Traditional trade theory Traditional trade theory (Ricardo, H-O): adopts countries as its basic unit for analysis firms do not exist at all emphasizes.

Traditional trade theoryTraditional trade theory (Ricardo, H-O):

adopts countries as its basic unit for analysis firms do not exist at all

emphasizes comparative advantage - that is variation in opportunity costs of production across countries and industries - as the basis for international trade

Countries trade because they are different in terms of technology and/or their relative supplies of the factors of production (labour, capital, land, etc.)

Traditional trade theory: predictions “Different” countries should trade more

the greater the differences in factor supplies and/or technological development, the greater the volume of trade among countries.

“Different” countries should specialize in “different” goods trade will be inter-industry: Portugese wine for English wool in

Ricardo's famous example

The increased trade will result in both increased specialization and a tendency to equalize factor incomes

Economic welfare for all countries could increase through the mutual specialization induced by dismantling of trade barriers.

Limitations of the traditional trade theory Comparative advantage has had limited success in explaining

trade patterns actual trade mostly intra-industry and

Europeans buying Boeing jets while Americans buy Airbus

mostly between countries that are similar in their factor supplies and technological level

Liberalizing countries were observed to diversify their production and trade rather than to specialize

The gains from trade liberalization based on comparative advantage were estimated to be surprisingly small compared to the apparently powerful role that trade expansion played in the growth of the global economy in the post-World War II period.

The New Trade TheoryThe New Theory of international trade

(Krugman,1980; Helpman, 1981; Ethier, 1982): considers the industry as its basic unit for analysis.

Firms exist but are homogeneous – assumption of a representative firm within each industry

Intra-industry trade is explained on the basis of love of variety by consumers and product differentiation by firms operating under conditions of monopolistic competition and facing increasing returns to scale

The New Trade Theory (ct’d)The presence of increasing returns to scale allows that:

similar countries will specialize in different goods to take advantage of large-scale production, thereby leading to trade

countries may exchange goods with similar factor content

The new trade theory provides new sources of gains from trade: reduction of monopoly profits – new firms enter the

market rise in efficiency resulting from increased scale of

production (firms move down their average cost curves) gains for consumers from access to increased variety and

from lower costs of imports

The New Trade Theory (ct’d)The new trade theory opened the door to

“strategic trade policy“ (Brander and Spencer, 1985) protection could promote exports and shift rents to

the protectionist country in this case, free trade was not necessarily the optimal

policy for an individual country But the gains from deviating from free trade were

small possibility of Prisoner’s Dilemma “lose-lose" outcomes if

rival governments subsidized the same industry to gain global market share in strategic industries (as in the case of commercial aircraft).

Arguments for protectionism

Key questions addressedWhat do countries gain by trading with each

other instead of opting for self-sufficiency?

What are the main instruments of trade policy?

What are the effects of trade policy on consumers, producers, the government and total welfare?

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Gains from tradeAutarchy

Consumers can only buy domestic productsProducers can only sell to domestic consumers

Domestic and international prices differ

Free trade • In any product countries can be:Net importers

international price lower than autarky price (pA>pf)Net exporters

international price higher than autarky price (pA<pf)

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Gains from tradeIn general:

consumers can buy more and cheaper products and resources like labour and capital are transferred from inefficient to efficient producers

Net importers gain because:Domestic consumers can buy cheaper products

and new varietiesInefficient domestic producers loose market

sharesNet exporters gain because:

Efficient domestic producers sell larger quantities of their products at a higher price

Domestic consumers reduce consumption of expensive products

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Welfare effectsConsumer surplus

The difference between the price buyers would be willing to pay and what they actually pay

Producer surplusThe revenue producers receive above the

minimum amount required to induce them to produce a good

Classification of Commercial Policy Instruments

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

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•Price based measures:–Tariffs

–Specific: p=pf + t –Ad valorem: p=(1+t)pf

–Export subsidies: px= pf + s –Export taxes: px= pf - T

•Quantitative restrictions:–Quotas–Voluntary Export Restraints

Defining tariffsA tariff is a tax (duty) levied on products as they move

between nationsImport tariff - levied on importsExport tariff - levied on exported goods as they leave the

countrySpecific tariff

a monetary sum that must be paid to import 1 physical unit of a product Advantage: easy to collect Disadvantage: doesn’t take price changes into account

Ad valorem tariff a percentage of the monetary value of 1 unit of import

Advantage: takes price changes into account Disadvantage: Need to know the monetary value of the

good and seller is tempted to undervalue the price

Other Features of Tariff SchedulesPreferential Duties:

tariffs applied to imports from particular group of countries

countries are charged a lower tariff than countries outside the group

Generalized System of Preferences:developed countries charge lower tariffs for

specific imports from developing countrieslist of goods chosen by developed countries

(textiles and clothing not included)

Basic Tariff AnalysisUseful 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.

Consumer SurplusProducer Surplus

Welfare effectsConsumer surplus

The difference between the price buyers would be willing to pay and what they actually pay

Producer surplusThe revenue producers receive above the

minimum amount required to induce them to produce a good

Consumer and producer surplusTariffs

Consumer and Producer Surplus

In a partial equilibrium approach we can use the concepts of consumer and producer surplus

Both reflect the fact that there is only one market price

Hence, there are consumers who would have been willing to pay more for the product

Similarly, all but the “last” unit is produced with lesser marginal cost than the market price received

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P

Price (P)

D

consumer surplus

Quantity (Q)

S = marginal costof production

producersurplus

How to evaluate trade and trade policyIndividual actors in the country introducing

the policy measure:Consumers:

Changes in prices and varieties of goods consumed ( changes in consumers’ surplus)

Producers: Changes in prices of goods produced and inputs

purchased (changes in producers’ surplus)Government:

Effects on net revenuesNet effect:

Sum of changes in consumers and producers surplus and in government’s net revenues

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Effects of trade policy in generalImport protection as well as export promotion

distort production and consumption decisions; therefore, they are generally welfare reducing.

They also have effects on the distribution of income. Even when trade policy reduces national income and causes serious inefficiency in the economic system, it always benefits some firms or individuals at the expense of the rest of society.

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Effects of a tariffp=pf + t or p=(1+t)pf

→ Domestic price increases→ Domestic quantity supplied increases→ Domestic quantity demanded falls → Increase of government revenues

Distributional effectsurplus is transferred from the consumers

to the producers and the governmentConsumers lose more than producers and

government win: deadweight loss

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The Impact of Import Tariff: The Small-Country* Case

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imports after tariff

DD

Q

SD

Pint

(1+τ)Pint

imports in free trade

increase ofproducersurplus ta

riff

to t

he

gove

rnm

en

t

dead

wei

ght

loss

deadweightloss

imports after tariff

P

DD

Q

SD

Pint

(1+τ)Pint

imports in free trade

Loss of consumer surplus

P

Loss of consumer surplus Increase of producer surplus andgovernment income

* Small country = cannot affect world prices

The impact of import tariff: the large-country case

In the absence of tariff, the world price of wheat (Pw) would be equalized in both countries.

With the tariff in place, the price of wheat rises to PT

at Home and falls to P*T (= PT – 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 impact of import tariff: the large-country case

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 (or Home import prices).If the terms of trade gain is greater than the efficiency

loss, the tariff increases welfare for the importing country.

Export SubsidiesExport 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.

Effects of a subsidy - small country

px= pf + sSmall country

Raises the domestic price of the exported goods: Consumers loose (less and more expensive products) Producers gain (get a transfer from the government

on their exported products and sell their products in the domestic market at a higher price)

Government looses (transfer to producers) Net welfare effect NEGATIVE because

Government subsidises inefficient producers (dead weight loss in government’s revenues)

Loss of opportunities for beneficial consumption

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Export Subsidies: Europe’s Common Agricultural Program

Price, P

Quantity, Q

S

D

EU price without imports

World price

= cost of government subsidy

Support price

Exports

Import QuotasAn 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.

Import QuotasAn 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. They accrue to licenses holders

Welfare analysis of import quotas versus 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.

Voluntary Export Restraints

Voluntary Export Restraints (VERS) A restriction on a country's imports that is achieved

by negotiating with the foreign exporting country for it to restrict its exports (foreign suppliers agree to “voluntary” refrain from sending some exports)

alternative to import quota importing home country pressures exporting country

to restrain its exports to the home market usually such agreements are made with the threat of

quotas being imposed if exports are not limited

H. Breinlich, U. of Essex, EC246: Free Trade vs. Protectionism

Voluntary Export RestraintsA 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.

Other non-tariff barriers (NTBs)

Local Content RequirementA 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.

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.

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.very restrictive policyusually seen in developing countries

trying to grow through import substitution

Government Procurement Provisions

Government agencies are obligated to purchase from domestic suppliers, even when they charge higher prices (or have inferior quality) compared to foreign suppliers.If quantity of government procurement is less

than the quantities produced by domestic firms in free trade, then there is no distortion on production and import

However, when it is higher than domestic original production, this will raise domestic price. As a result, producer surplus increasesBut Government has to pay more. It has

deadweight lossImport also decreases.

Government procurementIn the absence of government procurement

requirement, government buys S1, and import G-S1.

In the presence of government procurement requirement, government buy G but pays Pd. Total cost=a+b.

Producers gain=aDeadweight loss=b.Import decreases from M1 to M2 accordingly.

Nontariff Barriers (NTBs)

Technical barriers to trade - A technical regulation (health, environment and safety standards) or other requirement (for testing, labelling, packaging, marketing, certification, etc.) applied to imports in a way that restricts trade

Trade-Related Investment Measuresperformance requirements: forcing a foreign investor to use

domestic inputs, or export final productAdditional Restrictions

foreign exchange controls, import licencesadvance deposit requirements - firm has to deposit funds with

government equal to a percent of future import (to be refunded when import purchased)

Administered protection allowed by WTO rules

Antidumping duties - Tariff levied on dumped imports, i.e. imports provided at a price that is ‘unfairly low’, defined as either below the home market price or below cost

Countervailing duties - A tariff levied against imports that are subsidized by the exporting country's government, designed to offset (countervail) the effect of the subsidy

Safeguard measures: when imports cause “injury” to domestic industries

H. Breinlich, U. of Essex, EC246: Free Trade vs. Protectionism

Arguments for protectionismThe Infant Industry ArgumentThe Terms-of-Trade ArgumentThe Antidumping ArgumentArgument for a Tariff to Offset Foreign SubsidyArgument for a Tariff to Reduce Aggregate

UnemploymentTariff to Increase Employment in a Particular

IndustryThe National Defence Argument for a

Tariff

The Infant Industry ArgumentThere is a potential comparative advantage that cannot be

realized in the short run due to foreign competition. However, given a temporary tariff, domestic industry is able to mature, that is, it will achieve a reduction in unit cost by realizing the economies of scale OR through learning-by-doing

Objective to realize a potential comparative advantage

ConsistencyKey assumption: There is a market failure

(external economies of scale, imperfect capital markets…).

If this does not hold, you should ask why doesn’t the industry proceed on its own?

ImplementationProblem with identifying the right industriesTime consistency: will the protection eventually

become permanent?

The Terms-of-Trade Argument

Restrictive trade policy can improve country’s terms-of-trade and thus increase its welfare

Objectives increase the ratio PX/PM ( = to make imports cheaper) increase country’s aggregate welfare

Consistency & Implementation IF the country is large enough, imposing a tariff

may result enough decrease in world price and thus improvement in country’s terms of trade

o IF the benefits from improved terms of trade are larger than the costs (deadweight loss and reduction of exports due to tariff), country’s welfare increases

optimum tariff = a tariff structure that maximizes country’s welfare

The Antidumping Argument

Foreign firms’ dumping into the home country constitutes a threat to domestic producers. Thus we need to impose an antidumping duty to prevent this unfair practice.

Objective to stop an unfair trading practice (dumping)

Consistency: Depends on the type of dumping

Definitions of dumpingEconomics: 3rd degree price discrimination

(different price in separate markets when there is no difference in the production cost)

Trade laws: selling below the cost or “fair value”

Argument for a Tariff to Offset Foreign Subsidy

The foreign government subsidizes the foreign firm. This unfair subsidy should be matched with a tariff to restore equal footing to the home and foreign industry.

Objectiveto offset a distortion due to a foreign

subsidyConsistency

The subsidy moves foreign supply curve downwards, a tariff moves it upwards → a tariff can be used to offset the impact of a subsidy

Argument for a Tariff to Reduce Aggregate UnemploymentImposition of a tariff results a shift of demand from imports to

domestic goods, which increases the output of import-competing firms. Further, the new workers hired will use their salaries, setting off a Keynesian multiplier process. Hence also other industries will expand and create new jobs.

Objective to decrease aggregate unemployment

• Consistency Traditional models assume full employment a tariff/quota will increase the domestic production of

the protected good (and hence demand for labour in this sector)

however, it will decrease exports due to decrease of the foreign country’s purchasing power, retaliation and appreciation of the home currency

the net impact on unemployment is ambiguous, i.e. the policy may not accomplish the objective

Tariff to Increase Employment in a Particular Industry Tariff on imports will increase the domestic

production of the import competing goods and hence labour will move to this sector. We do not care that this may occur as an expense of the other sectors.

Objective to increase the production of and reallocate

labour to the import competing industryConsistency

setting a tariff will lead to the objectiveNegative net impact due to efficiency lossAlternative policy

again, subsidising the import-competing industry would result the same outcome with less cost

The National Defence Argument for aTariff

Some industries are vital during a time of war or national emergency. Thus these industries must be protected by imposing a sufficient tariff to ensure self-sufficiency.

Problem: Identifying the vital industriesMore efficient policies: creating joint

business- government R&D companies, subsidizing the domestic production