Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved....

Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Topic 4

The Instruments of Trade Policy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-2

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• Partial equilibrium analysis of tariffs: supply and demand in one industry

• Costs and benefits of tariffs

• Export subsidies

• Import quotas

• Voluntary export restraints

• Local content requirements


Introduction

• Previously discussed why nations trade.

• Now examine the policies that governments use to protect domestic industries from import competition. E.g., Should the U.S. use a tariff, quota, or

voluntary export restraint to protect automakers against competition from Japan and South Korea?

Who benefits and who loses from such policies? Will the benefits outweigh the costs?


Types of Tariffs

• A specific tariff is levied as a fixed charge for each unit of imported goods. E.g., $1 per lb of cheese

• An ad valorem tariff is levied as a fraction of the value of imported goods. E.g., 25% tariff on the value of imported cars.

• In both cases, tariffs raise the internal price of the imported good.


History of Tariffs

• Tariffs are the oldest trade policy and were used as a source of government income. Until income tax was introduced in U.S.,

government raised most of its revenues with tariffs.

• Main purpose is to protect domestic industries. E.g., Early 1800s: U.K. used tariffs to protect its

agriculture (Corn Laws).

E.g., Late 1800s: U.S. and Germany used tariffs to protect their growing manufacturing industries.


History of Tariffs (cont.)

• In modern times, use of tariffs has declined.

• Governments prefer to use a variety of non-tariff barriers to protect their domestic industries.


Supply, Demand, and Trade in a Single Industry

• Examine tariffs by using a partial equilibrium framework: ignore the rest of the economy and focus on 1 protected industry.

• Assume:

2 countries (home and foreign).

Both consume and produce wheat (W).

Zero transportation costs.

Wheat is produced in a perfectly competitive industry, so PW is determined by industry S and D.


Supply, Demand, and Trade in a Single Industry (cont.)

• Ignore currency differences and describe PW in terms of home’s currency.

• Trade arises if pre-trade prices of wheat differ between the 2 countries.

• PW > P*W

• When trade opens, shippers move wheat from foreign to home.

• Export of wheat: ↑P*W (via ↓S*) and ↓PW (via ↑S) until the PW is equal in both countries.


Supply, Demand, and Trade in a Single Industry (cont.)

• To determine world PW and QW traded, we need to define 2 curves: home import demand and foreign export supply –which are derived from domestic S and D curves. Home MD = excess of home D over home Q

Foreign XS = excess of foreign Q over foreign D

Fig. 1: Deriving Home’s Import Demand Curve

At P1: D = D1 and Q = S1 so MD = D1 - S1. At P2: D = D2 and Q = S2 so MD = D2 - S2

MD has a negative slope: as ↑P home’s producers ↑Q and consumers ↓D → ↓MD.

At PA: home’s S = D in autarky, so MD = 0.

Fig. 2: Deriving Foreign’s Export Supply Curve

At P1: Q = S*1 and D = D*1 so XS = S*1 – D*1. At P2: Q = S*2 and D = D*2 so XS = S*2 - D*2. XS has a positive slope.

At P*A: S* = D* in autarky, so XS = 0.

Fig. 3: World Equilibrium

World equilibrium occurs when X*S = MD at price of PW where the 2 curves intersect.

MD = X*S

D – S = S* - D*

D + D* = S + S*

World D = World S


The Effects of a Tariff

• A tariff can be viewed as an added cost of transportation, making sellers unwilling to ship goods unless the price difference between the domestic and foreign markets exceeds the tariff.

• If sellers are unwilling to ship wheat, there is excess demand for wheat in the domestic market and excess supply in the foreign market.

PW will tend to rise in the domestic market.

PW will tend to fall in the foreign market.


The Effects of a Tariff (cont.)

• Thus, a tariff will make ↑P in the domestic market and will make ↓P in the foreign market, until the price difference equals the tariff.

PT – P*T = t

PT = P*T + t

Price of the good in foreign (world) markets should fall if there is a significant drop in QD of the good caused by the domestic tariff.

Fig. 4: Effects of a Tariff

Price at home rises to PT and price abroad falls to P*T. Difference between PT and P*T is the amount of the specific tariff (t).

At home, ↑Q and ↓D → ↓DM. Abroad: ↓Q and ↑D → ↓X*S. Thus, the volume of wheat traded falls from QW to QT. Note that MD still equals X*S with the tariff.



• Because price at home rises to PT, domestic producers should supply more and consumers should demand less.

QM falls from QW to QT

• Because price in foreign falls to P*T, foreign

producers should supply less and consumers should demand more.

QX falls from QW to QT



• MD = X*S with the tariff

• In this case, the increase in the price of the good in the domestic country is less than the amount of the tariff. Why? The tariff causes the foreign country’s export

price to decline, and thus is not passed on to domestic consumers.

But this effect is sometimes not very significant:


The Effects of a Tariff in a Small Country

• When a country is “small,” it has no effect on the foreign (world) price of a good, because its demand for the good is insignificant.

Foreign price will not fall and remains at Pw

Price in the domestic market will rise to PT = Pw + t

Fig. 5: A Tariff in a Small Country

Here X*S is infinitely elastic. So the small country is a price taker on world markets. It can purchase as much or as little as it likes and not impact the price on world markets.

PT =


Effective Rate of Protection

• The effective rate of protection measures how much protection a tariff or other trade policy provides domestic producers.

Effective rates of protection often differ from tariff rates because: (1) large countries are able to lower the price of the imported good; and (2) tariffs affect sectors other than the protected sector.


Effective Rate of Protection (cont.)

• E.g., P car = $8,000 on world market

P car parts = $6,000 on world market

• Compare 2 countries (A and B):

A. Wants to develop an auto assembly industry.

B. Wants to develop a car parts industry (it already has an assembly industry).



• Country A places a 25% tariff on imported cars.

• Domestic producers can charge $10,000 (instead of $8,000).

• Before tariff: domestic assembly occurs if it can be done for $2,000 = [$8,000 (price of car) - $6,000 (cost of parts)] or less.

• After tariff: domestic assembly occurs if it costs as much as $4,000 ($10,000 – cost of parts).

• So 25% tariff rate yields effective protection of 100%!



• Country B places a 10% tariff on parts.

• Cost of parts increases from $6,000 to $6,600.

• Policy makes it less advantageous to produce cars domestically.

• Before tariff: assemble a car if it can be done for $2,000 = $8,000 - $6,000.

• After tariff: assemble a car if it can be done for $1,400 = $8,000 – $6,600.

• Tariff hurts domestic assemblers with a (negative) rate of protection = -$600/$2,000 = -30%.


Costs and Benefits of Tariffs

• A tariff raises the price of a good in the importing country, so we expect it to hurt consumers and benefit producers there.

• In addition, the government gains tariff revenue from a tariff.

• How do we measure these costs and benefits?

• We use the concepts of consumer surplus and producer surplus.


Consumer Surplus

• Consumer surplus measures the amount that consumers gain from purchases by the difference in the price that each pays from the maximum price each would be willing to pay.

The maximum price each would be willing to pay is determined by a demand function.

When the price increases, the quantity demanded decreases as well as the consumer surplus.

Fig. 6: Geometry of Consumer Surplus

If P = P1 then QD = Q1 and CS = area a.

CS = TU – TE; where TU = area under the D curve and TE = P x Q.

If price falls to P2, then QD = Q2 and gain in CS = area b. Total CS = a + b at P = P2.


Producer Surplus

• Producer surplus measures the amount that producers gain from a sale by the difference in the price each receives from the minimum price each would be willing to sell at.

The minimum price each would be willing to sell at is determined by a supply function.

When price increases, the quantity supplied increases as well as the producer surplus.

Fig. 7: Geometry of Producer Surplus

If P = P1, then QS = Q1. TR = P1 x Q1 and TC = area under the S curve. So PS = area c.

If price rises to P2, then QS = Q2 and gain in PS = area d. Total PS = c + d at P = P2.


Costs and Benefits of Tariffs

• A tariff raises the price of a good in the importing country, making its consumer surplus decrease and making its producer surplus increase.

• Also, government revenue will increase.

Fig. 8: Costs and Benefits of a Tariff in a Large Country

PT = price at home with tariff

PW = price in world before tariff

P*T = price in foreign with tariff

Net ∆welfare = area e – (b + d)

Area e = tot gain

Area b = over-production efficiency loss

Area d = under-consumption efficiency loss

tariff


Costs and Benefits of Tariffs (cont.)

• For a “large” country, whose imports and exports can affect world prices, the welfare effect of a tariff is ambiguous.

• The triangles b and d represent efficiency losses.

Compared with free trade, the tariff distorts production and consumption decisions: producers produce too much (QS rises from S1 to S2 where MC > PW). And consumers consume too little (QD falls from D1 to D2 where MU > PW).

• The rectangle e represents the terms of trade gain.

The tot increases because the tariff lowers foreign export (domestic import) prices.



• Government revenue from the tariff equals the tariff rate times the quantity of imports. t = PT – P*

T

QT = D2 – S2

Government revenue = t x QT = c + e

• Part of government revenue (rectangle e) represents the terms of trade gain, and part (rectangle c) represents part of the value of lost consumer surplus. The government gains at the expense of

consumers and foreigners.



• If the terms of trade gain exceeds the efficiency losses, then national welfare will increase under a tariff, at the expense of foreign countries.

However, this analysis assumes that foreign countries do not retaliate with their own tariffs.

Fig. 9: Net Welfare Effects of a Tariff in a Large Country

Fig. 10: Costs and Benefits of a Tariff in a Small Country

a cb d

Welfare effects of a tariff in a small country:

∆CS = - (a + b + c + d)

∆PS = + a

∆G rev = + c

Net ∆welfare = - (b + d)tariff



• A “small” country (in terms of world markets) cannot impact the price of the imported good. So a tariff lowers its net welfare.

• Area “e” disappears in Fig. 10 because there is no increase in the tot.

• A tariff leaves the small country with net welfare losses arising from the distortion to production and consumption decisions.



• Tariffs are the simplest form of trade policy, but most governments protect their domestic industries with export subsidies, import quotas, or voluntary export restraints.


Export Subsidy

• An export subsidy can also be specific or ad valorem

A specific subsidy is a payment per unit exported.

An ad valorem subsidy is a payment as a proportion of the value exported.

• An export subsidy raises the price of a good in the exporting country, decreasing its consumer surplus and increasing its producer surplus.

• Also, government revenue will decrease.


Export Subsidy (cont.)

• An export subsidy raises the price of a good in the exporting country, while lowering it in foreign countries.

• In contrast to a tariff, an export subsidy worsens the tot by lowering the price of domestic products in world markets.

Fig. 11: Effects of an Export Subsidy in a Large Country

Price at home rises from PW to PS and price abroad falls from PW to P*S.

Net ∆welfare = - ( e + f + d + g + b)

Area (e + f + g) = tot loss

Area d = over-production efficiency loss

Area b = under-consumption efficiency loss.

D1 S1D2 S2


Export Subsidy (cont.)

• An export subsidy unambiguously produces a negative effect on national welfare.

• The triangles b and d represent efficiency losses.

Compared with free trade, the subsidy distorts production and consumption decisions: producers produce too much (QS rises from S1 to S2 where MC > PW) and consumers consume too little (QD falls from D1 to D2 where MU > PW).

• The area b + c + d + e + f + g represents the cost of government subsidy.

In addition, the terms of trade decreases, because the price of exports falls in foreign markets to P*

s.

Fig. 12: Effects of an Export Subsidy in a Small Country

S

D

P

Q

PS

PW

a b c dsubsidy

S1 S2D1D2

exports before subsidy

exports after subsidy

Price in the home country rises by the full amount of the subsidy.

Welfare effects:

∆CS = - (a + b)

∆PS = + (a + b + c)

∆G rev = - (b + c + d)

Net ∆welfare = - (b + d)

There is no tot loss –only the efficiency losses from distorting consumer and producer decisions.


Export Subsidy in Europe

• Since 1957, EEC has had a large impact on trade policy –formed a customs union (removed all tariffs with respect to member countries) and have a huge export subsidy program.

• EEC’s Common Agricultural Policy (CAP) began to guarantee high prices for European farmers by purchasing agriculture products whenever the price fell below support levels.

• The price supports were backed with tariffs to keep imports of agricultural goods out.


Export Subsidy in Europe (cont.)

• Since 1970s, price supports are so high as to turn EU from an importer of agricultural goods to an exporter.

• Governments were buying and storing huge amounts of output under the price supports. In 1985: EU stored 780,000 tons of beef; 1.2

million tons of butter; and 12 million tons of wheat.

• Tired of the storage costs, EU decided to get rid of the surplus by subsidizing exports.

Fig. 13: Europe’s Common Agricultural Policy

Price support is set above the autarky and world price.

The exports tend to reduce the price of agricultural goods on world markets making the subsidy more expensive!

In 2005, cost of government subsidy was $60 billion.


Export Subsidy in Europe (cont.)

• CAP is currently under political pressure via government budget strain and trade conflicts with U.S.

• Recent reforms to CAP include efforts to reduce the distortions to production while still supporting farmers. If successful, farmers will receive direct payments that are not tied to output. This should lower agricultural prices and reduce production.


Import Quota

• An import quota is a restriction on the quantity of a good that may be imported.

• This restriction is usually enforced by issuing licenses to domestic firms that import, or in some cases to foreign governments of exporting countries.

• A binding import quota will push up the price of the import because the quantity demanded will exceed the quantity supplied by domestic producers and from imports.


Import Quota (cont.)

• When a quota instead of a tariff is used to restrict imports, the government receives no revenue.

Instead, the revenue from selling imports at high prices goes to quota license holders: either domestic firms or foreign governments.

These extra revenues are called quota rents.


An Import Quota: U.S. Sugar

• U.S. problem is similar to EU’s agricultural problem. U.S. guaranteed a price of sugar above world price but the domestic demand for sugar does exceed domestic supply.

• U.S. has been able to keep domestic prices at target levels with an import quota.

• Rights to sell sugar in U.S. are allocated to foreign governments. Thus, quota rents accrue to foreigners.


An Import Quota: U.S. Sugar (cont.)

• Fig. 14 shows an estimate of the effects of the sugar quota in 2005.

• Quota restricts imports to 1.7 million tons, so price of sugar in U.S. is twice as high as world price.

• Fig. 14 assumes U.S. is a small country in terms of world sugar market.

Fig. 14: Effects of the U.S. Import Quota on Sugar

Net ∆welfare = - (b + c + d) = $883 million/year

Areas b and d = efficiency losses

Area c = quota rents to foreigners

= $1.674 billion

= $853 million

= $364 million

quota


Voluntary Export Restraint

• A voluntary export restraint works like an import quota, except that the quota is imposed by the exporting country rather than the importing country.

• However, these restraints are usually requested by the importing country.

• The profits or rents from this policy are earned by foreign governments or foreign producers. Foreigners sell a restricted quantity at an increased

price.


Voluntary Export Restraint (cont.)

• VER is always more costly than a tariff because the exporting country gets the revenue that would have been collected by the government under a tariff.

• Study of 3 U.S. VERs in 1980s: textiles and apparel, steel, and autos found that two-thirds of the cost to consumers is accounted for by the rents earned by foreigners. Thus, the bulk of the cost represents a transfer of income

(from domestic consumers to foreign producers) rather than efficiency losses.


Voluntary Export Restraint (cont.)

• Some VERs involve several countries, instead of just one. E.g., Multi-Fiber Arrangement limited textiles from

22 countries until 2005. Such multilateral VERs are know as orderly marketing agreements.


VER: Japanese Autos

• In 1960s and 1970s, U.S. carmakers were shielded from import competition because U.S. had low gas taxes and large roads, so consumers had a preference for large cars.

• Foreign countries made small cars instead.

• However, in 1979, oil prices increased dramatically and U.S. consumers wanted smaller cars.

• Japanese fulfilled this demand.

• Political pressure from U.S. auto industry prompted the government to negotiate a VER with Japan.


VER: Japanese Autos (cont.)

• Japan agreed in fear U.S. would invoke other trade restrictions.

• In 1981, Japan limited exports to 1.7 million cars and in 1984, this was revised to 1.9 million.

• Japanese carmakers responded to the VER by raising the quality of their exports: selling larger cars with more features.

• Japanese carmakers captured the rents from the rising price of cars in U.S.

• U.S. TC in 1984 = $3.2 billion –primarily in transfers from domestic consumers to foreign producers.


Local Content Requirement

• A local content requirement is a regulation that requires a specified fraction of a final good to be produced domestically.

• It may be specified in value terms, by requiring that some minimum share of the value of a good represent domestic valued added, or in physical units.

• Local content requirements are often used in developing countries to encourage the production of intermediate goods.


Local Content Requirement (cont.)

• From the viewpoint of domestic producers of inputs, a local content requirement provides protection in the same way that an import quota would.

• From the viewpoint of firms that must buy domestic inputs, however, the requirement does not place a strict limit on imports, but allows firms to import more if they also use more domestic parts.



• Local content requirement provides neither government revenue (as a tariff would) nor quota rents.

• Instead the difference between the prices of domestic goods and imports is averaged into the price of the final good and is passed on to consumers.



• E.g., Price of auto parts = $6,000 in world market

• Price of auto parts = $10,000 in domestic market

• Local content requirement is 50% domestic parts.

• AC of parts = 0.5 ($6,000) + 0.5 ($10,000) = $8,000 which is reflected in the final price of a car.

• Recently, local content regulations allow firms to satisfy their local content requirement by exporting instead of using domestic parts. U.S. carmakers operating in Mexico chose to export some

components from Mexico to U.S. even though the parts could be produced more cheaply in the U.S. Because it allows U.S. carmakers to use less Mexican content when producing cars in Mexico for Mexico’s market.


Other Trade Policies

• Export credit subsidies A subsidized loan to exporters.

U.S. Export-Import Bank subsidizes loans to U.S. exporters.

• Government procurement Government agencies are obligated to purchase from

domestic suppliers, even when they charge higher prices (or have inferior quality) compared to foreign suppliers.

• Bureaucratic regulations Safety, health, quality, or customs regulations can act as

a form of protection and trade restriction.

Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved....

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