7 Trade Policy

8/3/2019 7 Trade Policy

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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



3

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)



4

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)



5

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.



7

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


Loss of consumer surplus

P

Loss of consumer surplusIncrease of producer surplus and

government income

* Small country = cannot affect world prices



10

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



11

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


PQ



12

imports after the subsidy

The Impact of Subsidy to Import-

Competing Industry (Small Country Case)

DD

Q

SD

P


Cost to thegovernment


P

imports after the subsidy

P

DD

Q

SD

P

increase of producersurplus



13

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



14

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



19

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



22

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


(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:



G o o d Y :


y 1


o u n t

r y 2

(PX /P Y )E’ = TOTE’



(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:



G o o d Y :


y 1


o u n t r y 2 (PX /P Y )E’



(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

7 Trade Policy

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