Trade Policy

1
Trade Policy

• Patrik Karpaty
• Spring 2005

2
Content

• Introduction
• Chapter 2 Helpman-Krugman (H-K), Tariff Analysis
  und perfect competition
• Chapter 3 imperfect competition
• Chapter 4 Trade taxes
• As an alternative for chapter 2 K-O (2000)

3
Introduction

• Trade policy, instruments
• Specific tariffs (a tariff on each unit of
  imports)
• Ad valorem tariffs (percentage of the import
  price)
• Import quotas
• Subsidize domestic production
• Subsidize the export of domestic production
• Export restraints

4
Trade policy

• International flows can be demonstrated to be
  beneficial for all countries involved
• Ricardian models, technology differences
• H-O, differences in factor abundance
• Critics against trade, unemployment, low wages
  etc
• Tariffs, import quotas (cars from Japan etc etc.)
  
• Trade restrictions have been falling since 1945
• GATT

5

• World trade in manufacturing goods is important
• Theoretical models up to the 80s assumed
  perfect competition
• But, firms are seldom price takers in reality
• Oligopolistic markets (concentrated production)
• Theory has eventually changed New Trade
  Theory
• More of Industrial Organization (IO)
• IRS (allow for large firms)
• Imperfect competition
• Differentiated goods
• Still, Trade Policy using new trade theory is
  not
• generally accepted
• Diversity of models, as in IO. I.e. no model
  consensus

6
Chapter 2 (abbreviated)

• Aim of this lecture
• Trade policy under perfect competition
• Analyze different policy tools and effects
• Winners and losers of different tools
• Tariff
• Import quotas
• Export subsidies
• Small and large countries (focus on large)
• Optimal tariff

7
Tools

• Partial equilibrium analysis
• Supply and demand depend only on the policies
  undertaken in that market
• World market, single competitive market
• General equilibrium
• When we consider the combined effects on both
  import and export in e.g. Home (e.g. allow exort
  tax affect imports)

8
Assumptions

• Two large countries, Home and Foreign
• A single competitive market, e.g. wheat
• Note that the figures in chapter 2 often is the
  World Market, while in other textbooks Home and
  Foreign is common figures (we will use both)
• Assume that there is a difference in price
  between Foreign and Home (higher in Home) Home
  import wheat
• When Foreign starts export wheat to Home, prices
  increase in Foreign and lowers the price in Home

9

• The reason for imports is that prices are lower
  in Foreign
• In Foreign prices will increase because of import
  demand from Home

10
Figure 1 Deriving Homes Import Demand Curve
Import demand curve MD Is the difference in
domestic production and consumption MD D(p)-S(p)
PA
P2
P1
11
Figure 2 Deriving Foreigns Export Supply Curve
P2
Foreigns export supply curve excess domestic
supply over domestic demand XSS(p)-D(p)
P1
PA
12
World market

• We now have a diagram for the world market
• This diagram will help us in finding pros and
  cons of different Trade Policies, Tariffs, Quota,
  Export subsidies, Export taxes

13
Tools in measuring welfare

• Consumer surplus (CS)
• CS measures the difference between the consumers
  reservation prices and the price the actually
  have to pay
• CS is the area above the price level and under
  the demand curve
• Producer surplus (PS)
• PS measures the difference between the producers
  reservation price and the price he actually
  receives
• PS is the area below the price and above the
  supply curve
• Government revenue

14
Terms of Trade (ToT)

• The relation between export prices and import
  prices
• A large country can use trade policy in order to
  change the Terms of Trade
• A small country cannot affect the world prices,
  and thus the Terms of Trade cannot change by trade

15
Figure 3 Effects of a Tariff
World market
Foreign market
Home market
S
PT
PW
PT
3
MD
D
16
Figure 4 Home country, PS and CS
pt
pF
pt pt-t
17
Figure 5 Determination of trade volume and
prices

Price p
World market

• Assume Home is large
• Equilibrium, without tariffs, pF
• Introduce a tariff t, price is now pt
• Price in Foreign falls
• CS decreases by 12345
• Government revenues 2367
• Distortion 125
• The gain 4567. ToT effect ()
• If Home is small, the gain vanish

XS
3
2
pt
1
4
5
pF
pt pt-t
6
7
MD
m
0
mF
mt
18
Effects on prices

• In the absence of a Tariff the equilibrium price
  is pF. Equalized in both countries
• Impose a Tariff t, (a wedge)
• pt is the new Home price on imports
• The price in Foreign falls to pt, i.e. pt-t
• At pt less imports is demanded in Home, and less
  export is supplied from Foreign, see figure 1
• Lower price in Foreign raises Foreign demand
• The volume of goods traded declines due to the
  Tariff
• The tariff rate difference in pt - pt

19
Effects on welfare in Home

• Consumers loose CS (-) (a tax on consumers)
• government win ()
• domestic producers win PS () (a subsidy)
• Terms of Trade () since pimp(-)
• A small tariff raises welfare
• If we lower the tariff a little, the gain (area
  4567) will not shrink as much
• Thus the gain is first order and loss second
  order
• For a small country the effects are always
  negative for welfare
• Large Tariffs, trade-off distortion and gain

20
Import quotas

• The import quota restricts the quantity that Home
  importers may import
• In figure 2.1 in H-K the imports decreases to mt
• The welfare analysis is the same as for the
  Tariffs, but the government in Home receives no
  revenue.
• The owner of licenses gain
• e.g. the licence owner buy at p, sell at pt
• If the licenses are assigned to foreigners, the
  foreigners get the rent

21
Welfare of licenses

• Example 1 auction
• the auction prices fully absorb the rent
• Example 2 assignment of import rights to Home
  residents
• residents receive the rents
• Example 3 Foreigners receive the licenses
• the foreigners receive the gain

22
Quotas examples

• U.S sugar quotas, the foreigners get the rents
  (unambiguous loss to the Home country)
• U.S has a quota on imports of foreign cheese
  (certain trading companies)
• Self-punishing policy

23
Export Subsidies

• The exporting firms in Home country receives
  payment, e.g. per unit export good
• The export subsidies raises the price in Home
  (take it or leave it), but lowers the price in
  Foreign
• Welfare effects differs as compared to a tariff
• The domestic producer win, while consumers lose
• In contrast to a tariff, subsidies worsens the ToT

24
Figure 6a Effects of an Export Subsidy
Home country
pS
pF
pS ps - s
25
Figure 6b Effects of an Export Subsidy
p
World market
S
Homes export supply
Distortion loss 127

• Subsidy raises the prices in Home (ps)
• Abroad ps
• difference subsidy
• Home producers gain, consumers lose
• Net change 1234 in PS and Cs
• Export rise from XF to XS
• ToT decreases for Home

3
ps
2
1
4
7
pF
6
pspS-S
5
D
Foreign import demand
X
XS
XF
26
Export Taxes

• So, a subsidy worsens ToT, tariff improves ToT
• The government in Home imposes an export tax
  instead
• Example
• This means that the Home producers export prices
  falls (they dont get the whole export price).
  I.e. the internal price of exports falls.
• Same effects as if Foreign imposes a import quota

27
Figure 7 Effects of an Export Tax

Price p
World market

• Assume Home is large
• Equilibrium, without tax, pF
• Introduce a tax t
• Price in Home falls to pt
• CSPS decreases by 12345
• Government tax revenues 4567
• Distortion 125
• The gain 4567. ToT effect ()
• If Home is small, the gain vanish
• Same effect when Foreign impose
• a import quota

XS
7
pt ptt
6
1
3
2
pF
pt
4
5
MD
m
0
mF
mt
28
Optimal trade taxes

• A small export tax increases wealth
• At some point taxes become harmful
• the gain in ToT, becomes off set by the
  distortion of the tax
• One limit is the social cost in exports
• Home cut its consumption, or
• increase its production
• Marginal social costs defined by the export
  supply curve
• Social return (marginal revenue of export)

29
Figure 8 Optimal Trade tax
p
SMC
5
6
pt
MR is below D since exporting more contributes
less to the gain from exporting The optimal tax
reduces XF to Xt
1
4
7
pF
ptpt-t
2
3
MR
D
X
XF
Xt
30
Optimal tax again

• The optimal tax rate is simply determined by the
  condition that the marginal revenue (MR) from
  exports be equal to the marginal cost of these
  exports
• The optimal tax can be shown to be a function of
  the elasticity of Foreign demand of Home exports
  (see page 18)

31
Table 1 A summary
32
Chapter 3

• Imperfectly competitive domestic industries faces
  competitively supplied imports
• Idea is that protection creates domestic monopoly
• Quota are worse than tariffs (Bhagwati 1965)
• Not so realistic
• a industry in Home that is Oligopolistic is often
  Oligopolistic in Foreign as well
• But we may isolate domestic market power

33
Import competing monopolist

• The only competition comes from abroad
• The Monopolist can not choose a profit max price
  due to foreign competition
• Protection would give market power
• Can be shown that import quotas creates more
  market power than tariffs

34
The monopolist

• Domestic demand (D)
• Marginal Revenue (MR)
• Imports assumed supplied perfectly elastic
• World price Pw
• No possibility of export
• If no trade the monopolist choses Pm, Xm
• But Pw is the upper bound
• If free trade the monopolist have no market power
  (PMC)

35
Figure 9 Import competing monopolist
p
MC
pm
pw world price of the good, the upper bound pm
is the optimal monopoly price If free trade, the
monopolist cant choose price and quantity
optimally XF is produced and no market power for
the monopolist
pw
D
MR
X
XF
Xm
36
Tariff is imposed

• Example, a specific unit tariff, t
• Import price is then pw t
• Effect of tariff depends on how large the tariff
  is.
• prohibitive, assume pp (i.e. no imports)

37
The tariff effect

• If pw t ltpp, small tariff
• no change in price and output
• Same effects as if the industry were perfectly
  competitive
• If pp lt pw t ltpm, medium tariff
• no imports, but only a threat
• perverse effect on output (see small lines)
• If pw t gtpp, large tariff
• closed economy monopoly levels

38
Figure 9b Import competing monopolist
p
MC
pm
pp
pw
MR
D
X
Xp
XF
Xm
39
Effects of a tariff

• The effects of the medium tariff is thus to
  increase prices but lower output (i.e. a
  pervasive effect on output)
• The price will still be lower than the monopoly
  price, because of the threat of imports.
• This pattern of different tariffs is illustrated
  in figure 10

40
Figure 10 Effects of a tariff
pw t
pm
pp
pw
X
Xp
XF
Xm
41
Import quota

• Impose a quota m
• First the quota is small, i.e. less than the free
  trade level of imports
• The quota will give the domestic firm a new
  demand function (three segments)
• if pgtpw import m
• if ppw horizontal segment
• if pltpw no imports, total domestic demand

42
Small import quota

• Domestic firm max profits where MR (new) is equal
  to MC (Xq, Pq)
• The quota gives the monopolist market power

43
Figure 11a Effects of a small quota
p
D
D
mc
MR
Assume a quota m less than free trade level of
imports
pq
1

• if pgtpw import m
• if ppw
• if pltpw no imports, total
• domestic demand

2
pw
3
X
XF
Xq
m
44
Large quota

• The import quota may give the domestic monopolist
  market power even if its large
• In figure 11.b two different profit max levels of
  output is depicted
• Point 1 is the free trade output
• Point 2 is where the monopolist can react to the
  quota (lower output, higher price)

45
Figure 11b Effects of a large quota
Import quota m set larger than free trade import
level
D
p
D
mc
pq2
First, MRgtMC, to xq2 where the quota becomes
binding
MR
Loss, due to less output
pw
1
2
Reduce profits
Gain due to less Output,and higher prices
x
xq2
46

• The size of the quota is important
• If the quota is large, it restricts the monopoly
  market power
• But at the same time the monopolist will chose a
  small output and high prices
• A quota that limits imports to precisely free
  trade level will definitely reduce output and
  higher prices

47
Tariff v.s. quotas

• Tariff and quota that lead to the same level of
  import have different effects
• A quota implies higher domestic price and lower
  domestic output
• Tariff may restrict imports, but prices are still
  below Pm and output larger than Xm
• The reason is that there is a threat from abroad
• The import quota eliminates this threat
• The tariff constrained demand curve is more
  elastic then the quota constrained demand

48

• Import quota creates more market power, as
  compared to a tariff that restricts imports by
  the same amount
• Lower domestic output and and a higher domestic
  price
• The quota reduces welfare more
• How robust are theses conclusions?

49
Declining marginal costs

• Increasing returns to scale
• Downward sloping marginal costs
• Discontinuity in the response of output to the
  tariff rate
• If free trade the monopolist is unable to operate
  profitably in the domestic market

50

• Impose a tariff ts
• Firm starts to produce a large positive output Xs
  (displaces all imports)
• If tariff is further increased, the monopolist
  can move against monopoly prices and output
• Nonequivalence of tariffs v.s. quotas remains (as
  in the case of upward sloping MC)
• Thus th result seem to be intact

51
p
pM
Pwts
AC
Pw
MC
MR
D
X
XM
XS
52
Imperfect subsitutes

• The single monopolist have some market power even
  under free trade
• Protection can no longer have the effect of
  creating brand new monopoly power, because there
  is always perfect substitutes
• Protection may of course increase monopoly power

53
Imperfect substitutes

• The firm will face a downward sloping demand
  curve
• The tariff will raise the price of competing
  imports
• The domestic demand for the good will increase
• If the domestic firm keep there prices and
  increase demand no increase in monopoly power
  (p-mc)/p

54
Imperfect substitutes

• The effect of a quota is again stronger than that
  of a tariff
• The reason is that when a quota restricts
  imports, a price increase in the monopoly firm
  will be accompanied by a price increase in
  imported goods as well.
• I.e. the demand curve with a quota is steeper
  than that of a tariff

55
Noncooperative domestic oligopoly

• Strategic variable?
• Price and then adjust demand?
• Levels of output
• Bertrand and Cournot
• Results are much the same
• Each firm will produce xX/n
• Same good (imperfect substituite for import)

56
Perceived demand curves