Protectionism: How Nations Restrict Trade

1
Protectionism How Nations Restrict Trade

• In a regime of Free Trade and free economic
  intercourse it would be of little consequence
  that iron lay on one side of a political
  frontier, and labor, coal, and blast furnaces on
  the other. But as it is, men have devised ways
  to impoverish themselves and one another and
  prefer collective animosities to individual
  happiness.
• (John Maynard Keynes, 1920)

2
The Goals of this Chapter

• Use both partial equilibrium and general
  equilibrium models to explain the effects of
  tariffs.
• Use the general equilibrium model of a tariff to
  explain the important Lerner Symmetry Theorem.
• Extend the analysis to trade quotas, and
  demonstrate the similarities between tariffs and
  quotas.
• Describe some the many other ways in which
  governments restrict international trade.
• Introduce the concept of rent seeking and how it
  applies to trade policy from both a static and an
  growth perspective.

3
The Economics of a Tariff

• A tariff is simply a tax on imports
• An ad valorem tariff is a tax that is expressed
  as a percentage of the value of the import being
  taxed
• A specific tariff is an import tax expressed as a
  fixed dollar amount per unit of imports

4
The Economics of a Tariff

• The economic analysis of a tariff makes use of
  the two-country partial equilibrium model of
  trade.
• This model can be applied to trace the effects of
  a tariff on producers and consumers in the market
  for a traded good in both the exporting and
  importing countries.

5
The Economics of a Tariff

• First, we look at the effect of a tariff on the
  importing country.
• The domestic effects can be seen by looking at
  the two left-most diagrams in Figure 6.1.
• That is, look just at the Homeland market and the
  International Market.

6
The Economics of a Tariff

• Suppose an ad valorem tariff is applied to
  imports.
• Such a tariff is illustrated in the International
  Market diagram as an increase in the supply curve
  of imports.
• The effective decrease in foreign supply raises
  the Homeland price and reduces the quantity of
  imports.

7
The Economics of a Tariff

• The perspective from Abroad can be illustrated in
  the center and right-most diagrams of Figure 6.1.
• In Abroad, the tariff looks like a decrease in
  foreign demand.
• As a result, the price in Abroad declines, and
  the volume of exports falls.

8
The Economics of a TariffThe Welfare Effects in
Homeland and Abroad
9
The Economics of a TariffThe Welfare Effects

• Prices rise in Homeland and fall in Abroad as the
  tariff drives a wedge between what exporters
  receive and importers pay.
• In the importing country, Homeland, consumers
  lose surplus equal to the areas AbCd.
• In Abroad, the exporting country, producers lose
  surplus equal to the areas WxYz.

10
The Economics of a TariffThe Welfare Effects

• The price rise in Homeland increases producer
  surplus by the area A.
• In Abroad, the fall in the price increases
  consumer surplus by the area W.

11
The Economics of a TariffThe Welfare Effects

• Both countries suffer deadweight losses from the
  tariff because the volume of trade is reduces and
  prices are distorted.
• Homeland loses areas bd
• Abroad loses areas xz.
• The deadweight losses are equal to the same
  colored areas in the center International Market
  diagram.

12
The Economics of a TariffThe Welfare Effects

• Total tariff revenue collected by Homelands
  government is equal to the sum of areas C and Y.
• Some of this tariff revenue, area C, comes out of
  the free trade consumer surplus.
• The rest of the tariff revenue comes out of the
  free trade producer surplus, namely area Y.

13
The two-country partial equilibrium model shows
that a tariff by one country on the others
exports causes

• A transfer of welfare from domestic consumers to
  domestic producers in the importing country.
• A transfer of welfare from producers to
  consumers in the exporting country.
• A transfer of consumer surplus in the importing
  country to the importing country government in
  the form of tariff revenue.
• A transfer of producer surplus in the exporting
  country to the government of the importing
  country.
• Deadweight losses in both importing and
  exporting countries.

14
Example 6.2The Gains and Losses from a Tariff

• Example 6.2 shows the welfare effects of a 3
  specific tariff in a market that imports 8
  million calculators with free trade.
• The welfare effects consist of changes in
  consumer surplus, producer surplus, and tariff
  revenue.

15
Example 6.2The Gains and Losses from a Tariff

• For Homeland, the welfare effects of shifting
  from free trade in calculators to a 3 specific
  tariff are as follows
• Homeland Consumer Surplus (AbCd)
  18.75 million
• Homeland Producer Surplus (A)
  11.25 million
• Homeland Govt Tariff Revenue (CY)
  6.00 million
• Net Welfare Change Ybd 1.50 million

16
Example 6.2The Gains and Losses from a Tariff

• Abroad suffers a net loss that exceeds Homelands
  net gain by the total deadweight losses in both
  countries
• Abroads Consumer Surplus (W) 11.25
  million
• Abroads Producer Surplus (WxYz)
  18.75 million
• Net Change Y x z 7.50 million
• The net loss for the world is
• World deadweight losses (bdxz) 9.0
  million

17
How Much Protection Does a Tariff Really Provide?

• The true protection that a tariff provides to an
  industry is more accurately stated in terms of
  the industrys value added.
• An effective tariff measures a nominal tariffs
  effect on the value added of an industry.
• For example, if a tariff raises the price of a
  final good by 20 percent, and the industry adds
  half the products value, the effective tariff is
  40 percent.

18
How Much Protection Does a Tariff Really Provide?

• A tariff on intermediate products can reduce an
  industrys value added.
• That is, an effective tariff can be negative.
• In the example, if a government imposes a tariff
  on inputs while imposing no tariff on the final
  product, then the producers of final products
  will find their value added squeezed from 5,000
  to 4,000.

19
The Economics of a Quota

• The effects of a quota can be illustrated using
  the partial equilibrium model of imports and
  exports.
• Suppose the quota is set at half the free trade
  quantity of imports.
• From Homeland, the foreign supply curve looks
  like the kinked curve in the International Market
  on the right.
• With restricted imports, the Homeland price rises.

20
The Economics of a Quota

• From Abroads perspective, the quota creates a
  kinked foreign demand curve in the International
  Market.
• The domestic price in Abroad falls as the
  quantity exported is reduced to the quota level.

21
The Economics of a QuotaThe Full Welfare Effects

• By raising the price in Homeland, the quota
  increases Homeland producers surplus by the area
  A.
• In Abroad, the price falls and consumers gain
  surplus equal to the area W.

22
The Economics of a QuotaThe Full Welfare Effects

• The price rise in Homeland, the importing
  country, reduces consumer surplus by the areas
  AbCd.
• In Abroad, the price decline there reduces
  producer surplus by the areas WxYz.

23
The Economics of a QuotaThe Full Welfare Effects

• The quota distorts prices and changes quantities
  from free trade levels, causing deadweight loses.
• In Homeland, the deadweight losses are bd, equal
  to the same colored area in the center diagram.
• In Abroad, deadweight losses are xz.

24
The Economics of a QuotaThe Full Welfare Effects

• The fundamental difference between a tariff and a
  quota is that a quota generates quota rent, not
  government revenue.
• This quota rent comes out of consumer surplus
  (area C) in the importing country and producer
  surplus (area Y) in the exporting country.

25
Example 6.3The Gains and Losses from a Quota

• Example 6.3 shows the welfare effects of imposing
  quota of 2 million calculators on a market that
  imports 8 million calculators with free trade.
• The welfare effects consist of changes in
  consumer surplus, producer surplus, and quota
  rent.

26
Example 6.3The Gains and Losses from a Quota

• If the rent accrues to domestic importers
• Homeland Consumer Surplus (AbCd)
  18.75 million
• Homeland Producer Surplus (A) 11.25
  million
• Homeland Quota Rent (CY) 6.0
  million
• Net Change Ybd 1.5 million

27
Example 6.3The Gains and Losses from a Quota

• Abroads Consumer Surplus (W) 11.25
  million
• Abroads Producer Surplus (WxYz)
  18.75 million
• Abroads Quota Rent 0 0.0 million
• Net Change Yxz 7.5 million
• World deadweight losses (bdxz) 9.0
  million

28
Example 6.3The Gains and Losses from a Quota

• If the rent from Homelands quota accrues to
  foreign exporters
• Homeland Consumer Surplus (AbCd)
  18.75 million
• Homeland Producer Surplus (A)
  11.25 million
• Homeland Quota Rent 0 0.0
  million
• Net Change Ybd 7.5 million

29
Example 6.3The Gains and Losses from a Quota

• Abroads Consumer Surplus (W)
  11.25 million
• Abroads Producer Surplus (WxYz)
  18.75 million
• Abroads Quota Rent (CY) 6.0 million
• Net Change (Yxz) 1.5 million
• World deadweight losses (bdxz) 9.0
  million

30
The Precise Welfare Effects of an Import Quota
Depend on Who Gets the Rent

• When Abroads exporters are able to raise their
  prices and capture the quota rent, Abroads
  overall welfare loss is smaller, 1.5 million
  rather than 7.5 million.
• If it is importers that purchase overseas at
  lowered world prices and sell domestically at the
  higher prices, then Homeland gains the quota rent
  and reduces its overall welfare loss from the
  imposing the quota.
• Who ultimately gains the quota rent depends on
  who collects the difference between the higher
  price in Homeland and the lower price in Abroad.

31
The Equivalence of Tariffs and Quotas

• There is an equivalent tariff for any given
  quota, and vice versa.
• The areas representing transfers from one group
  to another and deadweight losses seem to be the
  same for equivalent tariffs and quotas.
• The only exception is the area C, which
  represents tariff revenue in the case of the
  tariff and quota rent in the case of the quota.

32
Some Differences between Tariffs and Quotas

• If demand shifts out, a tariff and quota that
  were equivalent will come to have very different
  price and welfare effects.
• Under a tariff, an increase in demand creates a
  new market equilibrium at c.
• Under a quota, an increase in demand creates a
  new market equilibrium at d.

33
Some Differences between Tariffs and Quotas

• Under a tariff, the price rises to to Pt, under a
  quota it rises to Pq.
• Under a tariff, the quantity imported rises from
  a to b, under a quota imports are unchanged.
• An increase in demand results in a greater gain
  in consumer surplus under a tariff.
• Deadweight loss is also less under a tariff,
  compare the smaller blue triangle with the
  quotas red triangle.

34
Some Differences between Tariffs and Quotas

• A quota may also not ration rent opportunities as
  efficiently as a tariff.
• Consumers and producers along the green portions
  of the demand and supply curves should
  participate in the restricted trade.
• A quota could result in people at point B below
  the free trade price Pf getting import permits.
• Or, import permits may be denied to the
  lowest-cost suppliers and instead given to
  high-cost producers at point D.

35
The Costs of Costly Rent Seeking

• The costs of the resources used in rent seeking
  must be added to the costs of protection.
• Potential importers would be willing to spend
  some of the potential quota rent C to lobby
  policymakers to get the rent.
• If lobbying activities consume resources equal in
  value to half of the area C, then the total costs
  to the economy of the quota of bc would be equal
  to the deadweight losses bd plus the blue half
  of C.

36
The Costs of Costly Rent Seeking

• Potential importers are not the only ones who
  engage in rent seeking.
• Consumers may wish to organize to protect
  themselves against rent-seeking producers.
• Consumers would be willing to spend up to the
  lost consumer surplus (AbCd) to avoid the
  quota altogether.
• If lobbying costs consume half of the area A,
  then the darkly shaded area must also be added to
  the costs of protection.

37
Dynamic Rent Seeking Obstructing Creative
Destruction

• For the process of creative destruction to
  work, there must be destruction as well as
  creation.
• In a Schumpeterian environment of innovative
  competition, lobbying for protection against
  foreign competition may be motivated not by
  producers desire to increase producer surplus,
  but by the desire to slow the process of creative
  destruction and extend the period during which
  domestic innovators can reap profits.
• If such dynamic rent is successful,
  technological progress will slow, and welfare
  gains from economic growth will be lost.

38
Dynamic Rent Seeking Obstructing Creative
Destruction

• The welfare costs of obstructive dynamic rent
  seeking and the protection that it induces are
  potentially very large.
• The costs of dynamic rent seeking activity
  include the resources that are spent on
  obstructive activity rather than on the
  production of welfare-enhancing output.
• There are also the opportunity costs of lost
  future economic growth if the obstruction of
  competitive innovation is successful.
• Given the power of compounding, the opportunity
  cost of obstructing innovative activity can be
  enormous because the power of compounding
  magnifies even small changes in growth rates into
  large welfare changes.