1. ECON 321 chapter 5: TRADE POLICIES

2. Movements away from free trade
While it is generally accepted that free trade best enhances societal welfare, complete free trade is seldom practiced.
This situation generates two questions
Why is complete free trade seldom practiced?
What are the effects of deviating from free trade?
This chapter considers the second question by considering the effects of employing one common tool of deviating from free trade – the tariff.

3. Tariffs: Preliminary Details
A Tariff is a tax on imported goods
Tariffs will
Affect domestic consumption of a good
Affect domestic production of competing goods
Affect foreign production of the good
Affect the structure of the domestic economy

4. Tariffs: Preliminary Details
A revenue tariff is an import tax levied on a good that is not produced domestically.
A protective tariff is a tariff designed to protect a domestic industry from foreign competition

5. Types of Tariffs
A specific tariff is a per unit tax on imported goods.
Expressed as a certain amount per unit: $6 per imported ton.
Easy to administer
Not uniform across high and low priced goods

6. Types of Tariffs
An ad valorem tariff is expressed as a percentage of the value of the imported good.
Required valuation of the good to determine amount of tariff
Not regressive in nature
Incentives to under-invoice the price

7. Types of Tariffs
A compound tariff is comprised of both a specific tariff and an ad velorem tariff.
$6 per imported ton plus 4% of the value of the imported good.
Common on products whose prices fluctuate such as agricultural products.

8. Methods of Valuing Imports
Free on Board (F.O.B) - foreign market price plus costs of loading
Cost, Insurance, and Freight (C.I.F.) - foreign market price plus costs of loading plus inter-country transportation costs up to port of entry.

9. Consumer Surplus – A Review
Consumer Surplus is the difference between what consumers are willing to pay and what they actually pay for a good.
Represented graphically as the area under the demand curve to the price paid

10. Welfare effects: small country
To show the welfare changes from the tariff the concepts of consumer and producer surplus must be considered.
Consumer surplus is the difference between what consumers are willing to pay for a specific amount of a commodity and what they actually pay for it.
Graphically, consumer surplus is the area under the demand curve and above the price paid on every unit purchased.

11. Welfare effects: small country
Consumer surplus is the difference between what consumers are willing to pay for a specific amount of a commodity and what they actually pay for it.
Producer surplus is the extra payment received by producers above what needed to have been paid to cause them to produce the commodity.
Graphically, producer surplus is the area below the price received and above the supply curve on every unit sold.

12. Welfare effects: small country
Consumer surplus at autarky is given by the indicated region.
When the nation moves to free trade this surplus increases.
The imposition of a tariff reduces this surplus by the difference between the international and the tariff price.

13. Welfare effects: small country
Producer surplus at autarky is given by the shaded region.
Opening the economy to free trade reduces the surplus to the smaller shaded region.
Imposing a tariff increases the producer surplus.

14. Welfare effects: small country
The losses and gains from the imposition of a tariff exist in the shaded region.
The entire region is lost consumer surplus.
The dollar value of this region is ($10 x 70) + (½ x $10 x 10) or $750.

15. Welfare effects: small country
The entire region is lost consumer surplus.
Of this, the portion above the supply curve is gained by producers.
The dollar value of this region is ($10 x 20) + (½ x $10 x 10) or $250.

16. Welfare effects: small country
The entire region is lost consumer surplus.
Of this, the portion above the supply curve is gained by producers.
The rectangular area is gained by the government as tariff revenue.
The dollar value of this region is $10 x 40 or $400.

17. Welfare effects: small country
This leaves a net welfare loss to society of the two triangular shaded regions.
These regions are known as the deadweight loss of a tariff.
These have a dollar value of $750 - $250 (gained by producers) - $400 (gained by the government) or $100.

18. Effects of a tariff: large country
The effects of a tariff on a large country differ from that in a small country because the imposition of a tariff results in a fall in import demand that lowers the international price.
This is known is as the terms of trade effect.

19. Effects of a tariff: large country
In this case, the 50% tariff results in a drop of the international price from $20 to $15.
This takes the tariff price to $22.50 per unit.
The effects of this change are more clearly seen through a narrowing of focus in the graph.

20. Effects of a tariff: large country
With the tariff and improvement in the terms of trade, production rises from 20 to 22.5 units.
Consumption falls from 80 to 77.5 units.
Imports fall from 60 to 55 units.

21. Welfare effects: large country
Consumer surplus declines by the shaded region.
This has a dollar value of ($2.50 x 77.5) + (½ x $2.50 x 2.5) = $

22. Welfare effects: large country
Consumer surplus declines by the shaded region.
Producer surplus increases by the shaded region offsetting part of the consumer loss.
This has a dollar value of ($2.50 x 20) + (½ x $2.50 x 2.5) = $53.125

23. Welfare effects: large country
Consumer surplus declines by the shaded region.
Producer surplus increases by the shaded region offsetting part of the consumer loss.
Government revenue increases by $10 x 75 or $750.

24. Welfare effects: large country
The net effect is a welfare gain.
Consumer surplus falls by $
Producer surplus rises by $53.125
Government revenue increases by $750
This generates a net gain of $500 for this case.

25. Welfare effects: large country
This result arises as the improvement in the terms of trade more than offsets the potential deadweight loss of the tariff.
Welfare lost
Welfare gained

26. Consumer Surplus – A Review
Quantity of Cloth
Price of Cloth D P1 Pc Qc E

27. Consumer Surplus – A Review
Quantity of Cloth
Price of Cloth D P1 Pc Qc E

28. Producer Surplus – A Review
Producer surplus is the difference between what a producer is willing to accept and the price received.
Represented graphically as the area above the supply curve to the price received.

29. Producer Surplus – A Review
Quantity of Cloth
Price of Cloth S P2 Pc Qc E

30. Producer Surplus – A Review
Quantity of Cloth
Price of Cloth S P2 Pc Qc E

31. Market in Autarky
Equilibrium occurs at E, equilibrium price and quantity without any trade.
Producer and consumer surplus are shown in market by corresponding areas as before.

32. U.S. Cloth Market CS PS Price of Cloth P1 S E Pc P2 D Qc
Quantity of Cloth
Price of Cloth S P2 Pc Qc E D P1 CS PS

33. Imports and Free Trade
India has a comparative advantage in cloth production so U.S. decides to import cloth.
Assume U.S. is a small country so quantity purchased will not affect the world free-trade price.

34. Free Trade Cloth Market
Quantity of Cloth
Price of Cloth S P2 Pc Qc E D P1 Pw Qs Qd

35. Imports and Free Trade
Producer surplus falls with decrease in price and quantity supplied
Consumer surplus expands with decrease in price and increase in quantity demanded
Total country welfare increases with free trade equal to triangle GEF

36. Decrease in Producer Surplus
Quantity of Cloth
Price of Cloth S P2 Pc Qc E D P1 Pw Qs Qd

37. Increase in Consumer Surplus
Quantity of Cloth
Price of Cloth S P2 Pc Qc E D P1 Pw Qs Qd

38. Net Gain in Surplus Quantity of Cloth Price of Cloth S P2 Pc Qc E D P1Pw Qs Qd G F
Imports

39. Free Trade Effects Consumption Effect Production Effect
Consumers can buy more cloth at a lower price
Production Effect
Decline in domestic production from production cuts and/or business failure

40. Tariff in Small Country
Domestic government imposes tariff on cloth production in the amount of $T.
Remember U.S. is small country and cannot affect world price – world price stays constant at Pw.
Price of cloth in U.S. rises by the full amount of the tariff to Pt = Pw + T

41. Tariff in a Small Country
Quantity demanded falls with the new, higher price of cloth – Qd to Qd’.
Quantity supplied increases with the new, higher price of cloth – Qs to Qs’.
Imports decrease
Government collects tariff revenue

42. Tariff in Cloth Market Quantity of Cloth Price of Cloth S P2 Pc Qc E DPw Qs Qd Pt
Tariff
Qs’
Qd’
Imports

43. Tariff in Small Country
Consumer surplus falls with the increase in price and decrease in quantity demanded.
Producer surplus increase with the increase in price and quantity supplied.
Government revenue increases with implementation of tariff

44. Tariff Effects on CS Quantity of Cloth Price of Cloth S P2 Pc Qc E DPw Qs Qd Pt
Tariff
Qs’
Qd’
Imports
CS with Tariff
CS with Free Trade
Loss in CS with Tariff

45. Tariff Effects on PS and Govt.
Quantity of Cloth
Price of Cloth S P2 Pc Qc E D P1 Pw Qs Qd Pt
Tariff
Qs’
Qd’
Imports
Gain in PS with Tariff
Gain in Govt. Revenue
PS with Free Trade

46. Net Effects of Tariff a is loss in CS but gain in PS so net is 0
c is loss in CS but gain in Govt. Rev. so net is 0
b and d are net losses from CS – dead weight loss (DWL)
Quantity of Cloth
Price of Cloth S P2 Pc Qc E D P1 Pw Qs Qd Pt
Tariff
Qs’
Qd’
Imports a c b d

47. Non Tariff Barriers on Trade
Quota
Subsidy
Voluntary Export Restraints
Dumping
Administrative Procedures

48. Quota Is a quantitative restriction on the imports
Usually set by the importing country government in order to protect the domestic producers
It is either sold to importer companies with quota licences or used as “first come first served” basis
Not legal under WTO

49. The Effects of an Import Quota
Price A
Domestic
demand
Domestic
supply
Equilibrium
without trade + B
price with
quota
Equilibrium
with quota C D Q S E' Q D F
World
price
Price
without
quota =
E" Q S Q D G
Imports
with quota
Quantity
Imports
without quota

50. What is Dumping?
Cost based dumping – firm sells at price below cost of production in foreign market
Price based dumping – firm sells at a price lower than price in home market

51. Types of Dumping
Sporadic dumping – excessive inventories leads to a “sale” in the foreign market.
Recession in domestic market but boom in foreign market
Often seen as part of doing business
Can draw legal action from industry in importing country

52. Types of Dumping
Persistent Dumping – Sale of products in foreign market at a price lower than domestic market over an extended period of time
Markets have different elasticities of demand leading to price discrimination
Could cause lasting damage to importing industry

53. Types of Dumping
Predatory Dumping – price product with the goal of driving domestic firms out of business
If successful, foreign firm ends up with monopoly power
Can then increase price and decrease quantity to maximize long run profits

54. Other Measures Export credit subsidies National procurement
A form of a subsidized loan to the buyer of exports.
They have the same effect as regular export subsidies.
National procurement
Purchases by the government (or public firms) can be directed towards domestic goods, even if they are more expensive than imports.
Red-tape barriers (bureaucratic procedures)
Sometimes governments place substantial barriers based on health, safety and customs procedures.

55. Other Administered Protection
Countervailing Duty - A tariff designed to increase the price of the imported goods by a certain amount
Often used in export subsidy and dumping cases
Can be petitioned for my domestic industry to offset foreign government subsidies on exports