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© 2007 Pearson Addison-Wesley. All rights reserved Chapter 10 Protection and the National Welfare.

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1 © 2007 Pearson Addison-Wesley. All rights reserved Chapter 10 Protection and the National Welfare

2 10-2 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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

3 10-3 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

4 10-4 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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 countrys exports and a countrys imports. –Since exports and imports are traded in world markets, the terms of trade measures external prices.

5 10-5 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

6 10-6 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Import Tariffs and Distribution of Income Across Countries (cont.)

7 10-7 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

8 10-8 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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 will pay a higher relative price of cloth, and therefore be more willing to switch to food consumption: the relative demand curve will shift.

9 10-9 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Export Subsidies and Distribution of Income Across Countries (cont.)

10 10-10 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

11 10-11 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

12 10-12 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

13 10-13 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

14 10-14 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

15 10-15 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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. Lets now analyze how tariffs affect the economy.

16 10-16 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Supply, Demand and Trade in a Single Industry Lets 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

17 10-17 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

18 10-18 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Supply, Demand and Trade in a Single Industry (cont.)

19 10-19 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Supply, Demand and Trade in a Single Industry (cont.)

20 10-20 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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

21 10-21 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Supply, Demand and Trade in a Single Industry (cont.)

22 10-22 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

23 10-23 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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. P T – P * T = t P T = 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.

24 10-24 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Effects of a Tariff (cont.)

25 10-25 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Effects of a Tariff (cont.) Because the price in domestic markets rises (to P T ), domestic producers should supply more and domestic consumers should demand less. –The quantity of imports falls from Q W to Q T 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 Q W to Q T

26 10-26 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Effects of a Tariff (cont.) The quantity of domestic import demand equals the quantity of foreign export supply when P T – 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 countrys export price, and thus is not passed on to domestic consumers. –Pass-through Tariff –But this effect is often not very significant.

27 10-27 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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 P w –The price in the domestic market, however, will rise to P T = P w + t

28 10-28 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The Effects of a Tariff in a Small Country (cont.)

29 10-29 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

30 10-30 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

31 10-31 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Effective Rate of Protection (cont.) The effective rate of protection for domestic auto assembly firms is the change in value added: ($ $2000)/$2000 = 100% In this case, the effective rate of protection is greater than the tariff rate.

32 10-32 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

33 10-33 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

34 10-34 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Consumer Surplus (cont.)

35 10-35 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

36 10-36 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Producer Surplus (cont.)

37 10-37 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

38 10-38 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Costs and Benefits of Tariffs (cont.)

39 10-39 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

40 10-40 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Costs and Benefits of Tariffs (cont.) Government revenue from the tariff equals the tariff rate times the quantity of imports. –t = P T – P * T –Q T = D 2 – S 2 –Government revenue = t x Q T = 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.

41 10-41 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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).

42 10-42 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Costs and Benefits of Tariffs (cont.)

43 10-43 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.2 The Effect of a Tariff on Production

44 10-44 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The initial free-trade prices are shown by line 1; production is at A National income, measured in units of food, is OF. A tariff on imports of food raises the domestic relative price of food, as is shown by line 2. Resources are shifted into food, production moves to point B. At world prices national income in food units has been reduced to OD Line 3 is parallel to line 1.

45 10-45 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.3 The Effect of a Tariff on Demand

46 10-46 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Production remains at A on the right-angled TAT transformation schedule. A tariff raises the relative domestic price of food to line 2 (parallel to line 3 and 4). Food consumption falls by the substitution effect (from G to H) plus an income effect (from H to J) Distance EC measures the tariff revenue in terms of food. The trade triangle shrinks from GKA to JLA

47 10-47 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.4 The Effect of a Tariff on Imports

48 10-48 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

49 10-49 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Optimal Tariffs

50 10-50 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Optimal Tariffs

51 10-51 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Optimal Tariffs Then, we have:

52 10-52 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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 countrys exports and a countrys imports. –Since exports and imports are traded in world markets, the terms of trade measures external prices.

53 10-53 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Meltzer Paradox World price Internal price Internal price decreases (Pc/pf)w=3/5 (Pc/pf)w=3.1/5 (Pc/Pf)=3/5(1.2)=3/6 (Pc/Pf)=3.1/5(1.2)=3.1/6

54 10-54 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Meltzer Paradox: Another Example World price Internal price Internal price increases (Pc/pf)w=3/5 (Pc/pf)w=4/5 (Pc/Pf)=3/5(1.2)=3/6 (Pc/Pf)=4/5(1.2)=4/6

55 10-55 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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. Then, a country is better off.

56 10-56 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

57 10-57 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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 doesnt 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.

58 10-58 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Export Subsidy for Small Country

59 10-59 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Consumption loss=a+b Production gain=a+b+c Government cost=b+c+d Deadweight Loss=b+d

60 10-60 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

61 10-61 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Export Subsidies and Distribution of Income Across Countries (cont.)

62 10-62 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Export Subsidy (cont.)

63 10-63 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

64 10-64 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

65 10-65 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Export Subsidy in Europe The European Unions 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.

66 10-66 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

67 10-67 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Export Subsidy in Europe (cont.)

68 10-68 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

69 10-69 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

70 10-70 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Quota under perfect competition

71 10-71 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. US Import Quota on Sugar

72 10-72 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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

73 10-73 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

74 10-74 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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

75 10-75 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Quota under perfect competition

76 10-76 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Non-equivalence of tariff and quota

77 10-77 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

78 10-78 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Monopoly with tariffs & Quotas

79 10-79 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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

80 10-80 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Monopoly with Quotas With quota Q=M2, homes 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.

81 10-81 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Effect of change of domestic demand

82 10-82 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

83 10-83 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Effect of change of world supply

84 10-84 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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 ( )*40.

85 10-85 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

86 10-86 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Feenstras 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 In June, 1980, the United Automobile Workers applied to the ITC for protection under section 201 U.S. trade laws.

87 10-87 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Feenstras 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

88 10-88 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Feenstras 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 After that, however, actual imports were below the VER, so is stopped in Why? – Japan began assembling cars in the U.S. Social Welfare Cost: $1034 per import car.

89 10-89 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

90 10-90 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

91 10-91 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

92 10-92 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

93 10-93 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

94 10-94 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Government procurement

95 10-95 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

96 10-96 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Summary TariffExport subsidy Import quotaVoluntary export restraint Producer surplus Consumer surplus Government net revenue National welfare

97 10-97 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Summary TariffExport subsidy Import quotaVoluntary export restraint Producer surplus Consumer surplus Government net revenue National welfare Increases No change: rents to license holders IncreasesDecreases No change: rents to foreigners Ambiguous, falls for small country Ambiguous, falls for small country Decreases

98 10-98 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

99 10-99 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 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.

100 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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109 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.1 Effects on Welfare and Government Revenue of Tariff on Individual Product

110 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.5 A Tariff Improves the Terms of Trade

111 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.6 Domestic Welfare Depends on the Tariff Rate

112 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.7 A Tariff and World Production

113 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.A.1 The Optimal Tariff

114 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.A.2 The Tariff May Not Protect

115 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.A.3 The Tariff Pulls Consumption Off the Contract Curve


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