1. ECO 6705 Protectionism: Analyzing the Effects of Trade Restrictions Dr. Jeff Steagall September 22, 2003

2. Associated Reading  Van den Berg, chapter 6  Friedman, chapters 11-13

3. Types of Trade Restrictions  Trade policy –Set of rules & restrictions on international trade –Uses various policy tools (tariffs, quotas, etc.)  Tariffs (duties) –On  Imports  Exports (atypical—used when a country has market global power for the good, such as oil) –Amounts can be  Ad velorem (% of value)  Specific (per unit)  Combination

4. Types of Trade Restrictions  Non-tariff barriers (NTBs) –Quantitative restrictions  Quotas (on imports)  Voluntary Export Restraints (VERs)  Voluntary Restraint Agreements (VRAs)  Export controls (quotas) –Administrative protection –Unfair trade statutes  Antidumping  Anti-subsidy (countervailing)

5. Welfare Effects of Tariffs: Small Country in PE  Assume the country is small –No global market power in the sector –Country’s actions cannot affect world price –Country bears entire cost of its actions –Not necessary to draw Abroad or World markets to analyze effects of small country tariff  Assume specific tariff for simplicity –Analysis and results are similar for ad velorem or combination duties

6. Welfare Effects of Tariffs: Small Country in PE  Effects of tariff –World price remains unchanged at P FT  Country is too small to influence world price  Importers still pay world price on world markets –Domestic price rises by amount of tariff  Importers must pay the tariff to get the product through customs and into the domestic market  Consumer prices must rise to match  Tariff creates a wedge between domestic and world prices

7. Welfare Effects of Tariffs: Small Country in PE  Effects of tariff, cont. –Domestic consumer surplus (CS) falls –Domestic producer surplus (PS) rises –Government gains tariff revenue  Area in graph is a rectangle defined by –Import amount on horizontal axis –Tariff amount on vertical axis  Domestic consumers pay this tariff through higher prices –Decrease in CS is bigger than the combined increases in PS and tariff revenue (deadweight loss) –Domestic welfare is ALWAYS lower with a tariff than with free trade for a small country –Optimal tariff for small country is zero (i.e., free trade)

8. Welfare Effects of Tariffs: Large Country in PE  Assume the country is small –Has global market power in the sector, by definition of being a large country –Country’s actions do affect world price –Country does not bear entire cost of its actions –It is necessary to draw Abroad or World markets to analyze effects of large country tariff

9. Welfare Effects of Tariffs: Large Country in PE  Effects of tariff –Domestic price rises due to tariff  Importers must pay the tariff to get the product through customs and into the domestic market  Consumer prices must rise to match  Graphically, tariffs decrease international supply (left shift) –Increased domestic prices cause quantity demanded to fall  Since country is large, the units that used to be sold in Homeland are put back on the international market  At prevailing international price, those units remain unsold  International suppliers must drop their prices to sell these units  Equilibrium world price with large country tariff falls below P FT

10. Welfare Effects of Tariffs: Large Country in PE  Effects of tariff, cont. –Now importers  Purchase products in international markets at new world price  Bring products through customs, paying the tariff  Sell the product domestically at a new price that is equal to the new international price plus the tariff –Thus, domestic price  Is higher with the tariff than with FT  Is lower than the sum of P FT + Tariff

11. Welfare Effects of Tariffs: Large Country in PE  Effects of tariff, cont. –Domestic consumer surplus (CS) falls –Domestic producer surplus (PS) rises –Government gains tariff revenue  Area in graph is a rectangle defined by –Import amount on horizontal axis –Tariff amount on vertical axis  Tariff revenue is paid partly by –Domestic consumers in the form of higher prices –Foreign producers in the form of a lower international price –Large countries can shift part of tariff burden abroad!

12. Welfare Effects of Tariffs: Large Country in PE  Effects of tariff, cont. –Part of CS decrease is offset by PS increase –It is not clear whether tariff revenue is bigger or smaller than the part of CS loss that is not offset by the gain in PS –Thus, it is POSSIBLE that domestic welfare is higher or lower with a tariff than with free trade for a large country

13. Welfare Effects of Tariffs: Large Country in PE  Optimal tariff for large country –If one chooses the right tariff, it can be positive, but only if  Assumptions –Government redistributes tariff revenue in a welfare- increasing way  No waste, inefficiency, or administrative costs  No loss through rent-seeking behavior –Foreign governments don’t retaliate with their own tariffs  Unlikely!

14. Lerner Symmetry Theorem  An import tariff raises opportunity costs for domestic exporters (in the other sector), and therefore is a tax on both exports and imports –The price increase induced by the tariff  Causes import-competing industry to expand –Bid resources away from export sector –Increases opportunity cost for export sector –Decreases supply (left shift) in export sector –Since export sector has CA, tariffs cause a misallocation of resources across sectors  Some of the gains from specialization are unrealized  Draw export sector PE for a country imposing an import tariff to see this formally

15. Tariff Effects in GE  Students are responsible only for Figure 6.7 (not appendix)  Small country case –Tariff changes domestic prices  If X-axis represents import-competing product –Domestic price line gets steeper –Production point shifts (away from CA product)  Country still trades according to international prices  Consumers purchase based on domestic prices  Welfare is reduced

16. Summary of Tariff Effects: Large Country  Transfers of welfare occur –Domestic consumers to domestic producers –Domestic consumers to domestic government –Foreign producers to foreign consumers –Foreign producers to domestic government –Deadweight losses both domestically and abroad

17. Nominal vs Effective Protection  Nominal tariff –Reflects tariff on output product only –Ignores remainder of trade policy (e.g., tariffs on inputs) –Specific tariff dollar amount –Ad velorem tariff percentage

18. Nominal vs Effective Protection  Effective tariff –Considers entire trade policy  All protection that affects the industry –Tariff on output –Tariffs on inputs  Non-tariff protection would also be included, but for simplicity, we’ll stick to tariffs only in this class –Effective tariff is the percentage change in value added for the industry with the entire trade policy in place (vis-à-vis free trade)

19. Nominal vs Effective Protection  Value added = output price - cost of inputs –(VA)

20. Calculating Effective Tariff Rate (ETR)  Calculate free trade VA (VA FT )  Calculate prices of output & inputs with new trade policy  Calculate VA with trade policy (VA TP )  ETR = (VA TP - VA FT ) / VA FT –This is a fraction –Multiply by 100 to get the percentage  Students are responsible for this calculation

21. Effective Tariff Rate  ETR is sometimes called Effective Rate of Protection (ERP)  ETR can be –Positive  Trade policy increases value added vis-à-vis FT  Value of output protection exceeds harm of input protection –Negative  Trade policy increases value added vis-à-vis FT  Value of output protection is less than harm of input protection –Zero  Trade policy has no effect on VA  Value of output protection equals harm of input protection

22. Effects of NTBs  Students are responsible only for small country case of NTBs –Small country version of Figure 6.12 only –Not for Figures 6.10 and 6.11 –Not for Figure 6.12 for large nation  All NTB analyses will be for –Tariff-equivalent quota (TEQ): a quota that has the same effects on prices & quantities as a given tariff  Refer to tariff as “corresponding tariff” –This allows us to focus on differences between various trade policy tools

23. Effects of Quota, Small Nation  Some effects same as corresponding tariff –Decrease in CS –Increase in PS  Government revenue can be different –No tariff, so no tariff revenue –Allocation of quota can generate some revenue  Quota leaves country no better off, and most likely worse off, than an equivalent (corresponding tariff would have)

24. Effects of Quota, Small Nation  Ways to allocate quota rights –First-come, first-served  No revenue for government  Incentive for exporters is to be first into market –Lots of goods available early in year –No new imports late in year, as quota has been used up –Issue import licenses (i.e., import permits)  Each license gives firm the right to export some amount during the year  Firm chooses when to export, so goods can be available all year  Selling licenses can generate government revenue

25. Effects of Quota, Small Nation  Ways to allocate import licenses –Flat fee  Who sets fee?  Does fee reflect value of licenses? –Set requirements for exporters to be eligible –Require paperwork by exporters to justify why they should be able to export –Lotteries –Auctions

26. Effects of Quota, Small Nation –Auction, cont.  If set up efficiently, auction can generate up to same amount of government revenue that the corresponding tariff would generate –Firms that have licenses can sell at higher prices in the quota-imposing country than it can on world markets  Earn “rents” on exports  Total available rent is equal to tariff revenue with corresponding tariff  Firms will pay up to that amount in order to be eligible to earn those rents  Efficient auctions are fairly easy in practice

27. Rents and Rent-Seeking  What happens when import licenses are sold by government? –Government captures rents –Rent-seekers who feel entitled to having those rents transferred to them appear  Import-competing industry  Other ways that rents are captured –Higher profits by subsidiaries producing in the protecting country (e.g., Toyota plants in US)

28. Rent-Seeking Behavior  Rent-seeking is the use of scarce resources to induce transfers of wealth instead of using them to create new wealth –Lobbying

29. Effects of VERs: Small Nation  Same as quota situation, except –VER is policy of export-nation government, not import-nation government –Import-nation government has no import licenses to allocate, since it’s not actually restricting imports –VER allows no import-country government revenue –VER leaves country even worse off than with a quota

30. Relative Rankings of Trade Policies  So far, we know that –Free Trade (best) –Tariff –Quota –VER (worst)

31. Administrative Barriers to Trade  Bureaucratic procedures –Safety requirements –Foreign ownership restrictions –Threat of lawsuits (harassment of foreign firms) –Government procurement (buy domestically) –State, provincial & local restrictions