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‚Trade and Development‘

Table of Contents

3. Trade and Development

3.2 Trade protection – the arguments

a) Effects of an import tariff

b) Effects of an export subsidy

c) Arguments for trade policy

164Susanne Fricke ‐ Summer Term 2015


3.2 Trade protection

a) Effects of an import tariffAssumption: small country (tariff has no effect on terms of trade)

Partial equilibrium analysis

Consider the effect of a specific tariff/ ad valorem tariff on the domestic market forthe imported good:

• increase in domestic price or 1 above world marketprice

• protected industry expands domestic production• decrease in domestic consumption





Figure 7: Partial equilibrium analysis of an import tariff





Welfare analysis:

• ∆Welfare= ∆Consumer surplus + ∆producer surplus + ∆government balance

• ∆Consumer surplus: ‐(a+b+c+d)• ∆Producer surplus: +a• ∆Government: tariff revenues: +c• Total Welfare effect: ‐(b+d)

deadweight loss (production‐ and consumption bias)





General equilibrium analysis

An import tariff leads to output expansion in the import‐competing industry whichneeds a reallocation of resources (due to full employment condition) and, thus, affectsthe output of the export industry.

A tariff leads to an increase in the domestic relative price:

1






Figure 8: General equilibrium analysis of an import tariff





Effects of an import tariff in a small country

• expansion in import‐competing industry (y1) at the expense of export‐orientedindustry (y2)

• decrease in consumption: substitution‐ and income effect• decreasing trade flows, less specialization• decreasing welfare




a) Effects of an import tariff ‐ Differences between tariffs and quotas:

• c represents tariff revenues (in case of import tariff), and quota rents (in case ofimport quota), distribution of quota rents:– Distribution of import licenses to domestic firms (quota rent as profits from

importing), welfare loss as in the case of a tariff.– Auctioning of import licenses (c represents government revenues from

auction), welfare loss as in the case of a tariff.– Rent‐seeking activities to obtain import licenses (MR equal MC of rent‐

seeking), welfare loss is higher than in the case of a tariff.– Voluntary export restrains: quota rents obtained by foreign firms/government,

welfare loss higher than in the case of a tariff.• dynamic perspective on tariffs and quotas: efficiency enhancing effects of a tariff

vs. quality upgrading due to a quota• A quota is selective and discriminatory.




b) Effects of an export subsidyAssumption: small country (subsidy has no effect on terms of trade)


Consider the effects of an export subsidy on the domestic market for the exportedgoods

• increase in domestic price: or 1 above world marketprice creates incentives to produce export goods (for the domestic market)

• export industry expands production• decrease in domestic consumption





Figure 9: Partial equilibrium analysis of an export subsidy





• Welfare analysis:

• ∆Welfare= ∆Consumer surplus + ∆producer surplus + ∆government balance

• ∆Consumer surplus: ‐ (a+b)• ∆Producer surplus: +(a+b+c)• ∆Government: tariff revenues: ‐ (b+c+d)• Total Welfare effect: ‐ (b+d)

deadweight loss (production‐ and consumption bias)






An export subsidy leads to output expansion in the export industry (y2) which needs a reallocation of resources (full employment condition) and, thus, affect output of the import industry (y1).

An export subsidy leads to a decrease in the domestic relative price:

11






Figure 10: General equilibrium analysis of an export subsidy





Effects of an export subsidy in a small country

• further expansion of output in export‐oriented industry (y2) at the expense ofimport industry (y1)

• decrease in consumption: substitution‐ and income effect• increasing trade flows, inefficient specialization• decreasing welfare




c) Arguments for trade policy – 1. Infant industry argument(import‐substitution and industrialization)

• Protection of an industry would be desirable if firms in the industry will have apotential comparative advantage in the future.

• aim: industrialize and diversify export structure

• Achieving comparative advantage is not possible without protection because coststo produce the output are above world market price.

• Protection of the infant industry allows to gain learning curve effects, realizeeconomies of scale (decreasing average costs), and spillover effects to otherindustries.





Figure 11: Infant industry protection

A

B

AC0

P1 ACforeign

ACdomestic

cumulated Output

p, AC





Critical questions

• Do we know today how the industry will perform in the future?• Will import protection make inefficient firms efficient? Or will inefficient firms

enter the market due to import protection?• Is there any incentive for the firms to lower average costs such that the protection

becomes needless? (gaining rents from protection)• Protection may not be a short‐term issue but become a long‐term payment• Alternative instruments to support industrialization? (subsidies, grants)




c) Arguments for trade policy ‐ 2. Strategic trade policy(export promotion and rent‐shifting argument)

(Literature on strategic trade policy emerged in 1980s (i.e. Brander and Spencer1982))

The rent‐shifting argument

• Oligopolistic rents can be shifted from the foreign firm to the home firm. An export subsidy will lead to higher output and higher profits of the home firm and higher national welfare because the profit effect outbalances the costs of the subsidy (by assumption).

optimal level of subsidy maximizes national welfare





Assumptions of the models in general

• imperfect competition (oligopoly: two countries each having a single firm)

• firms produce homogenous good for a third market, no domestic sales

• Cournot competition: quantities not prices

• no consumers, welfare effect due to increase in firm profits





Critical questions:

• retaliation measures (foreign country pays subsidy as well) Prisoners Dilemma:subsidy is the dominant strategy, but free trade better than subsidies

• Bertrand competition on prices reverses the result: subsidy lead to decreasingprices and, thus, profits and welfare loss. A tax would be optimal.

• knowledge about the market?

• cost of lobbying reduce welfare




c) Arguments for trade policy ‐ 3. Optimal tariff(improvements of the terms‐of‐trade argument)

Assumption: large country (tariff has an effect on world demand and world prices)


Consider the effect of an import tariff on the domestic market in a large country:

• increase in domestic price: or 1 above world marketprice

• protected industry expands domestic production• decrease in domestic consumption• Decrease in domestic demand for import goods lead to lower world market price

for imports.





Figure 12: Partial equilibrium analysis of an import tariff (ToT‐effect)





Welfare analysis:• ∆Welfare= ∆Consumer surplus + ∆producer surplus + ∆government balance + ToT

• ∆Consumer surplus: ‐(a+b+c+d)• ∆Producer surplus: +a• ∆Government: tariff revenues: +c• ∆ Terms‐of‐trade: +e• Total Welfare effect: ‐(b+d) + e

total effect depends on terms‐of‐trade effect relative to deadweight loss positive if terms‐of‐trade effect outbalances deadweight loss






• An import tariff leads to output expansion in the import‐competing industry (y1)which needs a reallocation of resources (full employment condition) and, thus,affects output of the export industry (y2).

• An import tariff leads to an increase in the domestic relative price.

1






• On the world market: Decreasing domestic demand for imports and decreasingdomestic supply of exports lead to an improvement in the terms‐of‐trade:

↑

↓↑

With respect to the following figure:

↓

↑↓






Figure 13: General equilibrium analysis of an import tariff (ToT‐effect)





Effects of an import tariff in a large country

• expansion in import‐competing industry (y1) at the expense of export‐orientedindustry (y2)

• World market prices for imports decrease while world market prices for exportgoods increase (terms‐of‐trade effect)

• If terms‐of‐trade effect outbalances the production‐ and consumption bias, thecountry gains from an import tariff

• Export promotion instead of import substitution: What does the terms‐of‐tradeargument imply for an export subsidy?




c) Arguments for trade policy ‐ 3. Optimal tariff

Export subsidy in the case of a large country


Consider the effects of an export subsidy in a large country on the domestic market:

• increase in domestic price: or 1 above world marketprice

• export‐industry expands domestic production• decrease in domestic consumption• increase in domestic supply on world markets lead to lower world market price for

exports






Figure 14: Partial equilibrium analysis of an export subsidy (ToT‐effect)






Welfare analysis:• ∆Welfare= ∆Consumer surplus + ∆producer surplus + ∆government balance + ToT

• ∆Consumer surplus: ‐ (a+b)• ∆Producer surplus: +(a+b+c)• ∆Government: tariff revenues: ‐(b+c+d)• ∆ Terms‐of‐trade: ‐ (e+f+g)• Total Welfare effect: ‐ (b+d) – (e+f+g)

Total effect depends on terms‐of‐trade effect relative to deadweight loss. positive if terms‐of‐trade effect outbalances deadweight loss







• An export subsidy leads to output expansion in the export industry (y2) whichneeds a reallocation of resources (full employment condition) and, thus, negativelyaffects output of import industry (y1).

• An export subsidy leads to a decrease in the domestic relative price.

11







• On the world market: Increasing domestic supply of export goods and increasing domestic demand for import goods lead to a negative terms‐of‐trade effect:

↓

↑ ↓

• with respect to the following figure

↑

↓ ↑







Figure 15: General equilibrium analysis of an export subsidy (ToT‐effect)


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