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International Trade Policies
Under Perfect Competition
SURVEY OF INTERNATIONAL
ECONOMICS
Rafael López-MontiDepartment of Economics
George Washington University
Summer 2015(Econ 6280.20)
Required Reading:
Feenstra, R. and Taylor, A., International Economics (3e). Worth Publishers, CHAPTER 8
OR Feenstra, R. and Taylor, A., Essential of International Economics (3e). Worth Publishers, CHAPTER 7
* Material for teaching only. Please do not cite or circulate. Some typos might remain
2
INTERNATIONAL TRADE POLICIES
The Gains from Trade
Import Tariffs for a Small Country
Import Tariffs for a Large Country
Import Quotas
Export Subsidies
Export Tariffs
3
The Gains from Trade
Recall: the consumer surplus from purchasing quantity D1 at price P1 is the area
below the demand curve and above that price. The consumer who purchases D2 is
willing to pay price P2 but has to pay only P1. The producer surplus from supplying
the quantity S1 at the price P1 is the area above the supply curve and below that
price. The supplier who supplies unit S0 has marginal costs of P0 but sells it for P1
4
The Gains from Trade
Autarky (no-trade): home demand of D and supply of S, the no-trade equilibrium
is at point A, at the price PA producing Q0.
Free Trade: the world price is PW, so quantity demanded increases to D1 and
quantity supplied falls to S1. Since quantity demanded exceeds quantity supplied,
home imports D1 – S1, consumer surplus increases by the area (b + d), and
producer surplus falls by area b. The gains from trade are measured by area d.
Rise in consumer surplus: + (b + d)
Fall in producer surplus: − b
Net effect on Home welfare: + d
5
Import Tariffs
A tariff is a tax on imported goods
Types of tariffs:
A specific tariff is levied as a fixed charge for each unit of imported
goods. For example, $1 per kg of cheese
An ad valorem tariff is levied as a fraction of the value of imported
goods. For example, 25% tariff on the value of imported cars.
Tariffs raise the price of imported goods above the world
price by the amount of the tariff.
As a result, this will:
Reduce consumption, …
Increase production, and thereby …
Reduce the amount imported
6
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Imports
under free trade
Equilibrium
without trade
Price
before tariff
World
price
QS
QD
“Small Country” means that a country is too small to influence the world price
Import Tariffs for a Small Country
Home Price
7
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Price
after tariff Tariff
Imports
under free trade
Equilibrium
without trade
Price
before tariff
World
priceImports
with tariff
QS
QS
QD
QD
Effects of a Tariff on Prices and Quantities
Import Tariffs for a Small Country
Home Price
8
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Importsunder free trade
Equilibrium
without trade
Price
before tariff
World
price
QS
QD
Producer
surplus
before tariff
Consumer surplus
before tariff
Welfare under free trade
Import Tariffs for a Small Country
Home Price
9
A
B
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Price
after tariff Tariff
Importsunder free trade
Equilibrium
without trade
Price
before tariff
World
priceImports
with tariff
QS
QS
QD
QD
Consumer surplus
after tariff
Consumer Surplus after Tariff
Import Tariffs for a Small Country
Home Price
10
C
G
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Price
after tariff Tariff
Importsunder free trade
Equilibrium
without trade
Price
before tariff
World
price
QS
Imports
after tariff
QS
QD
QD
Producer
surplus
after tariff
Producer Surplus after Tariff
Import Tariffs for a Small Country
Home Price
11
E
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Price
after tariff Tariff
Imports
under free trade
Price
before tariff
World
price
QS
Imports
after tariff
QS
QD
QD
Tariff Revenue
Government’s Revenue from Tariff
Import Tariffs for a Small Country
Home Price
12
Effects of Tariff on Social Welfare
C
G
A
ED F
B
of Steel
0 Quantity
of Steel
Domestic Supply
Domestic
demand
Price
with tariff Tariff
Imports
without tariff
Price
without tariff
World
priceImports
after tariff
QS
QS
QD
QD
Deadweight Loss
Import Tariffs for a Small Country
Home Price
13
Consumers of the imported good are worse off
(compared to free trade)
Producers of the imported good are better off
The government gains some revenue
Total surplus decreases, because the loss to consumers
is larger than the gains to the producers and to the
government
The decrease in total surplus is called the deadweight
loss of the tariff.
Welfare Effects of a Tariff
14
As a result tariffs are the “third best”
The tariff can be thought of as the combination of a
consumption tax AND a production subsidy
The only rationale for a tariff is that “it helps producers”
But even that goal can be better achieved by using only
a production subsidy
That way, the bad effects of the consumption tax can be
avoided
Welfare Effects of a Tariff
15
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Consumption Tax
Imports
under free trade
Equilibrium
without trade
World
priceImports
after tax
= QS
QS
QD
Consumption Tax
Purchase price
after tax
Purchase price
before tax
QD
Home Price
16
of Steel
0 Quantity
of Steel
Consumption Tax
Imports
under free trade
Imports
after tax
= QS
QD
Consumption TaxAfter Tariff Consumption Tax
Change in Consumers’ Surplus -(C+D+E+F) -(C+D+E+F)
Change in Producers’ Surplus +C
Change in Government Income +E +C+D+E
Net Welfare Effect -(D+F) -F
Purchase price
before tax
DC
G
A
E F
B
Domestic
demand
Purchase price
after tax
QD
World
price
Domestic
supply
Equilibrium
without trade
Deadweight loss of
the consumption tax
QS
Home Price
17
When a small country imposes a consumption tax on
the imported good
Production is unchanged.
Consumption decreases.
Therefore, the amount imported decreases.
Consumers lose
Producers are unaffected
The government gains some tax revenue
The country as a whole is worse off
Welfare Effects of a Consumption Tax
18
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Production Subsidy
Imports
under free trade
World Price
Imports
after subsidy
QS
QS
QD Q
D=
Production Subsidy
Price sellers get
after subsidy
Price sellers get
before subsidy price buyers pay, with
or without the subsidy
Home Price
19
DC
G
A
E F
B
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Price
For sellers Production Subsidy
Importsunder free trade
Price
For buyers
World
priceImports
with subsidy
QS
QS
QD
Deadweight Loss
QD
=
Production Subsidy
After
Tariff
Production
Subsidy
Change in Consumers’ Surplus -(C+D+E+F)
Change in Producers’ Surplus +C +C
Change in Government Income +E -(C+D)
Net Welfare Effect -(D+F) -D
Home Price
20
When a small country gives a subsidy to domestic
producers of an imported good
Consumers are unaffected
Producers gain (C), same as under the tariff
Taxpayers have to pay for the subsidy (CD)
Overall, the country is worse off (D).
Recall that under the tariff, the country suffered even more (DF)
Tariffs are “third best”
Welfare Effects of a Production Subsidy
21
Tariff = Consumption Tax + Production Subsidy
Comparative Welfare Loss
Destruction of value that is not compensated by a gain somewhere else : area F
Efficiency loss is another deadweight loss which occurs on the production side: area D
22
Why and How Are Tariffs Applied?
If a small country suffers a loss when it imposes a tariff, why do so
many have tariffs as part of their trade policies?
One answer is that a developing country does not have any other
source of government revenue. Import tariffs are “easy to collect.”
A second reason is politics. The benefits to producers (and their
workers) are typically more concentrated on specific firms and states
than the costs to consumers, which are spread nationwide.
Import Tariffs for a Small Country
23
A tariff may have effects that are less predictable and
harder to quantify
Retaliation by other countries: adds to the net loss of a tariff by
hurting export markets of other industries; can escalate rapidly
Innovation: tariffs reduce competitive pressures on domestic firms
and thus their incentives to innovate and improve the quality of
existing products
Rent seeking: any activity that uses resources in order to capture
more income without actually producing a good (e.g., firms hire
lobbyists to maintain tariff protection)
Potential Costs of Tariffs
24
C
G
A
E1D F
B
of Steel
0 Quantity
of Steel
Domestic
supply
Price
with tariff Tariff
Imports
without tariff
World price before tariff
QS
QS
QD
QD
World price after tariffDomesticdemand
E2
A large country can use tariffs to force down the price of its
imported good worldwide. This improves its terms of trade: the
ratio of export prices to import prices ( 𝑷𝑬𝑿𝑷𝑶 𝑷𝑰𝑴𝑷𝑶).
Import Tariffs for a Large Country
After Tariff
Change in Consumers’ Surplus -(C+D+E1+F)
Change in Producers’ Surplus +C
Change in Government Income +(E1+E2)
Net Welfare Effect +E2 - (D+F)
Home Price
E2 area represents the terms-of-trade gain
25
Optimal Tariff for a Large Importing Country
Optimal Tariff = 𝟏
𝑬𝑿∗ , where 𝑬𝑿
∗ is the elasticity of Foreign export supply
A tariff initially increases the importer’s welfare because the terms-of-trade
gain exceeds the deadweight loss until the optimal tariff at optimal level
(point C). After that, welfare falls. If the tariff is too large (greater than at B),
then welfare will fall below the free-trade level.
26
Take a Break
27
Import Quota
An import quota is a limit imposed by the domestic government on the
quantity of a good that can be produced abroad and sold domestically.
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
demand
Imports
without quota
Equilibrium
without trade
World
price
World
price
Price
without
quota
=
QD
QS
Home Price
28
The Effects of an Import Quota
An import quota is a limit imposed by the domestic government on the
quantity of a good that can be produced abroad and sold domestically.
of Steel
0 Quantity
of Steel
Domestic
supply
Domestic
supply
+
Import supply
Domestic
demand
Isolandian
price with
quota
Imports
without quota
Equilibrium
with quota
Equilibrium
without trade
Quota
Imports
with quota
QD
World
price
World
price
Price
without
quota
=
QS
QD
QS
Home Price
29
A
E'C
B
G
D E" F
Home Priceof Steel
0 Quantity
of Steel
Domestic
Supply
Domestic
supply
+
Import supply
Domestic
demand
Isolandian
price with
quota
Imports
without quota
Equilibrium
with quota
Equilibrium
without trade
Quota
Imports
with quota
QD
World
price
World
price
Price
without
quota
=
QS
QD
QS
The Effects of an Import Quota
30
Whoever is actually importing the good will be able to
earn the difference between the World Price and the
higher Price with quota by selling the imports in the Home
market.
We call the difference between these two prices the rent
associated with the quota, and hence the area (E’+E’’)
represents the total quota rents.
Next we examine the four possible ways that these quota
rents can be allocated.
The Effects of an Import Quota
31
1. Giving the Quota to Home Firms
Quota licenses (i.e., permits to import the quantity allowed under the
quota system) can be given to Home firms: With home firms earning the
rents (E’+E’’) , the net effect of the quota on Home welfare is
Fall in consumer surplus: − (C+D+E’+E’’+F)
Rise in producer surplus: + C
Quota rents earned at Home + (E’+E’’)
Net effect on Home welfare: − (D+F)
The Effects of an Import Quota
How to “capture” the Quota rents
32
2. Rent Seeking
If licenses for the imported chemicals are allocated in proportion to
each firm’s production of steel in the previous years, then the Home
firms will likely produce more steel than they can sell (and at lower
quality) just to obtain the import licenses for the following year.
Alternatively, firms might engage in bribery or other lobbying activities
to obtain the licenses.
These kinds of inefficient activities done to obtain quota licenses are
called rent seeking. If rent seeking occurs, the welfare loss due to the
quota would be
Fall in consumer surplus: − (C+D+E’+E’’+F)
Rise in producer surplus: + C
Net effect on Home welfare: − (D+F+E’+E’’)
The Effects of an Import Quota
How to “capture” the Quota rents
33
3. Auctioning the Quota
A third possibility for allocating the rents that come from the quota is
for the government of the importing country to auction off the quota
licenses.
In a well-organized, competitive auction, the revenue collected should
exactly equal the value of the rents, so that area (E’+E’’) would be
earned by the Home government.
Using the auction method to allocate quota rents, the net loss in
domestic welfare due to the quota becomes
Fall in consumer surplus: − (C+D+E’+E’’+F)
Rise in producer surplus: + C
Auction revenue earned at Home + (E’+E’’)
Net effect on Home welfare: − (D+F)
The Effects of an Import Quota
How to “capture” the Quota rents
34
4. “Voluntary” Export Restraint
The final possibility for allocating quota rents is for the government of
the importing country to give authority for implementing the quota to
the government of the exporting country.
Because the exporting country allocates the quota among its own
producers, this is sometimes called a “voluntary” export restraint
(VER), or a “voluntary” restraint agreement (VRA).
In the 1980s the United States used this type of arrangement to restrict
Japanese automobile imports.
In this case, the quota rents are earned by foreign producers, so the loss
in Home welfare equals
The Effects of an Import Quota
How to “capture” the Quota rents
Fall in consumer surplus: − (C+D+E’+E’’+F)
Rise in producer surplus: + C
Net effect on Home welfare: − (D+F+E’+E’’)
35
Export Subsidy
Export Subsidies: the government gives to a particular domestic industry
subsidies and incentives to boost exports
Types:
Government grants low interest rate loans
U.S. Export-Import Bank (Exim Bank)
Tax breaks and tax abatements
WTO is against direct export subsidies, except agricultural subsidies and
developing countries that is developing an industry
Tariffication: economists convert import quotas and other non-tariff trade
barriers such as export subsidies into tariffs
A country could impose a countervailing duty
A tariff to nullify the effects of an export's country subsidy
Exporting country pays a tax to the importing country, nullifying the deadweight
losses
36
Export Subsidies in a Small Home Country
Demand
Supply
Quantity
Home
Price
Subsidy, per unitA
B C D E
F G HI
World Price
(Free Trade)
World Price + Subsidy
Exports
(Free Trade), X1
Exports
(with subsidy), X2
Autarky
37
Free Trade Export Subsidy
Consumers’ Surplus A+B+C A
Producers’ Surplus F+G+H+I B+C+D+F+G+H+I
Government Pays -(C+D+E)
Total Welfare A+B+C+F+G+H+I A+B+F+G+H+I-E
Policy Comparison : Welfare analysis
Exports actually rise as a result of the subsidy, from X1 to X2.
Net Welfare Effect = Export Subsidy – Free Trade
= (A+B+F+G+H+I-E) – A-B-C-F-G-H-I = -C-E = -(C+E)
As a result, the deadweight loss as a result of the subsidy is the
triangle (C+E)
38
Quantity
Price
Demand
Supply
Export Subsidy and
Import Tariff (CAP)
Imports under free trade
Exports after CAP
A
BC
D
E
F G H
I
Example: Europe’s Common Agricultural Policy
World Price + Subsidy
World Price
(Free Trade)
39
This table shows the agreements made at the 2005 WTO meeting in Hong Kong, which had as its
major focus the subsidies provided to agricultural products. This meeting was part of the Doha
Round of WTO negotiations, which have not yet been concluded.
TABLE (1 of 2) Agreements Made at the Hong Kong WTO Meeting, December 2005
WTO Goals on Agricultural Export Subsidies
40
TABLE (2 of 2) Agreements Made at the Hong Kong WTO Meeting, December 2005
WTO Goals on Agricultural Export Subsidies
41
Export Tariff in a Small Home Country
Demand
Supply
Quantity
Home
Price
Tariff per unitA
B C D E
F G HI
World Price
(Free Trade)
World Price -Tariff
Exports
(with Tariff), X2
Exports
(Free Trade), X1
Autarky
C’ E’
42
Free Trade Export Tariff
Consumers’ Surplus A A+B+C
Producers’ Surplus B+C+C’+D+E’+F+G+H+I F+G+H+I
Government Revenue +D
Total Welfare A+B+C+C’+D+E’+F+G+H+I A+B+C+F+G+H+I+D
Policy Comparison : Welfare analysis
Exports actually rise as a result of the subsidy, from X1 to X2.
Net Welfare Effect = Export Tariff – Free Trade
=(A+B+C+F+G+H+I+D) – A-B-C -C’-D-E’-F-G-H-I = -C’-E’ = -(C’+E’)
As a result, the deadweight loss as a result of the export tariff is the
triangle (C’+E’)