Instruments of Trade Policy

Introduction
• A specific tariff is levied as a fixed charge for each unit of imported goods.
For example, Rs 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.
• Let’s 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.
• 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.
• In equilibrium, import demand = export supply
domestic demand – domestic supply = foreign supply – foreign demand
• In equilibrium, world demand = world supply
Deriving Foreign’s Export Supply Curve
Deriving Home’s Import Demand Curve
World Equillibrium
 The Effects of a Tariff
• A tariff acts as an added cost of transportation, making shippers
unwilling to ship goods unless the price difference between the
domestic and foreign markets exceeds the tariff.
• If shippers 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.
• Thus, a tariff will make the price of a good rise in the domestic market
and will make the price of a good fall in the foreign market, until the
price difference equals the tariff.
• PT – P*T = t ; PT = 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.
• Because the price in domestic markets rises (to PT), domestic
producers should supply more and domestic consumers should
demand less.
• The quantity of imports falls from QW to QT
• 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 QW to QT
• The quantity of domestic import demand equals the quantity of
foreign export supply when PT – 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 tariff is reflected in a decline of the foreign country’s
export price, and thus is not passed on to domestic consumers.
Effects of 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 an
insignificant part of world demand.
Therefore, the foreign price will
not fall, but will remain at Pw
The price in the domestic market,
however, will rise to PT = Pw + t
 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 an industry adds to the
production process when trade policy changes.
The change in value that an industry provides 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, a fact which
affects the prices and value added for the protected sector.
• For example, suppose that an automobile sells on the world market for
Rs 8000, and the parts that made it are worth Rs 6000.
• The value added of the auto production is Rs 8000- Rs 6000
• Suppose that a country puts a 25% tariff on imported autos so that
domestic auto assembly firms can now charge up to Rs 10000 instead
of Rs 8000.
• Now auto assembly will occur if the value added is up to Rs 10000-
Rs 6000.
• The effective rate of protection for domestic auto assembly firms is the
change in value added: (Rs 4000 - Rs 2000)/ Rs 2000 = 100%
In this case, the effective rate of protection is greater than the tariff
rate.
 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.
• Consumer surplus measures the amount that a consumer gains from a
purchase by the difference in the price he pays from the price he would
have been willing to pay.
• The price he would have been willing to pay is determined by a demand
(willingness to buy) curve.
• When the price increases, the quantity demanded decreases as well as the
consumer surplus.
Consumer Surplus
 Producer Surplus
• Producer surplus measures the amount that a producer gains from a sale
by the difference in the price he receives from the price he would have
been willing to sell at.
The price he would have been willing to sell at is determined by a supply
(willingness to sell) curve.
When price increases, the quantity supplied increases as well as the
producer surplus.
• 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
Costs and benefits of tariffs for an importing
country
• For a “large” country that 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.
• 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.
• 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 (i.e., due to
retaliation).
Net Welfare effects of Tariff
 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,
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 decrease.
• 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.
• An export subsidy unambiguously produces a negative effect on
national welfare.
• 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 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.
 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.
• 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.
 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.
 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.
• 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.
• 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.
 Case for Free Trade

• The first case for free trade is the argument that producers and
consumers allocate resources most efficiently when governments do
not distort market prices through trade policy.
National welfare of a small country is highest with free trade.
With restricted trade, consumers pay higher prices.
With restricted trade, distorted prices cause overproduction either by
existing firms producing more or by more firms entering the industry.
 However, because tariff rates are already low for most countries,
estimated benefits of moving to free trade are only a small fraction of
national income for most countries.
Efficiency case for Free Trade
• A second argument for free trade is that allows firms or industry to
take advantage of economies of scale.
• A third argument for free trade is that it provides competition and
opportunities for innovation.
• A fourth argument, called the political argument for free trade, says
that free trade is the best feasible political policy, even though there
may be better policies in principle.
• Any policy that deviates from free trade would be quickly
manipulated by special interests, leading to decreased national
welfare.
 Case Against Free Trade
• The possibility that a tariff could improve national welfare for a large
country in international markets was first noted by Robert Torrens (1844).
Since the welfare improvement occurs only if the terms of trade gain
exceeds the total deadweight losses, the argument is commonly known as
the Terms of Trade Argument for protection.
• For a “large” country, a tariff or quota lowers the price of imports in world
markets and generates a terms of trade gain.
This benefit may exceed production and consumption distortions.
• In fact, a small tariff will lead to an increase in national welfare for a large
country.
But at some tariff rate, the national welfare will begin to decrease as the
economic efficiency loss exceeds the terms of trade gain.
Components of Welfare and Tariff
Optimum Tariff
For a large country, there is an
optimum tariff t0 at which the
marginal gains from improved
terms of trade just equals the
marginal efficiency loss from
production and consumption
distortion.
Trade liberalization?