited above includes

nontraded goods. Based on the standards outlined in the industrial organization

literature, however, the United States does not have sufficiently high market shares for

monopsony power and the ability to control prices in world markets.

We turn now to a simple model of world supply and demand that reveals more

directly the effect of U.S. tariffs on world prices. Figure 2 illustrates the effect of a drop

in U.S. imports due to tariff protection on world prices. Let rowS be the supply curve for

all countries outside of the U.S., and rowD be the demand curve in the rest of the world.

Demand outside of the U.S. plus U.S. demand for foreign goods ( usM ) must equal the

supply in the rest of the world plus the U.S. supply into world markets ( usX ). Suppose

that a U.S. trade barrier would reduce imports by usMΔ (from usM to 'usM ) if the world

price remained constant. The original world equilibrium is at point E, with a world price

of wP and quantity produced outside the U.S. of rowQ . The fall in U.S. demand shifts

14 World GDP outside the U.S. in 2003 equaled $40.43 trillion according to the CIA World Fact Book, 2004. Lipsey (2006, 14) reports that world goods output equaled 42.7% of world GDP in 1985-90. The product of these numbers yields $17.3 trillion as a rough estimate of 2003 non-U.S. world goods output.

9

the demand inward to 'usrow MD + , and the new equilibrium is at point 'E , with a world

price of 'wP and quantity produced of 'rowQ . We assume here that the demand and supply

curves have constant elasticities (similar results emerge when there are linear demand

curves). The equations for the demand and supply curves are:

(1) dPMQ usrowdε=+,

(2) sPXQ usrowsε=+, ,

where sε is the elasticity of supply in the rest of the world and dε is the demand

elasticity. Because the world demand curve includes U.S. imports, this demand elasticity

will be a weighted average of the ROW price elasticity of demand ( rowd ,ε ) and the U.S.

import demand elasticity ( mdε ):

(3) usrowd

usmdrowdrowdd MQ

MQ+

+=

,

,, εεε .

Notice that this setup is partial-equilibrium in that U.S. trade barriers do not reduce U.S.

exports, as they would in a general equilibrium model. In the long run, the fall in imports

must be completely offset by a decline in the country’s total exports (in all industries). In

a general equilibrium framework, then, the world price effects of the trade barriers will

be smaller than those predicted here because some of the drop in the industry’s imports

may be offset by a fall in exports.

Setting equations (1) and (2) equal to each other and solving for the percentage

change in the world price reveals:

(4) 1)1(%)1(

,−

+Δ

+=Δ − dsusrows

usw XQ

MP εε

10

Since supply elasticities are positive and demand elasticities negative, the world price

change will have the same sign as usMΔ . Thus, the world price declines when U.S.

imports fall due to tariff protection. Equation (4) shows that the effect of U.S. trade

barriers on world prices depends critically on the ratio usrows

usXQ

M+

Δ

,, or the change in

U.S. imports relative to world supply.

In order to measure predicted world price changes, we need estimates of demand

and supply elasticities. Demand and supply price elasticity estimates in world markets

are not available to our knowledge. Mansur and Whalley (1984) survey the empirical

literature estimating demand elasticities, and they present “central tendency” elasticity

estimates for a number of industries. We use their estimates (listed in Table 3 for each

industry) as measures of the ROW price elasticities of demand throughout the paper.

Price supply elasticity estimates are extremely rare and we have been unable to

find estimates for broad categories of manufactured goods. In order to get an estimate of

the supply elasticity among manufactured goods in world markets, we rewrite equations

(1) and (2) in logs and add real U.S. GDP ( usY ) as an exogenous demand shifter. This

setup is similar to the system of supply and demand equations in Greene (1990, p. 592):

(5) duswdusrowd uYPMQ ++=+ )log()log()log( 2, αε

(6) swsusrows PXQ εε +=+ )log()log( , .

In order to estimate this system we use data on import prices in manufacturing between

1982 and 1992 described in Feenstra (1996). Manufacturing output in 28 3-digit ISIC

industries for these years is available for 67 countries in the Trade and Production

Database described in Nicita and Olarreaga (2001). Unfortunately, some countries have

11

missing production data for some years. To deal with this problem we regress (within

each country) industry output on a time trend and replace missing production values with

their predicted levels from this regression. Summing over all industries and over all

countries except the U.S. provides a measure of rest of the world manufacturing output.

Greene (1990) shows that the indirect least squares estimator is a consistent estimate of

the price elasticity of supply: )log()log(

)log()log(ˆ ,

usw

ususrowss YonPofregressioninslope

YonXQofregressioninslope +=ε .

Using our data over the period 1982-1992, we get a supply elasticity estimate in world

markets of 982.0ˆ =sε . This estimate is clearly an imperfect measure of the true supply

elasticity in each industry, so later in the paper we discuss the impact on our price change

estimates of using alternative values for the supply elasticity.

Suppose that the United States raised its current trade barriers to prohibitive

levels in every industry. How much would such a drastic increase in trade barriers affect

world prices on average? For a preliminary measure of the aggregate price change due to

prohibitive U.S. tariffs, we use the estimated supply elasticity of 982.0ˆ =sε , and the

median demand elasticity among the Mansur and Whalley (1984) estimates:

659.0, −=rowdε . Kee, Nicita, and Olarreaga (2004) provide estimates of countries’

import demand elasticities at the 6-digit HS industry level.15 The import-weighted

average elasticity across all industries in the United States is 3.1, −=usmdε .16 The CIA

World Fact Book provides 2003 estimates of U.S. trade flows: TRM us 26.1$= and

BX us 5.714$= , and world goods outside of the U.S. are estimated to be

15 Special thanks go to Hiau Looi Kee for providing us with their estimates of import demand elasticities. 16 Whalley (1986) provides a “central tendency” import price elasticity in the literature that is slightly larger in magnitude: 66.1−=mde .

12

TR.$Q row,s 317= . Substituting these values into equation (4) reveals the predicted

world price change if imports dropped to zero: %.P% w 14−=Δ . World prices on average

would fall by about 4% if the United States were to block all imports (but U.S. exports

remained unchanged). Using a supply elasticity estimate of 5.0=sε would result in a

world price change of %.P% w 85−=Δ while raising the supply elasticity estimate to

2=sε would result in a world price change of %.P% w 52−=Δ due to prohibitive tariffs.

While the aggregate effect of U.S. prohibitive tariffs on world prices appears to be

quite small, the U.S. may have a greater ability to influence world prices in specific

industries. We examine the year 1992 because the Trade and Production Database has

the fewest missing production values for that year. The countries in the data set

accounted for 84% of extra-U.S. world GDP in 2003. Because not all countries in the

world are included in the data set, the world output levels in each industry are

understated (and the U.S. tariff effect on world prices overstated).

Table 2 presents an industry-level analysis of the effect that prohibitive tariffs

would have on world prices in each sector. The first column shows 1992 U.S. imports in

the industry in millions of dollars. The second column shows the ratio of U.S. imports to

the ROW supply: usXrows

usQ

M

+,. In the median manufacturing industry, U.S. imports are

4.13% of the world supply. The third column in Table 2 presents an estimate (using

equation 4) of the effect of a prohibitive U.S. tariff on world prices. Cutting the 1992

import levels to zero would have lowered the world prices of imports in the median

industry by 2.5%. Using supply elasticity estimates of 0.5 or 2.0 would change the price

effects of prohibitive tariffs to 3.5% and 1.6%, respectively, in the median industry.

13

It may be safe to assume that supply elasticities are higher than unity in the long

run. Elementary microeconomics teaches that entry, exit and output adjustments cause

supply curves to be quite elastic even in the medium run, especially on world markets.

Higher supply elasticity estimates would mean U.S. tariffs have smaller impacts on world

prices than those in Table 2.

Table 2 shows that the U.S. has little market power in most, but not all, sectors.

The largest impact of prohibitive U.S. tariffs on world prices occurs in the footwear

industry because U.S. imports account for about 19% of the potential import supply in

the industry. A prohibitive tariff in footwear would lower world prices by 11%. The

U.S. also has the potential to lower world prices by more than 5% if it cut off all imports

in the apparel, scientific equipment, leather products, and miscellaneous manufacturing

goods industries. The Justice Department market definition Guidelines use a sustained

5% increase in market price in addressing the monopoly question. As a monopsony

buyer, the U.S. has the ability to change market prices by more than 5% in only five

industries, accounting for 16% of U.S. manufacturing imports, even if it adopts

prohibitive tariffs.

The effects of a U.S. move to autarky on world prices are illustrated in Figure 3.

For 19 out of 28 industries, the United States would not change world prices by more

than 3% even if it were to cut off all imports. For another five industries, the impact of

such a move on world prices would be between 3 and 6%. The industries with the largest

dollar values of imports: transportation equipment, and electrical and non-electrical

machinery, would see a fall in world prices of between 4 and 5% if the U.S. blocked all

its imports.

14

The approach we have taken here is to examine the effect of U.S. tariffs on world

prices assuming that exporters do not treat foreign markets as segmented. With imperfect

competition and segmented markets, foreign firms might absorb part of tariff increases so

that the importing country gains a terms of trade advantage, as in Brander and Spencer

(1984). These arguments have to do with imperfect competition rather than with the size

of the importing country. As Gros (1987) shows, for example, very small importing

countries might induce foreign exporters to absorb part of a tariff increase under

imperfectly competitive conditions. Thus, the potential terms of trade gains of tariffs

under imperfect competition is a separate issue from the question of whether the United

States is a large country. The presence of imperfect competition does not weaken the

conclusions of this paper. All of results from the Justice Department and U.S. antitrust

standards for market shares and market power reported above and the American

empirical evidence of elevated prices in concentrated markets apply equally to markets

with and without imperfect competition.

The assumption we make in this paper of a unified world market for traded goods

may not yet be a reality (although the world seems to be moving in that direction). Eaton

and Kortum (2002), for instance, estimate that there are significant geographic barriers to

trade, and counterfactual simulations of their model indicate that a unilateral tariff

reduction by the United States lowers U.S. welfare. When transportation costs increase

with distance, the world effectively shrinks so that each country conducts most of its

trade within a trading region. In such a world, the United States can easily influence the

prices within its trading region (and might have sizable optimal tariffs) while leaving the

15

prices of goods trading in other regional markets unchanged.17 Claiming that the United

States is a large country in its region is not the same as claiming it is a large country in

the world trade market, however. The latter claim is the one that is most often made in

textbook treatments of optimal tariff arguments and the one that we examine in this

paper.

In fact, the geographically large world market actually reinforces the view that the

U.S. is a small country in world trade. First, many exporters to the United States are very

far away so that high transport costs are already an impediment. A U.S. attempt to

exploit them further with high protection would induce them to switch their exports to

closer and more convenient destinations. Second, industrial organization studies show

that the larger the market, the harder to exercise market power because of easier entry

and exit and more competitive alternatives. Carlton and Perloff (2005, 135) report that

“the existing evidence shows that cartels are often found in smaller geographic markets.”

Posner’s (1970) study of cartels from 1890 through 1969 showed that 47% were in local

or regional markets; 38% were nationwide and only 9% involved foreign trade.

The most important result in this section is that U.S. imports, even when they are

large shares of world trade, are usually very small fractions of world output. As a result,

even prohibitive U.S. tariffs would have only minor impacts on world prices in most

industries. Foreign exporters do not have to switch to other export destinations; they can

also sell more in their own countries, where transport costs are minimal.

3. Do United States trade policies influence world prices?

17 Magee, Yoo, Choi and Lee (2004) examine this geographic market question. Considering only the United States’ closest trading partners, providing 80% of U.S. imports, the U.S. import share of trade

16

3.1 Effects of United States tariffs on world prices

Equation (4) in the previous section provides a simple measure of how much

current U.S. tariffs affect world prices. If world prices do not change, then the tariff

would reduce U.S. imports by usmdavusus etMM ,**=Δ . This change constitutes the

inward shift of the world demand curve. The resulting change in world prices is

(7) 1)**

1(%)1(

,

, −+

+=Δ − dsusrows

usmdavustariffsw XQ

etMP εε .

The World Bank reports an average (unweighted) ad valorem tariff of %9.3=avt for the

United States in 2002. Substituting the aggregate values for each variable reported in

section 2 into equation (7) provides a preliminary estimate of the effect of tariffs on

world prices: %.P% tariffsw 210−=Δ . Thus, for the elasticities in this example, a normal

tariff, and the total U.S. import and world output levels, the drop in world price caused by

existing U.S. tariffs in the aggregate equals roughly two-tenths of one percent.

This estimate of the world price change is much smaller than the terms-of-trade

effects of U.S. tariffs estimated in Whalley (1986). He uses a general equilibrium eight-

region global trade model to estimate the effects of a 50% cut in U.S. tariffs and he

concludes that the U.S. terms-of-trade would fall by 2%. Deardorff and Stern (1986) also

use a computable general equilibrium model and find much smaller results on the terms

of trade. In fact, their estimate is that a 50% cut in U.S. tariffs would reduce the U.S.

terms-of-trade by 0.09%, a result that is similar to our own estimates of the price effects

of U.S. tariffs. In commenting on these two papers, de Melo (1986, p. 221) criticizes the

among this group of countries was less than 30% in the vast majority of 3-digit industries and less than 50% in all of them.

17

Armington CES assumption in the Whalley (W) model, which “is clearly responsible for

large terms-of-trade change reported by (W) and deserves further scrutiny.”

While the overall effect of U.S. tariffs on world prices is negligible in the estimate

presented above, the terms of trade effects may be much larger in specific industries,

particularly for ones in which the tariff is high and import demand elasticities are large.

The first four columns in Table 3 present measures of U.S. imports as a share of world

supply, the average U.S. tariff rate, the import demand elasticity estimate from Kee,

Nicita, and Olarreaga (2004), and the demand elasticity estimate from Mansur and

Whalley (1984) for each of 27 3-digit ISIC manufacturing industries. The final column

shows the estimated effect of U.S. tariffs on world prices. For the vast majority of

industries, U.S. trade policies has only negligible effects on world prices. In the median

industry, for example, eliminating U.S. tariffs would raise world prices by 0.12%. Using

supply elasticity estimates of 2=sε or 5.0=sε would result in a median industry world

price effect of between 0.08% and 0.18%. The small impacts on world prices are partly

the result of low average tariffs – the median industry tariff was below 5% in 1992 – and

partly caused by the fact that U.S. imports are relatively small fractions of world output

in most industries. Because of a lack of data, we do not present estimates of the effects

of U.S. nontariff barriers on world prices. The results in Table 3 indicate, however, that

world prices would fall by less than 1% in the median industry unless nontariff barriers

were over eight times more protective than tariffs in 1992.

Figure 4 illustrates the effect of U.S. tariffs on world prices. In 23 of the 27

industries, world prices fall less than one-half of one percent as a result of U.S. tariffs,

while in another two industries, world prices fall less than 1%. Nearly 86% of U.S.

manufacturing imports came in industries in which the effect of U.S. tariffs on world

18

prices was less than 0.5%. U.S. tariffs lowered world price by more than 1% in only two

industries (footwear and apparel), making up about 7% of U.S. manufacturing imports.

Thus, for all but a few industries, there is little evidence that the existing U.S. tariff

protection has significantly reduced the world prices of its imports.

Magee, Yoo, Choi, and Lee (2008) test some implications of the hypothesis that

the United States is a large country. The authors show that changes in an industry’s tariff

protection are not correlated with changes in the U.S. industry terms of trade during the

1980s. Using data for most of the 20th century, the authors also found that changes in

protection did not significantly affect the U.S. terms of trade after 1934.

3.2 Optimal tariffs for the United States

There is an extensive literature investigating optimal tariffs theoretically. Mai

and Hwang (1997), for example, examine optimal tariffs when firms choose their

production locations endogenously while Coates and Ludema (2001) incorporate political

economy considerations in foreign trading partners into the analysis. Williams (1999)

adds a distortionary income tax into the model of optimal trade policies, and Chiou, Hu,

and Lin (2003) introduce consumer preferences for home-country goods. Empirical

estimates of optimal tariffs, however, are much rarer, so in this paper we ignore many of

the complications in determining optimal tariffs in the theoretical literature in order to

provide empirical estimates of U.S. optimal tariffs. We do so in the simple model

presented in most international economics textbooks.

In order to simplify the analysis, we assume that markets are competitive (so that

there are no strategic trade policy considerations) and that supply and demand curves are

19

linear: bPaQS += , and dPcQD −= . Using linear demand and supply curves

generates tariff effects on world prices that are comparable to those in section 3.1.

Figure 5 shows the standard partial-equilibrium treatment of a large-country

tariff. If the U.S. has free trade, the world price of the good is wFTP . When the U.S.

imposes a specific tariff t , the world price falls to wP while the domestic U.S. price rises

to tPw + . The tariff leads to welfare losses in areas A and B in the graph while area C

represents a terms-of-trade gain. The net change in welfare from the tariff is

BACW −−=Δ . The optimal tariff is set when 0=∂∂

−∂∂

−∂∂

=∂Δ∂

tB

tA

tC

tW . The areas

are determined by the following equations:

(8) ))((21

2 FTwFTw QSQSPtPA −−+=

(9) ))((21

2QDQDPtPB FTwFTw −−+=

(10) ))(( 22 QSQDPPC wwFT −−=

The effect of a marginal increase in the tariff on country welfare is

(11) )])(()1)([(

21

)(])[(

2222

2222

tQD

tQS

PtPt

PQDQDQSQS

QSQDt

Pt

QSt

QDPP

tW

wFTww

FTFT

wwwFT

∂∂

−∂

∂−++

∂∂

+−+−−

−∂∂

−∂

∂−

∂∂

−=∂Δ∂

.

Let

rows

usxsmd

rows

us

rows

ususds

usmd

rows

FT

QX

eeQM

QXM

ee

eQMX

,,,

,

, ))(

1(

)(

+−−

−−

−= and

normalize the world free trade price to one: 1=wFTP . The post-tariff world price is

20

tXPw −= 1 . U.S. imports under free trade are FTFTFT QSQDM −= , and we can

replace )( bdMac FT ++=− . Setting 0=∂Δ∂

tW , we can solve for the optimal tariff:

(12) )1)(( 2Xdb

XMt FTopt−+

= .

As long as demand elasticities are negative and supply elasticities are positive, it

will be the case that 0≥X . In addition, the second order condition for the tariff in

equation (12) requires that 1

21

The third column in the table shows how much world prices would drop from

their free trade levels if the United States were to adopt its optimal tariff in each industry.

As the table makes clear, the terms-of-trade effects of the optimal tariff are very small in

most industries. Only four industries out of 27 would see a drop of more than 1% in the

world price if the United States were to move from free trade to its optimal tariff. The

final column shows the impact of the optimal tariff on domestic prices in the United

States, which equals the optimal tariff plus the accompanying change in the world price.

Because the world price effects are so small, nearly the entire tariff is reflected in higher

domestic prices. In the median industry, for example, the optimal tariff is 3.59%.

Domestic prices rise by 3.46% while the world price falls by 0.13%.

The most important determinant of optimal tariffs across industries is the ratio of

U.S. imports under free trade to world output. Not surprisingly, actual U.S. imports as a

share of world output provides an excellent predictor of optimal tariffs in each industry.

Regressing optimal tariffs on this variable (with no intercept) generates the following

estimate: rows

usQM

tariffoptimal,

82.0= , with 97.02 =R . Thus, for industries where

elasticity estimates are not readily available, 0.82 times imports as a share of extra-U.S.

world output provides a crude estimate of the optimal tariff.

Is there any relationship between the optimal tariffs and the existing U.S. tariff

levels? Interestingly, Figure 5 shows that there is a strong positive correlation between

the two. The tariff is 0.4 percentage points higher for each one percentage point increase

in the optimal tariff, and the coefficient is statistically significant at the 1% level. For a

cross-section regression with only one explanatory variable, the fraction of the variance

in tariffs explained by differences in optimal tariffs ( 41.02 =R ) is also remarkably large.

22

Dropping the four outliers in the graph (those with optimal tariffs above 10%) causes the

coefficient on the optimal tariff to increase to 0.5, but the statistical significance declines

(the new p-value is 052.0=p ).

The strong correlation between optimal and actual tariffs is consistent with a

situation in which policymakers consider the terms-of-trade gains in setting tariffs. There

are other possible explanations, however. Optimal tariffs are higher in industries in

which the United States has a comparative disadvantage (and thus large levels of imports

under free trade). Political economy considerations may also push tariff levels up in

industries where imports tend to be high, as Trefler (1993) shows. Thus, it is not clear

whether the result in Figure 5 is caused by sophisticated policymakers or by omitted

factors that are correlated with both optimal tariffs and existing tariffs.

Broda, Limao, and Weinstein (2006) provide one of the few other papers that

attempt to estimate optimal tariffs, and they also find that actual and optimal tariffs are

positively correlated. In other ways, however, their paper finds results that are exactly

the opposite of those in this paper. For the United States, they estimate that the optimal

tariffs are 160% for the median differentiated good and 41% for the median commodity.

They also estimate export supply elasticities faced by 15 countries that are not members

of the WTO, and their estimates suggest that the optimal tariffs in the median industry

range from 90% in Lebanon to nearly 300% in Paraguay. While these estimates are

surprisingly large (Paraguay has less than 0.04% of world imports), the authors indicate

that they are based on a linear tariff formula and thus are likely to overstate the true

optimal tariffs. In essence, though, their results suggest that almost no countries are

small in world trade, while this paper argues that not even the United States is large.

23

There are several explanations for the dichotomous results in the two papers.

Broda, Limao, and Weinstein use yearly data to estimate export supply elasticities for

varieties of each good, where a variety is a good imported from a particular exporting

country. They estimate relatively low elasticities on most goods, meaning that even

small importing countries have market power over their trading partner’s products. As

the authors point out, this result can be explained if goods are strongly differentiated by

their source of origin or if trade costs rise sharply with distance so that international

markets are segmented and countries have regional market power. Another possible

explanation is that longer-run elasticities are likely to be much larger, and countries’

market power considerably smaller. Since the industrial organization literature suggests

that control of prices over a period of two years or more may be necessary for

monopolistic behavior, the longer-run elasticities may be more relevant measures of

market power.

The low elasticity estimates in Broda, Limao, and Weinstein (2006), although

obtained using much more sophisticated techniques, are actually similar to results from

earlier studies in the 1970s and 1980s. As Athukorala and Riedel (1991) describe, “The

‘consensus view’ … is that the price elasticity of export demand, almost everywhere, is

between -0.5 and -1.0.” That consensus view suggests that almost no country in the

world is a small one in international trade, and it implies that countries should tax their

exports (if the price elasticity of export demand is -1, then the optimal export tax is

100%), just as Broda, Limao, and Weinstein’s results suggest that countries should tax

imports. Athukorala and Riedel (1991) show, however, that South Korea fits many

predictions of the small country hypothesis even though simple elasticity estimates find a

low price elasticity of demand for its exports. Riedel (1988) finds a similar result for

24

Hong Kong.18 Thus, it may be that estimates of elasticities based on yearly data overstate

countries’ market power in the long run. The phenomenon of low estimated price

elasticities, known as “elasticity pessimism in international trade,” has been around for

over 50 years since Guy Orcutt’s (1950) classic paper.

This paper has assumed that there is a unified world market and goods from

different origins are substitutable over the longer run. Because international markets are

contestable, meaning there is free entry and exit, countries face strong competition from

rival exporters. These assumptions are close to textbook models of trade which

emphasize long run effects. These simple standard models and industrial organization

economics provide what we believe is the best description of world markets in the long

run, namely that the United States is a small country. Taken together, the results in this

paper and those in Broda, Limao, and Weinstein (2006) suggest that the terms of trade

argument for tariffs needs to be modified to emphasize the importance of product

differentiation, segmented world markets, and imperfect competition. As this paper

argues, however, the standard terms of trade argument based solely on country size is

flawed because no country has the ability to control prices over sustained periods in a

competitive world market.

4. Conclusion

Is the United States a large country in world trade? We have argued here that for

most industries the impact of U.S. trade policies on world prices in the long run is

negligible. There are several variants of the “U.S. is a large country” hypothesis. The

most common is that a large country can influence world prices because it has a

18 We are grateful to an anonymous referee for pointing us to these last three references.

25

sufficiently large share of world imports. We have shown that the U.S. share of world

imports (17%) is smaller than the level deemed necessary for monopsony power in the

industrial organization literature (at least 50%). Furthermore, we have argued that it is

U.S. imports as a share of world output rather than of world imports that is the relevant

criterion to judge U.S. market power. Since U.S. imports as a share of the potential

supply of goods is only 7.3%, U.S. trade policy market power is severely limited.

Examining specific industries, we find that world prices in the median

manufacturing industry are lowered by only 0.12% due to U.S. tariffs. In 23 out of 27

industries, accounting for 86% of U.S. manufacturing imports, world prices fell by less

than one-half of one percent due to U.S. tariffs. The industries in which U.S. trade policy

has had the most significant influence on world prices are footwear and apparel. These

are the only two industries in which the world price effects of U.S. tariffs were larger

than 1%, and they accounted for about 7% of U.S. imports in 1992.

The results in this paper have important implications for the way countries set

their trade policies. In the United States, the median industry optimal tariff is 3.59%, and

16 out of 27 industries had tariffs higher than the optimal level in 1992. As a result, for

many years the United States had an incentive to liberalize unilaterally in most industries,

and optimal tariff considerations did not dampen the United States’ enthusiasm for more

open markets worldwide. Only recently has the U.S. had to weigh the gains from a

multilateral trade deal in improved access to foreign markets against the terms of trade

costs of reducing U.S. tariffs.

Since no other country in the world currently has even half of the U.S. level of

imports, their optimal tariffs should be much smaller than those for the U.S. Thus, terms-

of-trade and optimal tariff considerations are largely negligible when other countries set

26

their trade policies. This result strongly supports Irwin (2002, p. 63), who states that “the

terms-of-trade motive for trade restrictions has little relevance for most countries’

policies. Few countries have the ability to manipulate their terms of trade, and most

policy makers probably have little idea what the terms of trade are.” Given the results in

this paper, policy makers are rational to ignore the terms of trade in setting tariff barriers

in the vast majority of cases. The results here also suggest that countries do not enter into

GATT/WTO negotiations in order to resolve their terms-of-trade incentives to beggar-

thy-neighbor since these incentives are largely negligible for most participants.

Multilateral negotiations must be needed for other reasons, such as to co-opt exporters

into lobbying for trade liberalization by offering reciprocal tariff cuts abroad.

We have discussed several reasons (segmented markets, product differentiation,

and imperfect competition) why, in the absence of a competitive and integrated world

market, U.S. trade barriers may have an impact on the prices that foreign exporters

receive. Based on the standards set in the industrial organization literature, however,

world trade flows in most industries are highly competitive. The contention that world

markets are unified, or that “The world is flat” in the words of Thomas Friedman (2005),

is also a plausible description of the global economy, particularly in the long run. Under

these conditions, even the United States cannot significantly influence world prices in the

vast majority of industries. In other words, the United States is a small country in world

trade.

27

Figure 1

'usrow MD +

P

Q

usrow MD +

usrow XS +

'wP

'rowQ rowQ

wP E

E’

usMΔ

Figure 2

Herfindahl indexes in international trade, 1998

320

94

20

0

50

100

150

200

250

300

350

28

Figure 3

Figure 4

Prohibitive tariff effects on world prices in manufacturing industries

4

6

9

5

2 2

0

1

2

3

4

5

6

7

8

9

10

0-1 1-2 2-3 3-6 6-10 10+

% decline in world price due to a prohibitive US tariff

Num

ber o

f ind

ustri

es

Effect of US tariffs on world prices, 1992

12

65

2 2

0

2

4

6

8

10

12

14

0-0.1 0.1-0.2 0.2-0.5 0.5-1 1+

% change in world price due to tariff

Num

ber o

f ind

ustri

es

29

Figure 5

Effect of tariffs on welfare in a large country

Figure 6

P

Q

A B

C

Dus

Sus

Pw+t

Pw

PwFT

QDFT QD2 QSFT QS2

US tariffs and optimal tariffs, 1992

y = 0.3998x + 0.0343R2 = 0.4106

0%

2%

4%

6%

8%

10%

12%

14%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%Optimal tariff

Act

ual U

.S. t

ariff

apparel footwear

textiles

plastics pottery

leather

miscellaneous manufactures

food glass

b

steel

chemicals

printing

oil paper

machinery

transport

electrical machinery

wood rubber

30

Table 1: Country shares of world trade, 2003

Country Rank Imports ($B) Share of world imports

United States 1 1260 17.40 Germany 2 585 8.08 China 3 397 5.49 United Kingdom 4 364 5.02 Japan 5 347 4.79 France 6 340 4.69 Italy 7 271 3.74 Canada 8 240 3.32 Hong Kong 9 230 3.18 Netherlands 10 218 3.01 Spain 11 197 2.72 South Korea 12 176 2.43 Belgium 13 173 2.39 Mexico 14 169 2.33 Singapore 15 122 1.68 Taiwan 16 120 1.65 Switzerland 17 102 1.41 Sweden 18 83 1.15 Australia 19 83 1.15 Austria 20 82 1.13 World 7240 100.00 Four-country concentration ratio for imports 35.99 Four-country concentration ratio for exports 30.37 Herfindahl-Hirschman Index for imports 561 Herfindahl-Hirschman Index for exports 415

Source: CIA World Fact Book 2004,

http://www.odci.gov/cia/publications/factbook/index.html, accessed July 12, 2004.

http://www.odci.gov/cia/publications/factbook/index.html�

31

Table 2: Effect of prohibitive U.S. tariffs on world prices in manufacturing, 1992

Industry 1992 U.S. imports ($ M)

U.S. imports as % of world supply

Prohibitive tariff impact on world prices

Food products 16,100 1.48% -1.00% Beverages 4,547 2.24% -1.38% Tobacco 949 0.79% -0.54% Textiles 15,400 3.98% -2.62% Apparel 25,300 15.14% -8.98% Leather products 3,589 8.87% -5.23% Footwear 8,472 18.95% -10.76% Wood products 7,235 4.82% -2.45% Furniture 4,888 4.36% -2.20% Paper 10,500 3.84% -2.81% Printing, publishing 2,274 0.71% -0.53% Industrial chemicals 22,200 4.77% -2.85% Other chemicals 11,900 2.75% -1.62% Petroleum refineries 13,300 3.85% -1.50% Petroleum and coal products

488 1.68% -0.67%

Rubber products 4,492 4.28% -2.66% Plastic products 10,500 3.80% -2.34% Pottery china earthenware 1,833 6.79% -4.08% Glass and products 2,334 3.66% -2.31% Other non-metallic mineral products

2,158 0.84% -0.52%

Iron and steel 9,919 2.43% -1.17% Non-ferrous metals 10,000 5.75% -2.76% Fabricated metals 14,900 2.83% -1.37% Non-electric machinery 71,300 7.04% -4.45% Electric machinery 77,000 7.64% -4.73% Transport equipment 99,500 8.34% -4.27% Professional and scientific equipment

17,700 14.47% -9.44%

Other manufactures 21,500 19.01% -10.56% Median industry 10,250 4.13% -2.53%

32

Table 3: Effect of existing U.S. tariffs on world prices in manufacturing, 1992

Industry U.S. imports as % of world

supply

1992 U.S. tariff rate

Industry import demand elasticity d

e Estimated effect of U.S. tariffs on

world price Food products 1.48% 6.22% -0.82 -0.50 -0.05% Beverages 2.24% 6.25% -0.96 -0.61 -0.08% Textiles 3.98% 10.97% -2.10 -0.52 -0.60% Apparel 15.14% 13.38% -1.09 -0.54 -1.28% Leather products 8.87% 6.75% -1.19 -0.64 -0.41% Footwear 18.95% 11.72% -1.11 -0.56 -1.36% Wood products 4.82% 3.57% -1.02 -0.97 -0.09% Furniture 4.36% 4.81% -1.07 -0.97 -0.11% Paper 3.84% 1.85% -1.08 -0.39 -0.06% Printing, publishing 0.71% 1.81% -1.12 -0.37 -0.01% Industrial chemicals 4.77% 5.20% -1.14 -0.74 -0.17% Other chemicals 2.75% 3.87% -1.36 -0.74 -0.08% Petroleum refineries 3.85% 1.48% -0.78 -1.56 -0.02% Petroleum and coal products

1.68% 1.75% -0.84 -1.58 -0.01%

Rubber products 4.28% 4.08% -1.14 -0.61 -0.12% Plastic products 3.80% 8.40% -1.29 -0.62 -0.25% Pottery china earthenware

6.79% 8.00% -0.99 -0.62 -0.32%

Glass and products 3.66% 7.57% -1.15 -0.61 -0.20% Other non-metallic mineral products

0.84% 4.02% -1.27 -0.61 -0.03%

Iron and steel 2.43% 5.09% -1.14 -1.08 -0.07% Non-ferrous metals 5.75% 3.41% -1.08 -1.08 -0.10% Fabricated metals 2.83% 4.83% -1.12 -1.08 -0.07% Non-elec. machinery 7.04% 3.25% -1.11 -0.63 -0.16% Electric machinery 7.64% 4.37% -0.98 -0.62 -0.20% Transport equipment 8.34% 4.08% -1.08 -0.99 -0.18% Professional and scientific equipment

14.47% 5.79% -0.80 -0.62 -0.43%

Other manufactures 19.01% 5.58% -1.03 -0.67 -0.59% Median 4.13% 4.83% -1.10 -0.62 -0.12% Sources: demand elasticity estimates from Mansur and Whalley (1984); import demand elasticity

estimates from Kee, Nicita, and Olarreaga (2004)

33

Table 4: Optimal tariffs in manufacturing industries

Industry 1992 U.S. tariff rate

1992 Optimal

tariff

Estimated effect of optimal tariffs on

world price

Estimated effect of optimal tariffs on

U.S. domestic priceFood products 6.22% 1.43% -0.01% 1.42%

Beverages 6.25% 1.99% -0.03% 1.95%

Textiles 10.97% 5.16% -0.41% 4.75%

Apparel 13.38% 16.11% -2.14% 13.97%

Leather products 6.75% 7.68% -0.60% 7.07%

Footwear 11.72% 18.40% -2.92% 15.48%

Wood products 3.57% 3.13% -0.09% 3.04%

Furniture 4.81% 2.93% -0.08% 2.85%

Paper 1.85% 3.64% -0.14% 3.50%

Printing, publishing 1.81% 0.70% -0.01% 0.69%

Industrial chemicals 5.20% 3.85% -0.15% 3.70%

Other chemicals 3.87% 2.16% -0.06% 2.10%

Petroleum refineries 1.48% 1.75% -0.02% 1.72%

Petroleum and coal products

1.75% 0.77% 0.00% 0.76%

Rubber products 4.08% 3.59% -0.13% 3.46%

Plastic products 8.40% 3.71% -0.15% 3.56%

Pottery china earthenware 8.00% 6.16% -0.32% 5.84%

Glass and products 7.57% 3.48% -0.12% 3.36%

Other non-metallic mineral products

4.02% 0.72% -0.01% 0.71%

Iron and steel 5.09% 1.58% -0.03% 1.55%

Non-ferrous metals 3.41% 3.49% -0.12% 3.36%

Fabricated metals 4.83% 1.82% -0.03% 1.79%

Non-elec. machinery 3.25% 5.72% -0.34% 5.38%

Electric machinery 4.37% 6.33% -0.36% 5.97%

Transport equipment 4.08% 5.43% -0.29% 5.14%

Professional and scientific equipment

5.79% 12.60% -1.14% 11.45%

Other manufactures 5.58% 14.72% -1.97% 12.75%

Median industry 4.83% 3.59% -0.13% 3.46%

34

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