Trade Policy: Instruments and Impacts

1
Trade Policy Instruments and Impacts

• Appleyard Field ( Cobbs) Chapters 1314
• Krugman Obstfeld Chapter 8

2
Todays Lecture

1. Instruments of trade policy
2. Tariffs
3. Quotas
4. Other Non-tariff Barriers to Trade
5. Impact of trade policies
6. Partial Equilibrium Small Country
7. Partial Equilibrium Large Country
8. General Equilibrium Small Country
9. General Equilibrium Large Country

3
Tariffs

• Imports tariffs
• specific tariff (a monetary sum that must be
  paid to import 1 physical unit of a product)
• Advantage easy to collect
• Disadvantage doesnt take price changes into
  account
• 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
• Import subsidy ? negative import tariff
• Export tariff/subsidy (levied/paid on
  home-produced goods that are destined for export)

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Features of Tariff Schedules

• Preferential duties
• products form certain countries are subject to
  lower tariffs than the normal tariff rate
• Generalized System of Preferences (GSP) for
  developing countries
• Most-favoured-nation (MFN) treatment normal
  trade relations (NTR)
• if country A grants country B the status of
  most-favoured nation, it means that Bs 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)

5
Non-tariff Barriers to Trade (1)

• Import Quotas
• a government agency allocates the rights to
  import
• limits the number of goods (not the price) for a
  given time period
• Voluntary export restraints (VER)
• foreign suppliers agree to voluntary refrain
  from sending some exports
• Government procurement provisions
• restriction on purchasing foreign products by the
  domestic government agencies
• Domestic content provisions
• a given percentage of the value of a good must
  consist of domestic components or labour

6
Non-tariff Barriers to Trade (2)

• Administrative classification
• 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
• health, environment and safety standards
  packaging and labeling requirements inconsistent
  treatment of intellectual property rights
  subsidies to domestic firms...
• etc.

7
Impact of Trade Policy Levels of Study

• Partial Equilibrium analysis
• analysing one market and ignoring the subsequent
  or secondary effects
• General equilibrium analysis
• 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.

8
Consumer and Producer Surplus
Price (P)

• 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

S marginal cost of production
consumer surplus
P
producer surplus
D
Quantity (Q)
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The Impact of Import Tariff The Small-Country
Case
Small country cannot affect world prices
Increase of producer surplus and government income
Loss of consumer surplus
SD
SD
P
P
(1t)Pint
(1t)Pint
increase of producer surplus
tariff to the government
Loss of consumer surplus
deadweight loss
deadweight loss
Pint
Pint
DD
DD
imports after tariff
Q
Q
imports after tariff
imports in free trade
imports in free trade
10
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 effect
• surplus is transferred from the consumers to the
  producers and the government
• Consumers lose more than producers and government
  win deadweight loss

11
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)

SD
P
PQ
Pint
DD
Q
quota
imports in free trade
12
The Impact of Subsidy to Import-Competing
Industry (Small Country Case)
SD
SD
P
P
increase of producer surplus
Cost to the government
efficiency loss
P
P
DD
DD
imports after the subsidy
Q
imports after the subsidy
Q
imports in free trade
imports in free trade
13
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

14
Large country, partial equilibriumSingle Market,
Two Countries
Country B
Country A
P
P
SA
SB
DB
DA
Q
Q
15
Single Market, Two Countries
Country B
Country A
P
P
SA
SB
DB
DA
Q
Q
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
Country B
Country A
P
P
SA
SB
DB
tariff
DA
Q
Q
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)
17
Effect of a Tariff in a Single Market and
Two-Countries
Country B
Country A
P
P
DA
SA
DB
SB
PA
D
e
a
b
tariff
PFT
price decrease in country B
C
PB
Q
Q
Country A Loss of consumer surplus eaDb
increase of producer surplus e Increase of
government revenue CD. Gain for Country A
gainslosses (eCD)-(eaDb) C a b.
That is, if C gt 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
Country B
Country A
P
P
DA
SA
SB
PA
DB
PFT
tariff
e
D
a
b
price decrease in country B
C
PB
Q
Q
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
  As government revenue from the tariff) and C
  (loss of country Bs 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 D
• Then, if this gain is greater than the deadweight
  loss of the exporter (triangles around C), the
  exporting country will gain from the quota

20
General Equilibrium Analysis

• Partial Equilibrium analysis
• analysing one market and ignoring the subsequent
  or secondary effects
• General equilibrium analysis
• 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 doesnt change world prices,
  countrys 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 Y
CFT
Ct
Pt
PX/(1t)PY
PFT
(PX/PY)t
(PX/PY)FT
Ct
Good X
Pt
PFT
CFT
22
General Equilibrium Effects of a Subsidy for a
Small Country
Good Y

• 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

CFT
CS
PS
PX/(1t)PY
PFT
(PX/PY)FT
CS
Good X
PS
PFT
CFT
23
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 countrys 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

(PX/PY)E TOTE
(PX/PY)E TOTE
Country 2s offer curve
Good Y Imports to country 1 exports from
country 2
Country 1s offer curve
Good X Exports from country 1 Imports to
country 2
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Terms of Trade Effect of a Quota

• Country 1 sets a quota for imports of good Y
• ? country 1s offer curve becomes horizontal at
  the quota level
• ? Country 1s terms of trade improve

(PX/PY)E TOTE
(PX/PY)E TOTE
Country 2s offer curve
Good Y Imports to country 1 exports from
country 2
Country 1s offer curve
Good X Exports from country 1 Imports to
country 2
25
Terms of Trade Effect of a Voluntary Export
Restraints

• Country 2 uses voluntary export restraints (VER)
  to limit exports of good Y
• ? country 2s offer curve becomes horizontal
• ? country 2s terms of trade improve

(PX/PY)E
(PX/PY)E
Country 2s offer curve
Good Y Imports to country 1 exports from
country 2
Country 1s offer curve
Good X Exports from country 1 Imports to
country 2
26
Other Effects of Protection

• Restricting imports is likely to result decrease
  of exports as well
• Reallocation of domestic resources
• Retaliation by the trading partners
• Distributional Effects
• Transfer from the consumers to the
  import-competing producers
• HO-model transfer from the abundant factor to
  the scarce factor