Transcript Chapter 8

Topic 4
The Instruments
of Trade Policy
Slides prepared by Thomas Bishop
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Preview
• 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
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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?
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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.
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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.
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History of Tariffs (cont.)
• In modern times, use of tariffs has declined.
• Governments prefer to use a variety of nontariff barriers to protect their domestic
industries.
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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.
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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.
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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
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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.
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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.
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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.
The Effects of a Tariff (cont.)
• 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
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The Effects of a Tariff (cont.)
• 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:
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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
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Fig. 5: A Tariff in a Small Country
PT =
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.
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.
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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).
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Effective Rate of Protection (cont.)
• 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%!
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Effective Rate of Protection (cont.)
• 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%.
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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.
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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.
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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.
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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.
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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)
tariff
Area e = tot gain
Area b = over-production
efficiency loss
Area d = under-consumption
efficiency loss
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.
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Costs and Benefits of Tariffs (cont.)
• 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.
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Costs and Benefits of Tariffs (cont.)
• 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.
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Fig. 9: Net Welfare Effects of a Tariff in a Large
Country
Fig. 10: Costs and Benefits of a Tariff in a Small
Country
Welfare effects of a tariff in a
small country:
∆CS = - (a + b + c + d)
∆PS = + a
∆G rev = + c
tariff
a
b
c
d
Net ∆welfare = - (b + d)
Costs and Benefits of Tariffs (cont.)
• 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.
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Costs and Benefits of Tariffs (cont.)
• Tariffs are the simplest form of trade policy,
but most governments protect their domestic
industries with export subsidies, import
quotas, or voluntary export restraints.
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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.
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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.
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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
D2
D1
S1
S2
Area b = underconsumption efficiency
loss.
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.
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Fig. 12: Effects of an Export Subsidy in a Small Country
S
P
Price in the home
country rises by the full
amount of the subsidy.
PS
a
subsidy
b
c
d
PW
Welfare effects:
∆CS = - (a + b)
∆PS = + (a + b + c)
∆G rev = - (b + c + d)
Net ∆welfare = - (b + d)
D2
D1
S1
S2
exports before subsidy
exports after subsidy
There is no tot loss –only
D
the efficiency losses
from distorting consumer
Q 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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
quota
= $1.674 billion
= $853 million
= $364 million
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.
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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.
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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.
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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.
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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.
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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.
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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.
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Local Content Requirement (cont.)
• 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.
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Local Content Requirement (cont.)
• 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.
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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.
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