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Chapter 8 The Instruments of Trade Policy Amended slides originally prepared by Thomas Bishop, Pearson-Addison-Wesley.

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Presentation on theme: "Chapter 8 The Instruments of Trade Policy Amended slides originally prepared by Thomas Bishop, Pearson-Addison-Wesley."— Presentation transcript:

1 Chapter 8 The Instruments of Trade Policy Amended slides originally prepared by Thomas Bishop, Pearson-Addison-Wesley

2 2 Preview Partial equilibrium analysis of tariffs: supply, demand, and trade in a single industry Partial equilibrium analysis of tariffs: supply, demand, and trade in a single industry Costs and benefits of tariffs Costs and benefits of tariffs Export subsidies Export subsidies Import quotas Import quotas Voluntary export restraints Voluntary export restraints Local content requirements Local content requirements

3 3 Types of Tariffs A specific tariff is levied as a fixed charge for each unit of imported goods. 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. 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 analyze how tariffs affect the economy. Lets analyze how tariffs affect the economy.

4 4 Supply, Demand, and Trade in a Single Industry Lets construct a model measuring how a tariff affects a single (competitive) market, say that of wheat. Lets construct a model measuring how a tariff affects a single (competitive) 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. 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 –and the domestic country will import

5 5 Supply, Demand, and Trade in a Single Industry (cont.) How would you construct an export supply (XS) curve and an import demand (MD) curve? How would you construct an export supply (XS) curve and an import demand (MD) curve?

6 6 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 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. An import demand curve is the difference between the quantity that domestic consumers demand minus the quantity that domestic producers supply, at each price.

7 7

8 8 Fig. 8-1: Deriving Homes Import Demand Curve

9 9

10 10 Fig. 8-2: Deriving Foreigns Export Supply Curve

11 11 Supply, Demand, and Trade in a Single Industry (cont.) In equilibrium, the quantities of In equilibrium, the quantities of import demand = export supply domestic demand – domestic supply = foreign supply – foreign demand In equilibrium, the quantities of In equilibrium, the quantities of world demand = world supply

12 12 Fig. 8-3: World Equilibrium

13 13 Activity 1 D = 200 – 40P, and S = P D = 200 – 40P, and S = P D* = 160 – 40P, and S* = P D* = 160 – 40P, and S* = P Draw Homes Demand and Supply curve Draw Homes Demand and Supply curve Find the MD and XS curve Find the MD and XS curve What are the price and output with no trade, and in case there is trade between the two countries? What are the price and output with no trade, and in case there is trade between the two countries?

14 14 Answers Activity 1 MD = 160 – 80P MD = 160 – 80P XS = P XS = P No trade P = 2, Q = 120 No trade P = 2, Q = 120 No trade P* = 1, Q* = 120 No trade P* = 1, Q* = 120 With trade MD = XS With trade MD = XS 160 – 80P = P 240 = 160P 160 – 80P = P 240 = 160P P = 240/160 P w = 1.50 P = 240/160 P w = 1.50 Q w = (80 x 1.50) = 40 Q w = (80 x 1.50) = 40

15 15 The Effects of a Tariff What impact does an Import Tariff have on a large or small economy? What impact does an Import Tariff have on a large or small economy?

16 16 The Effects of a Tariff A tariff can be viewed as an added cost of transportation, making sellers unwilling to ship goods unless the price difference between the domestic and foreign markets exceeds the tariff. A tariff can be viewed as an added cost of transportation, making sellers unwilling to ship goods unless the price difference between the domestic and foreign markets exceeds the tariff. If sellers are unwilling to ship wheat, there is excess demand for wheat in the domestic market and excess supply in the foreign market. If sellers 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.

17 17 The Effects of a Tariff (cont.) Thus, a tariff will make the price of a good rise in the domestic market and will make it fall in the foreign market, until the price difference equals the tariff. Thus, a tariff will make the price of a good rise in the domestic market and will make it fall in the foreign market, until the price difference equals the tariff. P T – P * T = t P T – P * T = t 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 ( large country ). 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 ( large country ).

18 18 Fig. 8-4: Effects of a Tariff (Large)

19 19 The Effects of a Tariff (cont.) Because the price in domestic markets rises (P W to P T ), domestic producers should supply more and domestic consumers should demand less. Because the price in domestic markets rises (P W 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 (1 2) Because the price in foreign markets falls (P W to P * T ), foreign producers should supply less and foreign consumers should demand more. Because the price in foreign markets falls (P W 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 (1 3)

20 20 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 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. 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 effect of the tariff causes the foreign countrys export price to decline, and thus is not passed on to domestic consumers. –But this effect is sometimes not very significant:

21 21 The Effects of a Tariff in Small Country A small country has NO effect on the foreign (world) price of a good, because its demand of the good is an insignificant part of world demand. A small country has NO effect on the foreign (world) price of a good, because its demand of 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

22 22

23 23 Fig. 8-5: A Tariff in a Small Country

24 24 Activity 2 Determine the effects of a specific tariff of 0.50 on imports, i.e. Determine the effects of a specific tariff of 0.50 on imports, i.e. –what is the new world price, –the price at home including the tariff, –and the new import demand? Use MD old = 160 – 80P Use MD old = 160 – 80P XS = P XS = P

25 25 Answers Activity 2 MD old = 160 – 80P and XS = P MD old = 160 – 80P and XS = P MD st = 160 – 80(P + t) [ not MD avt = 160 – 80 (1 + t)P ] MD st = 160 – 80(P + t) [ not MD avt = 160 – 80 (1 + t)P ] MD st = 160 – 80(P ) = 120 – 80P MD st = 160 – 80(P ) = 120 – 80P MD st = XS 120 – 80P = P MD st = XS 120 – 80P = P 200 = 160P P = 200/160 P T* = = 160P P = 200/160 P T* = 1.25 P T = 1.75 [ as P T – P T* = 0.50 ] P T = 1.75 [ as P T – P T* = 0.50 ] [ P w prior to the tariff was 1.50, while Q w was 40 ] [ P w prior to the tariff was 1.50, while Q w was 40 ] Q T (MD st )=160 – 80(1.75) or (XS)=120 – 80(1.25) = 20 Q T (MD st )=160 – 80(1.75) or (XS)=120 – 80(1.25) = 20

26 26 Effective Rate of Protection The effective rate of protection (ERP) measures how much protection a tariff or other trade policy provides domestic producers. The effective rate of protection (ERP) measures how much protection a tariff or other trade policy provides domestic producers. –It represents the change in value that firms in an industry add to the production process when trade policy changes, –which depends on the change in prices when trade policies change. –ERPs often differ from tariff rates because tariffs affect sectors other than the protected sector, causing indirect effects on the prices and value added for the protected sector.

27 27 Effective Rate of Protection (cont.) For example, suppose that automobiles sell in world markets for $8,000, and they are made from factors of production worth $6,000. For example, suppose that automobiles sell in world markets for $8,000, and they are made from factors of production worth $6,000. –The value added of the production process is $8,000-$6,000 = $2,000 Suppose that a country puts a 25% tariff on imported autos so that domestic auto assembly firms can now charge up to $10,000 instead of $8,000. Suppose that a country puts a 25% tariff on imported autos so that domestic auto assembly firms can now charge up to $10,000 instead of $8,000. –Auto assembly will occur in the domestic country if the value added is up to $10,000-$6,000 = $4,000.

28 28 Effective Rate of Protection (cont.) The effective rate of protection (ERP) for domestic auto assembly firms is the change in value added: V T – V w / V w The effective rate of protection (ERP) for domestic auto assembly firms is the change in value added: V T – V w / V w ($4,000 - $2,000)/$2,000 = 100% In this case, the effective rate of protection is greater than the tariff rate. In this case, the effective rate of protection is greater than the tariff rate.

29 29 ERP Problem World price of cowbells is $230 and that of components is $120 World price of cowbells is $230 and that of components is $120 Vanuatu (island near Australia) Government imposes a 25% tariff on cowbells Vanuatu (island near Australia) Government imposes a 25% tariff on cowbells What is the ERP? What is the ERP?

30 30 Answer ERP Problem ERP: V T – V w / V w ERP: V T – V w / V w V w = 230 – 120 = 110 V w = 230 – 120 = 110 P w was 230 P T went up to P w was 230 P T went up to V T = – 120 = V T = – 120 = ERP = – 110 / 110 = 52.3% ERP = – 110 / 110 = 52.3%

31 31 Cost-Benefit Analysis Who is affected when an import tariff is introduced? Who is affected when an import tariff is introduced?

32 32 Cost-Benefit Analysis Price of the imported good increases affecting consumers; Price of the imported good increases affecting consumers; The tariff benefits domestic producers The tariff benefits domestic producers Government generates tariff revenue. Government generates tariff revenue. To measure these costs and benefits, we use consumer surplus and producer surplus. To measure these costs and benefits, we use consumer surplus and producer surplus.

33 33 Consumer Surplus Consumer surplus measures the amount that consumers gain from purchases by the difference in the price that each pays from the maximum price each would be willing to pay. Consumer surplus measures the amount that consumers gain from purchases by the difference in the price that each pays from the maximum price each would be willing to pay. –The maximum price each would be willing to pay is determined by a demand (willingness to buy) function. –When the price increases, the quantity demanded decreases as well as the consumer surplus.

34 34 Fig. 8-7: Geometry Consumer Surplus

35 35 Producer Surplus Producer surplus measures the amount that producers gain from a sale by the difference in the price each receives from the minimum price each would be willing to sell at. Producer surplus measures the amount that producers gain from a sale by the difference in the price each receives from the minimum price each would be willing to sell at. –The minimum price each would be willing to sell at is determined by a supply (willingness to sell) function. –When price increases, the quantity supplied increases as well as the producer surplus.

36 36 Fig. 8-8: Geometry of Producer Surplus

37 37 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) 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). and making its producer surplus increase (making its producers better off). Also, government revenue will increase. Also, government revenue will increase.

38 38

39 39 Fig. 8-9: Costs and Benefits of a Tariff for a Large Importing Country

40 40 Costs and Benefits of Tariffs (cont.) For a large country, whose imports and exports can affect foreign (world) prices, the net welfare effect of a tariff is ambiguous. For a large country, whose imports and exports can affect foreign (world) prices, the net welfare effect of a tariff is ambiguous. The triangles b and d represent the efficiency loss. The triangles b and d represent the efficiency loss. –The tariff distorts production (b) and consumption (d) 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 rectangle e represents the terms of trade gain. –The terms of trade increases because the tariff lowers foreign export (domestic import) prices.

41 41 Costs and Benefits of Tariffs (cont.) Government revenue from the tariff equals the tariff rate times the quantity of imports. 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. 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.

42 42 Costs and Benefits of Tariffs (cont.) If the terms of trade (P E /P M ) gain exceeds the efficiency loss, then national welfare will increase (recall Chapter 5) under a tariff, at the expense of foreign countries. If the terms of trade (P E /P M ) gain exceeds the efficiency loss, then national welfare will increase (recall Chapter 5) 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 (that is, due to retaliation).

43 43 Costs and Benefits of Tariffs (cont.) What is the Net Welfare Loss of an Import Tariff? Give all details. What is the Net Welfare Loss of an Import Tariff? Give all details.

44 44 Costs and Benefits of Tariffs (cont.) +a +c +e +a +c +e -a –b –c –d -a –b –c –d Net: +E versus -b -d Net: +E versus -b -d Large country +E larger than -b -d Large country +E larger than -b -d Small country no e, only -b -d Small country no e, only -b -d

45 45 Fig. 8-10: Net Welfare Effects of Tariff

46 46 The Effects of a Tariff in Small Country A small country has NO effect on the foreign (world) price of a good. A small country has NO effect on the foreign (world) price of a good. Costs of a tariff will exceed the benefits (only distortions b and d exist, no e) Costs of a tariff will exceed the benefits (only distortions b and d exist, no e) –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

47 47 Fig. 8-5: A Tariff in a Small Country

48 48 Export Subsidy An export subsidy can also be specific or ad valorem An export subsidy can also be specific or ad valorem –A specific subsidy is a payment per unit exported. –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, decreasing its consumer surplus (making its consumers worse off) and increasing its producer surplus (making its producers better off). An export subsidy raises the price of a good in the exporting country, decreasing its consumer surplus (making its consumers worse off) and increasing its producer surplus (making its producers better off). Also, government revenue will decrease. Also, government revenue will decrease.

49 49 Export Subsidy (cont.) An export subsidy raises the price of a good in the exporting country, while lowering it in foreign countries. An export subsidy raises the price of a good in the exporting country, while lowering it in foreign countries. An export subsidy worsens the terms of trade by lowering the price of domestic products in world markets (i.e. P E decreases). An export subsidy worsens the terms of trade by lowering the price of domestic products in world markets (i.e. P E decreases).

50 50 Fig. 8-11: Effects of an Export Subsidy

51 51 Export Subsidy (cont.) An export subsidy unambiguously produces a negative effect on national welfare. An export subsidy unambiguously produces a negative effect on national welfare. The triangles b and d represent the efficiency loss. The triangles b and d represent the efficiency loss. –The subsidy distorts production and consumption decisions: producers produce too much and consumers consume too little compared to the market outcome. The area b + c + d + e + f + g represents the cost of government subsidy. The area b + c + d + e + 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.

52 52 Export Subsidy (cont.) What is the Net Welfare Loss of an Export Subsidy? Give all details. What is the Net Welfare Loss of an Export Subsidy? Give all details.

53 53 Export Subsidy (cont.) +a +b +c +a +b +c -a –b -a –b -b –c –d –e –f -g -b –c –d –e –f -g Net: -b -d -e -f –g Net: -b -d -e -f –g

54 54 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 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. (Who are also affected?) The direct cost of this policy for European taxpayers is almost $50 billion. 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.

55 55 Fig. 8-12: Europes Common Agricultural Program

56 56 Import Quota An import quota is a restriction on the quantity of a good that may be imported. 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. 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. 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.

57 57 Import Quota (cont.) When a quota instead of a tariff is used to restrict imports, the government receives no revenue. 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.

58 58 Import Quota (cont.) What is the Net Welfare Loss of an Import Quota? Give all details. What is the Net Welfare Loss of an Import Quota? Give all details.

59 59 Import Quota (cont.) +a +a –a –b –c –d –a –b –c –d -c -c Net: -b –C -d Net: -b –C -d

60 60 Fig. 8-13: Effects of the U.S. Import Quota on Sugar

61 61 Voluntary Export Restraint A Voluntary Export Restraint (VER) works like an import quota, except that the quota is imposed by the exporting country rather than the importing country. A Voluntary Export Restraint (VER) 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. 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. The profits or rents from this policy are earned by foreign governments or foreign producers. –Foreigners sell a restricted quantity at an increased price.

62 62 Local Content Requirement A local content requirement is a regulation that requires a specified fraction of a final good to be produced domestically. 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. 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.

63 63 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 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. 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.

64 64 Local Content Requirement (cont.) Local content requirement provides neither government revenue (as a tariff would) nor quota rents. 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. 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.

65 65 Other Trade Policies Export credit subsidies Export credit subsidies –A subsidized loan to exporters –U.S. Export-Import Bank subsidizes loans to U.S. exporters. Government procurement 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 Bureaucratic regulations –Safety, health, quality, or customs regulations can act as a form of protection and trade restriction.

66 66 Summary Tariff Export subsidy Import quota Voluntary 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

67 67 Summary (cont.) 1. A tariff decreases the world price of the imported good, increases the domestic price of the imported good and reduces the quantity traded when a country is large. 2. A quota does the same. 3. An export subsidy decreases the world price of the exported good increases the domestic price of the exported good and increases the quantity produced when a country is large.

68 68 Summary (cont.) 4. The welfare effect of a tariff, quota and export subsidy can be measured by: –Efficiency loss from consumption and production –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.

69 69 Fig. 8A1-1: Free Trade Equilibrium for a Small Country

70 70 Fig. 8A1-2: A Tariff in a Small Country

71 71 Fig. 8A1-3: Effect of a Tariff on the Terms of Trade

72 72 Fig. 8A2-1: A Monopolist Under Free Trade

73 73 Fig. 8A2-2: A Monopolist Protected by a Tariff

74 74 Fig. 8A2-3: A Monopolist Protected by an Import Quota

75 75 Fig. 8A2-4: Comparing a Tariff and a Quota


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