Government Distortions inInternational Trade

Chapter 6

So far we have covered…

• Causes and consequences of trade– Trade leads to redistribution of production in an

economy– Also affects the returns paid to factors of

productions.

Gains from Trade

• Static and Dynamic Gains– Static Gains

• Consumption gains

• Production gains

– Dynamic Gains• Technology transfer

• Leads to greater competition

• Helps in achieving economies of scale.

• Leads to higher income

– Political gains

Major Types of Trade Barriers• Tariffs

– Import Tariffs– Export Tariffs

• Nontariff barriers– Quotas

• Import Quotas

• Export Quotas

– Subsidies• Import Subsidies

• Export Subsidies

– Qualitative restrictions

Tariffs

• It is a tax imposed by the government on imports and exports (US does not impose tariffs on exports)

• Tariffs are imposed:– To raise government revenue

– To protect domestic producers• Developed countries mostly impose tariffs to protect domestic

producers.

• U.S. tariff revenue accounts for less than 2 percent of government revenue

Types of Tariffs

• For every product there are three possible tariffs– Ad valorem tariffs: The tax is calculated as a

percentage of the value of the product.• Most of the tariffs are ad valorem in nature.

– Specific tariffs: The tax is calculated as a fixed amount of money per unit of goods.

Types of Tariffs

• For every product three are three possible tariffs– Compound Tariffs: It has both specific and ad

valorem components• Processed cherry products in the U.S. are protected

by a compound tariff of 6.9 cents per kilogram plus 4.5 percent of the product price

Tariff rates

• General rates of duty: is the duty applied to goods from countries to whom United States has granted most favored nations (MFN)

• A county confers MFN status upon agreeing not to charge tariffs on that country’s goods that are not higher than those it imposes on the goods of any other country

Tariff rates

• Special rate of duty: is the duty applied to goods from certain countries with whom United States has negotiated special trade agreements– Caribbean Basin Initiative– North American Free Trade Agreement– United States-Israel Free Trade Agreement

Tariff rates

• A complete list of U.S. Tariff schedule is available online at:– http://www.usitc.gov/taffairs.htm

Economic Analysis of Tariffs

• Tools to be used to analyze economic effects of tariffs:– Consumer surplus – Producer surplus

• Lets take an example of one commodity, say, wheat

Market Demand

price

D

Qo

q1

P1

P2

q2

P

X

Consumer Surplus

P

Q

a

Producer Surplus

P

Q

a

Price, and Production under Autarky (no trade) for wheat

Pe

D S Pi

QeQi

Wheat Exporting CountryWheat Importing Country

Gains from Free Trade for Wheat Importing Country

Pi

Qi

Pw

Sw

Dw

ab c

Welfare Effects in the Import Market

• Change in Consumer welfare:• a+b+c

• Change in Producer welfare:• -a

• Net welfare change:• b+c

Gains from Free Trade for Wheat Exporting Country

Pe

DW SW

Qe

PW

ef

g

Welfare Effects in the Export Market

• Change in Consumer welfare:• -(e+f)

• Change in Producer welfare:• +(e+f+g)

• Net welfare change:• g

The Effects of an Import Tariffs

• Lets impose a tariff of t dollars on imports

Pi

Qi

Pw

Dw

Pw+tTariffa

bc d e

Welfare Effects of a tariff imposed by a small country

• Change in Consumer welfare:

• Change in Producer welfare:

• Change in government revenue

• Net welfare change:

Deadweight Cost of the Tariff

• It is the cost to the society of imposing the tariff.

• It is also an amount that goes to no one.

• Dead weight cost of the tariff = ½*tariff*reduction in imports (for linear demand and supply curves)

The Deadweight Loss of an Import Tariffs

Pi

Qi

Pw

Dw

Pw+ta

bc d e

Production deadweight cost

Consumer deadweightcost

So far….

• We have analyzed the effects of tariff using some strict assumptions:– Regarding size of the country imposing tariff

• Suppose the country that imposes tariffs is a large country in the sense that it is significant importer or exporter of the product.

Illustration of a tariff for a large country

P’DA

P

PFT

P”

PFT

QBQt

SB

DB

Importing Country

Q1

Exporting Country

SA

P’

P

Q4 Q44Q33Q11 Q22Q3 Q2

a b c det

Welfare cost of a tariff

• Change in consumer surplus– -a -b -c -d

• Change in producer surplus– +a

• Change on government revenue– +c +e

• Net welfare change– -b -d +e