Tuesday, October 19, 2010

Rare Earth, Export Restrictions, and the Terms of Trade

China has been imposing export restrictions on rare earth metals (used in many high-tech and "green economy" industries, I'm told). By restricting supply, prices rise; rents accrue to the supplier(s) at the expense of foreign buyers. This is no different from what OPEC does to manipulate the quantity supplied in order to influence the market price of oil.
How is this different from the "optimal" tariff discussed in any undergraduate textbook? The optimal tariff is couched in the context of a tariff on imports. By restricting demand, prices (of imports) fall; rents accrue to the buyer(s) and/or the treasury in the tariff-imposing country at the expense of foreign sellers. One problem with this policy is that it can and often does lead to retaliatory tariffs by the country that sells those goods being targeted by the country that initially imposed its "optimal" tariff. The first country re-retaliates, and so on resulting in a trade war. Everyone loses; think Hoover, Smoot-Hawley, and competitive devaluations and tariffs that sank the world economy deeper and deeper into the Great Depression.
Popular opinion seems adamant that we "do something". Voters, politicians, and even some very bright economists are advocating some form of punishment against China. What most popular opinion neglects (and that very smart economists should be well aware of) is that restricting exports in the way China (and OPEC) has has a very similar effect as restricting imports. In fact, in relative terms, it has the exact same impact on prices, a concept known as Lerner Symmetry.
So what does one do about it? Well, we can do nothing and minimize our losses, or we can retaliate and instigate a potential trade war.

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