Instruments of Trade Policy

The Instruments of Trade Policy

Introduction

• This chapter examines government policies toward international trade, including taxes, subsidies, and legal limits.
• Brexit negotiations highlight the importance of trade policies, as tariffs and non-tariff barriers can significantly impact export costs.
• Outside the EU customs union, Britain could face increased export costs ranging from 2 to 15 percent, depending on the product.

Learning Goals

• Evaluate the costs and benefits of tariffs and their effects on welfare, identifying winners and losers.
• Discuss export and agricultural subsidies and their impact on trade, particularly in the U.S. and the EU.
• Recognize the effects of voluntary export restraints (VERs) on importing and exporting countries, and compare their welfare effects with tariffs and quotas.

Basic Tariff Analysis

• A tariff is a tax levied on imported goods.
• Specific tariffs are fixed charges per unit (e.g., $3 per barrel of oil).
• Ad valorem tariffs are a percentage of the value of imported goods (e.g., 25% U.S. tariff on imported trucks).
• Tariffs increase the cost of shipping goods to a country.

Historical Use of Tariffs

• Tariffs were historically used as a source of government income.
• They serve to generate revenue and protect domestic sectors.
• The UK used Corn Laws in the 19th century to protect agriculture.
• Europe saw tariffs as having a positive impact on growth, especially for infant industries. Sweden, Italy, and France had severe agricultural protection policies.
• Germany adopted protectionist policies in both agriculture and manufacturing, leading to strong growth in its infant industries.
• Countries like Canada, Australia, and the U.S. protected manufacturing and infant industries from European competition.

Modern Trade Policy

• The importance of tariffs has declined due to the rise of nontariff barriers such as import quotas and export restraints.
• Understanding tariffs is crucial for understanding other trade policies.

Partial Equilibrium Framework

• Trade policies can often be analyzed in a partial equilibrium framework, focusing on one sector without detailing repercussions on the entire economy.
• General equilibrium analysis is used when economy-wide effects are crucial.

Supply, Demand, and Trade in a Single Industry

• Consider two countries, Home and Foreign, both consuming and producing wheat with costless transportation between them.
• Wheat is a competitive industry where supply and demand curves depend on market price.
• Assume the exchange rate is unaffected by trade policies in this market, and prices are quoted in Home currency.
• Trade occurs if prices differ in the absence of trade.
• If the price of wheat is higher in Home than in Foreign, shippers move wheat from Foreign to Home until the price difference is eliminated.

Home Import Demand and Foreign Export Supply

• Home import demand is the excess of Home consumers' demand over Home producers' supply.
• Foreign export supply is the excess of Foreign producers' supply over Foreign consumers' demand.
• The Home import demand curve is downward sloping; as price increases, import demand declines.
• At price PA, Home supply and demand are equal, so the Home import demand curve intercepts the price axis at PA.
• The Foreign export supply curve is upward sloping; as price rises, the supply available for export rises.
• At price PA^, Foreign supply and demand are equal, so the Foreign export supply curve intersects the price axis at PA^.

World Equilibrium

• World equilibrium occurs when Home import demand equals Foreign export supply.
• At the equilibrium price P_W, world supply equals world demand.
• Home demand + Foreign demand = Home supply + Foreign supply, or World demand = World supply.

Effects of a Tariff

• A tariff acts like a transportation cost.
• If Home imposes a tariff of t per unit of wheat, shippers move wheat only if the price difference is at least t.
• The tariff drives a wedge between prices in the two markets, raising the price in Home to PT and lowering the price in Foreign to PT^* = P_T - t.
• In Home, producers supply more, and consumers demand less, reducing import demand.
• In Foreign, the lower price reduces supply and increases demand, decreasing export supply.
• The volume of wheat traded declines from QW (free trade) to QT (with tariff).
• The increase in price in Home is less than the tariff because the foreign export price declines.

Small Country Case

• When a small country imposes a tariff, it cannot affect foreign export prices.
• The tariff raises the price of the imported good in the country by the full amount of the tariff, from PW to PW + t.
• Production rises from S1 to S2, consumption falls from D1 to D2, and imports fall.

Measuring the Amount of Protection

• A tariff aims to protect domestic producers from low import prices by raising the price they receive.
• Protection is expressed as a percentage of the free trade price.
• Measuring protection using the tariff rate can be problematic.
• If the small-country assumption does not hold, part of the tariff lowers foreign export prices.
• Tariffs can have different effects on different stages of production.

Effective Rate of Protection

• Consider an automobile that sells for $8,000 with parts costing $6,000.
• A 25% tariff on imported autos allows domestic assemblers to charge $10,000 instead of $8,000.
• The assemblers' effective rate of protection is 100% because assembly can now cost up to $4,000 instead of $2,000.
• If a 10% tariff is imposed on imported parts, the cost of parts for domestic assemblers rises from $6,000 to $6,600.
• Local assembly is worthwhile only if it can be done for $1,400 ($8,000 - $6,600), resulting in a negative effective protection of -30% for assembly.

Trade Policies and Economic Development

• Trade policies aimed at promoting economic development often lead to effective protection rates much higher than tariff rates.

Costs and Benefits of a Tariff

• A tariff raises the price of a good in the importing country and lowers it in the exporting country.
• Consumers lose in the importing country and gain in the exporting country; producers gain in the importing country and lose in the exporting country.
• The government imposing the tariff gains revenue.

Consumer and Producer Surplus

• Consumer surplus measures the gain from a purchase by computing the difference between the price paid and the willingness to pay.
• Producer surplus measures the gain to producers from selling at a higher price than they would have been willing to accept.
• Consumer surplus is calculated by subtracting P * Q from the area under the demand curve up to Q.
• Producer surplus is calculated as P * Q minus the area under the supply curve up to Q.

Measuring Costs and Benefits

• The tariff raises the domestic price from PW to PT and lowers the foreign export price from PW to PT^*.
• Domestic production rises from S1 to S2, and domestic consumption falls from D1 to D2.
• Producer surplus increases by area a, consumer surplus decreases by area (a + b + c + d), and government revenue increases by area (c + e).

Net Welfare Effect

• The net cost of a tariff is Consumer loss - producer gain - government revenue: (a + b + c + d) - a - (c + e) = b + d - e.
• Triangles b and d represent efficiency losses due to distorted consumption and production incentives, while rectangle e represents the terms of trade gain.
• If the country is small and cannot affect world prices, region e disappears, and the tariff reduces welfare.

Distortions and Incentives

• A tariff distorts the incentives of producers and consumers by making imports seem more expensive than they are.
• Consumers reduce consumption, and domestic producers expand production inefficiently.

Tariffs and Retaliation

• Tariffs imposed by one country can lead to retaliation from others, resulting in tariff wars and reduced trade volume.
• An example is the "solar dispute" between the EU and China, where provisional tariffs were imposed on Chinese solar panels, leading to countermeasures from China.
• The EU imposed an 11.8 percent tariff on Chinese solar imports, set to rise to 47.6 percent within two months, affecting €21 billion worth of imports.
• China responded by launching anti-dumping and anti-subsidy probes into imports of European wine and threatened the EU luxury car industry.
• Eventually, both parties reached an agreement with a minimum price of €0.56 per watt peak for solar panels and a limitation on export volume.

Conclusion

• The negative effects of a tariff consist of production and consumption distortion losses (triangles b and d).
• The terms of trade gain (rectangle e) offsets some of these losses.
• In small countries, the costs of a tariff unambiguously exceed the benefits due to the vanishing terms of trade gain.