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Traditional trade theory Traditional trade theory (Ricardo, H-O): adopts countries as its basic unit for analysis firms do not exist at all emphasizes.

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Presentation on theme: "Traditional trade theory Traditional trade theory (Ricardo, H-O): adopts countries as its basic unit for analysis firms do not exist at all emphasizes."— Presentation transcript:

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2 Traditional trade theory Traditional trade theory (Ricardo, H-O): adopts countries as its basic unit for analysis firms do not exist at all emphasizes comparative advantage - that is variation in opportunity costs of production across countries and industries - as the basis for international trade Countries trade because they are different in terms of technology and/or their relative supplies of the factors of production (labour, capital, land, etc.)

3 Traditional trade theory: predictions “Different” countries should trade more the greater the differences in factor supplies and/or technological development, the greater the volume of trade among countries. “Different” countries should specialize in “different” goods trade will be inter-industry: Portugese wine for English wool in Ricardo's famous example The increased trade will result in both increased specialization and a tendency to equalize factor incomes Economic welfare for all countries could increase through the mutual specialization induced by dismantling of trade barriers.

4 Limitations of the traditional trade theory Comparative advantage has had limited success in explaining trade patterns actual trade mostly intra-industry and Europeans buying Boeing jets while Americans buy Airbus mostly between countries that are similar in their factor supplies and technological level Liberalizing countries were observed to diversify their production and trade rather than to specialize The gains from trade liberalization based on comparative advantage were estimated to be surprisingly small compared to the apparently powerful role that trade expansion played in the growth of the global economy in the post- World War II period.

5 The New Trade Theory The New Theory of international trade (Krugman,1980; Helpman, 1981; Ethier, 1982): considers the industry as its basic unit for analysis. Firms exist but are homogeneous – assumption of a representative firm within each industry Intra-industry trade is explained on the basis of love of variety by consumers and product differentiation by firms operating under conditions of monopolistic competition and facing increasing returns to scale

6 The New Trade Theory (ct’d) The presence of increasing returns to scale allows that: similar countries will specialize in different goods to take advantage of large-scale production, thereby leading to trade countries may exchange goods with similar factor content The new trade theory provides new sources of gains from trade: reduction of monopoly profits – new firms enter the market rise in efficiency resulting from increased scale of production (firms move down their average cost curves) gains for consumers from access to increased variety and from lower costs of imports

7 The New Trade Theory (ct’d) The new trade theory opened the door to “strategic trade policy“ (Brander and Spencer, 1985) protection could promote exports and shift rents to the protectionist country in this case, free trade was not necessarily the optimal policy for an individual country But the gains from deviating from free trade were small possibility of Prisoner’s Dilemma “lose-lose" outcomes if rival governments subsidized the same industry to gain global market share in strategic industries (as in the case of commercial aircraft).

8 Arguments for protectionism

9 Key questions addressed What do countries gain by trading with each other instead of opting for self-sufficiency? What are the main instruments of trade policy? What are the effects of trade policy on consumers, producers, the government and total welfare? 9

10 Gains from trade Autarchy Consumers can only buy domestic products Producers can only sell to domestic consumers  Domestic and international prices differ Free trade In any product countries can be: Net importers  international price lower than autarky price (p A >p f ) Net exporters  international price higher than autarky price (p A


11 Gains from trade In general: consumers can buy more and cheaper products and resources like labour and capital are transferred from inefficient to efficient producers Net importers gain because: Domestic consumers can buy cheaper products and new varieties Inefficient domestic producers loose market shares Net exporters gain because: Efficient domestic producers sell larger quantities of their products at a higher price Domestic consumers reduce consumption of expensive products 11

12 Welfare effects Consumer surplus The difference between the price buyers would be willing to pay and what they actually pay Producer surplus The revenue producers receive above the minimum amount required to induce them to produce a good

13 Classification of Commercial Policy Instruments Commercial Policy Instruments Trade Contraction Trade Expansion Tariff Export tax Import quota Voluntary Export Restraint (VER) Import subsidy Export subsidy Voluntary Import Expansion (VIE) PriceQuantity PriceQuantity

14 Instruments of Trade Policy 14 Price based measures: –Tariffs –Specific: p=p f + t –Ad valorem: p=(1+t)p f –Export subsidies: p x = p f + s –Export taxes: p x = p f - T Quantitative restrictions: –Quotas –Voluntary Export Restraints

15 Defining tariffs A tariff is a tax (duty) levied on products as they move between nations Import tariff - levied on imports Export tariff - levied on exported goods as they leave the country Specific tariff  a monetary sum that must be paid to import 1 physical unit of a product Advantage: easy to collect Disadvantage: doesn’t take price changes into account Ad valorem tariff  a percentage of the monetary value of 1 unit of import Advantage: takes price changes into account Disadvantage: Need to know the monetary value of the good and seller is tempted to undervalue the price

16 Other Features of Tariff Schedules Preferential Duties: tariffs applied to imports from particular group of countries countries are charged a lower tariff than countries outside the group Generalized System of Preferences: developed countries charge lower tariffs for specific imports from developing countries list of goods chosen by developed countries (textiles and clothing not included)

17 Basic Tariff Analysis Useful definitions: The terms of trade is the relative price of the exportable good expressed in units of the importable good. A small country is a country that cannot affect its terms of trade no matter how much it trades with the rest of the world. Consumer Surplus Producer Surplus

18 Welfare effects Consumer surplus The difference between the price buyers would be willing to pay and what they actually pay Producer surplus The revenue producers receive above the minimum amount required to induce them to produce a good

19 Consumer and producer surplus Tariffs

20 Consumer and Producer Surplus In a partial equilibrium approach we can use the concepts of consumer and producer surplus Both reflect the fact that there is only one market price Hence, there are consumers who would have been willing to pay more for the product Similarly, all but the “last” unit is produced with lesser marginal cost than the market price received 20 P Price (P) D consumer surplus Quantity (Q) S = marginal cost of production producer surplus

21 How to evaluate trade and trade policy Individual actors in the country introducing the policy measure: Consumers: Changes in prices and varieties of goods consumed ( changes in consumers’ surplus) Producers: Changes in prices of goods produced and inputs purchased (changes in producers’ surplus) Government: Effects on net revenues Net effect: Sum of changes in consumers and producers surplus and in government’s net revenues 21

22 Effects of trade policy in general Import protection as well as export promotion distort production and consumption decisions; therefore, they are generally welfare reducing. They also have effects on the distribution of income. Even when trade policy reduces national income and causes serious inefficiency in the economic system, it always benefits some firms or individuals at the expense of the rest of society. 22

23 Effects of a tariff p=p f + t or p=(1+t)p f → Domestic price increases → Domestic quantity supplied increases → Domestic quantity demanded falls → Increase of government revenues Distributional effect surplus is transferred from the consumers to the producers and the government Consumers lose more than producers and government win: deadweight loss 23

24 The Impact of Import Tariff: The Small-Country* Case 24 imports after tariff D Q SDSD P int (1+τ)P int imports in free trade increase of producer surplus tariff to the government deadweight loss deadweight loss imports after tariff P D Q SDSD P int (1+τ)P int imports in free trade Loss of consumer surplus P Increase of producer surplus and government income * Small country = cannot affect world prices

25 The impact of import tariff: the large-country case In the absence of tariff, the world price of wheat (P w ) would be equalized in both countries. With the tariff in place, the price of wheat rises to P T at Home and falls to P* T (= P T – t) at Foreign until the price difference is $t. In Home: producers supply more and consumers demand less due to the higher price, so that fewer imports are demanded. In Foreign: producers supply less and consumers demand more due to the lower price, so that fewer exports are supplied. Thus, the volume of wheat traded declines due to the imposition of the tariff.

26 The impact of import tariff: the large-country case The areas of the two triangles b and d measure the loss to the nation as a whole (efficiency loss) and the area of the rectangle e measures an offsetting gain (terms of trade gain). The efficiency loss arises because a tariff distorts incentives to consume and produce. Producers and consumers act as if imports were more expensive than they actually are. Triangle b is the production distortion loss and triangle d is the consumption distortion loss. The terms of trade gain arises because a tariff lowers foreign export prices (or Home import prices). If the terms of trade gain is greater than the efficiency loss, the tariff increases welfare for the importing country.

27 Export Subsidies Export subsidy A payment by the government to a firm or individual that ships a good abroad When the government offers an export subsidy, shippers will export the good up to the point where the domestic price exceeds the foreign price by the amount of the subsidy. It can be either specific or ad valorem.

28 Effects of a subsidy - small country p x = p f + s Small country Raises the domestic price of the exported goods: Consumers loose (less and more expensive products) Producers gain (get a transfer from the government on their exported products and sell their products in the domestic market at a higher price) Government looses (transfer to producers) Net welfare effect NEGATIVE because Government subsidises inefficient producers (dead weight loss in government’s revenues) Loss of opportunities for beneficial consumption 28

29 Export Subsidies: Europe’s Common Agricultural Program Price, P Quantity, Q S D EU price without imports World price = cost of government subsidy Support price Exports

30 Import Quotas An import quota is a direct restriction on the quantity of a good that is imported. Example: The United States has a quota on imports of foreign cheese. The restriction is usually enforced by issuing licenses to some group of individuals or firms. Example: The only firms allowed to import cheese are certain trading companies. In some cases (e.g. sugar and apparel), the right to sell in the United States is given directly to the governments of exporting countries.

31 Import Quotas An import quota always raises the domestic price of the imported good. License holders are able to buy imports and resell them at a higher price in the domestic market. The profits received by the holders of import licenses are known as quota rents. They accrue to licenses holders Welfare analysis of import quotas versus that of tariffs The difference between a quota and a tariff is that with a quota the government receives no revenue. In assessing the costs and benefits of an import quota, it is crucial to determine who gets the rents.

32 Voluntary Export Restraints Voluntary Export Restraints (VERS)  A restriction on a country's imports that is achieved by negotiating with the foreign exporting country for it to restrict its exports (foreign suppliers agree to “voluntary” refrain from sending some exports) alternative to import quota importing home country pressures exporting country to restrain its exports to the home market usually such agreements are made with the threat of quotas being imposed if exports are not limited H. Breinlich, U. of Essex, EC246: Free Trade vs. Protectionism

33 Voluntary Export Restraints A VER is exactly like an import quota where the licenses are assigned to foreign governments and is therefore very costly to the importing country. A VER is always more costly to the importing country than a tariff that limits imports by the same amount. The tariff equivalent revenue becomes rents earned by foreigners under the VER. Example: About 2/3 of the cost to consumers of the three major U.S. voluntary restraints in textiles and apparel, steel, and automobiles is accounted for by the rents earned by foreigners. A VER produces a loss for the importing country.

34 Other non-tariff barriers (NTBs)

35 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.

36 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.

37 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. very restrictive policy usually seen in developing countries trying to grow through import substitution

38 Government Procurement Provisions Government agencies are obligated to purchase from domestic suppliers, even when they charge higher prices (or have inferior quality) compared to foreign suppliers. 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.

39 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.

40 Nontariff Barriers (NTBs) Technical barriers to trade - A technical regulation (health, environment and safety standards) or other requirement (for testing, labelling, packaging, marketing, certification, etc.) applied to imports in a way that restricts trade Trade-Related Investment Measures performance requirements: forcing a foreign investor to use domestic inputs, or export final product Additional Restrictions foreign exchange controls, import licences advance deposit requirements - firm has to deposit funds with government equal to a percent of future import (to be refunded when import purchased)

41 Administered protection allowed by WTO rules Antidumping duties - Tariff levied on dumped imports, i.e. imports provided at a price that is ‘unfairly low’, defined as either below the home market price or below cost Countervailing duties - A tariff levied against imports that are subsidized by the exporting country's government, designed to offset (countervail) the effect of the subsidy Safeguard measures: when imports cause “injury” to domestic industries H. Breinlich, U. of Essex, EC246: Free Trade vs. Protectionism

42 Arguments for protectionism The Infant Industry Argument The Terms-of-Trade Argument The Antidumping Argument Argument for a Tariff to Offset Foreign Subsidy Argument for a Tariff to Reduce Aggregate Unemployment Tariff to Increase Employment in a Particular Industry The National Defence Argument for a Tariff

43 The Infant Industry Argument There is a potential comparative advantage that cannot be realized in the short run due to foreign competition. However, given a temporary tariff, domestic industry is able to mature, that is, it will achieve a reduction in unit cost by realizing the economies of scale OR through learning-by- doing Objective to realize a potential comparative advantage Consistency Key assumption: There is a market failure (external economies of scale, imperfect capital markets…). If this does not hold, you should ask why doesn’t the industry proceed on its own? Implementation Problem with identifying the right industries Time consistency: will the protection eventually become permanent?

44 The Terms-of-Trade Argument Restrictive trade policy can improve country’s terms-of- trade and thus increase its welfare Objectives increase the ratio PX/PM ( = to make imports cheaper) increase country’s aggregate welfare Consistency & Implementation IF the country is large enough, imposing a tariff may result enough decrease in world price and thus improvement in country’s terms of trade o IF the benefits from improved terms of trade are larger than the costs (deadweight loss and reduction of exports due to tariff), country’s welfare increases optimum tariff = a tariff structure that maximizes country’s welfare

45 The Antidumping Argument Foreign firms’ dumping into the home country constitutes a threat to domestic producers. Thus we need to impose an antidumping duty to prevent this unfair practice. Objective to stop an unfair trading practice (dumping) Consistency: Depends on the type of dumping Definitions of dumping Economics: 3rd degree price discrimination (different price in separate markets when there is no difference in the production cost) Trade laws: selling below the cost or “fair value”

46 Argument for a Tariff to Offset Foreign Subsidy The foreign government subsidizes the foreign firm. This unfair subsidy should be matched with a tariff to restore equal footing to the home and foreign industry. Objective to offset a distortion due to a foreign subsidy Consistency The subsidy moves foreign supply curve downwards, a tariff moves it upwards → a tariff can be used to offset the impact of a subsidy

47 Argument for a Tariff to Reduce Aggregate Unemployment Imposition of a tariff results a shift of demand from imports to domestic goods, which increases the output of import-competing firms. Further, the new workers hired will use their salaries, setting off a Keynesian multiplier process. Hence also other industries will expand and create new jobs. Objective to decrease aggregate unemployment Consistency Traditional models assume full employment a tariff/quota will increase the domestic production of the protected good (and hence demand for labour in this sector) however, it will decrease exports due to decrease of the foreign country’s purchasing power, retaliation and appreciation of the home currency the net impact on unemployment is ambiguous, i.e. the policy may not accomplish the objective

48 Tariff to Increase Employment in a Particular Industry Tariff on imports will increase the domestic production of the import competing goods and hence labour will move to this sector. We do not care that this may occur as an expense of the other sectors. Objective to increase the production of and reallocate labour to the import competing industry Consistency setting a tariff will lead to the objective Negative net impact due to efficiency loss Alternative policy again, subsidising the import-competing industry would result the same outcome with less cost

49 The National Defence Argument for a Tariff Some industries are vital during a time of war or national emergency. Thus these industries must be protected by imposing a sufficient tariff to ensure self-sufficiency. Problem: Identifying the vital industries More efficient policies: creating joint business- government R&D companies, subsidizing the domestic production


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