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1The Instruments of Trade Policy:
Part I, Tariffs• INTERNATIONAL
ECONOMICS,ECO 486
• Harmonized tariff schedule (HTS) of the United States:http://www.usitc.gov/taffairs.htm#HTS
2Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
3Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
4Gains from Trade
• Static Gains (PPF doesn’t shift)– Consumption gains– Production gains
• Dynamic Gains (PPF does shift)– Trade expands resources– Trade may raise productivity
• Political Gains
5
SOYBEANS, S (bushels per year)
0
A
TE
XT
ILE
S, T
(yar
ds
per
yea
r)
CIC0
Consumption & Production Gains
CIC1
CIC2
F
B
C
X
6
SOYBEANS, S (bushels per year)
0
A
TE
XT
ILE
S, T
(yar
ds
per
yea
r)
CIC0
Consumption & Production Gains
CIC1
CIC2
F
B
C
X
PS/PT = S=|slope of terms of trade line|
A to B shows consumption gainsB to C shows production gains
7Dynamic Gains from Trade
• Trade may speed economic growth
8Dynamic Gains from Trade
• Trade may speed economic growth– When more K goods are imported than produced in
autarky, PPF shifts out.– Trade diffuses new technology.– Trade raises real income. Savings rise.– Free trade an effective anti-trust policy– Trade expands the market, allowing firms to exploit
IRS.– When trade spurs development, decreasing-costs
may occur.
9Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
10Commercial Policy
• Governments action that may change the composition and volume of trade flows
– Tariffs
– Quotas
– Subsidies
– Other non-tariff barriers
• We’ll analyze the cost & benefits of these
11Tariffs
• Taxes on– Imports– Exports– Subsidies
• Components -- See HTS– Ad valorem-- % of value– Specific -- flat fee per unit– Compound -- both
12Positive Effects of Tariffs
• Revenue Effect -- provide tax revenue
• Protective Effect -- shelter domestic producers from foreign competition
13Tariff Terminology
• A pure-revenue tariff is one imposed on a good not produced domestically– A tariff on bananas imported to Iceland
• A prohibitive tariff is one that is so high that none of the good is imported– no revenue is collected
14Uses of Tariffs
• Developing countries may rely on tariffs to provide tax revenue
• Developed countries impose tariffs for their protective effect
15Tariffs as tools of int’l policy
• Most Favored Nation status, MFN– granted as a reward, withheld as a punishment
• Generalized System of Preferences, GSP– Most developed countries have GSP as means
of helping developing countries• access to markets of developed countries
16Welfare Cost Analysis
• Use (National) Supply and Demand– Partial equilibrium– One import or export good
• Measure Changes in Consumer Surplus and Producer Surplus
• Start with a small country– Its trade is too small to affect terms of trade
17Gains from free trade -- imports
3
6
10
0 1 4 10Quantity (millions bushels of grapes per year)
Pri
ce ($
per
bu
shel
of
gra
pes
)
7
2
18Gains from free trade -- imports
3
6
10
0 1 4 10
b
Domestic demand for grapes
Domestic Supplyof grapes
ac
Quantity (millions bushels of grapes per year)
Pri
ce ($
per
bu
shel
of
gra
pes
)
World price of grapes
7
2
19Welfare of a Move to Free Trade
A Small Country’s Imports
Change in Consumer Surplus
Change in Producer Surplus
Net Welfare Change
20Welfare of a Move to Free Trade
A Small Country’s Imports
Change in Consumer Surplus +a +b +c
Change in Producer Surplus -a
Net Welfare Change +b +c
21Gains from free trade -- exports
9
6
10
0 1 4 10Quantity (millions jars of honey per year)
Pri
ce ($
per
jar
of
hon
ey)
7
2
22Gains from free trade -- exports
9
6
10
0 1 4 10
f
Domestic demand for honey
Domestic Supplyof honey
g
Quantity (millions jars of honey per year)
Pri
ce ($
per
jar
of
hon
ey)
World price of honey
7
e
2
23Welfare of a Move to Free Trade
A Small Country’s Exports
Change in Consumer Surplus
Change in Producer Surplus
Net Welfare Change
24Welfare of a Move to Free Trade
A Small Country’s Exports
Change in Consumer Surplus -e -f
Change in Producer Surplus +e +f +g
Net Welfare Change +g
25Welfare Cost of a Tariffon Imports -- Small Country
3
5
10
0 1 10Quantity (millions bushels of grapes per year)
Pri
ce ($
per
bu
shel
of
gra
pes
)
7
2
3 5
26Welfare Cost of a Tariff on Imports -- Small Country
3
5
10
0 1 10
b
Domestic demand for grapes
Domestic Supplyof grapes
a c
Quantity (millions bushels of grapes per year)
Pri
ce ($
per
bu
shel
of
gra
pes
)
World price of grapes
7
2
World price + tariff $2/bu
3 5
d
27Welfare Cost of a Tariff on Imports -- Small Country
Change in Consumer Surplus
Change in Producer Surplus
Change in Gov't Revenue
Net Welfare Change (a.k.a. Deadweight loss)
Loss = 0.5 x tariff x change in imports
28Welfare Cost of a Tariff on Imports -- Small Country
Change in Consumer Surplus -a -b -c -d
Change in Producer Surplus +a
Change in Gov't Revenue +c
Net Welfare Change(a.k.a. Deadweight loss)
-b -d
Loss = 0.5 x tariff x change in imports
29Welfare Cost of a TariffSmall Country
3
5
10
0 1 10
b
Domestic demand for grapes
Domestic Supplyof grapes
c
Quantity (millions bushels of grapes per year)
Pri
ce ($
per
bu
shel
of
gra
pes
)
World price of grapes
7
2
World price + tariff $2/bu
3 5
d
30Welfare Cost of a Tariff on Imports -- Small Country
3
5
10
0 1 10
b
Domestic demand for grapes
Domestic Supplyof grapes
a1 c
Quantity (millions bushels of grapes per year)
Pri
ce ($
per
bu
shel
of
gra
pes
)
World price of grapes
7
2
World price + tariff $2/bu
3 5
d
a2
31Export Tariff -- Small Country
9
6
10
0 1 4 10
Domestic demand for honey
Domestic Supplyof honey
Quantity (millions jars of honey per year)
Pri
ce ($
per
jar
of
hon
ey)
7
2
32Export Tariff -- Small Country
9
6
10
0 1 4 10
b
Domestic demand for honey
Domestic Supplyof honey
c
Quantity (millions jars of honey per year)
Pri
ce ($
per
jar
of
hon
ey)
PW
7
a
2
PW -T
d
33Welfare Cost -- Export Tariff
Small Country Case
Change in Consumer Surplus
+a
Change in Producer Surplus -a -b -c -d
Change in Gov't Revenue +c
Net Welfare Change in A (a.k.a. Deadweight loss)
-b -d
34Welfare Cost -- Export Tariff
Small Country Case
Change in Consumer Surplus
+a
Change in Producer Surplus -a -b -c -d
Change in Gov't Revenue +c
Net Welfare Change in A (a.k.a. Deadweight loss)
-b -d
35Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
36Int’l Free Trade Eq. Large Country
Quantity (lb. of Lobster per year)
0
Pri
ce ($
per
lb.)
PA
PB
0
37Int’l Free Trade Eq. Large Country
Quantity (lb. of Lobster per year)
0
A’s demand for L
A’s Supplyof L
Pri
ce ($
per
lb.)
PA
PFT
Q1 Q2
PB
PFT
B’s demand for L
B’s Supplyof L
Q1’ Q2’0
38
0
A’s demand for Lobster
A’s Supplyof Lobster
Pri
ce ($
per
lb.)
PA
PFT
Import Demand
Quantity (lb. of Lobster per year)
PB
0
Pri
ce ($
per
lb.)
PA
M = QD - QS
PB
39
0
A’s demand for Lobster
A’s Supplyof Lobster
Pri
ce ($
per
lb.)
PA
PFT
Import Demand
Quantity (lb. of Lobster per year)
PB
0
A’s demand for imported lobster (excess demand); |slope| = rise/(sum of runs)
Pri
ce ($
per
lb.)
PA
M = QD - QS
PB
40Export Supply
0
Quantity (lb. of Lobster per year)
Pri
ce ($
per
lb.)
PA
X = QS - QD
PB
B’s demand for L
B’s Supplyof L
QD QS
0
PB
41Export Supply
0
B’s Supply of exports, excess supply; slope = rise/(sum of runs)
Quantity (lb. of Lobster per year)
Pri
ce ($
per
lb.)
PA
X = QS - QD
PB
B’s demand for L
B’s Supplyof L
QD QS
0
PB
42
0
A’s demand for Lobster
A’s Supplyof Lobster
Pri
ce ($
per
lb.)
PA
PFT
Q1 Q2
Export Supply & Import Demand
Quantity (lb. of Lobster per year)
0
PB
0
Pri
ce ($
per
lb.)
PA
PFT
M = Q2 - Q1
PFT
Export Supply, X
Import Demand, M
43Export Supply & Import Demand
0
Import Demand, M
Export Supply, X
Quantity (lb. of Lobster per year)
Pri
ce ($
per
lb.)
PA
PFT
0 M = Q2 - Q1
X = Q2‘ - Q1 ‘
PB
PFT
B’s demand for L
B’s Supplyof L
Q1’ Q2’0
PB
44Optimal Tariffs
• Large countries may force foreign producer to pay part of their tariff.
• Because they are important customers, they force foreign suppliers to cut price.
• The optimal tariff maximizes the net welfare change
• Retaliation is likely to offset this gain
45Equilibrium with a Tariff Large Country
0
A’s demand for L
A’s Supplyof L
Quantity (lb. of Lobster per year)
Pri
ce ($
per
lb.)
PFT
Q1 Q2
PFT
B’s demand for L
B’s Supplyof L
0
P’P’
P”
Q1’Q3 Q4Q2’Q3’ Q4’
46Equilibrium with a Tariff Large Country
0
A’s demand for L
A’s Supplyof L
Quantity (lb. of Lobster per year)
Pri
ce ($
per
lb.)
PFT
Q1 Q2
PFT
B’s demand for L
B’s Supplyof L
0
P’P’
P”
Q1’Q3 Q4Q2’Q3’ Q4’
a c de e
bh i j
47A’s Welfare Cost -- Import Tariff
Imposed by Large Country, AChange in Consumer Surplus
-a -b -c -d
Change in Producer Surplus +a
Change in Gov't Revenue +c +e
Net Welfare Change in A (a.k.a. Deadweight loss)
-b -d +e
48A’s Welfare Cost -- Import Tariff
Imposed by Large Country, A
Change in Consumer Surplus
-a -b -c -d
Change in Producer Surplus +a
Change in Gov't Revenue +c +e
Net Welfare Change in A (a.k.a. Deadweight loss)
-b -d +e
49B’s Welfare Cost from A’s Tariff
Import Tariff Imposed by AChange in Consumer Surplus
+h
Change in Producer Surplus -h -i -e -j
Change in Gov't Revenue
Net Welfare Change in B (a.k.a. Deadweight loss)
-i -e -j
50B’s Welfare Cost from A’s Tariff
Import Tariff Imposed by AChange in Consumer Surplus
+h
Change in Producer Surplus -h -i -e -j
Change in Gov't Revenue
Net Welfare Change in B (a.k.a. Deadweight loss)
-i -e -j
51World Welfare Cost of A’s Tariff
Net Welfare Change in A
-b -d +e
Net Welfare Change in B
-e -i -j
Net Welfare Change in World
-b
-d
-i
-j
52World Welfare Cost of A’s Tariff
Net Welfare Change in A
-b -d +e
Net Welfare Change in B
-e -i -j
Net Welfare Change in World
-b
-d
-i
-j
53World Welfare Changes
• Tariff raises the price in A to P” = PW + T
• Tariff lowers the world price to P’ = PW
• Tariff reduces the quantity world trade from Q1 Q2 to Q3 Q4
• A’s welfare change = – b – d + e
• B’s welfare change = – e – i – j
• World welfare change = – b – d – i – j
54Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
55B Subsidizes its ExportsLarge Country Case
0
A’s Supplyof L
Quantity (lb. of Lobster per year)
Pri
ce ($
per
lb.)
PFT
Q1 Q2
PFT
B’s demand for Lobster
B’s Supplyof L
0
P’P’
P”
Q1’Q3 Q4Q2’Q3’ Q4’
P”
A’s demand for Lobster
56B Subsidizes its ExportsLarge Country Case
0
A’s Supplyof L
Quantity (lb. of Lobster per year)
Pri
ce ($
per
lb.)
PFT
Q1 Q2
PFT
B’s demand for Lobster
B’s Supplyof L
0
P’P’
P”
Q1’Q3 Q4Q2’Q3’ Q4’
h j e
a
f
cP”
db
ki g
A’s demand for Lobster
57B’s Welfare Cost from its Export Subsidy
Change in Consumer Surplus
Change in Producer Surplus
Change in Gov't Revenue
Net Welfare Change in B
58B’s Welfare Cost from its Export Subsidy
Change in Consumer Surplus
-a -b
Change in Producer Surplus +a +b +c
Change in Gov't Revenue -b -e
-c -f
-d -g
Net Welfare Change in B
-b -e
-f
-d -g
59A’s Welfare Cost from B’s Export Subsidy
Change in Consumer Surplus
Change in Producer Surplus
Change in Gov't Revenue
Net Welfare Change in A
60A’s Welfare Cost from B’s Export Subsidy
Change in Consumer Surplus
+h +i +j +k
Change in Producer Surplus -h
Change in Gov't Revenue
Net Welfare Change in A
+i +j +k
61World Welfare Cost
from B’s Export Subsidy
Net Welfare Change in A
Net Welfare Change in B
Net Welfare Change in World
62World Welfare Cost
from B’s Export Subsidy
Net Welfare Change in A
+i +j +k
Net Welfare Change in B
-b -d -e -f -g
Net Welfare Change in World
-b -d +i -e
+j -f
+k -g
63World Welfare Changes
• Export subsidy raises price in B to P” = PW + S
• Subsidy lowers the world price to P’ = PW • World trade grows from Q1 Q2 to Q3 Q4 • B’s welfare change = – b – d – e – f – g• A’s welfare gain = + i + j + k• World welfare change = – b – d – e – f – g +
i + j + k
64Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
65Nominal & Effective Rates of Protection
• t = tariff
• P = free-trade price of good
• v = domestic value added with free trade
• v’= domestic value added with tariff
67Effective Rate of Protection
gj = Effective Rate of Protection on final product j
tj = nominal tariff rate on final product j
ti = nominal tariff rate on imported input i
aij = share of i in the total value of j in the absence of tariffs
ERP gt a t
ajj ij i
ij
, 1
68Welfare Cost of Tariffs as a
Percentage of GDP• Traditional: Square the tariff rate
– Ten percent tariff reduces GDP by 1%
• Tariffs & NTBs often exclude new goods– GDP loss almost twice the tariff rate
69Welfare Cost of Tariffs as a
Percentage of GDP• Traditional: Square the tariff rate
– Ten percent tariff reduces GDP by 1%
• Tariffs & NTBs often exclude new goods– GDP loss almost twice the tariff rate– Ten percent tariff lowers GDP by 19.8%– Twenty-five percent tariff lowers GDP by 47%
70Consumers’ Surplus
• Consumers’ Surplus is the difference between consumers’ maximum willingness-to-pay and the amount they actually paid.
• The amount actually paid equals PQ.• Graphically, Consumers’ Surplus (CS) is the area
under the demand curve above P.
71Producer Surplus
• Producer surplus is the price of a good minus the opportunity cost of producing it.– Graphically, Producers’ Surplus (PS) is the area
under the Price line and above Supply.
72Export Supply + Specific Tariff, T
0
Import Demand, M
Export Supply, X
Quantity (lb. of Lobster per year)
Pri
ce ($
per
lb.)
MFT
T
T
73Export Supply + Specific Tariff, T
0
Import Demand, M
Export Supply, X
Quantity (lb. of Lobster per year)
Pri
ce ($
per
lb.)
PA
PFT
MFT
PB
X + TARIFF, T
PW +T
PW
MT
T
T
gf
74Graphing Tariffs
• Specific tariff raises the y-intercept of the export supply curve, p = a + b q
p + T = a + b q + T
• Ad-valorem tariff raises the slope and y-intercept of the export supply curvep = a + b q
p (1 + t) = (a + b q) (1 + t) = (1 + t) a + (1 + t) b q
75Export Supply with Ad-Valorem Tariff, t
0
Import Demand, M
Export Supply, X
Quantity (lb. of Lobster per year)
Pri
ce ($
per
lb.)
PA
PFT
MFT
PB
X(1+t)
PW +T
PW
MT
gf
76Price Elasticity of Demand, ed
ed and slope are inversely related.
Q
P
SlopeQ
P
QP
Q
P
P
Q
P
P
Q
Q
P
P
Q
Q
d
d
e
e
11
77The Price Elasticity of Supply, es• The formula for price elasticity of supply,
es, at a point is shown below. Note that it’s
the same as the formula for ed , but lacks
the absolute value notation
seQ
P
P
Q Slope
P
Q
1
78Import Demand Elasticity, em
• The formula for price elasticity of import demand,
em, at a point is shown below. Q is the quantity
of imports; P is the price; P is the change in
price;Q is the change quantity imported
Q
P
SlopeP
P
Q
Qme
1
79Import Demand Elasticity, em
• The formula for price elasticity of import demand,
em, at a point is shown below
Qm is the quantity of imports; Qd is the quantity
demanded; Qs is the quantity supplied
eee sm
sd
m
dm Q
Q
Q
Q
80Interpreting em
•em is directly related to A’s ed and es
•em is inversely related to the share of imports in A’s consumption and production
eee sm
sd
m
dm Q
Q
Q
Q
81Export Supply Elasticity, ex
• The formula for price elasticity of export supply,
ex, at a point is shown below. Q is the quantity
of exports; P is the price; P is the change in
price;Q is the change quantity exported
Q
P
SlopeQ
P
P
Qex
1
82Export Supply Elasticity, ex
• The formula for price elasticity of export supply, ex, at a point is shown below.
– Qx is the quantity of exports; Qd is the quantity consumed; Qs is the quantity produced
eee sx
sd
x
dx Q
Q
Q
Q
83Interpreting ex
•ex is directly related to B’s ed and es
•ex is inversely related to the share of exports in B’s consumption and production
eee sx
sd
x
dx Q
Q
Q
Q
84Export Supply + Specific Tariff, T
0
Import Demand, M
Export Supply, X
Quantity (lb. of Lobster per year)
PA
PFT
MFT
PB
X + TARIFF, T
PW +T
PW
MT
T
g
fA’s burden, b
85Compare em and ex
to determine A’s burden, b; 0b1• When em = ex , b = _____
• When em > ex , b _______
• When em < ex , b _______
1
1
eeb
xm
86Compare em and ex
to determine A’s burden, b; 0b1• When em = ex , b = 0.5
• When em > ex , b < 0.5
• When em < ex , b > 0.5
1
1
eeb
xm
87
B’s burden, 1- bPW
Differing em
0
Inelastic M
Export Supply, X
Quantity (lb. of Lobster per year)
PA
PFT
MFT
X + TARIFF, T
PW +T
PW
MT
T
gfA’s burden, b
Elastic M
MT
PW +T
fg
88Differing ex
0
Import Demand, M
Elastic X
Quantity (lb. of Lobster per year)
PA
PFT
MFT
PB
Elastic X + T
PW +T
PW
MT
T
g
fA’s burden, b
Inelastic X
T
Inelastic X + T
89SUPACHAI CITES KEY NEGOTIATING AREAS
• Trade liberalization and poverty reduction– Welfare gains from eliminating trade barriers gains of up to
US$620 billion annually• about one third to one half would go to developing countries.
• Tariff “peaks” – agricultural products, textiles, clothing and footwear
• Market access conditions key in trade in services• Regional trade agreements
– 240 currently in force, perhaps 300 by 2005• Increasing use of contingency measures
– e. g., anti-dumping
90Learning Objectives
• Reprise the gains from trade
• Become familiar with tariffs
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Explain the effective rate of protection
• Learn the imperfect substitutes model
91Imperfect Substitutes
• Increased trade in final products relative to raw materials and intermediate goods
• A final-good import and competing domestic products are often imperfect substitutes
• Tariff increases demand for the domestic good
• Increased price of domestic good increases demand for the import
• Welfare cost is more difficult to estimate
92Imperfect Substitutes Small Country -- Free Market
0
DM
Quantity of Imports
Pri
ce o
f Im
por
t
PM
QM QD
0
SM
Quantity of Domestic Substitute
DD
SD
PD
Pri
ce
93Imperfect Substitutes Small Country -- Tariff
0
DM
Quantity of Imports
Pri
ce o
f Im
por
t
e
QM
QD0
SM
Quantity of Domestic Substitute
DD
SD
lP
rice
f
D’DD’M
S’M
m
h
i
r g
kj
n
tariff
Q’DQ’M Q”M
94Welfare Cost of a Tariff
Imperfect Substitutes
Change in Consumer Surplus
Change in Producer Surplus
Change in Government Revenue
Net Welfare Change (a.k.a. Deadweight loss)
95Welfare Cost of a Tariff
Imperfect Substitutes
Change in ConsumerSurplus
-areaefig
-arealmkj
Change in ProducerSurplus
+arealmkj
Change in GovernmentRevenue
+areaefir
Net Welfare Change(a.k.a. Deadweight loss)
-areargi
96Review homework
97Trade with a TariffVersus Autarky
65
10
0 1 10
Domestic demand for grapes
Domestic Supplyof grapes
e
Quantity (millions bushels of grapes per year)
Pri
ce ($
per
bu
shel
of
gra
pes
)
World price of grapes
7
2
World price + tariff $2/bu
3 5
d
3
98Pure Revenue TariffVersus Free Trade
5
10
0 1 10
Iceland’s demand for bananas
Domestic Supplyof grapes lies along y-axis
a
Quantity (millions bushels of bananas per year)
Pri
ce ($
per
bu
shel
of
ban
anas
)
World price of bananas
7
2
World price + tariff $2/bu
3 5
b3
c
99
PW
Differing em
0
Inelastic M
Export Supply, X
Quantity (lb. of Lobster per year)
PA
PFT
MFT
X + TARIFF, T
PW +T
PW
MT
T
g
f
Elastic M
MT
PW +T
fg