BA 187 – International Trade Krugman & Obstfeld, Chapter 8 Instruments of Trade Policy

June M. Collier, President, National Industries, Inc., 1985 Free enterprise made this country. Free trade will destroy it. For five years, I’ve been advocating a 20 percent tariff on all imports. We can either do that, or our industrial base will erode to the point where we can’t build products to defend ourselves in the event of war. Our people will walk the streets because we are exporting jobs and importing welfare. June M. Collier, President, National Industries, Inc., 1985

Instruments of Trade Policy Tariffs are taxes levied on imported goods. Specific Tariff: levied as fixed amount on each unit of goods imported. Ad Valorem Tariff: a tax levied as a fraction of the value of goods imported. Export Taxes or Subsidies are levied on exported goods. Either as specific tax (subsidy)or as an Ad Valorem tax (subsidy) on exports. Non-Tariff Barriers (NTB’s) Import Quotas: Limitations on the quantity of imports. Export Restraints: Limitations on quantity of exports (usually imposed by exporting country). Miscellaneous Restraints: Gov’t Procurement Provsions, Domestic Content Rules, Administrative Classifications, Border Taxes.

Partial Equilibrium Analysis Will examine effects of trade policy in a partial equilibrium framework. Ignore interactions across economy, focus on single market. Assumptions: Two countries, Home and Foreign. One good, which both countries produce and consume. Good can be costlessly transported between countries. Exchange rate constant throughout, quote price of good in terms of Home currency in both Home & Foreign. Home country assumed to import this good from Foreign. Equilibrium price determined by Home’s Import Demand and Foreign’s Export Supply Curves.

Home’s Import Demand Home Market Imports S D 1. At P0, Demand exceeds supply in Home market, hence demand for imports, D0 – S0. P0 D0 – S0 2. Rise in Price to P1, reduces Home excess demand, lowers import demand to D1 – S1. P1 D1 – S1 P2 3. Further rise in Price to P2, eliminates Excess Demand, reduces import demand to 0. MD 4. Result is a downward-sloping Import Demand Curve, MD, for Home Country. Price, P Home Market Imports Price, P S D1 – S1 D0 – S0 D Quantity, Q Quantity, Q

Foreign’s Export Supply 1. Can perform similar exercise for Foreign. Quote foreign price in Home currency. P0 2. At P0, Foreign Demand equals Supply so no exports of good are available. P1 S*1 – D*1 3. As Prices rise, Foreign Demand less than Supply so exports of good are available. XS 4. Result is an upward-sloping Export Supply Curve, XS, from Foreign country. Price, P Foreign Market Exports Price, P S* P2 S*2 – D*2 MC D* Quantity, Q Quantity, Q

World Partial Equilibrium Price, P XS 1. Foreign Country has upward- sloping Export Supply Curve, XS. World Market MD 2. Home Country has downward- sloping Import Demand, MD. PW QT 3. Trade is in equilibrium for the good when world price = PW and amount of good traded = QT. Quantity, Q

Effect of a Tariff on Imports Tariff drives a wedge between price paid by consumers in Home and price received by exporters in Foreign. Specific Tariff of $t per unit. Shifts the Export Supply Curve up by $t at each q. New equilibrium price in Home rises by less than $t. Why? Because new price received by Foreign exporter’s falls below initial price (terms of trade effect). Size of this effect depends on importance of Home Country in World market. Generally this effect is negligible. “Small Country Case” assumes no change in Foreign price, implying Home price rises by full amount of tariff. Quantity of good traded falls below free trade level.

Tariffs in Large Country 1. Begin in equilibrium at PW with Home imports equal Foreign exports t XS’ 2. Home imposes specific import tariff t, which shifts XS up by t. PT P*T 3. New equilibrium with home price PT = P*T + t. Quantity traded falls. t 4. How burden of tariff distributed between Home & Foreign depends on slopes of MD and XS curves, i.e. PT and P*T relative to initial PW. Domestic Price Home Country World Market Foreign Price Foreign Country Price DH SH DF SF XS PW MD

Measuring Amount of Protection “Height of the average tariff” is a measure of how much price interference exists in country’s tariff schedule. Unweighted Average Nominal Tariff rate: Does not take into account relative importance of each good. Tends to overstate true height of average tariff. Weighted Average Nominal Tariff rate: Each good’s tariff is weighted by the importance of the good in the bundle of imports. Tends to be biased downwards. Prohibitive Nominal Tariff rate: Tariff rate so high it prevents imports from coming into country. Effective Rate of Protection (ERP): Change in the value-added of an industry (relative to free trade) due to imposition of a tariff structure on intermediate & final products.

Nominal (t) and Effective (g) Tariff rates U.S. E.U. Japan Rates as of 1984 t g Agriculture/Forestry/Fish 1.8 1.9 4.9 4.1 18.4 21.4 Food/beverages/tobacco 4.7 10.2 10.1 17.8 25.4 50.3 Wearing Apparel 22.7 43.3 13.4 19.3 13.8 42.2 Footwear 8.8 15.4 11.6 20.1 15.7 50.0 Furniture & Fixtures 5.5 5.6 11.3 5.1 10.3 Chemicals 2.4 3.7 8.0 11.7 4.8 6.4 Glass & Glass Products 6.2 9.8 7.7 12.2 8.1 Iron & Steel 3.6 2.8 4.3 Electrical machinery 4.4 6.3 7.9 10.8 6.7 Simple Average Tariff 7.8 6.1 8.7 10.0 Source: Deardorf & Stern, The Effects of the Tokyo Round and the Structure of Protection

Costs and Benefits of Protectionist Policies Large Country Analysis

Measuring Market Costs & Benefits Measure costs/benefits of protection with monetary quantities. Consumer Costs/Benefits: Consumer surplus: measures the monetary amount between price consumer actually pays and price she/he willing to pay. Calculated as area under the Demand Curve above market price. Producer Costs/Benefits: Producer surplus: measures the monetary amount between price producer actually receives and price she/he willing to accept. Calculated as area above the Supply Curve but below market price. Government Costs/Benefits: Government Revenue: measures the monetary amount generated by the tariff that government receives as revenue.

Consumer & Producer Surplus Price, P Home Market 1. Foreign Country has upward- sloping Export Supply Curve, XS. DH 2. Home Country has downward- sloping Import Demand, MD. SH 3. Trade is in equilibrium for the good when world price = PW and amount of good traded = QT. P0 Quantity, Q

Costs and Benefits of a Tariff PT 1. Specific import tariff t on good, domestic price rises to PT from PW. P*T t D2 S2 Price, P Home Market 2. Consumer surplus falls by areas: a + b + c + d SH 3. Producer surplus rises by area: a 4. Government revenue rises by area: c + e 5. Deadweight loss (cost of protection): b + d (= pro’dn loss + consump loss) b d c a e QT PW 6. Terms of Trade Gain: e (decline in export good price to P*T DH S1 D1 Quantity, Q

Summary of Import Tariff Import Tariff brings three net effects to economy. Tariff raises domestic price of good above free trade level. Production Distortion (loss); Leads domestic producers to produce too much of the import good resulting in an efficiency loss. Consumption Distortion (loss); Tariff leads domestic consumers to consume too little of the import good resulting in a welfare loss. Terms of Trade Effect (gain); Tariff lowers world demand for import good, resulting in a fall in the world price of the import good. Likely to be small in reality. Summary of Import Tariff (Probable Welfare Loss); Terms of trade effect negligible, so tariff will probably reduce level of welfare in the country imposing the tariff.

Effects of an Export Subsidy P*S S PS Exports 1. Specific export subsidy, s, on good, domestic price rises to PS from PW. Price, P Home Market 2. Consumer surplus falls by areas: a + b SH 3. Producer surplus rises by areas: a + b + c a b c e f g d 4. Cost of Subsidy given by areas: b + c + d + e + f + g PW 5. Net Welfare Loss given by areas: b + d + e + f + g DH Quantity, Q

Summary of Export Subsidy Export Subsidy has exact opposite effects to import tariff. Subsidy raises domestic price of good above free trade level. Production Distortion (loss); Leads domestic producers to produce too much of the export good resulting in an efficiency loss. Consumption Distortion (loss); Subsidy leads domestic consumers to consume too little of the export good resulting in a welfare loss. Terms of Trade Effect (loss); Subsidy raises world supply of export good, resulting in a fall in the world price of the export good. Likely to be small in reality. Summary of Import Tariff (Welfare Loss); Even if terms of trade effect negligible, subsidy will certainly reduce level of welfare in the country giving the subsidy.

Agricultural Subsidies, 1979-1986 U.S. E.U. Japan '79-'81 '84-'86 Eggs 5% 7% 20% 18% 19% Milk 55 66 67 56 79 82 Poultry 5 10 24 27 19 16 Beef & Veal 9 42 53 Wheat 14 44 28 36 97 98 Sugar 15 76 34 75 46 72 Rice 7 61 68 71 86 Soybeans 6 43 59 84 Simple Average 35 31 49 58 64 Source: Rosenblatt et al, The Common Agricultural Policy of the EC, IMF 1988

Costs and Benefits of Protectionist Policies Small Country Analysis

Tariff for a Small Country ST DT PT 1. Import tariff, t, raises domestic price PT = PW + t for small country. t Price, P SH 2. Consumer surplus falls by areas: a + b + c + d 3. Producer surplus rises by area: a 4. Government revenue rises by area: c 5. Deadweight loss (cost of protection): b + d (= pro’dn loss + consump loss) a b c d PW DH S0 D0 Quantity, Q

Costs & Benefits of a Tariff 1. 100% import tariff on good, domestic price rises from $1 to $2. Price, P SH 2. Consumer surplus falls by areas: a + b + c + d = $60 $5 3. Producer surplus rises by area: a = $15 $4 4. Government revenue rises by area: c = $30 $3 5. Deadweight loss (cost of protection): b + d = $15 $2 a=$15 b =$5 c=$30 d=$10 $1 DH 10 20 30 40 50 60 70 Quantity, Q

U.S. Example: 1978 CB Radio Tariff Welfare Effect $ millions Consumer Surplus - 48.8 Tariff Revenue + 33.6 Producer Surplus + 3.0 Deadweight Loss - 12.2 Consumption -10.7 Production -1.5 In 1978, import tariffs on CB radios increased from 6% to 21%. FTC estimated this had the following effects: Price rose from $54 to $62. Demand fell 1.53 million Domestic Prod’n up 221,000 Assume no effect on world price, analyze effects on U.S. welfare. Costly to consumers with little benefit to producers or number of U.S. jobs created. Source: Morkre & Tarr, Effects of Restriction on U.S. Imports, FTC

Costs and Benefits of Protectionist Policies Non-Tariff Barriers (NTB’s)

Non-tariff Barrier – Import Quota Most common form of a Non-Tariff Barrier is an import quota which restricts the quantity of good imported. Import Quota Restricts quantity of good imported during a year. Effect is to increase home price of the good over free trade. Market effects identical to a specific tariff. In fact, any quota can be mimicked by an equivalent tariff. Welfare effects differ because gov’t does not necessarily receive revenue as under a tariff. May gain revenue if auctions off import licenses, otherwise additional revenue received by foreign exporters. Voluntary Export Restraint (VER’s) Foreign supplier “voluntarily” agrees to restrict quantity imported. Usually a political agreement so Home does not look protectionist. Market effects identical to an import quota, but welfare effects differ as foreign firms receive additional profit, Home gov’t receives nothing.

Effects of an Import Quota PqH 1. Import quota level set at Qq. Raises domestic price PqH, lowers foreign. Qq Quota PqW World Market Price, P XS’ 2. There exists an equivalent tariff, tq , for any quota that has same result. tq 3. Market effects of tariff and a quota are identical but not welfare effects. 4. Consumer surplus, producer surplus and associated Deadweight loss (= pro’dn loss + consump loss) are identical. XS 5. Quota brings no Government revenue increase of a tariff. Who earns this quota profit or rent depends on structure of quota. PW MD Q0 Quantity, Q

Demand Growth & Import Quota 1. Import quota level set at Qq with associated equivalent tariff, tq. World Market Price, P 2. Look at effects of Demand growth on market under quota vs. equiv. tariff. MD’ Quota 3. Under the quota, new equilibrium at E3 with Pq3 at same Qq. Pq3 E3 XS’ Qq2 Pq2 E2 4. Under the tariff, new equilibrium at E2 with Pq2 at higher Qq2. 5. With Demand Growth, quota leads to higher home price with no change in quantity. Quota rent increases. XS 6. With Demand Growth, equiv tariff leads higher home price & quantity. Gov’t revenue also increases. Pq1 E1 E0 tq PW PqW MD Qq1 Q0 Quantity, Q

NTB’s on Industrial Country Imports (as % of imports) Total NTB’s Quantitative Restrictions Of which VER’s 1981 1986 Agricultural Raw Materials 2.8 8.4 1.8 0.0 Agricultural Food 40.8 42.6 27.3 27.4 0.8 Minerals & Metals 12.7 24.7 4.5 16.8 2.1 14.4 Iron & Steel 29.0 64.2 7.8 47.3 6.6 45.2 Chemicals 13.2 8.1 7.6 Other Manufactures 18.6 20.5 11.7 12.2 9.3 9.7 All Products (except fuel) 19.6 23.1 5.6 7.7 Source: Grilli & Sassoon, The New Protectionist Wave, 1990.

Other Forms of NTB’s Government Procurement Provisions Restrict purchase of foreign goods by home gov’t agencies. Similar to an Ad Valorem import tax, where home producer receives certain percentage of price protection. Domestic Content Provisions Reserve some of value-added & product sales to home producers. European Border Taxes Value-added tax (VAT) in EU. Imports to EU must pay equivalent VAT, while EU exports receive rebate for VAT. Looks like an import tariff & an export subsidy Administrative Classification Import duty depends on classification, gives leeway to customs. Restrictions on Services Trade Less visible. Restrict foreign provision of certain services.

Welfare Effects of U.S. Trade Restrictions QR = Quantitative Restriction Welfare Gain Industry Employment Rest of Economy Employment ($billions) (000 work-yrs) Textile & Apparel Remove QR’s 11.92 -157.2 157.2 Capture Rents from Foreigners 6.05 -3.1 28.4 Automobiles 7.50 -1.2 1.3 7.15 +1.3 37.2 Steel 0.86 -20.7 22.3 0.74 -0.1 3.5 Source: De Melo & Tarr, Welfare Costs of Quotas on Textile, Steel, & Apparel