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Trade Policy: Instruments and Impacts
Appleyard & Field (& Cobbs): Chapters 13–14
Krugman & Obstfeld: Chapter 8
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Today’s Lecture
1. Instruments of trade policy1. Tariffs2. Quotas3. Other Non-tariff Barriers to Trade
2. Impact of trade policies1. Partial Equilibrium: Small Country2. Partial Equilibrium: Large Country3. General Equilibrium: Small Country4. General Equilibrium: Large Country
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Tariffs• Imports tariffs
o specific 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
o 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 instruments
o Import subsidy negative import tariffo Export tariff/subsidy (levied/paid on home-
produced goods that are destined for export)
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Features of Tariff Schedules• Preferential duties
o products form certain countries are subject to lower tariffs than the normal tariff rate
o Generalized System of Preferences (GSP) for developing countries
• Most-favoured-nation (MFN) treatment = normal trade relations (NTR)o “if country A grants country B the status
of most-favoured nation, it means that B’s exports will face tariff that are no higher (nor lower) than those applied to any other country that A calls a MFN” (Economics A-Z in The Economist website)
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Non-tariff Barriers to Trade (1)• Import Quotas
o a government agency allocates the rights to importo limits the number of goods (not the price) for a given
time period• “Voluntary” export restraints (VER)
o foreign suppliers agree to “voluntary” refrain from sending some exports
• Government procurement provisionso restriction on purchasing foreign products by the
domestic government agencies• Domestic content provisions
o a given percentage of the value of a good must consist of domestic components or labour
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Non-tariff Barriers to Trade (2)• Administrative classification
o different tariffs to different product categories + leeway for customs officials to decide on classification
• Restrictions on services trade• Trade-related investment measures• Domestic policies affecting trade
o health, environment and safety standards; packaging and labeling requirements; inconsistent treatment of intellectual property rights; subsidies to domestic firms...
etc.
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Impact of Trade Policy: Levels of Study
• Partial Equilibrium analysiso analysing one market and ignoring
the subsequent or secondary effects• General equilibrium analysis
o analysing all markets simultaneously (but still holding technology, endowments etc. constant)
• Note that here “market” means a market for one good (which can be sold in many countries). We will use both approaches to study one-country and two-country cases. The difference is that in general equilibrium analysis we take also into account what happens in the markets of goods not subject to trade policy.
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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
P
Price (P)
D
consumer surplus
Quantity (Q)
S = marginal costof production
producersurplus
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imports after tariff
The Impact of Import Tariff: The Small-Country* Case
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 surplusIncrease of producer surplus andgovernment income
* Small country = cannot affect world prices
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The Impact of Import Tariff: The Small-Country Case• Introducing a tariff
→ Domestic price increases→ Domestic quantity supplied increases→ Domestic quantity demanded falls → Increase of government revenues
• Distributional effecto surplus is transferred from the
consumers to the producers and the government
• Consumers lose more than producers and government win: deadweight loss
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The Impact of Import Quota:
The Small-Country Case• For every quota there
is an equivalent tariff (and for every tariff there is an equivalent quota)
• The changes in consumer and produce surplus are equivalent to that of a tariff
• However, the increase of government revenue may be lost (depending on how the quotas are allocated)
quota
P
DD
Q
SD
Pint
imports in free trade
PQ
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imports after the subsidy
The Impact of Subsidy to Import-Competing Industry (Small Country Case)
DD
Q
SD
P
imports in free trade
Cost to the government
imports in free trade
P
imports after the subsidy
P
DD
Q
SD
P
increase ofproducersurplus eff
icie
ncy
loss
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The Impact of Subsidy to Import-Competing Industry (Small Country Case)
• Equivalent subsidy = producers are subsidised to produce the same amount as they would under a tariff→ Equal increase in the producer surplus as under tariffs→ Large cost to the government→ No impact on price no impact on consumer surplus
• Cost to the government is larger than the increase of producer surplus, i.e. there is a loss of efficiency
• However, this cost is less than the loss of consumer surplus in the tariff/quota case → subsidies are more efficient than tariffs/quotas
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Large country, partial equilibriumSingle Market, Two Countries
Q Q
Country A Country B
DA
SA
SB
DB
PP
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Single Market, Two Countries
Q Q
Country A Country B
DA
SA
SB
DB
PP
Countries A and B have different supply curves (cost of production) and demand curves (preferences). In free trade equilibrium the world price is such that country B is willing to export the same quantity as country A is willing to import.
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Single Market, Two Countries, Tariff
Q Q
Country A Country B
tariff
DA
SA
SB
DB
PP
Price in Country A = Price in country B + tariff. If the price in country B would remain constant after a tariff is set, country B would be willing to export more that country A would be willing to import → price in country B must decrease (next slide)
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Effect of a Tariff in a Single Market and Two-Countries
Q Q
Country A Country B
tariffPFT
PA
PB
DASA
SBDB
PP
a b
Cprice decrease in country B
De
Country A:Loss of consumer surplus = e+a+D+b; increase of producer surplus = e; Increase of government revenue = C+D. Gain for Country A = gains–losses = (e+C+D)-(e+a+D+b) = C – a – b. That is, if C > a + b country A has gained from the imposition of the tariff (due to lower prices of imports before tariff).
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Impact of Elasticises
Q Q
Country A Country B
tariffPFT
PA
PB
DA
SA
SBDB
PP
a bC
price decrease in country B
De
The more elastic in the exporting market and the more inelastic in the importing market supply and demand are, the less chances the importing country has on gaining from tariff
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The Impact of Import Quota• Graphically identical to the case of tariff• The difference is in, who gets areas D
(country A’s government revenue from the tariff) and C (loss of country B’s producer surplus that is transferred to country A in the tariff setting)
• Voluntary export restraints (VER) can be seen as a way for the exporting country to capture areas C and Do Then, if this gain is greater than the
deadweight loss of the exporter (triangles around C), the exporting country will gain from the quota
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General Equilibrium Analysis• Partial Equilibrium analysis
o analysing one market and ignoring the subsequent or secondary effects
• General equilibrium analysiso analysing all markets simultaneously
(but still holding technology, endowments etc. constant)
• Note that here “market” means a market for one good (which can be sold in many countries). We will use both approaches to study one-country and two-country cases. The difference is that in general equilibrium analysis we take also into account what happens in the markets of goods not subject to trade policy.
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General Equilibrium Effects of a Tariff for a Small Country
• Import tariff on good Y changes the price ratio
• Producers adjust from point PFT to Pt
• Since the tariff doesn’t change world prices, country’s real income changes to (PX/PY)t
• Consumers maximize given domestic prices and real income and move to a lower utility level
• Note that real income is determined by the world prices Good XPt
Pt
Good Y
PFTCFT
PFT
CFT
(PX/PY)FT
PX/(1+τ)PY
Ct
Ct
(PX /P
Y ) t
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General Equilibrium Effects of a Subsidy for a Small Country
• Assume the government subsidizes producer of good Y to impose the same production pattern as with the tariff
• The real income of the country remains the same
• Consumers face world prices and are able to consume at a higher utility level
Good XPS
PS
Good Y
PFTCFT
PFT
CFT
(PX/PY)FT
PX/(1+τ)PY
CS
CS
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Terms of Trade Effect of a Tariff
• Imposing a tariff shifts offer curve inwards (the country is now willing to trade less for all terms of trade)
→ The tariff imposing country’s terms of trade improve (the
price of exports decrease), which may offset the, at least in part, the decrease of welfare due to efficiency loss
Good X: Exports from country 1
Imports to country 2
Good
Y:
Imp
ort
s to
cou
ntr
y 1
exp
ort
s fr
om
cou
ntr
y 2
(PX/PY)E’ = TOTE’
Country 1’s offer curve
Country 2’s offer curve
(PX/PY)E = TOTE
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Terms of Trade Effect of a Quota
• Country 1 sets a quota for imports of good Y
→ country 1’s offer curve becomes horizontal at the quota level
→ Country 1’s terms of trade improve
Good X: Exports from country 1
Imports to country 2
Good
Y:
Imp
ort
s to
cou
ntr
y 1
exp
ort
s fr
om
cou
ntr
y 2
(PX/PY)E’ = TOTE’
Country 1’s offer curve
Country 2’s offer curve
(PX/PY)E = TOTE
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Terms of Trade Effect of a Voluntary Export Restraints
• Country 2 uses voluntary export restraints (VER) to limit exports of good Y
→ country 2’s offer curve becomes horizontal
→ country 2’s terms of trade improve
Good X: Exports from country 1
Imports to country 2
Good
Y:
Imp
ort
s to
cou
ntr
y 1
exp
ort
s fr
om
cou
ntr
y 2
(PX/PY)E’
Country 1’s offer curve
Country 2’s offer curve
(PX/PY)E
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Other Effects of Protection
• Restricting imports is likely to result decrease of exports as wello Reallocation of domestic resourceso Retaliation by the trading partners
• Distributional Effectso Transfer from the consumers to the
import-competing producerso HO-model: transfer from the abundant
factor to the scarce factor