The Instruments of Trade Policy: Prepared by Iordanis Petsas To Accompany by Paul R. Krugman and Maurice Obstfeld

Chapter 8
The Instruments of Trade Policy

Prepared by Iordanis Petsas
To Accompany
International Economics: Theory and Policy, Sixth Edition
by Paul R. Krugman and Maurice Obstfeld

Slide 8-2 Copyright 2003 Pearson Education, Inc.
Introduction
Basic Tariff Analysis
Costs and Benefits of a Tariff
Other Instruments of Trade Policy
The Effects of Trade Policy: A Summary
Summary
Appendix I: Tariff Analysis in General Equilibrium
Appendix II: Tariffs and Import Quotas in the
Presence of Monopoly

Chapter Organization

Introduction
This chapter is focused on the following questions:
What are the effects of various trade policy
instruments?
Who will benefit and who will lose from these trade
policy instruments?
What are the costs and benefits of protection?
Will the benefits outweigh the costs?
What should a nations trade policy be?
For example, should the United States use a tariff or an
import quota to protect its automobile industry against
competition from Japan and South Korea?

Classification of Commercial Policy Instruments
Introduction
Commercial Policy Instruments
Trade Contraction
Trade Expansion
Tariff
Export tax
Import quota
Voluntary
Export
Restraint
(VER)
Import subsidy
Export subsidy
Voluntary
Import
Expansion
(VIE)

Price Quantity Price Quantity

Tariffs can be classified as:
Specific tariffs
Taxes that are levied as a fixed charge for each unit of
goods imported
Example: A specific tariff of $10 on each imported bicycle
with an international price of $100 means that customs
officials collect the fixed sum of $10.
Ad valorem tariffs
Taxes that are levied as a fraction of the value of the
imported goods
Example: A 20% ad valorem tariff on bicycles generates a $20
payment on each $100 imported bicycle.

A compound duty (tariff) is a combination of an ad valorem
and a specific tariff.
Modern governments usually prefer to protect domestic
industries through a variety of nontariff barriers, such as:
Import quotas
Limit the quantity of imports
Export restraints
Limit the quantity of exports


Supply, Demand, and Trade in a Single Industry
Suppose that there are two countries (Home and
Foreign).
Both countries consume and produce wheat, which can
be costless transported between the countries.
In each country, wheat is a competitive industry.
Suppose that in the absence of trade the price of wheat
at Home exceeds the corresponding price at Foreign.
This implies that shippers begin to move wheat from
Foreign to Home.
The export of wheat raises its price in Foreign and lowers its
price in Home until the initial difference in prices has been
eliminated.

To determine the world price (P
w
) and the quantity
trade (Q
w
), two curves are defined:
Home import demand curve
Shows the maximum quantity of imports the Home
country would like to consume at each price of the
imported good.
That is, the excess of what Home consumers demand over
what Home producers supply: MD = D(P) S(P)
Foreign export supply curve
Shows the maximum quantity of exports Foreign would
like to provide the rest of the world at each price.
That is, the excess of what Foreign producers supply over what
foreign consumers demand: XS = S*(P*) D*(P*)

Quantity, Q
Price, P
Price, P
Quantity, Q
MD
D
S
A
P
A

P
2

P
1

S
2

D
2
D
2
S
2

2
S
1
D
1
D
1
S
1

1
Figure 8-1: Deriving Homes Import Demand Curve

Properties of the import demand curve:
It intersects the vertical axis at the closed economy
price of the importing country.
It is downward sloping.
It is flatter than the domestic demand curve in the
importing country.


P
2

P
*
A

D
*

S
*

P
1

XS
Price, P
Price, P
Quantity, Q Quantity, Q S
*2
D
*2
S
*2
D
*2

Figure 8-2: Deriving Foreigns Export Supply Curve
D
*1
S
*1
S
*1
D
*1

Properties of the export supply curve:
It intersects the vertical axis at the closed economy
price of the exporting country.
It is upward sloping.
It is flatter that the domestic supply curve in the
exporting country.


Figure 8-3: World Equilibrium
XS
Price, P
Quantity, Q
MD
P
W

Q
W

1

Useful definitions:
The terms of trade is the relative price of the
exportable good expressed in units of the importable
good.
A small country is a country that cannot affect its
terms of trade no matter how much it trades with the
rest of the world.
The analytical framework will be based on either of
the following:
Two large countries trading with each other
A small country trading with the rest of the world


Effects of a Tariff
Assume that two large countries trade with each other.
Suppose Home imposes a tax of $2 on every bushel of
wheat imported.
Then shippers will be unwilling to move the wheat
unless the price difference between the two markets is at
least $2.
Figure 8-4 illustrates the effects of a specific tariff of
$t per unit of wheat.


XS
P
T

MD
D
*

S
*

D
S
P
W

2
Q
T

1
Q
W

Figure 8-4: Effects of a Tariff
P
*
T
3
t
Price, P
Quantity, Q
Price, P
Quantity, Q
Price, P
Quantity, Q
Home market World market Foreign market
Home market World market Foreign market

In the absence of tariff, the world price of wheat (P
w
)
would be equalized in both countries.
With the tariff in place, the price of wheat rises to P
T
at
Home and falls to P*
T
(= P
T
t) at Foreign until the
price difference is $t.
In Home: producers supply more and consumers demand
less due to the higher price, so that fewer imports are
demanded.
In Foreign: producers supply less and consumers demand
more due to the lower price, so that fewer exports are
supplied.
Thus, the volume of wheat traded declines due to the
imposition of the tariff.


The increase in the domestic Home price is less
than the tariff, because part of the tariff is reflected
in a decline in Foreign s export price.
If Home is a small country and imposes a tariff, the
foreign export prices are unaffected and the
domestic price at Home (the importing country)
rises by the full amount of the tariff.

Figure 8-5: A Tariff in a Small Country
S
Price, P
Quantity, Q
D
P
W
+ t
P
W

Imports after tariff
S
1
D
1

Imports before tariff
D
2
S
2


Measuring the Amount of Protection
In analyzing trade policy in practice, it is important
to know how much protection a trade policy
actually provides.
One can express the amount of protection as a
percentage of the price that would prevail under free
trade.
Two problems arise from this method of measurement:
In the large country case, the tariff will lower the foreign
export price.
Tariffs may have different effects on different stages of
production of a good.

Effective rate of protection
One must consider both the effects of tariffs on the
final price of a good, and the effects of tariffs on the
costs of inputs used in production.
The actual protection provided by a tariff will not equal
the tariff rate if imported intermediate goods are used in
the production of the protected good.
Example: A European airplane that sells for $50 million has
cost $60 million to produce. Half of the purchase price of the
aircraft represents the cost of components purchased from
other countries. A subsidy of $10 million from the European
government cuts the cost of the value added to purchasers of
the airplane from $30 to $20 million. Thus, the effective rate of
protection is (30-20)/20 = 50%.


A tariff raises the price of a good in the importing
country and lowers it in the exporting country.
As a result of these price changes:
Consumers lose in the importing country and gain in
the exporting country
Producers gain in the importing country and lose in the
exporting country
Government imposing the tariff gains revenue
To measure and compare these costs and benefits, we
need to define consumer and producer surplus.

Consumer and Producer Surplus
Consumer surplus
It measures the amount a consumer gains from a purchase
by the difference between the price he actually pays and
the price he would have been willing to pay.
It can be derived from the market demand curve.
Graphically, it is equal to the area under the demand curve
and above the price.
Example: Suppose a person is willing to pay $20 per
packet of pills, but the price is only $5. Then, the
consumer surplus gained by the purchase of a packet of
pills is $15.


8
$12
9
$10
10
$9
11
D
Figure 8-6: Deriving Consumer Surplus from the Demand Curve
Price, P
Quantity, Q

Figure 8-7: Geometry of Consumer Surplus
a
b
P
1

P
2

D
Price, P
Quantity, Q Q
2
Q
1

Producer surplus
It measures the amount a producer gains from a sale by
the difference between the price he actually receives and
the price at which he would have been willing to sell.
It can be derived from the market supply curve.
Graphically, it is equal to the area above the supply
curve and below the price.
Example: A producer willing to sell a good for $2 but
receiving a price of $5 gains a producer surplus of $3.


Figure 8-8: Geometry of Producer Surplus
d
c
P
2

P
1

S
Price, P
Quantity, Q
Q
2
Q
1

Measuring the Cost and Benefits
Is it possible to add consumer and producer surplus?
We can (algebraically) add consumer and producer
surplus because any change in price affects each
individual in two ways:
As a consumer
As a worker
We assume that at the margin a dollars worth of gain or
loss to each group is of the same social worth.

Figure 8-9: Costs and Benefits of a Tariff for the Importing Country
P
T

P
W

P
*
T

b
c
d
e
D
a
= consumer loss (a + b + c + d)
= producer gain (a)
= government revenue gain (c + e)
Q
T

D
2
S
2

S
S
1
D
1

Price, P
Quantity, Q

The areas of the two triangles b and d measure the loss
to the nation as a whole (efficiency loss) and the area
of the rectangle e measures an offsetting gain (terms of
trade gain).
The efficiency loss arises because a tariff distorts
incentives to consume and produce.
Producers and consumers act as if imports were more
expensive than they actually are.
Triangle b is the production distortion loss and triangle d is
the consumption distortion loss.
The terms of trade gain arises because a tariff lowers
foreign export prices.


If the terms of trade gain is greater than the efficiency
loss, the tariff increases welfare for the importing
country.
In the case of a small country, the tariff reduces welfare
for the importing country.


Figure 8-10: Net Welfare Effects of a Tariff
P
T

P
W

P
*
T

b d
e
D
= efficiency loss (b + d)
= terms of trade gain (e)
Imports
S
Price, P
Quantity, Q

Export Subsidies: Theory
Export subsidy
A payment by the government to a firm or individual
that ships a good abroad
When the government offers an export subsidy, shippers will
export the good up to the point where the domestic price
exceeds the foreign price by the amount of the subsidy.
It can be either specific or ad valorem.


b
a
Figure 8-11: Effects of an Export Subsidy
P
S

P
W

P
*
S

Price, P
Quantity, Q
Exports
g f e
Subsidy
d
c
= producer gain
(a + b + c)
= consumer loss (a + b)
= cost of
government subsidy
(b + c + d + e + f + g)
D
S

An export subsidy raises prices in the exporting
country while lowering them in the importing country.
In addition, and in contrast to a tariff, the export
subsidy worsens the terms of trade.
An export subsidy unambiguously leads to costs that
exceed its benefits.

Figure 8-12: Europes Common Agricultural Program
Price, P
Quantity, Q
S
D
EU
price
without
imports
World price
= cost of government
subsidy
Support price
Exports

Import Quotas: Theory
An import quota is a direct restriction on the quantity
of a good that is imported.
Example: The United States has a quota on imports of
foreign cheese.
The restriction is usually enforced by issuing licenses
to some group of individuals or firms.
Example: The only firms allowed to import cheese are
certain trading companies.
In some cases (e.g. sugar and apparel), the right to sell
in the United States is given directly to the
governments of exporting countries.


An import quota always raises the domestic price of
the imported good.
License holders are able to buy imports and resell
them at a higher price in the domestic market.
The profits received by the holders of import licenses
are known as quota rents.

Welfare analysis of import quotas versus of that of
tariffs
The difference between a quota and a tariff is that
with a quota the government receives no revenue.
In assessing the costs and benefits of an import
quota, it is crucial to determine who gets the rents.
When the rights to sell in the domestic market are
assigned to governments of exporting countries, the
transfer of rents abroad makes the costs of a quota
substantially higher than the equivalent tariff.


Price in U.S. Market 466
World Price 280
b
c
d
Demand
a
8.45 6.32
Supply
5.14 9.26
Price, $/ton
Quantity of sugar,
million tons
Figure 8-13: Effects of the U.S. Import Quota on Sugar
Import quota:
2.13 million tons
= consumer loss
(a + b + c + d)
= producer gain (a)
= quota rents (c)

Voluntary Export Restraints
A voluntary export restraint (VER) is an export
quota administered by the exporting country.
It is also known as a voluntary restraint agreement
(VRA).
VERs are imposed at the request of the importer and
are agreed to by the exporter to forestall other trade
restrictions.


A VER is exactly like an import quota where the
licenses are assigned to foreign governments and is
therefore very costly to the importing country.
A VER is always more costly to the importing country
than a tariff that limits imports by the same amount.
The tariff equivalent revenue becomes rents earned by
foreigners under the VER.
Example: About 2/3 of the cost to consumers of the three
major U.S. voluntary restraints in textiles and apparel, steel,
and automobiles is accounted for by the rents earned by
foreigners.
A VER produces a loss for the importing country.


Local Content Requirements
A local content requirement is a regulation that
requires that some specified fraction of a final good be
produced domestically.
This fraction can be specified in physical units or in value
terms.
Local content laws have been widely used by
developing countries trying to shift their manufacturing
base from assembly back into intermediate goods.


Local content laws do not produce either government
revenue or quota rents.
Instead, the difference between the prices of imports
and domestic goods gets averaged in the final price and
is passed on to consumers.
Example: Suppose that auto assembly firms are required to use
50% domestic parts. The cost of imported parts is $6000 and
the cost of the same parts domestically is $10,000. Then the
average cost of parts is $8000 (0.5 x $6000 + 0.5 x $10,000).
Firms are allowed to satisfy their local content
requirement by exporting instead of using parts
domestically.


Other Trade Policy Instruments
Export credit subsidies
A form of a subsidized loan to the buyer of exports.
They have the same effect as regular export
subsidies.
National procurement
Purchases by the government (or public firms) can
be directed towards domestic goods, even if they are
more expensive than imports.
Red-tape barriers
Sometimes governments place substantial barriers
based on health, safety and customs procedures.

The Effects of Trade Policy:
A Summary
Table 8-1: Effects of Alternative Trade Policies

Summary
A tariff drives a wedge between foreign and domestic
prices, raising the domestic price but by less than the
tariff rate (except in the small country case).
In the small country case, a tariff is fully reflected in
domestic prices.
The costs and benefits of a tariff or other trade policy
instruments may be measured using the concepts of
consumer and producer surplus.
The domestic producers of a good gain
The domestic consumers lose
The government collects tariff revenue

Summary
The net welfare effect of a tariff can be separated
into two parts:
Efficiency (consumption and production) loss
Terms of trade gain (is zero in the case of a small
country)
An export subsidy causes efficiency losses similar to
a tariff but compounds these losses by causing a
deterioration of the terms of trade.
Under import quotas and voluntary export restraints
the government of the importing country receives no
revenue.

Table 8AI-1: Free Trade Equilibrium for a Small Country
Appendix I: Tariff Analysis in
General Equilibrium
Slope = - P
*
M
/P
*
F

Manufactures production and
consumption, Q
M
, D
M

Food production and
consumption, Q
F
, D
F
D
1

Q
1

Q
F
, D
F

Q
M
, D
M

Q
2

D
2

Slope = - P
*
M
/P
*
F
(1 +t)
Table 8AI-2: A Tariff in a Small Country
General Equilibrium

Table 8AI-3: Effect of a Tariff on the Terms of Trade
General Equilibrium
F
M
1

Slope = (P
*
M
/P
*
F
)
1

1
Slope = (P
*
M
/P
*
F
)
2

M
2

2
3
Home exports of manufactures, Q
M
-

D
M
Foreign imports of manufactures, D
*
M
-

Q
*
M

Home imports of food, D
F
- Q
F
Foreign exports of food, Q
*
F
- D
*
F

O

D
Appendix II: Tariffs and Import
Quotas in the Presence of Monopoly
Table 8AII-1: A Monopolist Under Free Trade
Price, P

Quality, Q

P
W

P
M

MC
MR
D
f
Q
M
Q
f

D
Table 8AII-2: A Monopolist Protected by a Tariff
Price, P

Quality, Q

P
W

P
M

MC
MR
D
f
Q
M
Q
f
D
t
Q
t

P
W
+ t

Price, P

Quality, Q

P
W

P
q

Table 8AII-3: A Monopolist Protected by an Import Quota
MC
MR
q

D
q

D
Q
q

Price, P

Quality, Q

P
W

P
q

P
W
+ t
Table 8AII-4: Comparing a Tariff and a Quota
MC
MR
q

D
q

D
Q
t
Q
q

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Chapter 8

The Instruments of Trade Policy

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