The Instruments of Trade Policy

1
The Instruments of Trade Policy
2
Chapter Outline

• Introduction
• Basic tariff analysis
• Costs benefits of a tariff PE welfare analysis
• Simple GE tariff analysis
• Digression on Effective Rate of Protection
• Other instruments of trade policy
• The effects of trade policy a summary
• Chapter summary

3
Introduction

• In the various trade models discussed so far, two
  hypothetical scenarios are compared to illustrate
  the effects of free trade
• In reality, however, unrestricted trade is the
  not the norm
• Most countries have policies that restrict trade
  to some extent
• These policies are often called protectionism
• While restricting imports, they also favor
  domestic suppliers
• Protectionism is more prevalent in agricultural
  and food products than in industrial goods
• Two issues to be explored
• Why restricting trade?
• What are the effects of individual trade policy
  instruments?

4
Introduction

• This chapter is focused on the following
  questions
• What are the effects of trade policy instruments?
• Who will benefit and who will lose
• What are the costs and benefits of protection?
• Will the benefits outweigh the costs?
• What should a nations trade policy be?
• e.g. should the US use a tariff or an import
  quota to protect its automobile industry against
  competition from Japan South Korea?
• Why do countries choose to apply these
  instruments to restrict trade when there are
  gains from trade?
• to be discussed later in the course

5
Introduction

• Classification of Commercial Policy Instruments

Commercial Policy Instruments
6
Basic Tariff Analysis

• Tariffs
• Specific tariffs
• levied as a fixed charge for each unit of goods
  imported
• Ad valorem tariffs
• levied as a fraction of the value of the imported
  goods
• A compound duty (tariff)
• a combination of an ad valorem and a specific
  tariff.
• Non-tariff barriers
• Import quotas used to limit the quantity of
  imports
• Export restraints used to limit the quantity of
  exports

7
Basic Tariff Analysis

• Supply, Demand, and Trade in a single industry a
  partial equilibrium analysis
• Assumptions
• 2 countries (Home and Foreign).
• Both consume produce one good wheat.
• Costless transportation.
• In each country, wheat is a competitive industry.
• Suppose that in the absence of trade, the price
  of wheat at Home exceeds the corresponding price
  in Foreign.
• Therefore, it makes sense to export wheat from F
  to H
• The export of wheat raises its price in F and
  lowers its price in H until the initial
  difference in prices has been eliminated.

8
Basic Tariff Analysis

• To determine the world price (Pw) and the
  quantity of trade (Qw), two curves are defined
• Home import demand curve
• maximum quantity of imports Home would like to
  consume at each price of the imported good.
• i.e., the excess of what Home consumers demand
  over what Home producers supply MD D(P)
  S(P)
• Foreign export supply curve
• maximum quantity of exports Foreign would like to
  provide the rest of the world at each price.
• i.e., the excess of what Foreign producers supply
  over what foreign consumers demand XS S(P)
  D(P)
• Caution this is a PE analysis because only one
  market is considered.

9
Basic Tariff Analysis
Figure 8-1 Deriving Homes Import Demand Curve
PA
P2
P1
10
Basic Tariff Analysis

• Properties of the import demand curve
• It intersects the vertical axis at the closed
  economy price of the importing country.
• It is downward sloping.
• It is flatter than the domestic demand curve in
  the importing country.
• import demand more sensitive to price changes
• as the price increases, not only total domestic
  demand (for both domestic imported products)
  shrinks, domestic supply also increases, leading
  to a larger decrease in import demand (than the
  decrease in domestic demand that would be induced
  by the same price increase)

11
Basic Tariff Analysis
Figure 8-2 Deriving Foreign Export Supply Curve
P2
P1
PA
12
Basic Tariff Analysis

• Properties of the export supply curve
• It intersects the vertical axis at the closed
  economy price of the exporting country.
• It is upward sloping.
• It is flatter that the domestic supply curve in
  the exporting country
• More sensitive to price changes

13
Basic Tariff Analysis
Figure 8-3 World Equilibrium
The worldwide equilibrium for this product is
reached where the two curves intersect.
MD
14
Basic Tariff Analysis

• Useful definitions
• The terms of trade (TOT) is the relative price of
  the exportable expressed in units of the
  importable.
• A small country is a country that cannot affect
  its TOT no matter how much it trades with its
  partners.
• The following analysis will be based on
• either two large countries trading with each
  other
• or a small country trading with the rest of the
  world
• TOT for the small country is fixed

15
Basic Tariff Analysis

• Price and volume effects of a tariff
• First assume two large countries trading with
  each other.
• Suppose H imposes a specific tariff of t per
  unit.
• the price difference between the two markets must
  be at least t.
• Such a wedge is created when
• domestic price at H is up, lowering the excess
  demand
• Decreased demand and increased supply
• price in F (i.e. the world price, assuming no
  transportation cost) is down, lowering the excess
  supply
• Increased demand and decreased supply
• when the wedge equals t, H MD equals F XS
• i.e. total world demand and supply are equalized.
• Note the increase in domestic price at H lt t,
  because part of t is reflected in a decline in
  the F export price
• Trade volume ( equilibrium excess D or S) is
  smaller

16
Basic Tariff Analysis
Figure 8-4 Effects of a Tariff imposed by a
large country
World market
Foreign market
Home market
S
PT
PW
PT
3
MD
D
17
Basic Tariff Analysis
Figure 8-5 A Tariff in a Small Country
Second, assume H is small. If H is small and
imposes a tariff, then F export prices will be
unaffected and the domestic price at H will
rise by the full amount of the tariff.
PW t
PW
18
Costs and Benefits of a Tariff

• A tariff raises the price of a good in the
  importing country and may lower it in the
  exporting country.
• As a result of these price changes
• Consumers lose in the importing country and gain
  in the exporting country
• Producers gain in the importing country and lose
  in the exporting country
• Government imposing the tariff gains revenue
• To compare these costs and benefits, we need to
  measure the gains/losses using
• consumer and producer surplus.

19
Costs and Benefits of a Tariff

• Consumer and Producer Surplus
• (a review of your basic microeconomics!)
• Consumer surplus
• It measures the amount a consumer gains from a
  purchase by the difference between the price she
  actually pays and the price she would have been
  willing to pay.
• It can be derived from the market demand curve.
• Graphically, it is equal to the area under the
  demand curve and above the price.

20
Costs and Benefits of a Tariff
Figure 8-6 Deriving Consumer Surplus from the
Demand Curve
21
Costs and Benefits of a Tariff
Figure 8-7 Geometry of Consumer Surplus
P1
P2
22
Costs and Benefits of a Tariff

• Producer surplus
• It measures the amount a producer gains from a
  sale by the difference between the price he
  actually receives and the price at which he would
  have been willing to sell.
• It can be derived from the market supply curve.
• Graphically, it is equal to the area above the
  supply curve and below the price.

23
Costs and Benefits of a Tariff
Figure 8-8 Geometry of Producer Surplus
P2
P1
24
Costs and Benefits of a Tariff

• Measuring the Cost and Benefits
• Is it possible to add consumer producer
  surpluses?
• Yes, we can add them algebraically because any
  change in price affects each individual in two
  ways
• As a consumer
• As a worker
• But this assumption is needed
• at the margin a dollars worth of gain or loss to
  each group is of the same social worth.

25
Costs and Benefits of a Tariff
Figure 8-9 Costs and benefits of a tariff for a
large importing country
PT
PW
PT
26
Costs and Benefits of a Tariff
Figure 8-9 Costs and benefits of a tariff for a
small importing country
PT
PW
PT
27
Costs and Benefits of a Tariff

• The two triangles b and d measure the loss to the
  importing country as a whole (efficiency loss)
  and the rectangle e measures an offsetting gain
  (TOT gain).
• The efficiency loss arises because a tariff
  distorts incentives to consume and produce.
• Producers and consumers act as if imports were
  more expensive than they actually are.
• Triangle b is the production distortion loss and
  triangle d is the consumption distortion loss.
• The TOT gain arises because a tariff imposed by a
  big country lowers foreign export prices.
• If the TOT gain gt the efficiency loss, the tariff
  increases welfare for the importing country.
• however, the tariff definitely reduces welfare
  for a small importing country because of the
  efficiency loss and no TOT gains.

28
Costs and Benefits of a Tariff
Figure 8-10 Net Welfare Effects of a Tariff for
a big importing country
PT
PW
PT
29
Costs and Benefits of a Tariff
Figure 8-10 Net Welfare Effects of a Tariff for
a small importing country
PT
PW
PT
30
Costs and Benefits of a Tariff

• What are the effects on the exporting country
  when the importing country is a large country and
  imposes a tariff?
• Use the same PE framework in your analysis

31
Tariff Analysis in General Equilibrium
Table 8AI-1 Free Trade Equilibrium for a Small
Country
D1
32
Tariff Analysis in General Equilibrium
Table 8AI-2 A Tariff in a Small Country
D1
D3
D2
Q1
33
Tariff Analysis in General Equilibrium
Table 8AI-3 Effect of a Tariff on the TOT of a
large country
34
Digression measuring the degree of protection by
imposing a tariff

• Why tariff is considered protection?
• It lowers imports, increases supply of the
  import-competing product, and reduce domestic
  demand
• So it protects domestic producers at the
  expense of consumers!
• Measuring the Amount of Protection
• In analyzing trade policy in practice, it is
  important to know how much protection a trade
  policy instrument provides.
• usually this is defined as a of the price that
  would prevail under free trade.
• However, In the large country case, the observed
  foreign export price is lower than the price
  under free trade, which is unknown.
• Moreover, tariffs may have different effects on
  different stages of production of a good.

35
Digression measuring the degree of protection by
imposing a tariff

• Effective rate of protection
• One must consider both the effects of
  tariffs/subsidies on the final price of a good,
  and the effects on the costs of inputs used in
  production.
• The actual protection will not equal the nominal
  rate if imported inputs are used in producing the
  protected good.

36
Digression measuring the degree of protection by
imposing a tariff

• Effective rate of protection
• ERP (Vt Vw)/Vw where Vt is the value-added in
  the sector with the presence of the trade policy
  and Vw is the value-added at world price.
• Example a car can be sold at 8000 on the world
  market and the parts cost 6000. Consider the
  following two cases
• 25 tariff on imported cars only leading to a
  domestic price of 10000 (8000 x 1.25).
  Domestic assemblers can produce at a value-added
  of 4000. Protection provided by the tariff for
  domestic assemblers is (4000 - 2000)/2000
  100!
• In this case, assemblers are protected but not
  the parts producers
• 10 tariff on imported parts only. Now Vt is only
  1400 (8000 - 6600) whereas Vw remains at
  2000. So, the ERP is (1400 - 2000)/2000
  -30.
• This tariff actually provides negative protection
  to the assemblers, although it protects the auto
  parts producers.

37
Other Instruments of Trade Policy

• Export Subsidies Theory
• Export subsidy
• A payment by the govt to a firm that sells a
  good abroad
• When the government offers an export subsidy,
  shippers will export the good up to the point
  where the domestic price exceeds the foreign
  price by the amount of the subsidy.
• Suppose Pd 10 the subsidy is 2. Then, Pf
  (selling price in foreign) will be 8. Shippers
  cannot sell it at 7 because cost would be not
  covered fully. They will NOT sell it at 9
  because they can afford to sell it cheaper with
  the 2 subsidy.
• It can be either specific or ad valorem.

38
Other Instruments of Trade Policy
Figure 8-11 Effects of an Export Subsidy by a
big country
PS
PW
PS
39
Other Instruments of Trade Policy
Figure 8-11 Effects of an Export Subsidy by a
small country
PS
PW
PS
40
Other Instruments of Trade Policy

• An export subsidy raises prices in the exporting
  country while possibly lowering them in the
  importing country.
• In addition, and in contrast to a tariff, the
  export subsidy worsens TOT of a large exporting
  country.
• An export subsidy unambiguously leads to costs
  that exceed its benefits, regardless of the size
  of the exporting country.

41
Other Instruments of Trade Policy
Figure 8-12 Europes Common Agricultural Program
42
Other Instruments of Trade Policy

• Import Quotas Theory
• An import quota is a direct restriction on the
  quantity of imports.
• The restriction is usually enforced by issuing
  licenses to some group of individuals or firms.
• In some cases (e.g. sugar and apparel), the right
  to import is given directly to the governments of
  exporting countries.
• An import quota always raises the domestic price
  of imports.
• License holders are able to buy imports and
  resell them at a higher price in the domestic
  market.
• The profits received by the holders of import
  licenses are known as quota rents.

43
Other Instruments of Trade Policy

• Welfare analysis of import quotas versus of that
  of tariffs
• The difference between a quota and a tariff is
  that with a quota the government receives no
  revenue.
• In assessing the costs and benefits of an import
  quota, it is crucial to determine who gets the
  rents.
• When the rights to sell in the domestic market
  are assigned to governments of exporting
  countries, the transfer of rents abroad makes the
  costs of a quota substantially higher than the
  equivalent tariff.

44
Other Instruments of Trade Policy
Figure 8-13 Effects of the U.S. Import Quota on
Sugar
US domestic price 466
World Price 280
45
Other Instruments of Trade Policy

• Voluntary Export Restraints
• A voluntary export restraint (VER) is an export
  quota administered by the exporting country.
• It is also known as a voluntary restraint
  agreement (VRA).
• VERs are imposed at the request of the importer
  and are agreed to by the exporter to forestall
  other trade restrictions.

46
Other Instruments of Trade Policy

• A VER is exactly like an import quota where the
  licenses are assigned to foreign governments and
  is therefore very costly to the importing
  country.
• A VER is always more costly to the importing
  country than a tariff that limits imports by the
  same amount.
• The tariff equivalent revenue becomes rents
  earned by foreigners under the VER.
• A VER produces a loss for the importing country.

47
Other Instruments of Trade Policy

• Local Content Requirements
• A local content requirement is a regulation that
  requires that some specified fraction of a final
  good be produced domestically.
• This fraction can be specified in physical units
  or in value terms.
• Local content laws have been widely used by
  developing countries trying to shift their
  manufacturing base from assembly back into
  intermediate goods.

48
Other Instruments of Trade Policy

• Local content laws do not produce either
  government revenue or quota rents.
• Instead, the difference between the prices of
  imports and domestic goods gets averaged in the
  final price and is passed on to consumers.
• Firms are allowed to satisfy their local content
  requirement by exporting instead of using parts
  domestically.

49
Other Instruments of Trade Policy

• Other Trade Policy Instruments
• Export credit subsidies
• A form of a subsidized loan to the buyer of
  exports.
• They have the same effect as regular export
  subsidies.
• National procurement
• Purchases by the government (or public firms) can
  be directed towards domestic goods, even if they
  are more expensive than imports.
• Red-tape barriers
• Sometimes governments place substantial barriers
  based on health, safety and customs procedures.

50
The Effects of Trade Policy A Summary
Table 8-1 Effects of Alternative Trade Policies
51
Summary

• A tariff drives a wedge between foreign and
  domestic prices, raising the domestic price but
  by less than the tariff rate (except in the
  small country case).
• In the small country case, a tariff is fully
  reflected in increased domestic prices.
• The costs and benefits of a tariff or other trade
  policy instruments may be measured using the
  concepts of consumer and producer surplus.
• The domestic producers of a good gain
• The domestic consumers lose
• The government collects tariff revenue

52
Summary

• The net welfare effect of a tariff can be
  separated into two parts
• Efficiency (consumption and production) loss
• TOT gain (is zero in the case of a small country)
• An export subsidy causes efficiency losses
  similar to a tariff but compounds these losses by
  causing a deterioration of the terms of trade.
• Under import quotas and voluntary export
  restraints the government of the importing
  country receives no revenue.