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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 policy
1. Tariffs
2. Quotas
3. Other Non-tariff Barriers to Trade
2. Impact of trade policies
1. Partial Equilibrium: Small Country
2. Partial Equilibrium: Large Country 3. General Equilibrium: Small Country
4. General Equilibrium: Large Country
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Tariffs
• Imports tariffso 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 instrumentso Import subsidy negative import tariff o Export tariff/subsidy (levied/paid on home-produced
goods that are destined for export)
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Features of Tariff Schedules
• Preferential dutieso products form certain countries are subject to lower
tariffs than the normal tariff rateo 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 TheEconomist website)
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Non-tariff Barriers to Trade (1)
• Import Quotaso a government agency allocates the rights to import
o 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 provisionso 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 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 besold in many countries). We will use both approaches to study one-country and two-country cases. The difference is that in generalequilibrium analysis we take also into account what happens in themarkets 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 isonly 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 costthan the market price received
P
Price (P)
D
consumersurplus
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 of producer
surplus t a r i f f t o t h e
g o v
e r n m e n t
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 and
government 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 anequivalent tariff (and for every tariff there is an equivalent quota)
• The changes in consumer
and produce surplus areequivalent to that of a tariff
• However, the increase of government revenue may belost (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 thegovernment
imports in free trade
P
imports after the subsidy
P
DD
Q
SD
P
increase of producersurplus
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The Impact of Subsidy to Import-
Competing Industry (Small Country Case)
• Equivalent subsidy = producers are subsidised to produce thesame 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 inthe tariff/quota case → subsidies are more efficient thantariffs/quotas
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Large country, partial equilibrium
Single Market, Two Countries
Q Q
Country A Country B
D A
S A
SB
DB
PP
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Single Market, Two Countries
Q Q
Country A Country B
D A
S A
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 thesame quantity as country A is willing to import.
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Single Market, Two Countries, Tariff
Q Q
Country A Country B
tariff
D A
S A
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 toimport → 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
tariff PFT
P A
PB
D AS A
S
BDB
PP
a b
Cprice decreasein 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
tariff PFT
P A
PB
D A
S A
SB
DB
PP
a bC
price decreasein country B
De
The more elastic in the exporting market and the more inelastic in theimporting 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 producersurplus 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 orsecondary 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 besold in many countries). We will use both approaches to study one-country and two-country cases. The difference is that in generalequilibrium analysis we take also into account what happens in themarkets of goods not subject to trade policy.
b
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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 frompoint PFT to Pt
• Since the tariff doesn’tchange world prices,country’s real incomechanges to (PX /P Y )
t
• Consumers maximizegiven domestic prices
and real income andmove to a lower utility level
• Note that real income isdetermined by the worldprices Good XPt
Pt
Good Y
PFTCFT
PFT
CFT
(PX /P Y )FT
PX /(1+τ )P Y
Ct
Ct
G l ilib i ff f
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General Equilibrium Effects of a
Subsidy for a Small Country
• Assume the governmentsubsidizes producer of good Y to impose thesame production pattern
as with the tariff • The real income of the
country remains the same
• Consumers face worldprices and are able toconsume at a higherutility level
Good XPS
PS
Good Y
PFTCFT
PFT
CFT
(PX /P Y )FT
PX /(1+τ )P Y
CS
CS
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Terms of Trade Effect of a Tariff
• Imposing a tariff shiftsoffer curve inwards (thecountry is now willing to tradeless for all terms of trade)
→ The tariff imposing country’s terms of trade improve (the price
of exports decrease), whichmay offset the, at least
in part, the decrease of welfare due toefficiency loss
Good X:
Exports from country 1
Imports to country 2
G o o d Y :
I m p o r t s t o c o u n t r
y 1
e x p o r t s f r o m c
o u n t
r y 2
(PX /P Y )E’ = TOTE’
Country 1’s offer curve
Country 2’s offer curve
(PX /P Y )E = TOTE
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Terms of Trade Effect of a Quota
• Country 1 sets aquota for importsof good Y
→ country 1’s offer
curve becomeshorizontal at the
quota level→ Country 1’s terms
of trade improveGood X:
Exports from country 1
Imports to country 2
G o o d Y :
I m p o r t s t o c o u n t r
y 1
e x p o r t s f r o m c
o u n t
r y 2
(PX /P Y )E’ = TOTE’
Country 1’s offer curve
Country 2’s offer curve
(PX /P Y )E = TOTE
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Terms of Trade Effect of a Voluntary
Export Restraints
• Country 2 uses voluntary exportrestraints (VER) to
limit exports of good Y
→ country 2’s offercurve becomes
horizontal→ country 2’s terms
of trade improveGood X:
Exports from country 1
Imports to country 2
G o o d Y :
I m p o r t s t o c o u n t r
y 1
e x p o r t s f r o m c
o u n t r y 2 (PX /P Y )E’
Country 1’s offer curve
Country 2’s offer curve
(PX /P Y )E
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Other Effects of Protection
• Restricting imports is likely to result decrease of exports as well
o Reallocation of domestic resources
o Retaliation by the trading partners• Distributional Effects
o Transfer from the consumers to the import-competing producers
o HO-model: transfer from the abundant factor to thescarce factor