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Trade Policy: Instruments and Impacts

Appleyard & Field (& Cobbs): Chapters 13–14

Krugman & Obstfeld: Chapter 8

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Today’s Lecture

1. Instruments of trade policy1. Tariffs2. Quotas3. Other Non-tariff Barriers to Trade

2. Impact of trade policies1. Partial Equilibrium: Small Country2. Partial Equilibrium: Large Country3. General Equilibrium: Small Country4. General Equilibrium: Large Country

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Tariffs• Imports tariffs

o specific tariff: (a monetary sum that must be paid to import 1 physical unit of a product)

Advantage: easy to collect Disadvantage: doesn’t take price changes into account

o ad valorem tariff: (a percentage of the monetary value of 1 unit of import)

Advantage: takes price changes into account Disadvantage: Need to know the monetary value of the

good and seller is tempted to undervalue the price • Other instruments

o Import subsidy negative import tariffo Export tariff/subsidy (levied/paid on home-

produced goods that are destined for export)

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Features of Tariff Schedules• Preferential duties

o products form certain countries are subject to lower tariffs than the normal tariff rate

o Generalized System of Preferences (GSP) for developing countries

• Most-favoured-nation (MFN) treatment = normal trade relations (NTR)o “if country A grants country B the status

of most-favoured nation, it means that B’s exports will face tariff that are no higher (nor lower) than those applied to any other country that A calls a MFN” (Economics A-Z in The Economist website)

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Non-tariff Barriers to Trade (1)• Import Quotas

o a government agency allocates the rights to importo limits the number of goods (not the price) for a given

time period• “Voluntary” export restraints (VER)

o foreign suppliers agree to “voluntary” refrain from sending some exports

• Government procurement provisionso restriction on purchasing foreign products by the

domestic government agencies• Domestic content provisions

o a given percentage of the value of a good must consist of domestic components or labour

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Non-tariff Barriers to Trade (2)• Administrative classification

o different tariffs to different product categories + leeway for customs officials to decide on classification

• Restrictions on services trade• Trade-related investment measures• Domestic policies affecting trade

o health, environment and safety standards; packaging and labeling requirements; inconsistent treatment of intellectual property rights; subsidies to domestic firms...

etc.

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Impact of Trade Policy: Levels of Study

• Partial Equilibrium analysiso analysing one market and ignoring

the subsequent or secondary effects• General equilibrium analysis

o analysing all markets simultaneously (but still holding technology, endowments etc. constant)

• Note that here “market” means a market for one good (which can be sold in many countries). We will use both approaches to study one-country and two-country cases. The difference is that in general equilibrium analysis we take also into account what happens in the markets of goods not subject to trade policy.

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Consumer and Producer Surplus

• In a partial equilibrium approach we can use the concepts of consumer and producer surplus

• Both reflect the fact that there is only one market price

• Hence, there are consumers who would have been willing to pay more for the product

• Similarly, all but the “last” unit is produced with lesser marginal cost than the market price received

P

Price (P)

D

consumer surplus

Quantity (Q)

S = marginal costof production

producersurplus

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imports after tariff

The Impact of Import Tariff: The Small-Country* Case

DD

Q

SD

Pint

(1+τ)Pint

imports in free trade

increase ofproducersurplus ta

riff

to t

he

gove

rnm

en

t

dead

wei

ght

loss

deadweightloss

imports after tariff

P

DD

Q

SD

Pint

(1+τ)Pint

imports in free trade

Loss of consumer surplus

P

Loss of consumer surplusIncrease of producer surplus andgovernment income

* Small country = cannot affect world prices

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The Impact of Import Tariff: The Small-Country Case• Introducing a tariff

→ Domestic price increases→ Domestic quantity supplied increases→ Domestic quantity demanded falls → Increase of government revenues

• Distributional effecto surplus is transferred from the

consumers to the producers and the government

• Consumers lose more than producers and government win: deadweight loss

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The Impact of Import Quota:

The Small-Country Case• For every quota there

is an equivalent tariff (and for every tariff there is an equivalent quota)

• The changes in consumer and produce surplus are equivalent to that of a tariff

• However, the increase of government revenue may be lost (depending on how the quotas are allocated)

quota

P

DD

Q

SD

Pint

imports in free trade

PQ

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imports after the subsidy

The Impact of Subsidy to Import-Competing Industry (Small Country Case)

DD

Q

SD

P

imports in free trade

Cost to the government

imports in free trade

P

imports after the subsidy

P

DD

Q

SD

P

increase ofproducersurplus eff

icie

ncy

loss

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The Impact of Subsidy to Import-Competing Industry (Small Country Case)

• Equivalent subsidy = producers are subsidised to produce the same amount as they would under a tariff→ Equal increase in the producer surplus as under tariffs→ Large cost to the government→ No impact on price no impact on consumer surplus

• Cost to the government is larger than the increase of producer surplus, i.e. there is a loss of efficiency

• However, this cost is less than the loss of consumer surplus in the tariff/quota case → subsidies are more efficient than tariffs/quotas

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Large country, partial equilibriumSingle Market, Two Countries

Q Q

Country A Country B

DA

SA

SB

DB

PP

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Single Market, Two Countries

Q Q

Country A Country B

DA

SA

SB

DB

PP

Countries A and B have different supply curves (cost of production) and demand curves (preferences). In free trade equilibrium the world price is such that country B is willing to export the same quantity as country A is willing to import.

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Single Market, Two Countries, Tariff

Q Q

Country A Country B

tariff

DA

SA

SB

DB

PP

Price in Country A = Price in country B + tariff. If the price in country B would remain constant after a tariff is set, country B would be willing to export more that country A would be willing to import → price in country B must decrease (next slide)

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Effect of a Tariff in a Single Market and Two-Countries

Q Q

Country A Country B

tariffPFT

PA

PB

DASA

SBDB

PP

a b

Cprice decrease in country B

De

Country A:Loss of consumer surplus = e+a+D+b; increase of producer surplus = e; Increase of government revenue = C+D. Gain for Country A = gains–losses = (e+C+D)-(e+a+D+b) = C – a – b. That is, if C > a + b country A has gained from the imposition of the tariff (due to lower prices of imports before tariff).

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Impact of Elasticises

Q Q

Country A Country B

tariffPFT

PA

PB

DA

SA

SBDB

PP

a bC

price decrease in country B

De

The more elastic in the exporting market and the more inelastic in the importing market supply and demand are, the less chances the importing country has on gaining from tariff

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The Impact of Import Quota• Graphically identical to the case of tariff• The difference is in, who gets areas D

(country A’s government revenue from the tariff) and C (loss of country B’s producer surplus that is transferred to country A in the tariff setting)

• Voluntary export restraints (VER) can be seen as a way for the exporting country to capture areas C and Do Then, if this gain is greater than the

deadweight loss of the exporter (triangles around C), the exporting country will gain from the quota

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General Equilibrium Analysis• Partial Equilibrium analysis

o analysing one market and ignoring the subsequent or secondary effects

• General equilibrium analysiso analysing all markets simultaneously

(but still holding technology, endowments etc. constant)

• Note that here “market” means a market for one good (which can be sold in many countries). We will use both approaches to study one-country and two-country cases. The difference is that in general equilibrium analysis we take also into account what happens in the markets of goods not subject to trade policy.

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General Equilibrium Effects of a Tariff for a Small Country

• Import tariff on good Y changes the price ratio

• Producers adjust from point PFT to Pt

• Since the tariff doesn’t change world prices, country’s real income changes to (PX/PY)t

• Consumers maximize given domestic prices and real income and move to a lower utility level

• Note that real income is determined by the world prices Good XPt

Pt

Good Y

PFTCFT

PFT

CFT

(PX/PY)FT

PX/(1+τ)PY

Ct

Ct

(PX /P

Y ) t

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General Equilibrium Effects of a Subsidy for a Small Country

• Assume the government subsidizes producer of good Y to impose the same production pattern as with the tariff

• The real income of the country remains the same

• Consumers face world prices and are able to consume at a higher utility level

Good XPS

PS

Good Y

PFTCFT

PFT

CFT

(PX/PY)FT

PX/(1+τ)PY

CS

CS

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Terms of Trade Effect of a Tariff

• Imposing a tariff shifts offer curve inwards (the country is now willing to trade less for all terms of trade)

→ The tariff imposing country’s terms of trade improve (the

price of exports decrease), which may offset the, at least in part, the decrease of welfare due to efficiency loss

Good X: Exports from country 1

Imports to country 2

Good

Y:

Imp

ort

s to

cou

ntr

y 1

exp

ort

s fr

om

cou

ntr

y 2

(PX/PY)E’ = TOTE’

Country 1’s offer curve

Country 2’s offer curve

(PX/PY)E = TOTE

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Terms of Trade Effect of a Quota

• Country 1 sets a quota for imports of good Y

→ country 1’s offer curve becomes horizontal at the quota level

→ Country 1’s terms of trade improve

Good X: Exports from country 1

Imports to country 2

Good

Y:

Imp

ort

s to

cou

ntr

y 1

exp

ort

s fr

om

cou

ntr

y 2

(PX/PY)E’ = TOTE’

Country 1’s offer curve

Country 2’s offer curve

(PX/PY)E = TOTE

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Terms of Trade Effect of a Voluntary Export Restraints

• Country 2 uses voluntary export restraints (VER) to limit exports of good Y

→ country 2’s offer curve becomes horizontal

→ country 2’s terms of trade improve

Good X: Exports from country 1

Imports to country 2

Good

Y:

Imp

ort

s to

cou

ntr

y 1

exp

ort

s fr

om

cou

ntr

y 2

(PX/PY)E’

Country 1’s offer curve

Country 2’s offer curve

(PX/PY)E

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Other Effects of Protection

• Restricting imports is likely to result decrease of exports as wello Reallocation of domestic resourceso Retaliation by the trading partners

• Distributional Effectso Transfer from the consumers to the

import-competing producerso HO-model: transfer from the abundant

factor to the scarce factor