Global Trade:5

Global Trade: Lessons Lessons Topics Lesson 1 The World Economy and Global Trade: An Overview and Stylized Facts on Global Trade Lesson 2 Theories of International Trade-I: The Ricardian Model: Labor Productivity and Comparative Advantage: Lesson 3 Theories of International Trade-II: The Heckscher-Ohlin Model: Factor Endowments and Comparative Advantage Lesson 4 Theories of International Trade-III: The Standard Trade Model and Gains from Trade Combination of Labor Productivity and Factor Endowments Lesson 5 Policy Instruments of International Trade: Tariffs, Export Subsidies, Import Quotas, Export Restraints Lesson 6 Policy Issues of International Trade: Free Trade vs. Protectionism Liberalization in Developing Countries The Role of the World Trade Organization

Texts Recommended: Main Text: Required: International Economics: Theory & Policy, Krugman, P.R., and Obstfeld, M., 8th Edition, Pearson-Addison-Wesley. Recommended: International Economics, Husted, S., and Melvin, M., 8th Edition, Addison- Wesley. International Economics, Gerber, J., 5th Edition, Addison-Wesley. World Trade and Payments: An Introduction, Caves, R.E., Frankel, J.A., and Jones, R.W., 10th Edition, Pearson-Addison-Wesley. The World Economy: International Trade, Yarbrough, B.V., and Yarbrough, R.M., 7th Edition, Thomson-South-Western. Principles of Microeconomics, Only Chapter 3: Interdependence and the Gains from Trade, Mankiw, N.G., 5th Ed., South-Western Cengage Learning.

Lesson 5 Lesson 5: Trade Policy Instruments Procedure: The PowerPoint Presentation Duration: 60 minutes   Overview This lesson discusses different policy instruments of international trade: tariffs, export subsidies, import quotas, and voluntary export restraint.

Lesson 5 (cont.) Outline List of Class needs: the text, a computer, and a notebook. Pre-class reading and preparation: Chapter 8 of the text. Activities and timing: Go over the entire presentation in 60 minutes and think about the main findings of the lesson. Practice all diagrams in this section. Identification of Learning Objectives: Objective #5 from Section I Identification of the Global Workforce Skills for the lesson: Skill points 3 and 4 from Section II

Lesson 5 (cont.) Lesson notes and suggestions for Instructors: Read the relevant chapters in the recommended texts and look for online data for the latest figures of global trade. Acknowledgment: The Course Developer took help of different sources as referred while preparing the study materials. When a considerable number of diagrams have been developed to enhance interest in the subject, many diagrams come from the required text for the convenience of the students.

The instruments of trade policy Previous Lessons have answered the question, “Why do nations trade?” While this question is interesting in itself, its answer is much more interesting if it helps answer the question, “What should a nation’s trade policy be?” This lesson examines the policies that governments adopt toward international trade, policies that involve a number of different actions.

The instruments of trade policy (cont.) The main instruments covered in this Lesson are: Tariffs Export subsidies Import quotas Voluntary export restraint

Tariff A tariff, the simplest of trade policies, is a tax levied when a good is imported. 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.

Supply, Demand, &Trade 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

Export supply & import demand 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.

Deriving Home’s Import Demand Curve As the price of the good increases, Home consumers demand less, while Home producers supply more, so that the demand for imports declines.

Deriving Foreign’s Export Supply Curve As the price of the good rises, Foreign producers supply more while Foreign consumers demand less, so that the supply available for exports rises.

Supply, Demand, &Trade In equilibrium, the quantities of import demand = export supply Domestic demand – domestic supply = foreign supply – foreign demand world demand = world supply

World equilibrium The equilibrium world price is where Home import demand (MD curve) equals Foreign export supply (XS curve).

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. 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.

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. PT – P*T = t PT = 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.

Effects of a tariff (cont.) A tariff raises the price in Home while lowering the price in Foreign. The volume traded declines (Note: The description of the diagram follows in next pages).

Effects of a tariff (cont.) The previous figure illustrates the effects of a specific tariff of $t per unit of wheat (shown as t in the figure). In the absence of a tariff, the price of wheat would be equalized at PW. With the tariff in place, shippers are no willing to move wheat from Foreign to Home unless the Home price exceeds the Foreign price by at least $t. Thus the price in Home will rise and that in Foreign will fall until the price difference is $t.

Effects of a tariff (cont.) The tariff raises the price in Home to P and lowers the price in Foreign to PT* = PT – t. In Home producers supply more at the higher price, while consumers demand less, so that fewer imports are demanded. In Foreign the lower price leads to reduced supply and increased demand, and thus a smaller export supply. Thus the whole volume of wheat traded declines from Q W, the free trade volume, to QT, the volume with a tariff.

Costs & 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.

Export subsidy 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.

Export subsidy (cont.) An export subsidy raises the price of a good in the exporting country, while lowering it in foreign countries. Also, government revenue will decrease. In contrast to a tariff, an export subsidy worsens the terms of trade by lowering the price of domestic products in world markets.

Effects of an export subsidy An export subsidy raises prices in the exporting country while lowering them in the importing country.

Effects of an export subsidy (cont.) An export subsidy unambiguously produces a negative effect on national welfare. 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 + 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.

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.

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.

Effects of the U.S. Import Quota on Sugar

Effects of the U.S. Import Quota on Sugar (cont.) As the previous figure shows, the sugar import quota holds imports to about half the level that would occur under free trade. The result is that the price of sugar is $418 per ton, versus the $210 price on world markets. This produces a gain for U.S. sugar producers, but a much larger loss for U.S. consumers. There is no offsetting gain in revenue because the quota rents are collected by foreign governments.

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.

Activity/Homework Make a summary of the effects of the different instruments on trade policy. If you are asked to adopt a single trade policy, which one would you support and why?