Benefits from Free Trade

The United States has a population of about 290 million and land area of 9.17 million square kilometers, of which 19.3% is arable. By contrast, China’s population is 1.29 billion and its land area is 9.32 million square kilometers, of which 13.3% is arable.

American farmers produce wheat at lower marginal cost than Chinese farmers. Without trade, all American production would be sold to American consumers, and likewise in China. The market price of wheat would be lower in the US than in China.

Ignoring transportation costs, free trade between China and the US would result in a market equilibrium with one global price for wheat. This price wouuld be the same in both countries, and would be higher than the no-trade US price, but lower than the no-trade Chinese price.

With free trade, in each country the marginal benefit would equal the global price, and the marginal cost would equal the same global price. Hence

• American producers would benefit from a higher price and increased production,

• Chinese consumers would enefit from a lower price and increased consumption.

With free trade, American consumers and Chinese producers would lose, but by less than American producers and Chinese consumers respectively gain. This is how each country as a whole benefits from free trade.

Circumventing rent control: obituary pages and key money

Generally, when a market is out of free-market equilibrium, the marginal benefit is not equal to the marginal cost. Then, there is an opportunity to make a profit by resolving the economic inefficiency. In the case of rent control, landlords and renters resort to a number of creative mechanisms. Some New Yorkers regularly scan newspaper obituary pages to spot rent-controlled units that might become available. These activities are deadweight losses, as the costs incurred in such activities do not accrue as a benefit to another party.

Another way of circumventing rent control is “key money.” The owner or holder of a lease on a rent-controlled unit may charge a hefty nonrefundable fee to change the locks on the unit. Key money is a pure transfer from tenants to landlords, so it is not a deadweight loss. To the extent that renters can indirectly pay more than the regulated rent, the quantity of units supplied will be increased. Key money is an illicit way of raising the rent, and hence the quantity of units supplied to the free market equilibrium. To the extent that key money is effective in increasing the number of apartments for rent, it reduces the deadweight loss.

Price ceilings and the profitability of China’s state-owned enterprises

Shanghai Petrochemical is listed on the Hong Kong and New York Stock Exchanges. In 1993, the company was among the first of China’s state-owned enterprises to be restructured and listed on an international exchange. The following year, securities analysts applauded when the company announced its annual results. The company had achieved a 73% increase in profit to 1.78 billion yuan.

A closer look at the company, however, provided a different picture. In 1994, Shanghai Petrochemical was able to raise prices of synthetic fibers by 30-35%, as the Chinese government relaxed restrictions on the prices of chemicals.

Crude oil accounted for almost half of Shanghai Petrochemical’s costs. The Chinese government supplied Shanghai Petrochemical with 4.5 million metric tons of crude at a government-controlled price of 689 yuan. Compared with the free-market price of 1,100 yuan, this was an implicit subsidy of 1.85 billion yuan. When this subsidy was deducted from the company’s reported profit of 1.78 billion yuan, the financial picture did not look so rosy after all. In fact, the company’s profitability depended critically on continued government support.

Shanghai Petrochemical’s use of oil was not economically efficient. It was using oil at a price 35% below the market price that other manufacturers had to pay. Hence, the allocation of oil did not meet the equal marginal benefit condition for economic efficiency.

Source: I. P. L. Png and Changqi Wu, “A Tale of Two Companies,” Far Eastern Economic Review, October 12, 1995, p. 39.

PURPA and the market for wind-generated electricity

The Public Utility Regulatory Policies Act (PURPA) of 1978 required electric power utilities to purchase (wholesale) electricity at a fixed price from producers of renewable energy. PURPA gave birth to the California wind power industry. Under the terms of state-mandated contracts, utilities had to buy electricity at a wholesale purchase price that was fixed on the assumption that the price of oil would exceed $30 per barrel. By 1985, a total of 1,000 megawatts of wind-powered electric generating capacity had been installed, mainly in the Tehachapi and Altamont Passes.

Meanwhile, the price of oil fell to a low of $10.91 per barrel in July 1986, and then oscillated between $10 and $20 over the next ten years. In the mid-1990s, one of California’s major utilities, Pacific Gas and Electric, was paying over 7 cents per kilowatt hour for wind-generated electricity when it could generate electricity by conventional means for less than 3 cents per kilowatt hour.

With cheap oil, the market demand from electric power utilities for wind-generated electricity was low. In a free market equilibrium, the price of electricity generated by wind power would not diverge by much from that of electricity generated by other means. However, by fixing the price of wind-generated electricity above the market equilibrium, PURPA stimulated an excess supply.

California electric power utilities incurred about $1 billion a year in additional costs to pay for electricity from renewable energy producers under the state-mandated contracts. These costs were passed on to their business and residential consumers.

At current oil prices of $60 per barrel or higher, this floor price is no longer a binding constraint on power utilities.

Source: Richard T. Stuebi, “The Rise, Fall and Rebirth of Wind Energy in California: Lessons for the Renewable Energy Industry,” NextWave Energy, March 1999.