BA 187 – International Trade
Krugman & Obstfeld, Chapter 8
Instruments of Trade Policy
1
Free enterprise made this country. Free trade will destroy it. For five
years, I’ve been advocating a 20 percent tariff on all imports. We can
either do that, or our industrial base will erode to the point where we
can’t build products to defend ourselves in the event of war. Our people
will walk the streets because we are exporting jobs and importing
welfare.
June M. Collier, President,
National Industries, Inc., 1985
2
Instruments of Trade Policy

Tariffs are taxes levied on imported goods.
– Specific Tariff: levied as fixed amount on each unit of goods
imported.
– Ad Valorem Tariff: a tax levied as a fraction of the value of goods
imported.

Export Taxes or Subsidies are levied on exported goods.
– Either as specific tax (subsidy)or as an Ad Valorem tax (subsidy) on
exports.

Non-Tariff Barriers (NTB’s)
– Import Quotas: Limitations on the quantity of imports.
– Export Restraints: Limitations on quantity of exports (usually
imposed by exporting country).
– Miscellaneous Restraints: Gov’t Procurement Provsions, Domestic
Content Rules, Administrative Classifications, Border Taxes.
3
Partial Equilibrium Analysis

Will examine effects of trade policy in a partial
equilibrium framework.
– Ignore interactions across economy, focus on single market.

Assumptions:
–
–
–
–
Two countries, Home and Foreign.
One good, which both countries produce and consume.
Good can be costlessly transported between countries.
Exchange rate constant throughout, quote price of good in
terms of Home currency in both Home & Foreign.
– Home country assumed to import this good from Foreign.

Equilibrium price determined by Home’s Import
Demand and Foreign’s Export Supply Curves.
4
Home’s Import Demand
1. At P0, Demand exceeds supply in Home market, hence demand for imports, D0 – S0.
2. Rise in Price to P1, reduces Home excess demand, lowers import demand to D1 – S1.
3. Further rise in Price to P2, eliminates Excess Demand, reduces import demand to 0.
4. Result is a downward-sloping Import Demand Curve, MD, for Home Country.
Price, P
Home Market
Price, P
Imports
S
P2
P1
P0
D1 – S1
D0 – S0
MD
D
Quantity, Q
D1 – S1
D0 – S0
Quantity, Q
5
Foreign’s Export Supply
1. Can perform similar exercise for Foreign. Quote foreign price in Home currency.
2. At P0, Foreign Demand equals Supply so no exports of good are available.
3. As Prices rise, Foreign Demand less than Supply so exports of good are available.
4. Result is an upward-sloping Export Supply Curve, XS, from Foreign country.
Price, P
Foreign Market
S*
S*2 – D*2
P2
Price, P
Exports
XS
S*1 – D*1
P1
MC
P0
D*
Quantity, Q
S*1 – D*1 S*2 – D*2
Quantity, Q
6
World Partial Equilibrium
Price, P
World Market
1. Foreign Country has upwardsloping Export Supply Curve, XS.
XS
2. Home Country has downwardsloping Import Demand, MD.
3. Trade is in equilibrium for the
good when world price = PW and
amount of good traded = QT.
PW
MD
QT
Quantity, Q
7
Effect of a Tariff on Imports

Tariff drives a wedge between price paid by consumers in
Home and price received by exporters in Foreign.

Specific Tariff of $t per unit.
– Shifts the Export Supply Curve up by $t at each q.
– New equilibrium price in Home rises by less than $t.
– Why? Because new price received by Foreign exporter’s
falls below initial price (terms of trade effect).
Size of this effect depends on importance of Home Country in
World market. Generally this effect is negligible.
 “Small Country Case” assumes no change in Foreign price,
implying Home price rises by full amount of tariff.

– Quantity of good traded falls below free trade level.
8
Tariffs in Large Country
1. Begin in equilibrium at PW with Home imports equal Foreign exports
2. Home imposes specific import tariff t, which shifts XS up by t.
3. New equilibrium with home price PT = P*T + t. Quantity traded falls.
4. How burden of tariff distributed between Home & Foreign depends on
slopes of MD and XS curves, i.e. PT and P*T relative to initial PW.
Domestic
Price
Home Country
World Market
XS’
DH
PT
PW
Price
Foreign
Price
SH
Foreign Country
DF
t
SF
XS
t
P*T
MD
9
Measuring Amount of Protection

“Height of the average tariff” is a measure of how much price
interference exists in country’s tariff schedule.

Unweighted Average Nominal Tariff rate:
– Does not take into account relative importance of each good. Tends
to overstate true height of average tariff.

Weighted Average Nominal Tariff rate:
– Each good’s tariff is weighted by the importance of the good in the
bundle of imports. Tends to be biased downwards.

Prohibitive Nominal Tariff rate:
– Tariff rate so high it prevents imports from coming into country.

Effective Rate of Protection (ERP):
– Change in the value-added of an industry (relative to free trade)
due to imposition of a tariff structure on intermediate & final
products.
10
Nominal (t) and Effective (g) Tariff rates
U.S.
E.U.
Japan
t
g
t
g
t
g
Agriculture/Forestry/Fish
1.8
1.9
4.9
4.1
18.4
21.4
Food/beverages/tobacco
4.7
10.2
10.1
17.8
25.4
50.3
Wearing Apparel
22.7
43.3
13.4
19.3
13.8
42.2
Footwear
8.8
15.4
11.6
20.1
15.7
50.0
Furniture & Fixtures
4.1
5.5
5.6
11.3
5.1
10.3
Chemicals
2.4
3.7
8.0
11.7
4.8
6.4
Glass & Glass Products
6.2
9.8
7.7
12.2
5.1
8.1
Iron & Steel
3.6
6.2
4.7
11.6
2.8
4.3
Electrical machinery
4.4
6.3
7.9
10.8
4.3
6.7
Simple Average Tariff
4.7
7.8
6.1
8.7
6.1
10.0
Rates as of 1984
Source: Deardorf & Stern, The Effects of the Tokyo Round and the Structure of Protection
11
Costs and Benefits of Protectionist
Policies
Large Country Analysis
12
Measuring Market Costs & Benefits

Measure costs/benefits of protection with monetary quantities.

Consumer Costs/Benefits:
– Consumer surplus: measures the monetary amount between price
consumer actually pays and price she/he willing to pay.
– Calculated as area under the Demand Curve above market price.

Producer Costs/Benefits:
– Producer surplus: measures the monetary amount between price
producer actually receives and price she/he willing to accept.
– Calculated as area above the Supply Curve but below market price.

Government Costs/Benefits:
– Government Revenue: measures the monetary amount generated by
the tariff that government receives as revenue.
13
Consumer & Producer Surplus
Price, P
Home Market
1. Foreign Country has upwardsloping Export Supply Curve, XS.
SH
2. Home Country has downwardsloping Import Demand, MD.
3. Trade is in equilibrium for the
good when world price = PW and
amount of good traded = QT.
P0
DH
Quantity, Q
14
Costs and Benefits of a Tariff
Price, P
1. Specific import tariff t on good,
domestic price rises to PT from PW.
2. Consumer surplus falls by areas:
a+b+c+d
3. Producer surplus rises by area:
a
4. Government revenue rises by area:
c+e
Home Market
SH
PT
t
5. Deadweight loss (cost of protection):
b + d (= pro’dn loss + consump loss)
a
b
PW
c
d
6. Terms of Trade Gain:
e (decline in export good price to P*T
e
P*T
DH
S1
S2
D2
D1
Quantity, Q
QT
15
Summary of Import Tariff

Import Tariff brings three net effects to economy.
– Tariff raises domestic price of good above free trade level.

Production Distortion (loss);
– Leads domestic producers to produce too much of the import good
resulting in an efficiency loss.

Consumption Distortion (loss);
– Tariff leads domestic consumers to consume too little of the import
good resulting in a welfare loss.

Terms of Trade Effect (gain);
– Tariff lowers world demand for import good, resulting in a fall in
the world price of the import good. Likely to be small in reality.

Summary of Import Tariff (Probable Welfare Loss);
– Terms of trade effect negligible, so tariff will probably reduce level
of welfare in the country imposing the tariff.
16
Effects of an Export Subsidy
Home Market
Price, P
SH
PS
S
PW
a
c
b
e
f
d
1. Specific export subsidy, s, on good,
domestic price rises to PS from PW.
2. Consumer surplus falls by areas:
a+b
3. Producer surplus rises by areas:
a+b+c
4. Cost of Subsidy given by areas:
b+c+d+e+f+g
g
P*
5. Net Welfare Loss given by areas:
b+d+e+f+g
S
DH
Quantity, Q
Exports
17
Summary of Export Subsidy

Export Subsidy has exact opposite effects to import tariff.
– Subsidy raises domestic price of good above free trade level.

Production Distortion (loss);
– Leads domestic producers to produce too much of the export good
resulting in an efficiency loss.

Consumption Distortion (loss);
– Subsidy leads domestic consumers to consume too little of the
export good resulting in a welfare loss.

Terms of Trade Effect (loss);
– Subsidy raises world supply of export good, resulting in a fall in
the world price of the export good. Likely to be small in reality.

Summary of Import Tariff (Welfare Loss);
– Even if terms of trade effect negligible, subsidy will certainly
reduce level of welfare in the country giving the subsidy.
18
Agricultural Subsidies, 1979-1986
U.S.
E.U.
'79-'81 '84-'86
Japan
'79-'81 '84-'86
'79-'81
'84-'86
Eggs
5%
7%
20%
18%
20%
19%
Milk
55
66
67
56
79
82
Poultry
5
10
24
27
19
16
Beef & Veal
9
9
42
53
53
55
Wheat
14
44
28
36
97
98
Sugar
15
76
34
75
46
72
Rice
7
61
15
68
71
86
Soybeans
6
10
43
59
82
84
Simple Average
15
35
31
49
58
64
Source: Rosenblatt et al, The Common Agricultural Policy of the EC, IMF 1988
19
Costs and Benefits of Protectionist
Policies
Small Country Analysis
20
Tariff for a Small Country
1. Import tariff, t, raises domestic
price PT = PW + t for small country.
2. Consumer surplus falls by areas:
a+b+c+d
3. Producer surplus rises by area:
a
4. Government revenue rises by area:
c
Price, P
SH
5. Deadweight loss (cost of protection):
b + d (= pro’dn loss + consump loss)
PT
t
a
b
c
d
DH
PW
S0
ST
DT
D0
Quantity, Q
21
Costs & Benefits of a Tariff
1. 100% import tariff on good,
domestic price rises from $1 to $2.
2. Consumer surplus falls by areas:
a + b + c + d = $60
3. Producer surplus rises by area:
a = $15
4. Government revenue rises by area:
c = $30
Price, P
SH
$5
$4
$3
5. Deadweight loss (cost of protection):
b + d = $15
$2
a=$15
$1
10
b
=$5
20
c=$30
30
d=$10
40
50
60
DH
70
Quantity, Q
22
U.S. Example: 1978 CB Radio Tariff


In 1978, import tariffs on
CB radios increased from
6% to 21%.
FTC estimated this had the
following effects:
– Price rose from $54 to $62.
– Demand fell 1.53 million
– Domestic Prod’n up 221,000


Assume no effect on world
price, analyze effects on
U.S. welfare.
Costly to consumers with
little benefit to producers or
number of U.S. jobs created.
Welfare Effect
$ millions
Consumer Surplus
- 48.8
Tariff Revenue
+ 33.6
Producer Surplus
+ 3.0
Deadweight Loss
- 12.2
Consumption -10.7
Production
-1.5
Source: Morkre & Tarr, Effects of Restriction on U.S. Imports, FTC
23
Costs and Benefits of Protectionist
Policies
Non-Tariff Barriers (NTB’s)
24
Non-tariff Barrier – Import Quota


Most common form of a Non-Tariff Barrier is an import quota
which restricts the quantity of good imported.
Import Quota
– Restricts quantity of good imported during a year.
– Effect is to increase home price of the good over free trade.
– Market effects identical to a specific tariff. In fact, any quota can be
mimicked by an equivalent tariff.
– Welfare effects differ because gov’t does not necessarily receive revenue
as under a tariff. May gain revenue if auctions off import licenses,
otherwise additional revenue received by foreign exporters.

Voluntary Export Restraint (VER’s)
– Foreign supplier “voluntarily” agrees to restrict quantity imported.
– Usually a political agreement so Home does not look protectionist.
– Market effects identical to an import quota, but welfare effects differ as
foreign firms receive additional profit, Home gov’t receives nothing.
25
Effects of an Import Quota
World Market
1. Import quota level set at Qq. Raises
domestic price PqH, lowers foreign.
Quota
2. There exists an equivalent tariff, tq ,
for any quota that has same result.
Price, P
3. Market effects of tariff and a quota
are identical but not welfare effects.
XS’
XS
tq
PqH
4. Consumer surplus, producer surplus
and associated Deadweight loss (= pro’dn
loss + consump loss) are identical.
5. Quota brings no Government
revenue increase of a tariff. Who
earns this quota profit or rent
MD depends on structure of quota.
PW
PqW
Qq
Q0
Quantity, Q
26
Demand Growth & Import Quota
World Market
1. Import quota level set at Qq with
associated equivalent tariff, tq.
Quota
2. Look at effects of Demand growth on
market under quota vs. equiv. tariff.
Price, P
3. Under the quota, new equilibrium
at E3 with Pq3 at same Qq.
XS’
E3
Pq3
Pq2
Pq1
E2
E
1
tq
XS
5. With Demand Growth, quota leads
to higher home price with no change
in quantity. Quota rent increases.
E
PW
0
MD’
PqW
MD
Qq Qq Q0
1
2
4. Under the tariff, new equilibrium
at E2 with Pq2 at higher Qq2.
6. With Demand Growth, equiv tariff
leads higher home price & quantity.
Gov’t revenue also increases.
Quantity, Q
27
NTB’s on Industrial Country Imports
(as % of imports)
Total NTB’s
Quantitative
Restrictions
Of which
VER’s
1981
1986
1981
1986
Agricultural Raw
Materials
2.8
8.4
1.8
1.8
0.0
0.0
Agricultural Food
40.8
42.6
27.3
27.4
0.8
1.8
Minerals & Metals
12.7
24.7
4.5
16.8
2.1
14.4
Iron & Steel
29.0
64.2
7.8
47.3
6.6
45.2
Chemicals
13.2
12.7
8.1
7.6
0.0
0.0
Other Manufactures
18.6
20.5
11.7
12.2
9.3
9.7
All Products (except fuel)
19.6
23.1
12.2
14.4
5.6
7.7
1981 1986
Source: Grilli & Sassoon, The New Protectionist Wave, 1990.
28
Other Forms of NTB’s

Government Procurement Provisions
– Restrict purchase of foreign goods by home gov’t agencies.
– Similar to an Ad Valorem import tax, where home producer receives
certain percentage of price protection.

Domestic Content Provisions
– Reserve some of value-added & product sales to home producers.

European Border Taxes
– Value-added tax (VAT) in EU. Imports to EU must pay equivalent
VAT, while EU exports receive rebate for VAT. Looks like an import
tariff & an export subsidy

Administrative Classification
– Import duty depends on classification, gives leeway to customs.

Restrictions on Services Trade
– Less visible. Restrict foreign provision of certain services.
29
Welfare Effects of U.S. Trade Restrictions
QR = Quantitative
Restriction
Welfare Gain
Industry
Employment
Rest of Economy
Employment
($billions)
(000 work-yrs)
(000 work-yrs)
Remove QR’s
11.92
-157.2
157.2
Capture Rents from
Foreigners
6.05
-3.1
28.4
Remove QR’s
7.50
-1.2
1.3
Capture Rents from
Foreigners
7.15
+1.3
37.2
Remove QR’s
0.86
-20.7
22.3
Capture Rents from
Foreigners
0.74
-0.1
3.5
Textile & Apparel
Automobiles
Steel
Source: De Melo & Tarr, Welfare Costs of Quotas on Textile, Steel, & Apparel
30