The role of a production capacity limit in international trade policy analysis

Abstract

The empirical trade literature is rich in analyzing how an international trade policy such as a tariff increase or a ban distorts trade flows. However, the role of a production capacity limit is often ignored in these studies, which may be problematic for certain agricultural products and many other products that have close to perfectly inelastic supply in the short run. This study fills this gap in the literature by illustrating how to incorporate a production capacity limit into partial equilibrium multi-country trade models. Given that FDA halted shipments of imported orange juice over a fungicide scare in 2012, we illustrate the role of a production capacity limit using orange juice global trade data. Our results show that ignoring production capacity limit might lead to large bias in policy analysis.