ECO 6705 Protectionism: Analyzing the Effects of Trade Restrictions Dr. Jeff Steagall September 22, 2003

ECO 6705ECO 6705Protectionism: Analyzing the Protectionism: Analyzing the Effects of Trade RestrictionsEffects of Trade Restrictions

Dr. Jeff SteagallDr. Jeff Steagall

September 22, 2003September 22, 2003

Associated ReadingAssociated Reading

Van den Berg, chapter 6Van den Berg, chapter 6 Friedman, chapters 11-13Friedman, chapters 11-13

Types of Trade RestrictionsTypes of Trade Restrictions

Trade policyTrade policy– Set of rules & restrictions on international tradeSet of rules & restrictions on international trade– Uses various policy tools (tariffs, quotas, etc.)Uses various policy tools (tariffs, quotas, etc.)

Tariffs (duties)Tariffs (duties)– OnOn

ImportsImports Exports (atypical—used when a country has market global Exports (atypical—used when a country has market global

power for the good, such as oil)power for the good, such as oil)– Amounts can beAmounts can be

Ad velorem (% of value)Ad velorem (% of value) Specific (per unit)Specific (per unit) CombinationCombination

Types of Trade RestrictionsTypes of Trade Restrictions

Non-tariff barriers (NTBs)Non-tariff barriers (NTBs)– Quantitative restrictionsQuantitative restrictions

Quotas (on imports)Quotas (on imports) Voluntary Export Restraints (VERs)Voluntary Export Restraints (VERs) Voluntary Restraint Agreements (VRAs)Voluntary Restraint Agreements (VRAs) Export controls (quotas)Export controls (quotas)

– Administrative protectionAdministrative protection– Unfair trade statutesUnfair trade statutes

AntidumpingAntidumping Anti-subsidy (countervailing)Anti-subsidy (countervailing)

Welfare Effects of Tariffs: Welfare Effects of Tariffs: Small Country in PESmall Country in PE

Assume the country is smallAssume the country is small– No global market power in the sectorNo global market power in the sector– Country’s actions cannot affect world priceCountry’s actions cannot affect world price– Country bears entire cost of its actionsCountry bears entire cost of its actions– Not necessary to draw Abroad or World markets Not necessary to draw Abroad or World markets

to analyze effects of small country tariffto analyze effects of small country tariff Assume specific tariff for simplicityAssume specific tariff for simplicity

– Analysis and results are similar for ad velorem Analysis and results are similar for ad velorem or combination dutiesor combination duties


Effects of tariffEffects of tariff– World price remains unchanged at PWorld price remains unchanged at PFTFT

Country is too small to influence world priceCountry is too small to influence world price Importers still pay world price on world marketsImporters still pay world price on world markets

– Domestic price rises by amount of tariffDomestic price rises by amount of tariff Importers must pay the tariff to get the product Importers must pay the tariff to get the product

through customs and into the domestic marketthrough customs and into the domestic market Consumer prices must rise to matchConsumer prices must rise to match Tariff creates a wedge between domestic and world Tariff creates a wedge between domestic and world

pricesprices


Effects of tariff, cont.Effects of tariff, cont.– Domestic consumer surplus (CS) fallsDomestic consumer surplus (CS) falls– Domestic producer surplus (PS) risesDomestic producer surplus (PS) rises– Government gains tariff revenueGovernment gains tariff revenue

Area in graph is a rectangle defined byArea in graph is a rectangle defined by– Import amount on horizontal axisImport amount on horizontal axis– Tariff amount on vertical axisTariff amount on vertical axis

Domestic consumers pay this tariff through higher pricesDomestic consumers pay this tariff through higher prices– Decrease in CS is bigger than the combined increases Decrease in CS is bigger than the combined increases

in PS and tariff revenue (deadweight loss)in PS and tariff revenue (deadweight loss)– Domestic welfare is ALWAYS lower with a tariff than Domestic welfare is ALWAYS lower with a tariff than

with free trade for a small countrywith free trade for a small country– Optimal tariff for small country is zero (i.e., free trade)Optimal tariff for small country is zero (i.e., free trade)

Welfare Effects of Tariffs: Welfare Effects of Tariffs: Large Country in PELarge Country in PE

Assume the country is smallAssume the country is small– Has global market power in the sector, by Has global market power in the sector, by

definition of being a large countrydefinition of being a large country– Country’s actions do affect world priceCountry’s actions do affect world price– Country does not bear entire cost of its actionsCountry does not bear entire cost of its actions– It is necessary to draw Abroad or World markets It is necessary to draw Abroad or World markets

to analyze effects of large country tariffto analyze effects of large country tariff


Effects of tariffEffects of tariff– Domestic price rises due to tariffDomestic price rises due to tariff

Importers must pay the tariff to get the product through customs Importers must pay the tariff to get the product through customs and into the domestic marketand into the domestic market

Consumer prices must rise to matchConsumer prices must rise to match Graphically, tariffs decrease international supply (left shift)Graphically, tariffs decrease international supply (left shift)

– Increased domestic prices cause quantity demanded to Increased domestic prices cause quantity demanded to fallfall Since country is large, the units that used to be sold in Since country is large, the units that used to be sold in

Homeland are put back on the international marketHomeland are put back on the international market At prevailing international price, those units remain unsoldAt prevailing international price, those units remain unsold International suppliers must drop their prices to sell these unitsInternational suppliers must drop their prices to sell these units Equilibrium world price with large country tariff falls below PEquilibrium world price with large country tariff falls below PFTFT


Effects of tariff, cont.Effects of tariff, cont.– Now importersNow importers

Purchase products in international markets at new Purchase products in international markets at new world priceworld price

Bring products through customs, paying the tariffBring products through customs, paying the tariff Sell the product domestically at a new price that is Sell the product domestically at a new price that is

equal to the new international price plus the tariffequal to the new international price plus the tariff

– Thus, domestic priceThus, domestic price Is higher with the tariff than with FTIs higher with the tariff than with FT Is lower than the sum of PIs lower than the sum of PFTFT + Tariff + Tariff


Effects of tariff, cont.Effects of tariff, cont.– Domestic consumer surplus (CS) fallsDomestic consumer surplus (CS) falls– Domestic producer surplus (PS) risesDomestic producer surplus (PS) rises– Government gains tariff revenueGovernment gains tariff revenue

Area in graph is a rectangle defined byArea in graph is a rectangle defined by– Import amount on horizontal axisImport amount on horizontal axis

– Tariff amount on vertical axisTariff amount on vertical axis

Tariff revenue is paid partly byTariff revenue is paid partly by– Domestic consumers in the form of higher pricesDomestic consumers in the form of higher prices

– Foreign producers in the form of a lower international priceForeign producers in the form of a lower international price

– Large countries can shift part of tariff burden abroad!Large countries can shift part of tariff burden abroad!


Effects of tariff, cont.Effects of tariff, cont.– Part of CS decrease is offset by PS increasePart of CS decrease is offset by PS increase– It is not clear whether tariff revenue is bigger or It is not clear whether tariff revenue is bigger or

smaller than the part of CS loss that is not offset smaller than the part of CS loss that is not offset by the gain in PSby the gain in PS

– Thus, it is POSSIBLE that domestic welfare is Thus, it is POSSIBLE that domestic welfare is higher or lowerhigher or lower with a tariff than with free trade with a tariff than with free trade for a large countryfor a large country


Optimal tariff for large countryOptimal tariff for large country– If one chooses the right tariff, it can be positive, If one chooses the right tariff, it can be positive,

but only ifbut only if AssumptionsAssumptions

– Government redistributes tariff revenue in a welfare-Government redistributes tariff revenue in a welfare-increasing wayincreasing way

No waste, inefficiency, or administrative costsNo waste, inefficiency, or administrative costs No loss through rent-seeking behaviorNo loss through rent-seeking behavior

– Foreign governments don’t retaliate with their own tariffsForeign governments don’t retaliate with their own tariffs Unlikely!Unlikely!

Lerner Symmetry TheoremLerner Symmetry Theorem

An import tariff raises opportunity costs for An import tariff raises opportunity costs for domestic exporters (in the other sector), and domestic exporters (in the other sector), and therefore is a tax on both exports and importstherefore is a tax on both exports and imports– The price increase induced by the tariffThe price increase induced by the tariff

Causes import-competing industry to expandCauses import-competing industry to expand– Bid resources away from export sectorBid resources away from export sector– Increases opportunity cost for export sectorIncreases opportunity cost for export sector– Decreases supply (left shift) in export sectorDecreases supply (left shift) in export sector

– Since export sector has CA, tariffs cause a misallocation Since export sector has CA, tariffs cause a misallocation of resources across sectorsof resources across sectors Some of the gains from specialization are unrealizedSome of the gains from specialization are unrealized Draw export sector PE for a country imposing an import tariff to Draw export sector PE for a country imposing an import tariff to

see this formallysee this formally

Tariff Effects in GETariff Effects in GE

Students are responsible only for Figure 6.7 Students are responsible only for Figure 6.7 (not appendix)(not appendix)

Small country caseSmall country case– Tariff changes domestic pricesTariff changes domestic prices

If X-axis represents import-competing productIf X-axis represents import-competing product– Domestic price line gets steeperDomestic price line gets steeper– Production point shifts (away from CA product)Production point shifts (away from CA product)

Country still trades according to international pricesCountry still trades according to international prices Consumers purchase based on domestic pricesConsumers purchase based on domestic prices Welfare is reducedWelfare is reduced

Summary of Tariff Effects: Summary of Tariff Effects: Large CountryLarge Country

Transfers of welfare occurTransfers of welfare occur– Domestic consumers to domestic producersDomestic consumers to domestic producers– Domestic consumers to domestic governmentDomestic consumers to domestic government– Foreign producers to foreign consumersForeign producers to foreign consumers– Foreign producers to domestic governmentForeign producers to domestic government– Deadweight losses both domestically and Deadweight losses both domestically and

abroadabroad

Nominal vs Effective ProtectionNominal vs Effective Protection

Nominal tariffNominal tariff– Reflects tariff on output product onlyReflects tariff on output product only– Ignores remainder of trade policy (e.g., tariffs on Ignores remainder of trade policy (e.g., tariffs on

inputs)inputs)– Specific tariff dollar amountSpecific tariff dollar amount– Ad velorem tariff percentageAd velorem tariff percentage


Effective tariffEffective tariff– Considers entire trade policyConsiders entire trade policy

All protection that affects the industryAll protection that affects the industry– Tariff on outputTariff on output– Tariffs on inputsTariffs on inputs

Non-tariff protection would also be included, but for Non-tariff protection would also be included, but for simplicity, we’ll stick to tariffs only in this classsimplicity, we’ll stick to tariffs only in this class

– Effective tariff is the percentage change in value Effective tariff is the percentage change in value added for the industry with the entire trade added for the industry with the entire trade policy in place (policy in place (vis-à-visvis-à-vis free trade) free trade)


Value added = output price - cost of inputsValue added = output price - cost of inputs– (VA)(VA)

Calculating Effective Tariff Rate Calculating Effective Tariff Rate (ETR)(ETR)

Calculate free trade VA (VACalculate free trade VA (VAFTFT)) Calculate prices of output & inputs with new Calculate prices of output & inputs with new

trade policytrade policy Calculate VA with trade policy (VACalculate VA with trade policy (VATPTP)) ETR = (VAETR = (VATP TP - VA- VAFTFT) / VA) / VAFTFT

– This is a fractionThis is a fraction– Multiply by 100 to get the percentageMultiply by 100 to get the percentage

Students are responsible for this calculationStudents are responsible for this calculation

Effective Tariff RateEffective Tariff Rate

ETR is sometimes called Effective Rate of ETR is sometimes called Effective Rate of Protection (ERP)Protection (ERP)

ETR can beETR can be– PositivePositive

Trade policy increases value added vis-à-vis FTTrade policy increases value added vis-à-vis FT Value of output protection exceeds harm of input protectionValue of output protection exceeds harm of input protection

– NegativeNegative Trade policy increases value added vis-à-vis FTTrade policy increases value added vis-à-vis FT Value of output protection is less than harm of input protectionValue of output protection is less than harm of input protection

– ZeroZero Trade policy has no effect on VATrade policy has no effect on VA Value of output protection equals harm of input protectionValue of output protection equals harm of input protection

Effects of NTBsEffects of NTBs

Students are responsible only for small country Students are responsible only for small country case of NTBscase of NTBs– Small country version of Figure 6.12 onlySmall country version of Figure 6.12 only– Not for Figures 6.10 and 6.11Not for Figures 6.10 and 6.11– Not for Figure 6.12 for large nationNot for Figure 6.12 for large nation

All NTB analyses will be forAll NTB analyses will be for– Tariff-equivalent quota (TEQ): a quota that has the Tariff-equivalent quota (TEQ): a quota that has the

same effects on prices & quantities as a given tariffsame effects on prices & quantities as a given tariff Refer to tariff as “corresponding tariff”Refer to tariff as “corresponding tariff”

– This allows us to focus on differences between various This allows us to focus on differences between various trade policy toolstrade policy tools

Effects of Quota, Small NationEffects of Quota, Small Nation

Some effects same as corresponding tariffSome effects same as corresponding tariff– Decrease in CSDecrease in CS– Increase in PSIncrease in PS

Government revenue can be differentGovernment revenue can be different– No tariff, so no tariff revenueNo tariff, so no tariff revenue– Allocation of quota can generate some revenueAllocation of quota can generate some revenue

Quota leaves country no better off, and most Quota leaves country no better off, and most likely worse off, than an equivalent likely worse off, than an equivalent (corresponding tariff would have)(corresponding tariff would have)


Ways to allocate quota rightsWays to allocate quota rights– First-come, first-servedFirst-come, first-served

No revenue for governmentNo revenue for government Incentive for exporters is to be first into marketIncentive for exporters is to be first into market

– Lots of goods available early in yearLots of goods available early in year– No new imports late in year, as quota has been used upNo new imports late in year, as quota has been used up

– Issue import licenses (i.e., import permits)Issue import licenses (i.e., import permits) Each license gives firm the right to export some amount during Each license gives firm the right to export some amount during

the yearthe year Firm chooses when to export, so goods can be available all Firm chooses when to export, so goods can be available all

yearyear Selling licenses can generate government revenueSelling licenses can generate government revenue


Ways to allocate import licensesWays to allocate import licenses– Flat feeFlat fee

Who sets fee?Who sets fee? Does fee reflect value of licenses?Does fee reflect value of licenses?

– Set requirements for exporters to be eligibleSet requirements for exporters to be eligible– Require paperwork by exporters to justify why Require paperwork by exporters to justify why

they should be able to exportthey should be able to export– LotteriesLotteries– AuctionsAuctions


– Auction, cont.Auction, cont. If set up efficiently, auction can generate up to same If set up efficiently, auction can generate up to same

amount of government revenue that the amount of government revenue that the corresponding tariff would generatecorresponding tariff would generate

– Firms that have licenses can sell at higher prices in the Firms that have licenses can sell at higher prices in the quota-imposing country than it can on world marketsquota-imposing country than it can on world markets

Earn “rents” on exportsEarn “rents” on exports Total available rent is equal to tariff revenue with Total available rent is equal to tariff revenue with

corresponding tariffcorresponding tariff Firms will pay up to that amount in order to be eligible Firms will pay up to that amount in order to be eligible

to earn those rentsto earn those rents Efficient auctions are fairly easy in practiceEfficient auctions are fairly easy in practice

Rents and Rent-SeekingRents and Rent-Seeking

What happens when import licenses are What happens when import licenses are sold by government?sold by government?– Government captures rentsGovernment captures rents– Rent-seekers who feel entitled to having those Rent-seekers who feel entitled to having those

rents transferred to them appearrents transferred to them appear Import-competing industryImport-competing industry

Other ways that rents are capturedOther ways that rents are captured– Higher profits by subsidiaries producing in the Higher profits by subsidiaries producing in the

protecting country (e.g., Toyota plants in US)protecting country (e.g., Toyota plants in US)

Rent-Seeking BehaviorRent-Seeking Behavior

Rent-seeking is the use of scarce resources Rent-seeking is the use of scarce resources to induce transfers of wealth instead of to induce transfers of wealth instead of using them to create new wealthusing them to create new wealth– LobbyingLobbying

Effects of VERs: Small NationEffects of VERs: Small Nation

Same as quota situation, exceptSame as quota situation, except– VER is policy of export-nation government, not VER is policy of export-nation government, not

import-nation governmentimport-nation government– Import-nation government has no import Import-nation government has no import

licenses to allocate, since it’s not actually licenses to allocate, since it’s not actually restricting importsrestricting imports

– VER allows no import-country government VER allows no import-country government revenuerevenue

– VER leaves country even worse off than with a VER leaves country even worse off than with a quotaquota

Relative Rankings of Trade PoliciesRelative Rankings of Trade Policies

So far, we know that So far, we know that – Free Trade (best)Free Trade (best)– TariffTariff– QuotaQuota– VER (worst)VER (worst)

Administrative Barriers to TradeAdministrative Barriers to Trade

Bureaucratic proceduresBureaucratic procedures– Safety requirementsSafety requirements– Foreign ownership restrictionsForeign ownership restrictions– Threat of lawsuits (harassment of foreign firms)Threat of lawsuits (harassment of foreign firms)– Government procurement (buy domestically)Government procurement (buy domestically)– State, provincial & local restrictionsState, provincial & local restrictions

Documents

ECO 6705 Protectionism: Analyzing the Effects of Trade Restrictions Dr. Jeff Steagall September 22, 2003