Brian David ButlerMiami Campus FacilitatorInternational Economics & Trade (Prof. Grosse)

Email: bdbutler@global.t-bird.eduhome: 305-396-6116

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Session #5

Class outline

Last week todayTrade theory trade barriersWhy trade? Economics of tariffsComparative advantage

Question…

1. Why is protectionism bad?2. What should a nations trade policy be?3. Should the USA use a Import tariff or an

import quota to protect its auto industry from Japan or south Korea? Who will benefit and who will loose from an import quota? Do the benefits outweigh the costs?

Making the case for “free trade”…

1. Comparative Advantage– Benefits of specialization + free trade– Increased efficiency– Minimized opportunity costs– Last class

2. Troubles with protectionism– Prove the benefits of free trade by looking at

harm caused by protectionism…– This class

Many “wrong” reasons

• Protect firms• Save jobs• Become independent• Encourage FDI• Reduce Balance of Payments issues• Promote export growth• Political motivation

Only “good” reasons

1. Promote infant industries2. Health & safety standards3. Stop foreign dumping4. Political motivation (?)

US trade policy fundamentals

1. Countervailing duties – offset foreign subsidies

2. Antidumping – tariff to offset foreign firm’s selling into U.S.

market at prices below cost

3. Trade Adjustment Assistance– Retrain, compensate for job loss from imports

What caused the “Great Depression”?

• Not the stock market crash of 1929• But, trade protectionism of 1930’s

– “beggar thy neighbor”– Smoot Hawley– Between 1929 – 1933, trade declined by 54%

Trade barrier: Definitions• Import tariff - taxes levied on imports…raises

the price of imported goods • Export subsidy - payments given to domestic

producers who sell abroad…incentive to export…effect is to raise prices at home

• Quota : restriction on the quantity of goods that can be imported. This type of import control is usually accomplished by issuing a license to a company

Trade barrier: definitions

• Dumping: selling for less than the cost. very difficult to prove. Most anti-dumping cases only look at price in one country vs price in other....which is not right....instead you need to look at cost...but how to you know what the actual cost to produce is? you cant...so anti-dumping is very subjective.

• Terms of trade: relative prices of a country's exports to imports

TariffsTariff = tax on imports, like cost of transportWith tariff, shippers not willing to move wheat from

foreign to home unless home price exceeds foreign price by at least $t

But, if no wheat is being shipped, then • Home: demand > supply and price will rise• Foreign: supply > demand and price will fallResult?• Home demand will fall, • Quantity of imports will fall

Tariff

• Does foreign export price really fall?• Only if home (importer that imposes tariff) is very

large, and can change world price.

– “When a small country imposes a tariff, its share of the world market for the goods it imports is usually minor to begin with, so that’s its import reduction has very little effect on the world price”

– See figure 8-4 “effects of tariff”

K&O, 8th ed. p.180

Tariffs

• Who benefits / who is hurt by tariffs?– Benefit: consumers in exporting country +

government in importing country– Hurt: consumers in importing country

• How to quantify benefit / pain?– Consumer / producer surplus

Consumer Surplus: Difference between what consumers would have paid & what they actually paid for last unit.

Producer Surplus: A producer willing to sell a good for $2 but receiving a price of $5 gains a producer surplus of $3

http://en.wikipedia.org/wiki/Consumer_surplus

Tariffs

1. Import tariff– Raises price in importing country & decreases

price in exporting country

PRICES•Tariff raises domestic price •But, lowers foreign export price (if large country can influence world price)

QUANTITY•Domestic Production increases •Domestic consumption falls

= consumer loss (a+b+c+d)= producer gain (a)= government revenue gain (c+ e)

2D

1D

Price, P

Quantity, Q

P T

P W

P* T

1S

2S

S

D

PRICES•Tariff raises domestic price from Pw to Pt•But, lowers foreign export price from Pw to Pt*

QUANTITY•Domestic Production increases from S1 to S2•Domestic consumption falls from D1 to D2

}

Q R

dc

ba

e

Costs and Benefits of a Tariff for The Importing Country

K&O, 8th ed. p.190

The costs and benefits to different groups can be represented as sums of the five area a, b, c, d, and e.

The box e only exists if the country is large and can influence world prices.

= efficiency loss (b + d)= terms of trade gain (e)

Price, P

Quantity, Q

P T

P W

P* T

S

D

The colored triangles represent efficiency losses, while the rectangle represents a terms of trade gain. Since the US is a large country, it may be able to force the foreign suppliers to lower their prices to P*T .

}db

e

Imports

Net Welfare Effects of a Tariff

K&O, 8th ed. p.192

Loss from Tariff

• The loss from the triangles = efficiency loss that arises because a tariff distorts incentives to consume and produce

• The rectangle represents the (potential) terms of trade gain that arise if big country can lower world export price with tariff

• How BAD is a tariff?– Compare triangles vs rectangle– But, if small country can not drive down price …then

clearly tariff is very BAD (reduces welfare)

Export Subsidies

1. Export Subsidies– Payment to a firm or individual that ships a good

abroad.– When a gov’t 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.

– Effects? Exactly the REVERSE of the tariff• Importing country: price rises• Exporting country : price falls

Export Subsidy – who benefits? Who hurts?

• Exporting country:– Consumers are hurt, producers gain, and

government loses because it spends $ on subsidy

• In contrast to

Export Subsidies

“Above the Supply / Demand” curve

– Main difference = no revenue for government– Cost (tax break or subsidized loans)– But, politically difficult to pass in USA– Example: Europe Common Agriculture Policy

Import Quotas

1. qutotas– Basically same as tariff– But with NO government revenue– Instead…benefit goes to foreigners - rents

Price impact for importers

Price Impact for exporters

Impact on local consumers

Impact on local producers

Impact on local gov’t

Net Impact country as whole

Tariff Increases price

Decreases*

Large loss Small gain Large gain Depends on terms of trade

Export subsidy

Decreases price

Increases Small loss Large gain Massive cost

Negative always

Import quota

Increases price

Decreases Large loss Small gain None** Depends on terms of trade

* Only if importer is large country that can influence world price and terms of trade

** quota benefit goes to foreigners who benefit from quota rents… excess profits from holding import quota licenses

Review example:

1. Cost producing one bottle wine or one ton chemicals, assume quality is same

2. Which country has:• Absolute advantage? • Comparative advantage?

3. What exchange rate will result in 2-way trade?

Chemicals wineFrance FF 500 FF 50Germany DM 180 DM 20

Comparative: =50/18 = 50/20= 2.78 =

2.5

• Absolute advantage? Germany in both• Comparative? France in wine

• 2-way trade between FF2.78 / DM and FF 2.5 / DM

chem wineFrance FF 500 FF 50Germany DM 180 DM 20