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International Trade Policy in eRepublik – Or How I Stopped Worrying And Learned to Love Open Trade

Author: Kemal Ergenekon


Introduction


Throughout the many years I have played in eRepublik, I have come to see many different opinions on international trade policy. Considering how controversial the topic is in the real world, it is no wonder that the divergences occur here as well. It directly affects the welfare of the country, and it creates winners and losers at the same time.

On the other hand, eRepublik provides us clearly defined rules that make it possible to predict the influences of policy decisions exactly at least qualitatively. The lack of consensus on the outcomes of international trade policy is therefore not a product of theoretical disagreement, but lack of pre-knowledge of existing international trade models and literature.

No one can expect our congressmen and executives to be experts on economic theory, but they should at least be acquainted with the basics. In order to have better policy decisions, I will try to address the international trade issue in my article.

In the beginning, I wil provide the baseline model of international trade that is used in the real world. Then I will extend the model to take into account specific additions that eRepublik system has, that doesn’t exist in the real world. In the end, I will discuss what policy implications the model implies, especially for the US. I will also exactly explain who are the winners and losers in with free trade policy vis-a-vis protectionism.

This article is intended to be a tl;dr document, so that it can be used for educational purposes in the future. You may want to skim over some parts, to get to the part you are interested in.


The Baseline International Trade Model

For the most simple exposition, we will use a partial equilibrium model: The classical supply-demand, with and without international supply. I will explain each component as we go along. Think of the industry in question as the market for Q5 weapons if you would like.


Supply – Demand Model for a Closed Economy





The first figure is the traditional supply-demand graph that summarizes Adam Smith’s idea: Everything else equal, consumers would like more of a good if it is cheaper, and producers would supply more of a good if the price increases. The supply and demand schedules are the aggregate amount of goods that consumers are willing to buy, and the producers are willing to provide, given a price.

The point where two schedules cross each other is the equilibrium of the economy: A pair (P*,Q😉: Equilibrium price and equilibrium quantity. In an equilibrium the markets must clear – i.e. supply must equal demand. This is exactly where the curves meet. You can think of yourself how the equilibrium price and quantity would change if one of the curves moves up or down (e.g. demand for weapons would go up during a major battle, the supply of food would increase if the country acquired more food raw materials, etc.)





In the second figure you see two colored areas. The red one is called “Consumer Surplus”, and the blue one is called “Producer Surplus”. They are offered as appropriate welfare metrics that measure the well-being of consumers and producers. Although I wouldn’t advocate they are what we should care about in actuality, they are both very simple to calculate, and qualitatively they yield the same conclusions as you would derive from the most complicated Dynamic Stochastic General Equilibrium model you could come up with. So they are good enough proxies for our analysis.

Intuitively, you could think of consumer surplus as the difference between what the consumers were willing to pay, and what they actually paid. The guy who was willing to pay 50 USD for a tank, but who paid 30 USD, has a “surplus” of 20 USD. If we sum this across all consumers and purchases, it becomes the integral of the demand curve minus the price line, up until the quantity demanded. Yes, exactly the red area.

The producer surplus is linearly related with profits in most microeconomic models of the firm, so just think of it as the total profits earned by the producers. The only thing it doesn’t include is fixed costs (like the cost of opening the firm).

The sum of Consumer Surplus and Producer Surplus is called Total Surplus, and can be considered a welfare metric for the overall welfare of the country.

Up until now, I have introduced the supply-demand model for a closed economy. Now we will move on to an open economy by introducing foreign supply.


Supply – Demand Model for an Open Economy





In the third figure, we have an additional line in the model: foreign supply. What it reflects is the lowest price in the world that producers are willing to supply the good at. It is nearly a flat line in comparison to the domestic demand, because the number of producers in the world are so large that a change in domestic demand of the country we are considering doesn’t affect their supply decision too much.

You can see that the equilibrium price in the open economy is lower than the closed economy case: this is because the world price of the good is lower. The opposite could never be true in eRepublik, because it is impossible to prevent exports, so it is not considered here.

Now you can see that the domestic supply and domestic demand curves do not cross each other at the equilibrium price. Domestic supply at P** is lower than domestic demand at P**. This difference is exactly equal to Imports / Foreign Supply. Now let’s consider how our welfare metrics have change😛





As you can see, the red area we call Consumer Surplus has increased in comparison to the closed economy case. But Producer Surplus decreased. Total Surplus has increased since the total shaded area increased by the triangle you see.

What does this mean in eRepublik sense? Allowing imports have increased the buying power of the citizens: They bought more weapons at a cheaper price. But the weapons producers in the country suffered a loss in profits.

The model predicts that open trade is better for the country, and this is what 100% of the economists would agree in the absence of other concerns. The only concerns in the real world are stuff like unemployment (we have none in eRep), infant industry argument (the production function is fixed in eRep), and national security issues (we have only two indursties in eRep, and there is an abundant number of firms operating in each).

In eRepublik, we have two policy tools that allows us to determine how open or closed our economy is. One is import taxes, and the other one is trade embargoes against countries. Now we will look in the grey area between a totally open and a closed economy.


Import Taxes





In this last figure, you see two foreign supply lines. The lower one is the foreign supply when there are no import taxes for this industry. The upper one is the foreign supply when there is 20% import taxes. The height between them is exactly equal to 20% of the lowest world price. The graph exactly shows you the effect of an increase/decrease in import taxes: If the import taxes are high, the equilibrium price in the economy will be higher and the quantity bought will be smaller. The government will be able to accrue some tax revenues from the whole ordeal. Let’s look at how our welfare metrics change:

Consumer Surplus:

-With Import Taxes: A
-Without Import Taxes: A + B + C + E + F

Producer Surplus:

-With Import Taxes: B + D
-Without Import Taxes: D

Government Revenues:

-With Import Taxes: C + F
-Without Import Taxes: none

Total Surplus:

-With Import Taxes: A + B + C + D + F
-Without Import Taxes: A + B + C + D + E + F


What does all of this mean? Increasing import taxes increases the government revenues somewhat, and increases the profits of domestic firms, but makes the consumers much worse off. They both face higher prices, and choose to consume less weapons (which would mean a drop in the damage output of the country in eRep). The total surplus is also lowered by high import taxes.

So in the end, any increase in import taxes results in transfer of wealth from the consumers to the producers. In eRepublik terms, this means transfer of wealth from the low and middle income players, to old players with many companies, or Q5 company owners who hire-fire to produce hundreds of weapons in a given day.

At the end of the day, what our government tries to do is to maximize the effectiveness of our military power, and increasing our total damage output. How would this wealth transfer effect the total damage output?

The answer is not trivial, but here is my personal estimate: since the people who are better off by increase in import taxes are already players who are able to use all training boosters, and can produce more food and Q5 weapons that they can consume in a given day, the extra profits they make go into vanity gold fights. The low and medium income players, on the other hand, would use the extra money they have to buy food and weapons that they lack, so that they can hit more; increasing the total damage output of the country more than the vanity gold fights, at the same cost.





Trade Embargoes


This time, I will use no graphs, since the story is similar to the import tax case. When you embargo a country, they cannot conduct any trade with you. What this effectively does is to prevent your citizens from selling goods in that country’s markets, and prevent their citizens from selling goods in your country.

What is the effect in our model? It would shift the foreign supply upwards, and rotate it a little counter-clockwise. The result is increased prices and reduced consumption in our economy. Since the foreign country can no longer export to us, their producers choose to sell more elsewhere, including their own country. This drives the prices in their own country down, and increases quantity consumed.

Let’s pick a more concrete example: Let the domestic economy be the US, and the foreign economy be Poland. Poland has cheaper weapons than the US, so the Polish producers are willing to export to the US. Since Poland has ridiculously high import taxes, US producers exporting to Poland is out of question, so the effect is only one-sided.

If we embargo Poland, the goods prices in the US increase, and the quantity consumed in the US decreases. On the opposite side, the goods prices in Poland decrease, and the quantity consumed in Poland increases.

What did we gain by the embargo? The profits of the companies in the US increased, but the weapons and food consumption decreased, which reduced our total damage output. The profits of the companies in Poland decreased, but Polish people now have access to cheaper weapons and food, and their total damage output has increased.

There are some people who counter this argument by saying embargoing a single country doesn’t have very high quantitative effects. I would counter this by three arguments:

1) If the price increase in the US isn’t so noticable, so is the profit decrease of the Polish fatcats.

2) The effect of embargoing a single country might be unnoticable, but embargoing the strongest ONE countries means embargoing half of the world – and *that* has a noticable effect, I can assure you.

3) The qualitative answer to the question is obvious: An embargo reduces the damage output of our side, and increases the damage output of our opponent. Arguing the impact of an embargo is small is the same as arguing your mistaken decision isn’t so hazardous to the country – it doesn’t change the fact that it is hazardous.

Now we will consider eRepublik-specific features of the economy that require attention, and a deviation from the economic theory that applies in the real world.





eRep Feature 1: Smuggling / Black Market


A person who cares more about the firm owners rather than the low and middle income players might think that increasing import taxes sky-high, and embargoing each and every country increases their profits. And it certainly does. However the increase in profits is not as high as the above model would predict, because eRepublik allows player transactions to evade import taxes and embargoes.

If the prices in the country increase due to a rise in import taxes or embargoes, some citizens of the country can move to the countries where the goods are cheap, and sell them in their own country without paying any import taxes. This drives down the prices and lessens the negative impact of the import taxes and embargoes on damage output.

On the other hand, the profits that would accrue to the domestic firms and the government go into the pockets of these profiteers that I choose to call “smugglers”. The producers of the country who actually invested their resources to make profit lost, and so did the government. And these profiteers whose only merit is to notice the arbitrage opportunity collected all the benefits, while taking no risk, investing no more than a small operating capital, and producing nothing in real terms in the end. Neither are the consumers as better off as the case with no protectionist measures.

So, in eRepublik’s unique case, protectionism doesn’t only reduce welfare as seen in the real world case, but also creates opportunities for profiteers, whereas it reduces government revenues and profitability in the domestic country. The second one especially reduces the incentive to invest, which doesn’t affect the old players since they cannot sell their companies anyway, but affects the mid-income players incentives to invest in long-run businesses, and consume pre-maturely. This is what we call “dynamic inefficiency” – saving less than optimal.





eRep Feature 2: Daily 100,000 Donation Upper Bound


Increasing the import taxes to a point where it maximizes government revenues might be advocated by some, and if we do have reason to believe the government makes better use of money than the average citizen, this might be a concern. However the daily amount we can withdraw from the country treasury is capped above by 100,000 USD per day (not counting the rare hospital / defense system purchases).

As a result, if we are already generating more than 100,000 daily revenue from income and VAT taxes, the increase in government revenues that results from high import taxes are not as necessary, and the case for free trade which lowers domestic prices is stronger than the real world case.

Another implication of the upper bound is that the real purchasing power of the government increases as the prices fall. For example, if the prices of a Q5 tank is 20 USD, the government can buy 5000 tanks daily. If the price is 30 USD, this is reduced to 3333 tanks.

So decrasing prices increases the real government budget. This is in favor of free trade, since having no embargoes and low import taxes reduces prices.





eRep Feature 3: The Exogeneous Buyer


As you well know, sometimes the offers on the market which are far away from the current market price are bought mysteriously. I will call this phenomenon “the exogeneous buyer”.

Two things that you should know about the exogeneous buyer are the following:

1) In the past it bought so that the net revenue you collected from your sale was a fixed amount for each commodity. So the maximal price that would induce the exogeneous buyer purchase was “Base Price + Taxes”. This exact formula isn’t working in many top 20 countries as of now, but still there are occasional purchases between the market price and the base price.

2) As recent as three months earlier, the exogeneous buyer paid the taxes to the country treasury like a usual person. This is no longer the case. The results have been verified by many experiments, and tickets regarding the topic received no satisfactory reply. So high import taxes could have been used to generate free currency for the government before the change. It no longer can.

Why does this concern international trade policy? Here is the reasoning:

Some people would defend high import taxes to increase government revenues from the exogeneous buyer purchases (I myself supported this before the change). Due to point 2, this argument is no longer valid.

Some people would defend high import taxes to stop foreigners from selling commodities to our country, because they would have USD out of thin air, which would create inflation. Due to point 1, the level of import taxes is irrelevant in determination of the USD they get in exchange of their sale. It was fixed at the base price in the past; now it is fixed somewhere between the base price and the market price. The import tax rate has no effect on that whatsoever.

A trade embargo on the other hand is still viable on the other hand. But whether the decrease in the inflationary effect is worth the decrease in relative damage output is subject to debate.





eRep Feature 4: Speculation


Speculation is the art of buying low and selling high. A player with a large storage capacity and lots of money can buy everything he sees on the market, and sell all of them at a higher price than he bought them. If he is fast and wealthy enough, he can make a profit out of this. In effect, this increases his own personal wealth, at the cost of hurting everyone else.

The greatest obstacle before the speculators are the marginal taxes. In the case of weapons and food, a VAT rate greater than 3-4% is generally enough to prevent speculation. However in the raw materials market there is no VAT.

This means that the citizens of the country can pull speculative strikes whenever they want. But having a little import tax (3-4😵 might mean kicking away all foreign speculators out of the picture. So although low import taxes are better for damage output as a whole, one might still want to have a small percentage in the raw materials markets to prevent foreign speculators from interfering with our markets. Unfortunately there is no cure for domestic speculators.





eRep Feature 5: Raw Materials vs Manufactured Goods


In eRepublik, we have four industries: FRM, WRM, Food and Weapons. The FRM and WRM prices directly affect the input costs, and therefore the profitabilities of the food and weapons firms.

Increasing import taxes for raw materials would have even worse effects than increasing import taxes for foods and weapons, because of the following:

1) They influence the investment decision between manufacturing and raw materials. If the price of raw materials are high enough, no one would invest in manufacturing companies. In the long run, our country would be majorly a producer of raw materials and not weapons, which could prove problematic: we would be depending on others for food and weapons! (in fact here you see the national security argument working against protectionism)

2) Raw materials are a lot more bulky than the consumption goods. A consumer can presumably buy and stock Q5 bread and tanks from a black-market dealer to last him a week. A producer can only store up to one day’s worth of raw materials himself (if he didn’t over-invest in storage). He cannot use the black market to circumvent the negative effect, or jump across countries everyday to find the best prices. (that is also accompanied by the problem of converting currencies which I won’t even go into...)

3) If one has higher import taxes for a raw material with respect to the import tax in the related manufactured good (i.e. FRM-Food or WRM-Weapon), it effectively means the domestic manufacturing firms have to shut down production as they will be facing much higher marginal costs than their international competitors, whereas they will be facing full competition in their own sales market. As a rule of thumb, the import taxes on a manufactured commodity (i.e. Food / Weapons) must always be higher than the tax on the associated raw material (FRM / WRM).





Conclusions


Given all the discussion above, I am tempted to give exact numbers I deem optimal for the US right now, but to prevent accusations of bias, I will refrain from doing so. Suffice to say that I am advocating for a relatively free trade policy, despite the fact that I own enough companies to personally profit from protectionism that most of our congressmen and old players are a fan of.

I hope my article will be helpful for all eRepublik players and eUS Congressmen to have an educated opinion international trade, and policy decisions regarding import taxes and embargoes. All the views above belong solely to me, and are not official views of the executive, or the EC.


Best regards,
Kemal Ergenekon
Secretary of Treasury
Member of the Economic Council