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Chapter 8
The Instruments of
Trade Policy
Slides prepared by Thomas Bishop, edited by Mishelle Segui
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
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• Partial equilibrium analysis of tariffs:
supply, demand, and trade in a single
industry
• Costs and benefits of tariffs
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8-2
Introduction
• In the previous chapters we have answered
the question “Why do nations trade?”
• Now: “What should a nation’s trade policy
be?”
• In particular, we will try to answer questions
like, “What trade policy should the US
implement to protect its automobile
industry?”
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8-3
Types of Tariffs
• A tariff is a tax levied when a good is imported.
• The effect of the tariff is to raise the cost of
shipping goods to a country
• 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.
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8-4
Types of Tariffs (cont.)
• What are the reasons for the US government to
imposes tariffs?
• The importance of tariffs has declined over time,
and instead new forms of protections have been
implemented
 Nontariff barriers
• Import quotas – limitations on the quantity of imports
• Export restraints – limitations on the quantity of exports
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8-5
Supply, Demand, and Trade
in a Single Industry
• Let’s analyze how tariffs affect the economy.
• Let’s construct a model measuring how a tariff
affects a single market, say that of wheat.
• 2 countries: Home and Foreign
 Both consume and produce wheat, which can be
costlessly transported between countries
• Wheat is a simple competitive industry, in which
the demand and the supply are functions of the
market price
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8-6
Supply, Demand, and Trade
in a Single Industry (cont.)
• Not worry for exchange rates
Prices in both markets in terms of Home
currency
• Trade will occur if prices are different in the
absence of trade
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8-7
Supply, Demand, and Trade
in a Single Industry (cont.)
• Suppose that in the absence of trade the
price of wheat in the foreign country is
lower than that in the domestic country.
• What would the shippers in both countries
do?
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8-8
Supply, Demand, and Trade
in a Single Industry (cont.)
With trade the foreign country will export:
construct an export supply curve
With trade the domestic country will import:
construct an import demand curve
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8-9
Supply, Demand, and Trade
in a Single Industry (cont.)
• An export supply curve is the difference
between the quantity that foreign producers
supply minus the quantity that foreign
consumers demand, at each price.
• An import demand curve is the difference
between the quantity that domestic
consumers demand minus the quantity that
domestic producers supply, at each price.
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8-10
Fig. 8-1: Deriving Home’s Import
Demand Curve
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8-11
Supply, Demand, and Trade
in a Single Industry (cont.)
• At PA, import demand is equal to zero
• Why is IM downward-sloping?
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8-12
Fig. 8-2: Deriving Foreign’s Export
Supply Curve
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8-13
Supply, Demand, and Trade
in a Single Industry (cont.)
• Why is XS upward-sloping?
• At PA, export supply is equal to zero
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8-14
Supply, Demand, and Trade
in a Single Industry (cont.)
• World equilibrium occurs when Home import
demand equals Foreign export supply
• In equilibrium, the quantities of
import demand = export supply
domestic demand – domestic supply =
foreign supply – foreign demand
• In equilibrium, the quantities of
world demand = world supply
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8-15
Fig. 8-3: World Equilibrium
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8-16
The Effects of a Tariff
• A tariff can be viewed as an added cost of
transportation. Why?
• The price of wheat will tend to rise in the domestic
market.
• The price of wheat will tend to fall in the foreign
market.
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8-17
The Effects of a Tariff (cont.)
• Until the price difference equals the tariff.
PT – P*T = t
PT = P*T + t
Introducing a tariff drives a wedge between the
prices in the two markets
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8-18
Fig. 8-4: Effects of a Tariff
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8-19
The Effects of a Tariff (cont.)
• Because the price in domestic markets rises (to PT)
 domestic producers should supply more and domestic
consumers should demand less.
 The quantity of imports falls from QW to QT
• Because the price in foreign markets falls (to P*T)
 foreign producers should supply less and foreign
consumers should demand more.
 The quantity of exports falls from QW to QT
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8-20
The Effects of a Tariff (cont.)
• The quantity of domestic import demand
equals the quantity of foreign export supply
when PT – P*T = t
• In this case, the increase in the price of the
good in the domestic country is less than the
amount of the tariff.
But…
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8-21
The Effects of a Tariff in a Small Country
• When a country is “infinitely small,” it has no
effect on the foreign (world) price of a good
 Therefore, the foreign price will not fall, but will remain
at Pw
 The price in the domestic market, however, will rise to
PT = Pw + t
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8-22
Fig. 8-5: A Tariff in a Small Country
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