BA 187 – International Trade

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BA 187 – International Trade

Krugman & Obstfeld, Chapter 8

Instruments of Trade Policy

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Free enterprise made this country. Free trade will destroy it. For five years, I’ve been advocating a 20 percent tariff on all imports. We can either do that, or our industrial base will erode to the point where we can’t build products to defend ourselves in the event of war. Our people will walk the streets because we are exporting jobs and importing welfare.

June M. Collier, President,

National Industries, Inc., 1985

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Instruments of Trade Policy Tariffs Tariffs are taxes levied on imported goods.

– Specific TariffSpecific Tariff: levied as fixed amount on each unit of goods imported.

– Ad Valorem TariffAd Valorem Tariff: a tax levied as a fraction of the value of goods imported.

Export Taxes or Subsidies Export Taxes or Subsidies are levied on exported goods.– Either as specific tax (subsidy)or as an Ad Valorem tax (subsidy) on

exports.

Non-Tariff Barriers (NTB’s)Non-Tariff Barriers (NTB’s)– Import QuotasImport Quotas: Limitations on the quantity of imports.

– Export RestraintsExport Restraints: Limitations on quantity of exports (usually imposed by exporting country).

– Miscellaneous RestraintsMiscellaneous Restraints: Gov’t Procurement Provsions, Domestic Content Rules, Administrative Classifications, Border Taxes.

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Partial Equilibrium Analysis Will examine effects of trade policy in a partial

equilibrium framework.– Ignore interactions across economy, focus on single market.

Assumptions:– Two countries, Home and Foreign. – One good, which bothboth countries produce and consume. – Good can be costlessly transported between countries.– Exchange rate constant throughout, quote price of good in

terms of Home currency in both Home & Foreign.– Home country assumed to import this good from Foreign.

Equilibrium price determined by Home’s Import Demand and Foreign’s Export Supply Curves.

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MD

4. Result is a downward-sloping Import Demand Curve, MD, for Home Country.

Home’s Import Demand

Price, P

Quantity, Q Quantity, Q

Home Market ImportsPrice, P

1. At P0, Demand exceeds supply in Home market, hence demand for imports, D0 – S0.

P0

D0 – S0

2. Rise in Price to P1, reduces Home excess demand, lowers import demand to D1 – S1.

P1

D1 – S1

P2

3. Further rise in Price to P2, eliminates Excess Demand, reduces import demand to 0.

D1 – S1 D0 – S0

S

D

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XS

4. Result is an upward-sloping Export Supply Curve, XS, from Foreign country.

Foreign’s Export Supply

Price, P

Quantity, Q Quantity, Q

MC

Foreign Market ExportsPrice, P

1. Can perform similar exercise for Foreign. Quote foreign price in Home currency.

P2

S*2 – D*2

S*2 – D*2

S*

D*

P0

2. At P0, Foreign Demand equals Supply so no exports of good are available.

P1

S*1 – D*1

S*1 – D*1

3. As Prices rise, Foreign Demand less than Supply so exports of good are available.

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World Partial Equilibrium

Price, P

Quantity, Q

XS

1. Foreign Country has upward- sloping Export Supply Curve, XS.

PW

QT

3. Trade is in equilibrium for the good when world price = PW and amount of good traded = QT.

World Market

MD

2. Home Country has downward- sloping Import Demand, MD.

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Effect of a Tariff on Imports Tariff drives a wedge between price paid by consumers in

Home and price received by exporters in Foreign.

Specific Tariff of $t per unitSpecific Tariff of $t per unit.– Shifts the Export Supply Curve up by $t at each q.

– New equilibrium price in Home rises by less than $t.

– Why? Because new price received by Foreign exporter’s falls below initial price (terms of trade effect).

Size of this effect depends on importance of Home Country in World market. Generally this effect is negligible.

““Small Country Case”Small Country Case” assumes no change in Foreign price, implying Home price rises by full amount of tariff.

– Quantity of good traded falls below free trade level.

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t

XS’

2. Home imposes specific import tariff t, which shifts XS up by t.

Tariffs in Large Country1. Begin in equilibrium at PW with Home imports equal Foreign exports

Home Country World Market Foreign Country

SHDHDF

XS

MD

SF

PW

DomesticPrice Price Foreign

Price

4. How burden of tariff distributed between Home & Foreign depends on slopes of MD and XS curves, i.e. PT and P*T relative to initial PW.

PT

P*T

3. New equilibrium with home price PT = P*T + t. Quantity traded falls.

t

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Measuring Amount of Protection “Height of the average tariff” is a measure of how much price

interference exists in country’s tariff schedule.

Unweighted Average Nominal Tariff rate:– Does not take into account relative importance of each good.

Tends to overstate true height of average tariff.

Weighted Average Nominal Tariff rate:– Each good’s tariff is weighted by the importance of the good in the

bundle of imports. Tends to be biased downwards.

Prohibitive Nominal Tariff rate:– Tariff rate so high it prevents imports from coming into country.

Effective Rate of Protection (ERP):– Change in the value-added of an industry (relative to free trade)

due to imposition of a tariff structure on intermediate & final products.

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Nominal (t) and Effective (g) Tariff rates

U.S.U.S. E.U.E.U. JapanJapan

Rates as of 1984Rates as of 1984 tt gg tt gg tt gg

Agriculture/Forestry/Fish 1.8 1.9 4.9 4.1 18.4 21.4

Food/beverages/tobacco 4.7 10.2 10.1 17.8 25.425.4 50.350.3

Wearing Apparel 22.722.7 43.343.3 13.413.4 19.319.3 13.813.8 42.242.2

Footwear 8.8 15.4 11.611.6 20.120.1 15.715.7 50.050.0

Furniture & Fixtures 4.1 5.5 5.6 11.3 5.1 10.3

Chemicals 2.4 3.7 8.0 11.7 4.8 6.4

Glass & Glass Products 6.2 9.8 7.7 12.2 5.1 8.1

Iron & Steel 3.6 6.2 4.7 11.6 2.8 4.3

Electrical machinery 4.4 6.3 7.9 10.8 4.3 6.7

Simple Average TariffSimple Average Tariff 4.74.7 7.87.8 6.16.1 8.78.7 6.16.1 10.010.0

Source: Deardorf & Stern, The Effects of the Tokyo Round and the Structure of Protection

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Costs and Benefits of Protectionist Policies

Large Country Analysis

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Measuring Market Costs & Benefits Measure costs/benefits of protection with monetary quantities.

Consumer Costs/Benefits:– Consumer surplus:Consumer surplus: measures the monetary amount between price

consumer actually pays and price she/he willing to pay.

– Calculated as area under the Demand Curve above market price.

Producer Costs/Benefits:– Producer surplus:Producer surplus: measures the monetary amount between price

producer actually receives and price she/he willing to accept.

– Calculated as area above the Supply Curve but below market price.

Government Costs/Benefits:– Government Revenue:Government Revenue: measures the monetary amount generated by

the tariff that government receives as revenue.

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DH

2. Home Country has downward- sloping Import Demand, MD.

SH

3. Trade is in equilibrium for the good when world price = PW and amount of good traded = QT.

Consumer & Producer Surplus

Price, P

Quantity, Q

1. Foreign Country has upward- sloping Export Supply Curve, XS.

P0

Home Market

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2. Consumer surplus falls by areas: a + b + c + d

4. Government revenue rises by area: c + e

3. Producer surplus rises by area: a

b dca

e

QT

Costs and Benefits of a Tariff

Price, P

Quantity, Q

SH

S1

5. Deadweight lossDeadweight loss (cost of protection): b + d (= pro’dn loss + consump loss)

DH

PW

D1

PT

1. Specific import tariff t on good, domestic price rises to PT from PW.

P*T

t

D2 S2

6. Terms of Trade GainTerms of Trade Gain: e (decline in export good price to P*T

Home Market

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Summary of Import Tariff Import Tariff brings three net effects to economy.

– Tariff raises domestic price of good above free trade level.

Production Distortion (loss);Production Distortion (loss);– Leads domestic producers to produce too much of the import good

resulting in an efficiency loss.

Consumption Distortion (loss);Consumption Distortion (loss);– Tariff leads domestic consumers to consume too little of the

import good resulting in a welfare loss.

Terms of Trade Effect (gain);Terms of Trade Effect (gain);– Tariff lowers world demand for import good, resulting in a fall in

the world price of the import good. Likely to be small in reality.

Summary of Import Tariff (Probable Welfare Loss);Summary of Import Tariff (Probable Welfare Loss);– Terms of trade effect negligible, so tariff will probably reduce

level of welfare in the country imposing the tariff.

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4. Cost of Subsidy given by areas:

b + c + d + e + f + g

2. Consumer surplus falls by areas:

a + b3. Producer surplus rises by areas:

a + b + c

Effects of an Export Subsidy

Price, P

Quantity, Q

SH

a b c

e f g

dPW

DH

P*S

S

PS

Exports

1. Specific export subsidy, s, on good, domestic price rises to PS from PW.

5. Net Welfare LossNet Welfare Loss given by areas:

b + d + e + f + g

Home Market

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Summary of Export Subsidy Export Subsidy has exact opposite effects to import tariff.

– Subsidy raises domestic price of good above free trade level.

Production Distortion (loss);Production Distortion (loss);– Leads domestic producers to produce too much of the export good

resulting in an efficiency loss.

Consumption Distortion (loss);Consumption Distortion (loss);– Subsidy leads domestic consumers to consume too little of the

export good resulting in a welfare loss.

Terms of Trade Effect (loss);Terms of Trade Effect (loss);– Subsidy raises world supply of export good, resulting in a fall in

the world price of the export good. Likely to be small in reality.

Summary of Import Tariff (Welfare Loss);Summary of Import Tariff (Welfare Loss);– Even if terms of trade effect negligible, subsidy will certainly

reduce level of welfare in the country giving the subsidy.

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Agricultural Subsidies, 1979-1986

U.S.U.S. E.U.E.U. JapanJapan

'79-'81 '84-'86 '79-'81 '84-'86 '79-'81 '84-'86

Eggs 5% 7% 20% 18% 20% 19%

Milk 55 66 67 56 79 82

Poultry 5 10 24 27 19 16

Beef & Veal 9 9 42 53 53 55

Wheat 14 44 28 36 97 98

Sugar 15 76 34 75 46 72

Rice 7 61 15 68 71 86

Soybeans 6 10 43 59 82 84

Simple Simple AverageAverage

1515 3535 3131 4949 5858 6464

Source: Rosenblatt et al, The Common Agricultural Policy of the EC, IMF 1988

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Costs and Benefits of Protectionist Policies

Small Country Analysis

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Tariff for a Small Country

Price, P

Quantity, Q

SH

PW

D0

DH

2. Consumer surplus falls by areas: a + b + c + d

3. Producer surplus rises by area: a

4. Government revenue rises by area: c

5. Deadweight loss (cost of protection): b + d (= pro’dn loss + consump loss)

a b c d

ST DT

PT

1. Import tariff, t, raises domestic price PT = PW + t for small country.

t

S0

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Costs & Benefits of a Tariff

Price, P

Quantity, Q

SH

$2

$1

$5

$3

20

$4

10 30 40 50 60 70

DH

2. Consumer surplus falls by areas: a + b + c + d = $60

3. Producer surplus rises by area: a = $15

4. Government revenue rises by area: c = $30

5. Deadweight loss (cost of protection): b + d = $15

1. 100% import tariff on good, domestic price rises from $1 to $2.

a=$15 b=$5

c=$30d=$10

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U.S. Example: 1978 CB Radio Tariff

In 1978, import tariffs on CB radios increased from 6% to 21%.

FTC estimated this had the following effects:– Price rose from $54 to $62.– Demand fell 1.53 million– Domestic Prod’n up 221,000

Assume no effect on world price, analyze effects on U.S. welfare.

Costly to consumers with little benefit to producers or number of U.S. jobs created.

Welfare EffectWelfare Effect $ millions$ millions

Consumer SurplusConsumer Surplus - 48.8- 48.8

Tariff RevenueTariff Revenue + 33.6+ 33.6

Producer SurplusProducer Surplus + 3.0+ 3.0

Deadweight LossDeadweight Loss - 12.2- 12.2

Consumption -10.7

Production -1.5

Source: Morkre & Tarr, Effects of Restriction on U.S. Imports, FTC

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Costs and Benefits of Protectionist Policies

Non-Tariff Barriers (NTB’s)

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Non-tariff Barrier – Import Quota Most common form of a Non-Tariff Barrier is an import quota

which restricts the quantity of good imported. Import QuotaImport Quota

– Restricts quantity of good imported during a year.– Effect is to increase home price of the good over free trade.– Market effects identical to a specific tariff. In fact, any quota can be

mimicked by an equivalent tariffequivalent tariff.– Welfare effects differ because gov’t does not necessarily receive

revenue as under a tariff. May gain revenue if auctions off import licenses, otherwise additional revenue received by foreign exporters.

Voluntary Export Restraint (VER’s)Voluntary Export Restraint (VER’s)– Foreign supplier “voluntarily” agrees to restrict quantity imported.– Usually a political agreement so Home does not look protectionist.– Market effects identical to an import quota, but welfare effects differ as

foreign firms receive additional profit, Home gov’t receives nothing.

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Effects of an Import Quota

Price, P

Quantity, Q

PW

MD

3. Market effects of tariff and a quota are identical but not welfare effects.

5. Quota brings nono Government revenue increase of a tariff. Who earns this quota profit or rentquota profit or rent depends on structure of quota.

4. Consumer surplus, producer surplus and associated Deadweight loss (= pro’dn loss + consump loss) are identical.

XS’

2. There exists an equivalent tariff, tequivalent tariff, tqq , , for any quota that has same result.

tq

Q0

XS

World Market

PqH

1. Import quota level set at Qq. Raises domestic price Pq

H, lowers foreign.

Qq

Quota

PqW

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6. With Demand Growth, equiv tariff leads higher home price & quantity. Gov’t revenue also increases.

Demand Growth & Import Quota

Price, P

Quantity, Q

PW

MD

5. With Demand Growth, quota leads to higher home price with no change in quantity. Quota rent increases.

XS’

Q0

XS

World Market

Pq1

1. Import quota level set at Qq with associated equivalent tariff, tq.

Qq1

Quota

PqW

2. Look at effects of Demand growth on market under quota vs. equiv. tariff.

MD’

E0tq

E1

Qq2

Pq2

E2

4. Under the tariff, new equilibrium at E2 with Pq2 at higher Qq2.

3. Under the quota, new equilibrium at E3 with Pq3 at same Qq.

Pq3E3

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NTB’s on Industrial Country Imports(as % of imports)

Total NTB’sTotal NTB’sQuantitative Quantitative RestrictionsRestrictions

Of which Of which VER’sVER’s

19811981 19861986 19811981 19861986 19811981 19861986

Agricultural Raw Materials 2.8 8.4 1.8 1.8 0.0 0.0

Agricultural Food 40.8 42.6 27.3 27.4 0.8 1.8

Minerals & Metals 12.7 24.7 4.5 16.8 2.1 14.4

Iron & Steel 29.0 64.2 7.8 47.3 6.6 45.2

Chemicals 13.2 12.7 8.1 7.6 0.0 0.0

Other Manufactures 18.6 20.5 11.7 12.2 9.3 9.7

All Products (except fuel) 19.6 23.1 12.2 14.4 5.6 7.7

Source: Grilli & Sassoon, The New Protectionist Wave, 1990.

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Other Forms of NTB’s Government Procurement Provisions

– Restrict purchase of foreign goods by home gov’t agencies. – Similar to an Ad Valorem import tax, where home producer receives

certain percentage of price protection.

Domestic Content Provisions– Reserve some of value-added & product sales to home producers.

European Border Taxes– Value-added tax (VAT) in EU. Imports to EU must pay equivalent

VAT, while EU exports receive rebate for VAT. Looks like an import tariff & an export subsidy

Administrative Classification– Import duty depends on classification, gives leeway to customs.

Restrictions on Services Trade– Less visible. Restrict foreign provision of certain services.

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Welfare Effects of U.S. Trade RestrictionsQR = Quantitative

Restriction Welfare GainWelfare GainIndustry Industry

EmploymentEmploymentRest of Economy Rest of Economy EmploymentEmployment

($billions) (000 work-yrs) (000 work-yrs)

Textile & ApparelTextile & Apparel

Remove QR’s 11.92 -157.2 157.2

Capture Rents from Foreigners

6.05 -3.1 28.4

AutomobilesAutomobiles

Remove QR’s 7.50 -1.2 1.3

Capture Rents from Foreigners

7.15 +1.3 37.2

SteelSteel

Remove QR’s 0.86 -20.7 22.3

Capture Rents from Foreigners

0.74 -0.1 3.5

Source: De Melo & Tarr, Welfare Costs of Quotas on Textile, Steel, & Apparel