INTERNATIONAL ECONOMICSLecture 10 | Carlos Cuerpo | The Instruments of Trade Policy

TRADE POLICY INSTRUMENTS

• Motivation: Until now we have seen how individual countries gain from the Autarky to Free Trade transition, but countries do implement intermediate positions.

– To assess its welfare consequences, we need to know the effects of restricting trade

Free-Trade as a starting point and then impose trade restrictions

• Outline: 1. Tariffs: Partial and General Equilibrium Analysis. Small vs. Large countries.2. Effective Protection Theory.3. Non-Tariff Barriers.

TRADE POLICY INSTRUMENTS: TARIFFS

• Concept:

• Types:1. Ad-Valorem: A percentage of the value of the imported article.

– Rise automatically with inflation.– Tax different qualities of the roduct at the same rate (progressive).– It creates opportunities for cheating through false invoicing.

2. Specific: A given amount of money per unit.– Its protective effect will decline in periods of inflation.– Charges more the lower priced itmes within a product cathegory, giving

incentives to producers to upgrade their production.– Easier to implement.

3. Compound: a combination of both.

Tariff: a tax levied by a government on imports or occasionally exports for purposes

of protection, support of the balance of payments, or the raising of revenue

TRADE POLICY INSTRUMENTS: TARIFFS

• Partial Equilibrium Analysis in a small country:– The industry is small compared to the rest of the economy.

– Perfect Competition; no firm is big enough to affect the final result

• Market for shoes in the US:

P

Q

Demand

Supply

a b c d

Q Q’ Q’’ Q’’’

Pt

Pw

• Free-Trade Equilibrium: Pw becomes the import price as D>S.• The tariff doesn’t affect the world price.• Tariff effects:

i. Higher Price: lower C and higher P.ii. Less imports. When is the tariff prohibitive?iii. Welfare effects:

• Consumer Surplus drops: a+b+c+d• Producer Surplus peaks: a• Tariff revenues: c• Deadweight losses: b+d, from inefficiency

in production and less favorable consumer choice.

MN

TRADE POLICY INSTRUMENTS: TARIFFS

• Small country case:

Q

Demand

Supply

a b c

Q Q’ Q’’ Q’’’

Pt

Pw

MN

Q

Residual D (represents loss to

consumers net of the

gains to producers)

c b+d

M2 M1

Pt

PwSfd

Sf+tariffPa

• Deadweight-loss: changes in imports times the tariff and divided by 2.

TRADE POLICY INSTRUMENTS: TARIFFS

• Large country: There is an extra effect on the Terms of Trade.

Q

Demand

Supply

a b c

Q Q’ Q’’ Q’’’

Pt

PwM

N

Q

Residual D (represents loss to

consumers net of the

gains to producers)

eb+d

M2 M1

Pt

Pw

Sf

d

Sf+tariff

Pa

• Net Welfare Change: e-(b+d)• The tariff is passed forward partially to consumers ( , elasticity of demand for imports) and foreign producers who ( , elasticity of foreign export supply) perceive less for their imports. Then the % increase in price to consumers:

Pw’

ce

/ / ( )* /P P T P

TRADE POLICY INSTRUMENTS: TARIFFS

• Welfare changes:If we are not given the diagram, how to calculate the deadweight loss?If we know how much is spent on the imported good and we have information about the elasticity of

demand for imports

1. Calculate the % reduction in imports (ΔM/M) thanks to the elasticity (η) and the predicted %change in prices (ΔP/P)

2. Assuming that the foreign supply curve is horizontal; the loss will be higher, the larger the elasticity of demand (in absolute valule), the larger the tariff and the larger the initial spending on imports.

Elasticity of D for imports: %reduction in the imported quantity that results from a 1% increase in their price.

/ *( / ) *( / )M M P P Tariff P

2_ 0.5* * 0.5*( / )*( / )* 0.5* *( / )Welfare loss M P M M P P PM T P PM

TRADE POLICY INSTRUMENTS: QUOTAS

• Alternative ways to restrict imports witout raising tariffs:

• Objective: increase the price by limiting the quantity

• Effects:Similar effects than tariffs in general: increase in the domestic production, decrease in consumption and lower imports.

Quotas: Limits on the physical volume of a product that may be imported per period

of time (eg: agricultural products).

Q

Demand

Domestic S

a b c

Q Q’ Q’’ Q’’’

Pt

Pw

M

N

Domestic S+Q

Quota

d

• There is always an equivalent tariff.• Main differences wrt tariffs:

i. Who gets area c? Importers if quota rights are allocated to

them. Foreign Gov’t if there is a tax to exports

(export quota tickets).ii. Less transparent, harder to notice.iii. Changes with S and D changes.iv. Arbitrary decision: more distortions.

TRADE POLICY INSTRUMENTS: QUOTAS

• Which one is preferable?– Domestic producers prefer quotas as they restric competition:

i. They are insulated from foreign competition: if there is a foreign innovation that allows lower prices or higher quality, they won't suffer the consequences.

ii. If market demand expands, foreigners won't be able to cover a greater share of the market.

iii. Imperfect competition situations are enhanced.

– It implies a higer welfare loss and therefore after WWII there was a movement towards converting them into their tariff equivalents.

NEOCLASSICAL THEORY

• General Equilibrium, small country case:– Initial situation: free-trade

Good Y

Good X

P

R

R

UQ

T

T

U’

Country A

C

C’

RMS RMT ToT

• Tariff on Y effects:i. Changes in the production of Y and X.ii. Decrease in Consumption: two conditions are

satisfied. Marginal rates coincide and the difference between the domestic and the world price is the tariff wedge.

iii. Lower triangle of trade: lower imports and lower exports.

iv. Lower value of production: we are poorer.v. Net welfare loss.

NEOCLASSICAL THEORY

• General Equilibrium, large country case:– Initial situation: free-trade

Good Y

Good X

P

R

R

UQ

T

T

U’

Country A

C C’

RMS RMT ToT

• Tariff on Y effects:i. Terms of Trade will improve, increasing the

slope of the world prices.ii. The tariff is again measured by the size of the

wedgeiii. What happens to production, consumption,

trade and net welfare?

TRADE POLICY INSTRUMENTS: EXPORTS SUBSIDIES

• Objective: encourage exports to improve its trade balance, aid a specific industry, help a depressed region, etc., via Direct cash payment, grants, favorable financing or taxes.

Q

D

S

a b c

Q Q’ Q’’ Q’’’

P1P0

Q

Drow

e

b+d

X0 X1

P0

Pw’

Sx

d

Sx+subsidyP1

• Producers expand output and divert sales from the domestic to the foreign market.• Foreign buyers benefit from a lower price, assuming no reimporting possibility.• e+f represent the ToT loss to the exporting country. C+b+d+e+f is the subsidy’s cost.• Net loss of domestic welfare= b+d+e+f. What abour the ROW? Unfair Trade practices.

c

f

ExportsDomestic Market

TRADE POLICY INSTRUMENTS: EFFECTIVE PROTECTION

• Let's assume that there is trade in intermediate goodsThe ad-valorem tariff might be an incorrect measure of the rate of protection

• Nominal tariff rate vs. Effective rate of Protection (ERP)

• This generates tariff escalation: higher tariffs on fully processes (tj) goods than on raw materials (ti), as it increases ERP.

ERP: % increase in an industry ‘s value added per unit of output, that results from a country’s tariff structure.

1

j ij i

ij

ij

i

t a t

ea

TRADE POLICY INSTRUMENTS: CASE STUDY

• Europe's CAP.

• US Sugar.

• Japanese Autos.