Chapter 8 – Trade policy
Tariff: a tax levied when a good is imported.
specific tariffs (fixed charge – in dollars)
ad valorem tariff (% of value of good)
True purpose: not just government revenue, but also to protect particular domestic sectors )Corn
Laws, e.g.)
Partial equilibrium analysis: just focus on protected industry
Use “import demand” and export supply” curves
Deriving Import Demand Curves
Figure 8.1
MD is downward-sloping because import demand decreases as price increases.
Deriving Foreign’s Export Supply
XS is upward-sloping because the supply available for export increases as the price increases.
Figure 8.2
Price, P
Price, P
equation is XS*(P*)=QS*(P)-QD*(P)
S
D
Quantity, Q
Foreign Market
Quantity, Q
Deriving Foreign’s Export Supply (XS)
Put these together to determine world equilibrium price and imports/exports into/from each
country:
Figure 8.3
Now consider the effects of a tariff. The price in Home will rise and that in Foreign will drop
until the price difference is t.
Figure 8.4
So the distribution of t to Home and Foreign depends on the size of the country.
Example of small country in Figure 8.5
Discuss the amount (%) of protection of a tariff (pp. 192-3) – 2 examples. See the equation in
footnote 3.
Costs and Benefits of a Tariff
Since a tariff raises the price of a good in the importing country and lowers it in the exporting
country, consumers lose in the importing country and gain in the exporting country. This is
reversed for the producers. The government imposing a tariff gains revenue.
Welfare of consumers represented via Consumer Surplus – the area under the demand curve and
under the price:
Figure 8-7
Welfare of producers represented via Producer Surplus – the area above the supply curve and
under the price:
Figure 8.8
Measuring costs and benefits – Figure 8.9, Figure 8.10
Change in CS= -(a+b+c+d)
Change in PS= a
Change in government revenue = c+e
Net gain to Home: e-(b+d)
Efficiency loss:
consumption distortion: d
production distortion: b
Terms of trade gain: e
(extract rent from Foreign via change in terms of trade - lowering of foreign export prices)
So if terms of trade gain exceeds consumption plus production distortion, Home is better off by
imposing unilateral tariff.
If a country is “small”, then has no effect on world prices, only experiences production and
consumption distortions (no terms of trade gain) and so loses unambiguously from unilateral
tariff.
But if it is large, can gain from a small tariff:
Price, P
Supply
DWL triangles
PD´
tsmall
P0W
terms of trade gain
S0 S´
D´ D0
Demand
Quantity, Q
General Equilibrium Analysis (Appendix 1)
Two goods, manufactures (PM) and food (PF).
Look first at small country (takes prices as given, so PWM/PWF = P*M/P*F).
Suppose country is initially exporting manufactures:
Figure 8AI-1
Now suppose imposes ad valorem import tariff, t, on food.
Figure 8AI-2
Then domestic consumers and producers face P*M/P*F(1+t).
New budget constraint is different though: passes through production point Q2 with a slope of =
-P*M/P*F. The consumption point must lie on this new budget constraint.
See that tariff reduces exports of manufactures, decreases imports of food for given world
relative prices. Reduced welfare, from a) inefficient production (economy doesn’t produce at a
point that maximizes the value of income at world prices, and b) consumers do not choose the
welfare-maximizing point on the budget constraint (indifference curve not tangent to true budget
constraint). These distortions are due to the fact that domestic consumers and producers face
prices that differ from world prices.
Tariff in a large country
Use offer curves and diagram we just developed.
Saw that for unchanged world relative prices, tariff reduces exports, increases exports. Implies
Home offer curve for manufactures contracts towards 0 when imposes a tariff.
Foreign exports of food, Q*F - D*F,
Home imports of food , DF - QF
(-P*M/P*F)0
Man0
(-P*M/P*F)1
Man1
Food0
Home exports of manufactures, QM - DM,
Foreign imports of manufactures, D*M - Q*M
Observe:
Home import tariff reduces Home imports/exports at any given world price
 decrease in imports demanded drives down price of imports,
 see Home’s terms of trade improve.
Export subsidies:
definition: a payment to a firm or individual that ships a good abroad (either specific or ad
valorem)
If domestic consumers must buy from domestic producers, then export subsidy has similar effect
as tariff (except government has to pay for the subsidy)
Change in CS= -(a+b)
Change in PS= a+b+c
Note: Subsidy drives down the
world price
Change in Gov’t revenue= -(b + c + d + e + f + g+h+j)
Net welfare change= - (b + d + e + f + g+h+j) < 0
 Country worse off because increased subsidy payments plus lost consumer surplus outweighs
increase in producer surplus.
In summary,
Export subsidy worsens countries terms of trade
plus induces production distortion.
 either way, export subsidies unambiguously makes country worse off.
Examples of export subsidies:
EU – tried to help own farmers by creating price supports (minimum prices for domestically
produced goods)
 farmers ended up producing more than European consumers wanted to buy
 EU bought up excess supply, stockpiled it, then sold it on international markets at a discount
(thus price support acts as an export subsidy)
 EU agricultural policy/price supports remains very contentious issue at WTO talks –
developing countries want them eliminated.
Figure 8.11
Import quotas
Definition: a direct restriction of the quantity of some good that can be imported.
Usually involves licenses either to firms or foreign governments. An import quota (when
binding) always raises the domestic price of the imported good. This will be the same amount as
a tariff that limits imports to the same level.
The difference is that there is no revenue for the government. Sugar example.
Figure 8-13
Consumer cost per job saved is $500,000!!!
VERs (voluntary export restraints)
instead of imposing an import quota, an importing country may try to protect a domestic importcompeting industry by negotiating with exporter for exporter to reduce own exports.
This has same overall welfare effects as a quota except quota rents now go to Foreign producers
– so are always more costly to importing country than quotas.
So why use one?
imposing a new quota may run contrary to rules of free trade agreements (e.g. WTO)
But WTO will only rule a policy is unfair if an injured party complains first.
If impose an import quota, overseas producers will complain.
If use a VER:
 domestic producers better off
 face higher price
 foreign producers might be better off
 get VER rent
 don’t have to fear quota instead
 don’t complain to WTO
 domestic consumers worse off
 face higher price and their government doesn’t get any of the quota/VER rent to
redistribute amongst them.
Example – Japanese autos
1981-1985 – Japan “volunteered” to restrict exports to US to 1.68 million autos.
Estimated that cost of this protection of US auto industry cost US $3.2 billion, most of which was
rent transferred to Japanese producers.
Non-tariff barriers to trade
Government procurement provisions
 restrictions on government agencies to purchase domestic, rather than imported, products
Example:
US used to have a “Buy American” Act:
 stipulated that federal government agencies must purchase from U.S. firms unless the firm’s
price was more than 6% above the foreign supplier’s price.
 (12% for Department of Defense purchases).
 For a while the figure was 50%!
Many states in US still have these acts.
Local content requirements
 require goods producers incur some of their value-adding costs in importing country
(a version of “import-substitution” – popular in 70s in developing countries)
 provisions clearly interfere with division of labor according to comparative advantage.
production standards
 require goods imported to be produced using some minimum production standard
e.g.
 use turtle-excluder devices when catching shrimp
 pay workers U.S. minimum wage
 last of these is obviously a ploy to reduce comparative advantage of workers in unskilled-labor
abundant countries.
 what about turtle-excluder devices?
 WTO (organization that administers GATT rules and mediates disputes) says that
production standards are just non-tariff trade barriers and are not allowed.
Red tape generally – France, Japan, etc.
Summarize the effects of trade policy. Table 8.1.
Tariffs seem best, since at least the government gets the revenues.
So why do we see alternative trade policies used more and more? Next chapter.