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Chapter 8
The Instruments
of Trade Policy
Slides prepared by Thomas Bishop
Preview
• Partial equilibrium analysis of tariffs: supply,
demand and trade in a single industry
• Costs and benefits of tariffs
• Export subsidies
• Import quotas
• Voluntary export restraints
• Local content requirements
Import Tariffs and Export Subsidies
• Import tariffs are taxes levied on imports
• Export subsidies are payments given to
domestic producers that export.
• Both policies influence the terms of trade and
therefore national welfare.
Import Tariffs and Export Subsidies (cont.)
• Import tariffs and export subsidies drive a
wedge between prices in world markets (or
external prices) and prices in domestic
markets (or internal prices).
• The terms of trade refers to the relative value
of a country’s exports and a country’s imports.

Since exports and imports are traded in world
markets, the terms of trade measures external
prices.
Import Tariffs and Distribution of Income
Across Countries
• If the domestic country imposes a tariff on food
imports, the price of food relative to price cloth that
domestic citizens face is higher.

Likewise, the price of cloth relative to the price of food that
domestic consumers and producers pay is lower.

Domestic producers will receive a lower relative price of cloth,
and therefore will be more willing to switch to food production:
the relative supply curve will shift.

Domestic consumers will pay a lower relative price of cloth,
and therefore be more willing to switch to cloth consumption:
the relative demand curve will shift.
Import Tariffs and Distribution of Income
Across Countries (cont.)
Import Tariffs and Distribution of Income
Across Countries (cont.)
• When the domestic country imposes an import tariff,
the terms of trade increases and the welfare of the
country may increase.
• The magnitude of this effect depends on the size of
the domestic country relative to the world economy.

If the country is small part of the world economy, its tariff (or
subsidy) policies will not have much effect on world relative
supply and demand, and thus on the terms of trade.

But for large countries, a tariff rate that maximizes national
welfare at the expense of foreign countries may exist.
Export Subsidies and Distribution of Income
Across Countries
• If the domestic country imposes a subsidy on
cloth exports, the price of cloth relative to price
food that domestic citizens face is higher.

Domestic producers will receive a higher relative
price of cloth, and therefore will be more willing to
switch to cloth production: the relative supply curve
will shift.

Domestic consumers have to pay more on Cloth,
otherwise producers would like to sell their
products to foreign to enjoy the subsidy.

Domestic consumers will pay a higher relative price
of cloth, and therefore be more willing to switch to
food consumption: the relative demand curve will
shift.
Export Subsidies and Distribution of
Income Across Countries (cont.)
Export Subsidies and Distribution of
Income Across Countries (cont.)
• When the domestic country imposes an
export subsidy, the terms of trade decreases
and the welfare of the country decreases to
the benefit of the foreign country.
Import Tariffs, Export Subsidies and
Distribution of Income Across Countries
• The two country, two good model predicts that

an import tariff by the domestic country can
increase domestic welfare at the expense of the
foreign country.

an export subsidy by the domestic country
reduces domestic welfare to the benefit of the
foreign country.
Import Tariffs and Export Subsidies
• Export subsidies on a good decrease the
relative world price of that good by increasing
relative supply of that good and decreasing
relative demand of that good.
• Import tariffs on a good decrease the relative
world price of that good (and increase the
relative world price of other goods) by
increasing the relative supply of that good and
decreasing the relative demand of that good.
Import Tariffs, Export Subsidies and
Distribution of Income Within a Country
• Because of changes in relative prices,
import tariffs and export subsidies have
effects on income distribution among
producers within a country.
Import Tariffs, Export Subsidies and
Distribution of Income Within a Country (cont.)
• Generally, a domestic import tariff increases income
for domestic import-competing producers by allowing
the price of their goods to rise to match increased
import prices, and it shifts resources away from the
export sector.
• Generally, a domestic export subsidy increases
income for domestic exporters, and it shifts resources
away from the import-competing sector.
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.
• Let’s now analyze how tariffs affect the
economy.
Supply, Demand and Trade
in a Single Industry
• Let’s construct a model measuring how a tariff
affects a single market, say that of wheat.
• Suppose that in the absence of trade the price
of wheat in the foreign country is lower than
that in the domestic country.

With trade the foreign country will export: construct
an export supply curve

With trade the domestic country will import:
construct an import demand curve
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.
Supply, Demand and Trade
in a Single Industry (cont.)
Supply, Demand and Trade
in a Single Industry (cont.)
Supply, Demand and Trade
in a Single Industry (cont.)
• In equilibrium,
import demand = export supply
domestic demand – domestic supply =
foreign supply – foreign demand
• In equilibrium,
world demand = world supply
Supply, Demand and Trade
in a Single Industry (cont.)
The Effects of a Tariff
• A tariff acts as an added cost of transportation,
making shippers unwilling to ship goods unless the
price difference between the domestic and foreign
markets exceeds the tariff.
• If shippers are unwilling to ship wheat, there is excess
demand for wheat in the domestic market and excess
supply in the foreign market.

The price of wheat will tend to rise in the domestic market.

The price of wheat will tend to fall in the foreign market.
The Effects of a Tariff (cont.)
• Thus, a tariff will make the price of a good rise
in the domestic market and will make the price
of a good fall in the foreign market, until the
price difference equals the tariff.

PT – P*T = t

PT = P*T + t

The price of the good in foreign (world) markets
should fall if there is a significant drop in the
quantity demanded of the good caused by the
domestic tariff.
The Effects of a Tariff (cont.)
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
The Effects of a Tariff in a Small Country
• When a country is “small”, it has no effect on
the foreign (world) price of a good, because
its demand for the good is an insignificant part
of world demand.

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
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.

Part of the tariff is reflected in a decline of the
foreign country’s export price, and thus is not
passed on to domestic consumers.

“Pass-through” Tariff

But this effect is often not very significant.
The Effects
of a Tariff in a Small Country (cont.)
Effective Rate of Protection
• The effective rate of protection measures how
much protection a tariff or other trade policy provides
domestic producers.

It represents the change in value that an industry adds to the
production process when trade policy changes.

The change in value that an industry provides depends on
the change in prices when trade policies change.

Effective rates of protection often differ from tariff rates
because tariffs affect sectors other than the protected sector,
a fact which affects the prices and value added for the
protected sector.
Effective Rate of Protection (cont.)
• For example, suppose that an automobile sells on the
world market for $8000, and the parts that made it are
worth $6000.
 The value added of the auto production is
$8000-$6000
• Suppose that a country puts a 25% tariff on imported
autos so that domestic auto assembly firms can now
charge up to $10000 instead of $8000.
• Now auto assembly will occur if the value added is up
to $10000-$6000.
Effective Rate of Protection (cont.)
• The effective rate of protection for domestic
auto assembly firms is the change in value
added:
($4000 - $2000)/$2000 = 100%
• In this case, the effective rate of protection is
greater than the tariff rate.
Effective Rate of Protection
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-32
Effective Rate of Protection
• Effective rate of protection could be negative.
• This happens when import tariffs on intermediate
goods are higher than that of final goods.
• For example, when import tariffs on intermediate
goods are 75% whereas that on final goods is only
50%.
• 8000(1+.75)=14000
• 10000(1+.5)=15000
• ERP=(1000-2000)/2000=-50%
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-33
Costs and Benefits of Tariffs
• A tariff raises the price of a good in the
importing country, so we expect it to hurt
consumers and benefit producers there.
• In addition, the government gains tariff
revenue from a tariff.
• How to measure these costs and benefits?
• We use the concepts of consumer surplus
and producer surplus.
Consumer Surplus
• Consumer surplus measures the amount
that a consumer gains from a purchase by the
difference in the price he pays from the price
he would have been willing to pay.

The price he would have been willing to pay is
determined by a demand (willingness to buy) curve.

When the price increases, the quantity demanded
decreases as well as the consumer surplus.
Consumer Surplus (cont.)
Producer Surplus
• Producer surplus measures the amount that
a producer gains from a sale by the difference
in the price he receives from the price he
would have been willing to sell at.

The price he would have been willing to sell at is
determined by a supply (willingness to sell) curve.

When price increases, the quantity supplied
increases as well as the producer surplus.
Producer Surplus (cont.)
Costs and Benefits of Tariffs
• A tariff raises the price of a good in the
importing country, making its consumer
surplus decrease (making its consumers
worse off) and making its producer surplus
increase (making its producers better off).
• Also, government revenue will increase.
Costs and Benefits of Tariffs (cont.)
Costs and Benefits of Tariffs (cont.)
• For a “large” country that can affect foreign (world)
prices, the welfare effect of a tariff is ambiguous.
• The triangles b and d represent the efficiency loss.

The tariff distorts production and consumption decisions:
producers produce too much and consumers consume too
little compared to the market outcome.
• The rectangle e represents the terms of trade gain.

The terms of trade increases because the tariff lowers foreign
export (domestic import) prices.
Costs and Benefits of Tariffs (cont.)
• Government revenue from the tariff equals the
tariff rate times the quantity of imports.
t = PT – P*T
 QT = D2 – S2
 Government revenue = t x QT = c + e

• Part of government revenue (rectangle e)
represents the terms of trade gain, and part
(rectangle c) represents part of the value of
lost consumer surplus.

The government gains at the expense of
consumers and foreigners.
Costs and Benefits of Tariffs (cont.)
• If the terms of trade gain exceeds the
efficiency loss, then national welfare will
increase under a tariff, at the expense of
foreign countries.

However, this analysis assumes that the terms of
trade does not change due to tariff changes by
foreign countries (i.e., due to retaliation).
Costs and Benefits of Tariffs (cont.)
Figure 10.4 The Effect of a Tariff on
Imports
• A tariff raises the domestic relative price of food
(shown by lines 2 and 3) above the fixed world price
(shown by lines 1 and 4).
• Domestic production of food rises from A to B.
• Domestic consumption of food falls from G to J.
• The trade triangle shrinks form GKA to JLB.
Optimal Tariffs
Optimal Tariffs
Optimal Tariffs
• Then, we have:
e
(b  d )



M
dP *
dM 1 dP dM
 P *

d
d 2 d d
M

dP *
dM
 P *
d
d
M dP * d
M dP *

 1/  X
P * dM / d P * dM
Import Tariffs and Export Subsidies (cont.)
• Import tariffs and export subsidies drive a
wedge between prices in world markets (or
external prices) and prices in domestic
markets (or internal prices).
• The terms of trade refers to the relative value
of a country’s exports and a country’s imports.

Since exports and imports are traded in world
markets, the terms of trade measures external
prices.
Meltzer Paradox
•
World price
(Pc/pf)w=3/5
(Pc/pf)w=3.1/5
• Internal price decreases
Internal price
(Pc/Pf)=3/5(1.2)=3/6
(Pc/Pf)=3.1/5(1.2)=3.1/6
Meltzer Paradox: Another Example
•
World price
Internal price
(Pc/pf)w=3/5
(Pc/Pf)=3/5(1.2)=3/6
(Pc/pf)w=4/5
(Pc/Pf)=4/5(1.2)=4/6
• Internal price increases
Metzler Paradox
• An import tariff has the direct effect of raising the
internal relative import price.
• However, an import tariff might improve a country’s
TOT so much—that is, raise the relative price of
export good so much on the world markets.
• As a result, the internal relative price of the import
good fall, or say, internal relative price of the export
good increase.
Export Subsidy
• An export subsidy can also be specific or ad valorem

A specific subsidy is a payment per unit exported (Korean,
1960s).

An ad valorem subsidy is a payment as a proportion of the
value exported.
• An export subsidy raises the price of a good in the
exporting country, making its consumer surplus
decrease (making its consumers worse off) and
making its producer surplus increase (making its
producers better off).
• Also, government revenue will decrease.
Export Subsidy (cont.)
• An export subsidy raises the price of a good in the
exporting country, while lowering it in foreign
countries.
• Suppose A and B produce same products, if A
exports to get higher price, and if domestic price
doesn’t change, B will envy and export too
• At a result, no firm will supply the domestic market.
• Consumers have to pay Pw+s to get the exportable.
• In contrast to a tariff, an export subsidy worsens the
terms of trade by lowering the price of domestic
products in world markets.
Export Subsidies and Distribution of
Income Across Countries (cont.)
Export Subsidy for Small Country
• Consumption loss=a+b
• Production gain=a+b+c
• Government cost=b+c+d
• Deadweight Loss=b+d
Export Subsidy in Small & Large Country
• For small country, an export subsidy raises the price
of a good in the exporting country.
• For large country, an export subsidy raises the price
of a good in the exporting country, while lowering it in
foreign countries.
• This is because the export subsidy makes domestic
firm supply more to the foreign country.
• In contrast to a tariff, an export subsidy worsens the
terms of trade by lowering the price of domestic
products in world markets.
Export Subsidies and Distribution of
Income Across Countries (cont.)
Export
Subsidy
(cont.)
Export Subsidy (cont.)
• An export subsidy unambiguously produces a
negative effect on national welfare.
• The triangles b and d represent the efficiency loss.

The tariff distorts production and consumption decisions:
producers produce too much and consumers consume too
little compared to the market outcome.
• The area b + c + d + f + g represents the cost of
government subsidy.

In addition, the terms of trade decreases, because the price
of exports falls in foreign markets to P*s.
Welfare Loss: Large vs. Small
country
• For large country, its welfare loss is much larger than
its counterpart for a small country.
• Deadweight loss in Large= (b+e)+(d+g)+f
• B+e in large=B in small: consumption distortion
• D+g in large=D in small: production distortion
• F is the extra loss in large country when compared to
small country.
• Implication: for a large economy, it is unwise to use
the export subsidy policy.
Export Subsidy in Europe
• The European Union’s Common Agricultural Policy
sets high prices for agricultural products and
subsidizes exports to dispose of excess production.

The subsidized exports reduce world prices of agricultural
products.

Consider the determination of TOT
• The direct cost of this policy for European taxpayers
is almost $50 billion.

But the EU has proposed that farmers receive direct
payments independent of the amount of production to help
lower EU prices and reduce production.
Agricultural Export Subsidy
• The top four regimes:
• (1) EU, account for 90% in the world.
• (2) Switzerland, 5%
• (3) U.S. :2%
• (4) Norway 1%
• The agricultural export subsidy is scheduled to be
terminated in 2013.
Export Subsidy in Europe (cont.)
Import Quota
• An import quota is a restriction on the quantity
of a good that may be imported.
• This restriction is usually enforced by issuing
licenses to domestic firms that import, or in
some cases to foreign governments of
exporting countries.
• A binding import quota will push up the price
of the import because the quantity demanded
will exceed the quantity supplied by domestic
producers and from imports.
Import Quota (cont.)
• When a quota instead of a tariff is used to
restrict imports, the government receives no
revenue.

Instead, the revenue from selling imports at high
prices goes to quota license holders: either
domestic firms or foreign governments.

These extra revenues are called quota rents.
Quota under perfect competition
US Import
Quota
on Sugar
Quota Rent Allocations
• Direct offer to the importing firms: firms get benefit C.
• Indirect offer to the importing firms according to
applications: firms get less benefit C.
• Public Auction: benefit=C.
• Grant to the exporting country
Why Quota but not tariffs?
• It is more direct . Under tariffs, maybe foreign
exporters can lower their price to attract home to
import more.
• WTO pressure. Tariffs vs NTBs
• Rich countries’ tariff is reduced from 40% to 3%.
• Pool countries’ tariff is reduced to 10%.
• Only some restrictions on the Tokyo round in 1979.
Two different effects of Import Quotas
• Equivalence of import tariff and import
quota under perfect competition
• Non-equivalence of import tariff and
import quota under imperfect
competition
• Monopoly
Quota under perfect competition
Non-equivalence of tariff and quota
Monopolist under free trade
• Without trade, the monopolist set price
at Pm and produce Qm to earn the extra
profit according to MR=MC
• In the presence of free trade, price
equals world price, and then it produces
Qf, which is lower than Qm.
Monopoly with tariffs & Quotas
Monopoly with tariffs
• With tariff, the domestic price now is pw+t, which is
still lower than the monopoly price.
• The domestic monopolist still cannot get the
monopoly power.
• Consumers consume C2 and the firm produces Qt.
• Import M2.
• The deadweight loss is b+d
Monopoly with Quotas
• With quota Q=M2, home’s total demand minus the
quota is the domestic residual demand.
• Such demand is supplied by the monopolist.
• Therefore, the monopolist can set a monopoly price at
Pq, which is higher than the market price with tariff,
Pw+t.
• Consumption is C3 and production is Qq.
Effect of change of domestic demand
Effect of change of domestic demand
• Before change, effect of quota equals that of tariff:
Q=40, t=0.5
• Now if domestic demand increases, for this small
country, foreign demand shifts to the right also.
• For tariff: import more, increase from 40 to 60,
deadweight loss is k.
• But, suppose import quota keeps fixed at 40, then the
excess demand will push up the domestic price to 2.
• However, this causes more deadweight loss, now is
h+i+j+k, though the quota rent also increases.
Effect of change of world supply
Effect of change from world supply
• Small home country
• World price is 1, impose tariff t=0.5, it is the same as
to impose quota 40.
• However, when foreign export supply increases, the
foreign supply curve shifts right.
• The new world price is 0.5, domestic price is 1 given
tariff is 0.5, then the deadweight loss is k.
• However, if quota is still fixed at 40, then the
deadweight loss is i+j+k.
• Quota rent increases from (1.5-1)*40 to (1.5-0.5)*40.
Voluntary Export Restraint
• A voluntary export restraint works like an
import quota, except that the quota is imposed
by the exporting country rather than the
importing country.
• However, these restraints are usually
requested by the importing country.
• The profits or rents from this policy are earned
by foreign governments or foreign producers.

Foreigners sell a restricted quantity at an
increased price.
Feenstra’s Research on VER
• Section 201: Domestic Tariffs are allowed if there is
substantial injury by foreign’s tariffs.
• Substantial Cause: Tariffs are most important cause
of injury to the domestic industry.
• In the early 1980, Paul Volcker uses tight monetary
policy to contract the economy, interest rate increases,
a strong dollar, and a deep recession beginning in
January 1980.
• In June, 1980, the United Automobile Workers applied
to the ITC for protection under section 201 U.S. trade
laws.
Feenstra’s Research on VER
• However, U.S. ITC deny their application to confirm
that the U.S. recession was a more important cause
of injury in autos than were increased imports.
• Then, several senates in the Midwestern states
pursued import limits by other means.
• CARs—VER
• Trucks—Complete tariffs, chicken war with Germany
• Heavyweight Motorcycle—tariffs
• Japan agrees to voluntary restraint their export to the
U.S.A
Feenstra’s Research on VER
• On May 1,1981, 2 weeks before the hearing, Japan
agree to restrict their export.
• 1981: 1.83 million
• 1984: 2.02 million
• 1992: 2.51 million
• The VER was nearly exactly satisfied in early years,
and remain binding until 1987.
• After that, however, actual imports were below the
VER, so is stopped in 1994.
• Why? –Japan began assembling cars in the U.S.
• Social Welfare Cost: $1034 per import car.
Local Content Requirement
• A local content requirement is a regulation
that requires a specified fraction of a final
good to be produced domestically.
• It may be specified in value terms, by
requiring that some minimum share of the
value of a good represent domestic valued
added, or in physical units.
Local Content Requirement (cont.)
• From the viewpoint of domestic producers of
inputs, a local content requirement provides
protection in the same way that an import
quota would.
• From the viewpoint of firms that must buy
domestic inputs, however, the requirement
does not place a strict limit on imports, but
allows firms to import more if they also use
more domestic parts.
Local Content Requirement (cont.)
• Local content requirement provides neither
government revenue (as a tariff would) nor
quota rents.
• Instead the difference between the prices of
domestic goods and imports is averaged into
the price of the final good and is passed on to
consumers.
Other Trade Policies
• Export credit subsidies

A subsidized loan to exporters

US Export-Import Bank subsidizes loans to US exporters.
• Government procurement

Government agencies are obligated to purchase from
domestic suppliers, even when they charge higher prices
(or have inferior quality) compared to foreign suppliers.
• Bureaucratic regulations

Safety, health, quality or customs regulations can act as
a form of protection and trade restriction.
Government procurement
• If quantity of government procurement is less than the
quantities produced by domestic firms in free trade,
then there is no distortion on production and import
• However, when it is higher than domestic original
production, this will raise domestic price.
• As a result, producer surplus increases
• But Government has to pay more.
• It has deadweight loss
• Import also decreases.
Government procurement
Government procurement
• In the absence of government procurement
requirement, government buys S1, and import G-S1.
• In the presence of government procurement
requirement, government buy G but pays Pd. Total
cost=a+b.
• Producers gain=a
• Deadweight loss=b.
• Import decreases from M1 to M2 accordingly.
Summary
Tariff
Producer
surplus
Consumer
surplus
Government
net revenue
National
welfare
Export
subsidy
Import quota
Voluntary
export
restraint
Summary
Tariff
Export
subsidy
Import quota
Voluntary
export
restraint
Producer
surplus
Increases
Increases
Increases
Increases
Consumer
surplus
Decreases
Decreases
Decreases
Decreases
Government
net revenue
National
welfare
Increases
Decreases
Ambiguous,
falls for small
country
Decreases
No change:
No change:
rents to
rents to
license holders foreigners
Ambiguous,
Decreases
falls for small
country
Summary (cont.)
1. A tariff decreases the world price of the
imported good when a country is “large”,
increases the domestic price of the imported
good and reduces the quantity traded.
2. A quota does the same.
3. An export subsidy decreases the world
price of the exported good when a country
is “large”, increases the domestic price of
the exported good and increases the
quantity produced.
Summary (cont.)
4. The welfare effect of a tariff, quota and export
subsidy can be measured by:

Efficiency loss from consumers and producers

Terms of trade gain or loss
5. With import quotas, voluntary export restraints and
local content requirements, the government of the
importing country receives no revenue.
6. With voluntary export restraints and occasionally
import quotas, quota rents go to foreigners.
Figure 10.1
Effects on
Welfare and
Government
Revenue of
Tariff on
Individual
Product
Figure 10.5 A Tariff Improves the
Terms of Trade
Figure 10.6 Domestic Welfare
Depends on the Tariff Rate
Figure 10.7 A Tariff and World
Production
Figure 10.A.1 The Optimal Tariff
Figure 10.A.2 The Tariff May Not
Protect
Figure 10.A.3 The Tariff Pulls
Consumption Off the Contract Curve