Chapter 8
The Instruments of Trade Policy
Slide 8-2Copyright ? 2003 Pearson Education,Inc.
?Introduction
?Basic Tariff Analysis
?Costs and Benefits of a Tariff
?Other Instruments of Trade Policy
?The Effects of Trade Policy,A Summary
?Summary
Chapter Organization
Slide 8-3Copyright ? 2003 Pearson Education,Inc.
?Appendix I,Tariff Analysis in General
Equilibrium
?Appendix II,Tariffs and Import Quotas in
the Presence of Monopoly
Slide 8-4Copyright ? 2003 Pearson Education,Inc.
Introduction
? This chapter is focused on the following questions:
? What are the effects of various trade policy instruments?
– Who will benefit,and who will lose?
? What are the costs and benefits of protection?
– Will the benefits outweigh the costs?
? What should a nation’s trade policy be?
Slide 8-5Copyright ? 2003 Pearson Education,Inc.
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
Slide 8-6Copyright ? 2003 Pearson Education,Inc.
Basic Tariff Analysis
? Tariffs can be classified as:
? Specific tariffs
– Taxes that are levied as a fixed charge for each unit
of goods imported
– Example,A specific tariff of $10 on each imported bicycle
with an international price of $100 means that customs
officials collect the fixed sum of $10.
? Ad valorem tariffs
– Taxes that are levied as a fraction of the value of the
imported goods
– Example,A 20% ad valorem tariff on bicycles generates a
$20 payment on each $100 imported bicycle.
Slide 8-7Copyright ? 2003 Pearson Education,Inc.
? A compound duty (tariff) is a combination of an ad
valorem and a specific tariff.
? Modern governments usually prefer to protect domestic
industries through a variety of nontariff barriers,such
as:
– Import quotas
– Limit the quantity of imports
– Export restraints
– Limit the quantity of exports
Basic Tariff Analysis
Slide 8-8Copyright ? 2003 Pearson Education,Inc.
? Supply,Demand,and Trade in a Single Industry
? Suppose that there are two countries (Home and Foreign).
? Both countries consume and produce wheat,which can be
costless transported between the countries.
? In each country,wheat is a competitive industry.
? Suppose that in the absence of trade the price of wheat at
Home exceeds the corresponding price at Foreign.
– This implies that shippers begin to move wheat from Foreign to
Home,
– The export of wheat raises its price in Foreign and lowers its price
in Home until the initial difference in prices has been eliminated.
Basic Tariff Analysis
Slide 8-9Copyright ? 2003 Pearson Education,Inc.
? To determine the world price (Pw) and the quantity trade
(Qw),two curves are defined:
? Home import demand curve
– Shows the maximum quantity of imports the Home country
would like to consume at each price of the imported good.
– That is,the excess of what Home consumers demand over what
Home producers supply,MD = D(P) – S(P)
? Foreign export supply curve
– Shows the maximum quantity of exports Foreign would like to
provide the rest of the world at each price.
– That is,the excess of what Foreign producers supply over what
foreign consumers demand,XS = S*(P*) – D*(P*)
Basic Tariff Analysis
Slide 8-10Copyright ? 2003 Pearson Education,Inc.
Quantity,Q
Price,PPrice,P
Quantity,Q
MD
D
S
A
PA
P2
P1
S2 D2 D2 – S2
2
S1 D1 D1 – S1
1
Figure 8-1,Deriving Home’s Import Demand Curve
Basic Tariff Analysis
Slide 8-11Copyright ? 2003 Pearson Education,Inc.
? Properties of the import demand curve:
? It intersects the vertical axis at the closed
economy price of the importing country.
? It is downward sloping.
? It is flatter than the domestic demand curve in
the importing country.
Basic Tariff Analysis
Slide 8-12Copyright ? 2003 Pearson Education,Inc.
P2
P*A
D*
S*
P1
XS
Price,P Price,P
Quantity,Q Quantity,QS*2 – D*2S*2D*2
Figure 8-2,Deriving Foreign’s Export Supply Curve
Basic Tariff Analysis
D*1 S*1 S*1 – D*1
Slide 8-13Copyright ? 2003 Pearson Education,Inc.
? Properties of the export supply curve:
? It intersects the vertical axis at the closed
economy price of the exporting country.
? It is upward sloping.
? It is flatter that the domestic supply curve in the
exporting country.
Basic Tariff Analysis
Slide 8-14Copyright ? 2003 Pearson Education,Inc.
Figure 8-3,World Equilibrium
XS
Price,P
Quantity,Q
MD
PW
QW
1
Basic Tariff Analysis
Slide 8-15Copyright ? 2003 Pearson Education,Inc.
? Useful 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.
? The analytical framework will be based on either
of the following,
? Two large countries trading with each other
? A small country trading with the rest of the world
Basic Tariff Analysis
Slide 8-16Copyright ? 2003 Pearson Education,Inc.
? Effects of a Tariff
? Assume that two large countries trade with each
other.
? Suppose Home imposes a tax of $2 on every bushel
of wheat imported,
– Then shippers will be unwilling to move the wheat
unless the price difference between the two markets
is at least $2.
? Figure 8-4 illustrates the effects of a specific tariff
of $t per unit of wheat.
Basic Tariff Analysis
Slide 8-17Copyright ? 2003 Pearson Education,Inc.
XS
PT
MD
D*
S*
D
S
PW
2
QT
1
QW
Basic Tariff Analysis
Figure 8-4,Effects of a Tariff
P*T
3
t
Price,P
Quantity,Q
Price,P
Quantity,Q
Price,P
Quantity,Q
Home market World market Foreign marketHo e arket orld arket Foreign market
Slide 8-18Copyright ? 2003 Pearson Education,Inc.
? 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.
Basic Tariff Analysis
Slide 8-19Copyright ? 2003 Pearson Education,Inc.
? The increase in the domestic Home price is less
than the tariff,because part of the tariff is
reflected in a decline in Foreign’ s export price,
– If Home is a small country and imposes a tariff,
the foreign export prices are unaffected and the
domestic price at Home (the importing country)
rises by the full amount of the tariff.
Basic Tariff Analysis
Slide 8-20Copyright ? 2003 Pearson Education,Inc.
Figure 8-5,A Tariff in a Small Country
SPrice,P
Quantity,Q
D
PW + t
PW
Imports after tariff
S1 D1
Imports before tariff
D2S2
Basic Tariff Analysis
Slide 8-21Copyright ? 2003 Pearson Education,Inc.
? Measuring the Amount of Protection
? In analyzing trade policy in practice,it is
important to know how much protection a trade
policy actually provides.
– One can express the amount of protection as a
percentage of the price that would prevail under
free trade.
– Two problems arise from this method of measurement:
? In the large country case,the tariff will lower the foreign
export price.
? Tariffs may have different effects on different stages of
production of a good.
Basic Tariff Analysis
Slide 8-22Copyright ? 2003 Pearson Education,Inc.
? Effective rate of protection
? One must consider both the effects of tariffs on the
final price of a good,and the effects of tariffs on the
costs of inputs used in production.
– The actual protection provided by a tariff will not
equal the tariff rate if imported intermediate goods
are used in the production of the protected good.
– Example,A European airplane that sells for $50 million
has cost $60 million to produce,Half of the purchase price
of the aircraft represents the cost of components purchased
from other countries,A subsidy of $10 million from the
European government cuts the cost of the value added to
purchasers of the airplane from $30 to $20 million,Thus,
the effective rate of protection is (30-20)/20 = 50%.
Basic Tariff Analysis
Slide 8-23Copyright ? 2003 Pearson Education,Inc.
Costs and Benefits of a Tariff
? A tariff raises the price of a good in the importing
country and lowers it in the exporting country.
? As a result of these price changes:
? Consumers lose in the importing country and gain
in the exporting country
? Producers gain in the importing country and lose in
the exporting country
? Government imposing the tariff gains revenue
? To measure and compare these costs and benefits,
we need to define consumer and producer surplus.
Slide 8-24Copyright ? 2003 Pearson Education,Inc.
? Consumer and Producer Surplus
? Consumer surplus
– It measures the amount a consumer gains from a
purchase by the difference between the price he
actually pays and the price he would have been willing
to pay.
– It can be derived from the market demand curve.
– Graphically,it is equal to the area under the demand
curve and above the price.
– Example,Suppose a person is willing to pay $20 per
packet of pills,but the price is only $5,Then,the
consumer surplus gained by the purchase of a packet
of pills is $15.
Costs and Benefits of a Tariff
Slide 8-25Copyright ? 2003 Pearson Education,Inc.
Figure 8-6,Deriving Consumer Surplus from the Demand Curve
Costs and Benefits of a Tariff
8
$12
9
$10
10
$9
11
D
Price,P
Quantity,Q
Slide 8-26Copyright ? 2003 Pearson Education,Inc.
Figure 8-7,Geometry of Consumer Surplus
Costs and Benefits of a Tariff
a
b
P1
P2
D
Price,P
Quantity,QQ2Q1
Slide 8-27Copyright ? 2003 Pearson Education,Inc.
? Producer surplus
– It measures the amount a producer gains from a sale
by the difference between the price he actually
receives and the price at which he would have been
willing to sell.
– It can be derived from the market supply curve.
– Graphically,it is equal to the area above the supply
curve and below the price.
– Example,A producer willing to sell a good for $2
but receiving a price of $5 gains a producer surplus
of $3.
Costs and Benefits of a Tariff
Slide 8-28Copyright ? 2003 Pearson Education,Inc.
Figure 8-8,Geometry of Producer Surplus
Costs and Benefits of a Tariff
d
c
P2
P1
S
Price,P
Quantity,QQ2Q1
Slide 8-29Copyright ? 2003 Pearson Education,Inc.
Costs and Benefits of a Tariff
? Measuring the Cost and Benefits
? Is it possible to add consumer and producer
surplus?
– We can (algebraically) add consumer and producer
surplus because any change in price affects each
individual in two ways,
– As a consumer
– As a worker
– We assume that at the margin a dollar’s worth of
gain or loss to each group is of the same social worth.
Slide 8-30Copyright ? 2003 Pearson Education,Inc.
Figure 8-9,Costs and Benefits of a Tariff for the Importing Country
Costs and Benefits of a Tariff
PT
PW
P*T
b c d
e
D
a
= consumer loss (a + b + c + d)
= producer gain (a)
= government revenue gain (c + e)
QT
D2S2
S
S1 D1
Price,P
Quantity,Q
Slide 8-31Copyright ? 2003 Pearson Education,Inc.
? 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.
Costs and Benefits of a Tariff
Slide 8-32Copyright ? 2003 Pearson Education,Inc.
? If the terms of trade gain is greater than the
efficiency loss,the tariff increases welfare for the
importing country.
– In the case of a small country,the tariff reduces
welfare for the importing country.
Costs and Benefits of a Tariff
Slide 8-33Copyright ? 2003 Pearson Education,Inc.
Figure 8-10,Net Welfare Effects of a Tariff
PT
PW
P*T
b d
e
D
= efficiency loss (b + d)
= terms of trade gain (e)
Imports
SPrice,P
Quantity,Q
Costs and Benefits of a Tariff
Slide 8-34Copyright ? 2003 Pearson Education,Inc.
? Export Subsidies,Theory
? Export 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.
Other Instruments of Trade Policy
Slide 8-35Copyright ? 2003 Pearson Education,Inc.
ba
Figure 8-11,Effects of an Export Subsidy
Other Instruments of Trade Policy
PS
PW
P*S
Price,P
Quantity,Q
Exports
gfe
Subsidy dc = producer gain
(a + b + c)
= consumer loss (a + b)
= cost of
government subsidy
(b + c + d + e + f + g)
D
S
Slide 8-36Copyright ? 2003 Pearson Education,Inc.
? An export subsidy raises prices in the exporting
country while lowering them in the importing
country.
? In addition,and in contrast to a tariff,the export
subsidy worsens the terms of trade.
? An export subsidy unambiguously leads to costs
that exceed its benefits,
Other Instruments of Trade Policy
Slide 8-37Copyright ? 2003 Pearson Education,Inc.
Figure 8-12,Europe’s Common Agricultural Program
Other Instruments of Trade Policy
Price,P
Quantity,Q
S
D
EU
price
without
imports
World price
= cost of government
subsidy
Support price
Exports
Slide 8-38Copyright ? 2003 Pearson Education,Inc.
? Import Quotas,Theory
? An 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.
Other Instruments of Trade Policy
Slide 8-39Copyright ? 2003 Pearson Education,Inc.
? An 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.
Other Instruments of Trade Policy
Slide 8-40Copyright ? 2003 Pearson Education,Inc.
? Welfare analysis of import quotas versus of 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.
– When the rights to sell in the domestic market are
assigned to governments of exporting countries,the
transfer of rents abroad makes the costs of a quota
substantially higher than the equivalent tariff.
Other Instruments of Trade Policy
Slide 8-41Copyright ? 2003 Pearson Education,Inc.
Price in U.S,Market 466
World Price 280 b c d
Demand
a
8.456.32
Supply
5.14 9.26
Price,$/ton
Quantity of sugar,
million tons
Figure 8-13,Effects of the U.S,Import Quota on Sugar
Other Instruments of Trade Policy
Import quota:
2.13 million tons
= consumer loss
(a + b + c + d)
= producer gain (a)
= quota rents (c)
Slide 8-42Copyright ? 2003 Pearson Education,Inc.
? Voluntary Export Restraints
? A voluntary export restraint (VER) is an export
quota administered by the exporting country.
– It is also known as a voluntary restraint agreement
(VRA).
? VERs are imposed at the request of the importer
and are agreed to by the exporter to forestall other
trade restrictions.
Other Instruments of Trade Policy
Slide 8-43Copyright ? 2003 Pearson Education,Inc.
? A 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 Instruments of Trade Policy
Slide 8-44Copyright ? 2003 Pearson Education,Inc.
? Local Content Requirements
? A local content requirement is a regulation that
requires that some specified fraction of a final good
be produced domestically.
– This fraction can be specified in physical units or in
value terms.
? Local content laws have been widely used by
developing countries trying to shift their
manufacturing base from assembly back into
intermediate goods.
Other Instruments of Trade Policy
Slide 8-45Copyright ? 2003 Pearson Education,Inc.
? Local content laws do not produce either government
revenue or quota rents.
– Instead,the difference between the prices of imports and
domestic goods gets averaged in the final price and is passed on
to consumers.
– Example,Suppose that auto assembly firms are required to use
50% domestic parts,The cost of imported parts is $6000 and the
cost of the same parts domestically is $10,000,Then the average
cost of parts is $8000 (0.5 x $6000 + 0.5 x $10,000).
? Firms are allowed to satisfy their local content requirement
by exporting instead of using parts domestically.
Other Instruments of Trade Policy
Slide 8-46Copyright ? 2003 Pearson Education,Inc.
? Other Trade Policy Instruments
? Export credit subsidies
– A form of a subsidized loan to the buyer of exports,
– They have the same effect as regular export subsidies.
? National procurement
– Purchases by the government (or public firms) can be
directed towards domestic goods,even if they are more
expensive than imports.
? Red-tape barriers
– Sometimes governments place substantial barriers based
on health,safety and customs procedures.
Other Instruments of Trade Policy
Slide 8-47Copyright ? 2003 Pearson Education,Inc.
The Effects of Trade Policy,
A Summary
Table 8-1,Effects of Alternative Trade Policies
Slide 8-48Copyright ? 2003 Pearson Education,Inc.
Summary
? A tariff drives a wedge between foreign and
domestic prices,raising the domestic price but by
less than the tariff rate (except in the,small”
country case).
? In the small country case,a tariff is fully reflected
in domestic prices.
? The costs and benefits of a tariff or other trade
policy instruments may be measured using the
concepts of consumer and producer surplus.
? The domestic producers of a good gain
? The domestic consumers lose
? The government collects tariff revenue
Slide 8-49Copyright ? 2003 Pearson Education,Inc.
Summary
? The net welfare effect of a tariff can be separated
into two parts,
? Efficiency (consumption and production) loss
? Terms of trade gain (is zero in the case of a small
country)
? An export subsidy causes efficiency losses similar
to a tariff but compounds these losses by causing
a deterioration of the terms of trade.
? Under import quotas and voluntary export
restraints the government of the importing
country receives no revenue.
Slide 8-50Copyright ? 2003 Pearson Education,Inc.
Table 8AI-1,Free Trade Equilibrium for a Small Country
Appendix I,Tariff Analysis in
General Equilibrium
Slope = - P*M/P*F
Manufactures production and
consumption,QM,DM
Food production and
consumption,QF,DF
D1
Q1
Slide 8-51Copyright ? 2003 Pearson Education,Inc.
QF,DF
QM,DM
Q2
D2
Slope = - P*M/P*F (1 + t)
Table 8AI-2,A Tariff in a Small Country
Appendix I,Tariff Analysis in
General Equilibrium
Slide 8-52Copyright ? 2003 Pearson Education,Inc.
Table 8AI-3,Effect of a Tariff on the Terms of Trade
Appendix I,Tariff Analysis in
General Equilibrium
F
M1
Slope = (P*M/P*F)1
1
Slope = (P*M/P*F)2
M2
2
3
Home exports of manufactures,QM - DM
Foreign imports of manufactures,D*M - Q*M
Home imports of food,DF - QF
Foreign exports of food,Q*F - D*F
O
Slide 8-53Copyright ? 2003 Pearson Education,Inc.
D
Appendix II,Tariffs and Import
Quotas in the Presence of
Monopoly
Table 8AII-1,A Monopolist Under Free Trade
Price,P
Quality,Q
PW
PM MC
MR
DfQMQf
Slide 8-54Copyright ? 2003 Pearson Education,Inc.
D
Appendix II,Tariffs and Import
Quotas in the Presence of
Monopoly
Table 8AII-2,A Monopolist Protected by a Tariff
Price,P
Quality,Q
PW
PM MC
MR
DfQMQf DtQt
PW + t
Slide 8-55Copyright ? 2003 Pearson Education,Inc.
Price,P
Quality,Q
PW
Pq
Appendix II,Tariffs and Import
Quotas in the Presence of
Monopoly
Table 8AII-3,A Monopolist Protected by an Import Quota
MC
MRq
Dq D
Qq
Slide 8-56Copyright ? 2003 Pearson Education,Inc.
Price,P
Quality,Q
PW
Pq
PW + t
Appendix II,Tariffs and Import
Quotas in the Presence of
Monopoly
Table 8AII-4,Comparing a Tariff and a Quota
MC
MRq
Dq D
QtQq
The Instruments of Trade Policy
Slide 8-2Copyright ? 2003 Pearson Education,Inc.
?Introduction
?Basic Tariff Analysis
?Costs and Benefits of a Tariff
?Other Instruments of Trade Policy
?The Effects of Trade Policy,A Summary
?Summary
Chapter Organization
Slide 8-3Copyright ? 2003 Pearson Education,Inc.
?Appendix I,Tariff Analysis in General
Equilibrium
?Appendix II,Tariffs and Import Quotas in
the Presence of Monopoly
Slide 8-4Copyright ? 2003 Pearson Education,Inc.
Introduction
? This chapter is focused on the following questions:
? What are the effects of various trade policy instruments?
– Who will benefit,and who will lose?
? What are the costs and benefits of protection?
– Will the benefits outweigh the costs?
? What should a nation’s trade policy be?
Slide 8-5Copyright ? 2003 Pearson Education,Inc.
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
Slide 8-6Copyright ? 2003 Pearson Education,Inc.
Basic Tariff Analysis
? Tariffs can be classified as:
? Specific tariffs
– Taxes that are levied as a fixed charge for each unit
of goods imported
– Example,A specific tariff of $10 on each imported bicycle
with an international price of $100 means that customs
officials collect the fixed sum of $10.
? Ad valorem tariffs
– Taxes that are levied as a fraction of the value of the
imported goods
– Example,A 20% ad valorem tariff on bicycles generates a
$20 payment on each $100 imported bicycle.
Slide 8-7Copyright ? 2003 Pearson Education,Inc.
? A compound duty (tariff) is a combination of an ad
valorem and a specific tariff.
? Modern governments usually prefer to protect domestic
industries through a variety of nontariff barriers,such
as:
– Import quotas
– Limit the quantity of imports
– Export restraints
– Limit the quantity of exports
Basic Tariff Analysis
Slide 8-8Copyright ? 2003 Pearson Education,Inc.
? Supply,Demand,and Trade in a Single Industry
? Suppose that there are two countries (Home and Foreign).
? Both countries consume and produce wheat,which can be
costless transported between the countries.
? In each country,wheat is a competitive industry.
? Suppose that in the absence of trade the price of wheat at
Home exceeds the corresponding price at Foreign.
– This implies that shippers begin to move wheat from Foreign to
Home,
– The export of wheat raises its price in Foreign and lowers its price
in Home until the initial difference in prices has been eliminated.
Basic Tariff Analysis
Slide 8-9Copyright ? 2003 Pearson Education,Inc.
? To determine the world price (Pw) and the quantity trade
(Qw),two curves are defined:
? Home import demand curve
– Shows the maximum quantity of imports the Home country
would like to consume at each price of the imported good.
– That is,the excess of what Home consumers demand over what
Home producers supply,MD = D(P) – S(P)
? Foreign export supply curve
– Shows the maximum quantity of exports Foreign would like to
provide the rest of the world at each price.
– That is,the excess of what Foreign producers supply over what
foreign consumers demand,XS = S*(P*) – D*(P*)
Basic Tariff Analysis
Slide 8-10Copyright ? 2003 Pearson Education,Inc.
Quantity,Q
Price,PPrice,P
Quantity,Q
MD
D
S
A
PA
P2
P1
S2 D2 D2 – S2
2
S1 D1 D1 – S1
1
Figure 8-1,Deriving Home’s Import Demand Curve
Basic Tariff Analysis
Slide 8-11Copyright ? 2003 Pearson Education,Inc.
? Properties of the import demand curve:
? It intersects the vertical axis at the closed
economy price of the importing country.
? It is downward sloping.
? It is flatter than the domestic demand curve in
the importing country.
Basic Tariff Analysis
Slide 8-12Copyright ? 2003 Pearson Education,Inc.
P2
P*A
D*
S*
P1
XS
Price,P Price,P
Quantity,Q Quantity,QS*2 – D*2S*2D*2
Figure 8-2,Deriving Foreign’s Export Supply Curve
Basic Tariff Analysis
D*1 S*1 S*1 – D*1
Slide 8-13Copyright ? 2003 Pearson Education,Inc.
? Properties of the export supply curve:
? It intersects the vertical axis at the closed
economy price of the exporting country.
? It is upward sloping.
? It is flatter that the domestic supply curve in the
exporting country.
Basic Tariff Analysis
Slide 8-14Copyright ? 2003 Pearson Education,Inc.
Figure 8-3,World Equilibrium
XS
Price,P
Quantity,Q
MD
PW
QW
1
Basic Tariff Analysis
Slide 8-15Copyright ? 2003 Pearson Education,Inc.
? Useful 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.
? The analytical framework will be based on either
of the following,
? Two large countries trading with each other
? A small country trading with the rest of the world
Basic Tariff Analysis
Slide 8-16Copyright ? 2003 Pearson Education,Inc.
? Effects of a Tariff
? Assume that two large countries trade with each
other.
? Suppose Home imposes a tax of $2 on every bushel
of wheat imported,
– Then shippers will be unwilling to move the wheat
unless the price difference between the two markets
is at least $2.
? Figure 8-4 illustrates the effects of a specific tariff
of $t per unit of wheat.
Basic Tariff Analysis
Slide 8-17Copyright ? 2003 Pearson Education,Inc.
XS
PT
MD
D*
S*
D
S
PW
2
QT
1
QW
Basic Tariff Analysis
Figure 8-4,Effects of a Tariff
P*T
3
t
Price,P
Quantity,Q
Price,P
Quantity,Q
Price,P
Quantity,Q
Home market World market Foreign marketHo e arket orld arket Foreign market
Slide 8-18Copyright ? 2003 Pearson Education,Inc.
? 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.
Basic Tariff Analysis
Slide 8-19Copyright ? 2003 Pearson Education,Inc.
? The increase in the domestic Home price is less
than the tariff,because part of the tariff is
reflected in a decline in Foreign’ s export price,
– If Home is a small country and imposes a tariff,
the foreign export prices are unaffected and the
domestic price at Home (the importing country)
rises by the full amount of the tariff.
Basic Tariff Analysis
Slide 8-20Copyright ? 2003 Pearson Education,Inc.
Figure 8-5,A Tariff in a Small Country
SPrice,P
Quantity,Q
D
PW + t
PW
Imports after tariff
S1 D1
Imports before tariff
D2S2
Basic Tariff Analysis
Slide 8-21Copyright ? 2003 Pearson Education,Inc.
? Measuring the Amount of Protection
? In analyzing trade policy in practice,it is
important to know how much protection a trade
policy actually provides.
– One can express the amount of protection as a
percentage of the price that would prevail under
free trade.
– Two problems arise from this method of measurement:
? In the large country case,the tariff will lower the foreign
export price.
? Tariffs may have different effects on different stages of
production of a good.
Basic Tariff Analysis
Slide 8-22Copyright ? 2003 Pearson Education,Inc.
? Effective rate of protection
? One must consider both the effects of tariffs on the
final price of a good,and the effects of tariffs on the
costs of inputs used in production.
– The actual protection provided by a tariff will not
equal the tariff rate if imported intermediate goods
are used in the production of the protected good.
– Example,A European airplane that sells for $50 million
has cost $60 million to produce,Half of the purchase price
of the aircraft represents the cost of components purchased
from other countries,A subsidy of $10 million from the
European government cuts the cost of the value added to
purchasers of the airplane from $30 to $20 million,Thus,
the effective rate of protection is (30-20)/20 = 50%.
Basic Tariff Analysis
Slide 8-23Copyright ? 2003 Pearson Education,Inc.
Costs and Benefits of a Tariff
? A tariff raises the price of a good in the importing
country and lowers it in the exporting country.
? As a result of these price changes:
? Consumers lose in the importing country and gain
in the exporting country
? Producers gain in the importing country and lose in
the exporting country
? Government imposing the tariff gains revenue
? To measure and compare these costs and benefits,
we need to define consumer and producer surplus.
Slide 8-24Copyright ? 2003 Pearson Education,Inc.
? Consumer and Producer Surplus
? Consumer surplus
– It measures the amount a consumer gains from a
purchase by the difference between the price he
actually pays and the price he would have been willing
to pay.
– It can be derived from the market demand curve.
– Graphically,it is equal to the area under the demand
curve and above the price.
– Example,Suppose a person is willing to pay $20 per
packet of pills,but the price is only $5,Then,the
consumer surplus gained by the purchase of a packet
of pills is $15.
Costs and Benefits of a Tariff
Slide 8-25Copyright ? 2003 Pearson Education,Inc.
Figure 8-6,Deriving Consumer Surplus from the Demand Curve
Costs and Benefits of a Tariff
8
$12
9
$10
10
$9
11
D
Price,P
Quantity,Q
Slide 8-26Copyright ? 2003 Pearson Education,Inc.
Figure 8-7,Geometry of Consumer Surplus
Costs and Benefits of a Tariff
a
b
P1
P2
D
Price,P
Quantity,QQ2Q1
Slide 8-27Copyright ? 2003 Pearson Education,Inc.
? Producer surplus
– It measures the amount a producer gains from a sale
by the difference between the price he actually
receives and the price at which he would have been
willing to sell.
– It can be derived from the market supply curve.
– Graphically,it is equal to the area above the supply
curve and below the price.
– Example,A producer willing to sell a good for $2
but receiving a price of $5 gains a producer surplus
of $3.
Costs and Benefits of a Tariff
Slide 8-28Copyright ? 2003 Pearson Education,Inc.
Figure 8-8,Geometry of Producer Surplus
Costs and Benefits of a Tariff
d
c
P2
P1
S
Price,P
Quantity,QQ2Q1
Slide 8-29Copyright ? 2003 Pearson Education,Inc.
Costs and Benefits of a Tariff
? Measuring the Cost and Benefits
? Is it possible to add consumer and producer
surplus?
– We can (algebraically) add consumer and producer
surplus because any change in price affects each
individual in two ways,
– As a consumer
– As a worker
– We assume that at the margin a dollar’s worth of
gain or loss to each group is of the same social worth.
Slide 8-30Copyright ? 2003 Pearson Education,Inc.
Figure 8-9,Costs and Benefits of a Tariff for the Importing Country
Costs and Benefits of a Tariff
PT
PW
P*T
b c d
e
D
a
= consumer loss (a + b + c + d)
= producer gain (a)
= government revenue gain (c + e)
QT
D2S2
S
S1 D1
Price,P
Quantity,Q
Slide 8-31Copyright ? 2003 Pearson Education,Inc.
? 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.
Costs and Benefits of a Tariff
Slide 8-32Copyright ? 2003 Pearson Education,Inc.
? If the terms of trade gain is greater than the
efficiency loss,the tariff increases welfare for the
importing country.
– In the case of a small country,the tariff reduces
welfare for the importing country.
Costs and Benefits of a Tariff
Slide 8-33Copyright ? 2003 Pearson Education,Inc.
Figure 8-10,Net Welfare Effects of a Tariff
PT
PW
P*T
b d
e
D
= efficiency loss (b + d)
= terms of trade gain (e)
Imports
SPrice,P
Quantity,Q
Costs and Benefits of a Tariff
Slide 8-34Copyright ? 2003 Pearson Education,Inc.
? Export Subsidies,Theory
? Export 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.
Other Instruments of Trade Policy
Slide 8-35Copyright ? 2003 Pearson Education,Inc.
ba
Figure 8-11,Effects of an Export Subsidy
Other Instruments of Trade Policy
PS
PW
P*S
Price,P
Quantity,Q
Exports
gfe
Subsidy dc = producer gain
(a + b + c)
= consumer loss (a + b)
= cost of
government subsidy
(b + c + d + e + f + g)
D
S
Slide 8-36Copyright ? 2003 Pearson Education,Inc.
? An export subsidy raises prices in the exporting
country while lowering them in the importing
country.
? In addition,and in contrast to a tariff,the export
subsidy worsens the terms of trade.
? An export subsidy unambiguously leads to costs
that exceed its benefits,
Other Instruments of Trade Policy
Slide 8-37Copyright ? 2003 Pearson Education,Inc.
Figure 8-12,Europe’s Common Agricultural Program
Other Instruments of Trade Policy
Price,P
Quantity,Q
S
D
EU
price
without
imports
World price
= cost of government
subsidy
Support price
Exports
Slide 8-38Copyright ? 2003 Pearson Education,Inc.
? Import Quotas,Theory
? An 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.
Other Instruments of Trade Policy
Slide 8-39Copyright ? 2003 Pearson Education,Inc.
? An 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.
Other Instruments of Trade Policy
Slide 8-40Copyright ? 2003 Pearson Education,Inc.
? Welfare analysis of import quotas versus of 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.
– When the rights to sell in the domestic market are
assigned to governments of exporting countries,the
transfer of rents abroad makes the costs of a quota
substantially higher than the equivalent tariff.
Other Instruments of Trade Policy
Slide 8-41Copyright ? 2003 Pearson Education,Inc.
Price in U.S,Market 466
World Price 280 b c d
Demand
a
8.456.32
Supply
5.14 9.26
Price,$/ton
Quantity of sugar,
million tons
Figure 8-13,Effects of the U.S,Import Quota on Sugar
Other Instruments of Trade Policy
Import quota:
2.13 million tons
= consumer loss
(a + b + c + d)
= producer gain (a)
= quota rents (c)
Slide 8-42Copyright ? 2003 Pearson Education,Inc.
? Voluntary Export Restraints
? A voluntary export restraint (VER) is an export
quota administered by the exporting country.
– It is also known as a voluntary restraint agreement
(VRA).
? VERs are imposed at the request of the importer
and are agreed to by the exporter to forestall other
trade restrictions.
Other Instruments of Trade Policy
Slide 8-43Copyright ? 2003 Pearson Education,Inc.
? A 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 Instruments of Trade Policy
Slide 8-44Copyright ? 2003 Pearson Education,Inc.
? Local Content Requirements
? A local content requirement is a regulation that
requires that some specified fraction of a final good
be produced domestically.
– This fraction can be specified in physical units or in
value terms.
? Local content laws have been widely used by
developing countries trying to shift their
manufacturing base from assembly back into
intermediate goods.
Other Instruments of Trade Policy
Slide 8-45Copyright ? 2003 Pearson Education,Inc.
? Local content laws do not produce either government
revenue or quota rents.
– Instead,the difference between the prices of imports and
domestic goods gets averaged in the final price and is passed on
to consumers.
– Example,Suppose that auto assembly firms are required to use
50% domestic parts,The cost of imported parts is $6000 and the
cost of the same parts domestically is $10,000,Then the average
cost of parts is $8000 (0.5 x $6000 + 0.5 x $10,000).
? Firms are allowed to satisfy their local content requirement
by exporting instead of using parts domestically.
Other Instruments of Trade Policy
Slide 8-46Copyright ? 2003 Pearson Education,Inc.
? Other Trade Policy Instruments
? Export credit subsidies
– A form of a subsidized loan to the buyer of exports,
– They have the same effect as regular export subsidies.
? National procurement
– Purchases by the government (or public firms) can be
directed towards domestic goods,even if they are more
expensive than imports.
? Red-tape barriers
– Sometimes governments place substantial barriers based
on health,safety and customs procedures.
Other Instruments of Trade Policy
Slide 8-47Copyright ? 2003 Pearson Education,Inc.
The Effects of Trade Policy,
A Summary
Table 8-1,Effects of Alternative Trade Policies
Slide 8-48Copyright ? 2003 Pearson Education,Inc.
Summary
? A tariff drives a wedge between foreign and
domestic prices,raising the domestic price but by
less than the tariff rate (except in the,small”
country case).
? In the small country case,a tariff is fully reflected
in domestic prices.
? The costs and benefits of a tariff or other trade
policy instruments may be measured using the
concepts of consumer and producer surplus.
? The domestic producers of a good gain
? The domestic consumers lose
? The government collects tariff revenue
Slide 8-49Copyright ? 2003 Pearson Education,Inc.
Summary
? The net welfare effect of a tariff can be separated
into two parts,
? Efficiency (consumption and production) loss
? Terms of trade gain (is zero in the case of a small
country)
? An export subsidy causes efficiency losses similar
to a tariff but compounds these losses by causing
a deterioration of the terms of trade.
? Under import quotas and voluntary export
restraints the government of the importing
country receives no revenue.
Slide 8-50Copyright ? 2003 Pearson Education,Inc.
Table 8AI-1,Free Trade Equilibrium for a Small Country
Appendix I,Tariff Analysis in
General Equilibrium
Slope = - P*M/P*F
Manufactures production and
consumption,QM,DM
Food production and
consumption,QF,DF
D1
Q1
Slide 8-51Copyright ? 2003 Pearson Education,Inc.
QF,DF
QM,DM
Q2
D2
Slope = - P*M/P*F (1 + t)
Table 8AI-2,A Tariff in a Small Country
Appendix I,Tariff Analysis in
General Equilibrium
Slide 8-52Copyright ? 2003 Pearson Education,Inc.
Table 8AI-3,Effect of a Tariff on the Terms of Trade
Appendix I,Tariff Analysis in
General Equilibrium
F
M1
Slope = (P*M/P*F)1
1
Slope = (P*M/P*F)2
M2
2
3
Home exports of manufactures,QM - DM
Foreign imports of manufactures,D*M - Q*M
Home imports of food,DF - QF
Foreign exports of food,Q*F - D*F
O
Slide 8-53Copyright ? 2003 Pearson Education,Inc.
D
Appendix II,Tariffs and Import
Quotas in the Presence of
Monopoly
Table 8AII-1,A Monopolist Under Free Trade
Price,P
Quality,Q
PW
PM MC
MR
DfQMQf
Slide 8-54Copyright ? 2003 Pearson Education,Inc.
D
Appendix II,Tariffs and Import
Quotas in the Presence of
Monopoly
Table 8AII-2,A Monopolist Protected by a Tariff
Price,P
Quality,Q
PW
PM MC
MR
DfQMQf DtQt
PW + t
Slide 8-55Copyright ? 2003 Pearson Education,Inc.
Price,P
Quality,Q
PW
Pq
Appendix II,Tariffs and Import
Quotas in the Presence of
Monopoly
Table 8AII-3,A Monopolist Protected by an Import Quota
MC
MRq
Dq D
Slide 8-56Copyright ? 2003 Pearson Education,Inc.
Price,P
Quality,Q
PW
Pq
PW + t
Appendix II,Tariffs and Import
Quotas in the Presence of
Monopoly
Table 8AII-4,Comparing a Tariff and a Quota
MC
MRq
Dq D
QtQq
