Slides prepared by Thomas Bishop Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Chapter 8
The Instruments
of Trade Policy
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Partial equilibrium analysis of tariffs: supply,
demand, and trade in a single industry
Costs and benefits of tariffs
Export subsidies
Import quotas
Voluntary export restraints
Local content requirements
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Types of Tariffs
A specific tariff is levied as a fixed charge for
each unit of imported goods.
For example, $1 per kg of cheese
An ad valorem tariff is levied as a fraction of
the value of imported goods.
For example, 25% tariff on the value of imported
cars.
Lets analyze how tariffs affect the economy.
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Supply, Demand, and Trade
in a Single Industry
Lets construct a model measuring how a tariff
affects a single market, say that of wheat.
Suppose that in the absence of trade the price
of wheat in the foreign country is lower than
that in the domestic country.
With trade the foreign country will export: construct
an export supply curve
With trade the domestic country will import:
construct an import demand curve
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Supply, Demand, and Trade
in a Single Industry (cont.)
An export supply curve is the difference
between the quantity that foreign producers
supply minus the quantity that foreign
consumers demand, at each price.
An import demand curve is the difference
between the quantity that domestic
consumers demand minus the quantity that
domestic producers supply, at each price.
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Fig. 8-1: Deriving Homes Import
Demand Curve
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Fig. 8-2: Deriving Foreigns Export
Supply Curve
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Supply, Demand, and Trade
in a Single Industry (cont.)
In equilibrium, the quantities of
import demand = export supply
domestic demand domestic supply =
foreign supply foreign demand
In equilibrium, the quantities of
world demand = world supply
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Fig. 8-3: World Equilibrium
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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.
The price of wheat will tend to rise in the domestic market.
The price of wheat will tend to fall in the foreign market.
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The Effects of a Tariff (cont.)
Thus, a tariff will make the price of a good rise
in the domestic market and will make it fall in
the foreign market, until the price difference
equals the tariff.
P
T
P
*
T
= t
P
T
= P
*
T
+ t
The price of the good in foreign (world) markets
should fall if there is a significant drop in the
quantity demanded of the good caused by the
domestic tariff.
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Fig. 8-4: Effects of a Tariff
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The Effects of a Tariff (cont.)
Because the price in domestic markets rises
(to P
T
), domestic producers should supply
more and domestic consumers should
demand less.
The quantity of imports falls from Q
W
to Q
T

Because the price in foreign markets falls
(to P
*
T
), foreign producers should supply less
and foreign consumers should demand more.
The quantity of exports falls from Q
W
to Q
T

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The Effects of a Tariff (cont.)
The quantity of domestic import demand
equals the quantity of foreign export supply
when P
T
P
*
T
= t
In this case, the increase in the price of the
good in the domestic country is less than the
amount of the tariff.
Part of the effect of the tariff causes the foreign
countrys 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 of the good is an insignificant part
of world demand.
Therefore, the foreign price will not fall, but will
remain at P
w

The price in the domestic market, however, will
rise to P
T
= P
w
+ t
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Fig. 8-5: A Tariff in a Small Country
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Effective Rate of Protection
The effective rate of protection measures how
much protection a tariff or other trade policy provides
domestic producers.
It represents the change in value that firms in an industry add
to the production process when trade policy changes.
The change in value that firms in an industry provide
depends on the change in prices when trade policies change.
Effective rates of protection often differ from tariff rates
because tariffs affect sectors other than the protected sector,
causing indirect effects on the prices and value added for the
protected sector.
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Effective Rate of Protection (cont.)
For example, suppose that automobiles sell in
world markets for $8,000, and they are made
from factors of production worth $6,000.
The value added of the production process is
$8,000-$6,000
Suppose that a country puts a 25% tariff on
imported autos so that domestic auto
assembly firms can now charge up to $10,000
instead of $8,000.
Auto assembly will occur in the domestic country if
the value added is at least $10,000-$6,000.
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Effective Rate of Protection (cont.)
The effective rate of protection for domestic
auto assembly firms is the change in value
added:
($4,000 - $2,000)/$2,000 = 100%
In this case, the effective rate of protection is
greater than the tariff rate.
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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 to 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 (willingness to buy)
function.
When the price increases, the quantity demanded
decreases as well as the consumer surplus.
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Fig. 8-7: Geometry of Consumer Surplus
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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 (willingness to sell)
function.
When price increases, the quantity supplied
increases as well as the producer surplus.
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Fig. 8-8: Geometry of Producer Surplus
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Costs and Benefits of Tariffs
A tariff raises the price of a good in the
importing country, making its consumer
surplus decrease (making its consumers
worse off) and making its producer surplus
increase (making its producers better off).
Also, government revenue will increase.
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Fig. 8-9: Costs and Benefits of a Tariff for
the Importing Country
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Costs and Benefits of Tariffs (cont.)
For a large country, whose imports and exports can
affect foreign (world) prices, the welfare effect of a
tariff is ambiguous.
The triangles b and d represent the efficiency loss.
The tariff distorts production and consumption decisions:
producers produce too much and consumers consume too
little compared to the market outcome.
The rectangle e represents the terms of trade gain.
The terms of trade 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 = P
T
P
*
T

Q
T
= D
2
S
2
Government revenue = t x Q
T
= 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 loss, then national welfare will
increase under a tariff, at the expense of
foreign countries.
However, this analysis assumes that the terms of
trade does not change due to tariff changes by
foreign countries (that is, due to retaliation).
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Fig. 8-10: Net Welfare Effects of a Tariff
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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
(making its consumers worse off) and increasing its
producer surplus (making its producers better off).
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 terms of trade by lowering the
price of domestic products in world markets.
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Fig. 8-11: Effects of an Export Subsidy
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Export Subsidy (cont.)
An export subsidy unambiguously produces a
negative effect on national welfare.
The triangles b and d represent the efficiency loss.
The subsidy distorts production and consumption decisions:
producers produce too much and consumers consume too
little compared to the market outcome.
The area b + c + d + 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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Export Subsidy in Europe
The European Unions Common Agricultural Policy
sets high prices for agricultural products and
subsidizes exports to dispose of excess production.
The subsidized exports reduce world prices of agricultural
products.
The direct cost of this policy for European taxpayers
is almost $50 billion.
But the EU has proposed that farmers receive direct
payments independent of the amount of production to help
lower EU prices and reduce production.
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Fig. 8-12: Europes Common Agricultural
Program
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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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Fig. 8-13: Effects of the U.S. Import Quota
on Sugar
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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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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.
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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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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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Summary
Tariff Export
subsidy
Import
quota
Voluntary
export
restraint
Producer
surplus
Consumer
surplus
Government
net revenue
National
welfare
Increases Increases Increases Increases
No change:
rents to
license holders
Increases Decreases
Decreases Decreases Decreases Decreases
No change:
rents to
foreigners
Ambiguous,
falls for small
country
Ambiguous,
falls for small
country
Decreases
Decreases
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Summary (cont.)
1. A tariff decreases the world price of the
imported good, increases the domestic price
of the imported good and reduces the
quantity traded when a country is large.
2. A quota does the same.
3. An export subsidy decreases the world price
of the exported good increases the domestic
price of the exported good and increases the
quantity produced when a country is large.
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Summary (cont.)
4. The welfare effect of a tariff, quota and export
subsidy can be measured by:
Efficiency loss from consumption and production
Terms of trade gain or loss
5. With import quotas, voluntary export restraints and
local content requirements; the government of the
importing country receives no revenue.
6. With voluntary export restraints and occasionally
import quotas, quota rents go to foreigners.
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Additional Chapter Art
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Fig. 8-6: Deriving Consumer Surplus from
the Demand Curve
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Table 8-1: Effects of Alternative Trade
Policies
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Fig. 8A1-1: Free Trade Equilibrium for a
Small Country
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Fig. 8A1-2: A Tariff in a Small Country
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Fig. 8A1-3: Effect of a Tariff on the Terms
of Trade
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Fig. 8A2-1: A Monopolist Under Free
Trade
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Fig. 8A2-2: A Monopolist Protected by a
Tariff
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Fig. 8A2-3: A Monopolist Protected by
an Import Quota
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Fig. 8A2-4: Comparing a Tariff and a Quota