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Trade Policy and Its Instruments

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1 Trade Policy and Its Instruments
Assessing and Addressing the Effects of Trade on Employment : A knowledge Sharing Workshop Le Meridian Hotel Jakarta. Indonesia 12 – 16, July 2010.

2 Objective To understand trade policy and its instruments; and
To understand the welfare effects of various trade policy instruments on consumers’, producers’ and governments’ welfare in both the applying county (the home country) and its trading partners (foreign countries).

3 Outline Trade policy Trade policy instruments Tariffs Subsidies
Import quotas Voluntary export restraints Others …

4 Trade Policy What is trade policy? Objectives of trade policy?
A set of rules and regulations applied to trade. Objectives of trade policy?

5 Common Instruments 1. Tariff – a levy on imports and exports.
Specific tariff Ad valorem tariff 2. Subsidies Import subsidies Export subsidies Tariffs and subsidies are the two most common instruments of trade policy. Tariffs are broadly divided into specific and ad valorem tariffs, while subsidies could be provided for imports of exports. In the context of the multilateral trade negotiations notions such as applied tariffs, bound tariffs, tariff waters, tariff peaks, tariff escalations and so on are important concepts. These concepts will be discussed during the face-to-face phase of the course.

6 Tariffs Specific tariffs
Fixed charge for each unit of goods imported (often based on weight, number, length, volume or other unit of measurement). often levied on foodstuffs and raw materials E.g. $1 per kill of apple etc … Ad valorem tariff – levy as percentage of value (instead of quantity, weight etc.) Specific tariffs are fixed charges and are easy to administer. Whereas, ad valorem tariff is a bit more complex due to the need to determine the value of the import.

7 Why tariff? A tariff could be levied for one or all of the following purposes: To protect domestic producers from foreign competition (i.e. protective tariff). In extreme cases a tariff could be so high that it effectively prohibits imports (i.e. prohibitive tariff). To raise Revenue for government (i.e. revenue tariffs). For environmental and health purposes, i.e. to discourage the consumption of goods that are harmful for environment (i.e. green tariff; a.k.a. eco-tariff) and/or health (e.g. tariffs on cigarettes and liquors). Tariffs are the oldest and easiest forms of trade policy. They have traditionally been used as a source of government income. However, tariffs have often been imposed to protect certain domestic industries from external competition. Nowadays, the popularity of tariffs for trade protection has declined as governments revert to nontariff barriers such as import quotas (restriction on quantity of imports), export restrains (restriction on quantity of exports at the importing country's request) other restrictions on the basis of technical and sanitary requirements. Recently, tariffs aimed at protecting the environment and human and animal health are becoming popular.

8 Effects of tariffs Tariffs lead to:
Case 1: Effects in the tariff imposing country Tariffs lead to: Higher cost of importing goods Higher price of imported goods The main impact of a tariff is to raise the cost of importation. As such, a tariff has the same effect as an increase in shipping cost. Its implication is to raise the price of imported goods thereby reducing the demand for them. Lower demand for imported goods

9 Effects of tariff Case 2: For the country whose exported goods face the tariff and that the tariff imposing country accounts for a negligible share of total demand for the good: Lower demand for the good in the tariff imposing country Negligible effect on aggregate demand for the exporting country Negligible effect on global prices for the good In the case where the tariff imposing country (the home country) is too small to affect the global demand for the good, the effect of tariffs is limited within the domestic market. In this case, the tariff creates differences between the international price of the good and the domestic price of the good. However, the tariff in this case will have a negligible effect on the international prices of, and the global demand for, the good hence the production, supply and global trade remains unaffected in any significant way. Negligible effect on production and supply of the good Negligible effect on global trade of the good

10 Effects of tariff Case 3: For the country whose exported goods face the tariff and that the tariff imposing country accounts for a significant share of total demand for the good: Lower demand for the good in the tariff imposing country Lower aggregate demand for the good Excess supply of the good Here, the tariff causes the domestic price of the good to increase. Since the tariff imposing country is a significant player in the market for the good (accounting for a significant share), hence the lower demand for the good in the importing country will cause excess supply of the good at global level. This will lead to a decline in the export price (the international price). The lower international prices discourage production by the exporters in turn leading to a decline in global production of the good and the volume traded. Lower export (international) prices for the good Lower production of the good Lower global trade of the good

11 How much protection does a tariff offer?
The actual protection that a tariff provides is measured by a concept called effective rate of protection. An analysis of effective rate of protection provided to an industry takes into account the effects of tariffs on inputs as well as on outputs. How do we calculate the effective rate of protection? Let’s see this example: As already indicated, one of the most important objectives of a tariff is to protect domestic producers from external competition. But, how much protection does a tariff provide to domestic producers? In analysing trade policy in practice and/or even for imposing how high a tariff is needed to provide just enough protection for domestic producers, it is important to know how much protection a tariff actually provides. The amount of protection that a tariff provides is often measured by a concept called effective rate of protection.

12 Example: Consider: International price of car: $10,000 Cost of parts for assembly: $8,000 Assemblers value added is $2000 (i.e. 10,000 – 8,000) Assume a country wants to promote an auto industry, it imposes a tariff of 20% on auto. Hence: Domestic price of auto would now be $12,000. Cost of parts for assembly remains the same. Assemblers value added now is $4,000 (12,000 – 8,000). Note: The nominal protection was 20%. The effective protection however is captured by the percentage difference in value added that the tariff created: ([(4,000 – 2,000)/2,000)]*100%) = 100%. The effective rate of protection of the 20% tariff levied is 100%. In other words, the effective impact of the tariff is to double the margin between the cost of the parts and the final price of the auto. Prior to the levy of the tariff, domestic assemblers can assemble cars profitably if and only if the cost of assembly does not exceed Because, the parts of the car to be assembled will cost them 8,000 and the final price of the cars is 10,000. If the cost of assembly exceeds 2,000 the assemblers will lose. What the tariff achieved is to make it possible for assemblers to profitably operate even at a cost of assembly as high as 4,000. Because, with the 20% tariff, the price of cars is now increased to 12,000.

13 Who is more effectively protected?
Firm A: Bicycle Assembler Cost of imports of bicycle parts to make a bicycle = 200 Bicycle price = 300 Firm B: Auto Assembler Total cost of imports of auto spares to make a car = 5,000 Auto price = 6,000. Whose is more protected (Firm A or Firm B) if we levy 30% tariff on bicycles and 20 % on autos? At first glance, it may appear that bicycle assemblers are more protected than auto assemblers. But, as we saw, the real protection of a tariff can only be assessed by the effective rate of protection. Let’s calculate the effective rate of protection for the two groups: For bicycle assemblers: The 30% tariff on bicycles increases the price of bicycles from 300 to 390; the difference between the price of bicycle and bicycle parts increase from 100 to 190. i.e. a 90% increase. Hence the effective protection for the bicycle assemblers is 90%. For auto assemblers: the price of autos increases by 1,200 (from 6,000 to to 7,200) as a result of the 20% tariff. The difference between the prices of auto spares and autos would increase from 1000 to 2,200. That is an increase of 120%. So the effective protection is 120%. Therefore, even though the nominal tariff is higher on bicycles than autos, the effective protection is higher for the auto assemblers.

14 Costs and benefits of tariffs
Tariffs are the simplest trade policies Tariffs increase the price of imported goods, as a result: consumers pay higher (negative effect on their welfare) producers gain from higher prices. Government earns tariff revenue By artificially inflating prices of imported goods, tariffs encourage the substitution of lower price (efficient) imports by higher price (less efficient) domestic products. Hence, there is a loss of efficiency. But of course, to get the full picture one needs to look at the dynamic effect of tariffs (encouraging domestic industries etc (the so called infant industry argument). The loss of efficiency for the economy refers to that part of consumer welfare that does not get transferred to producers and/or governments. This is a net loss for the economy. It is caused by distortion of incentives of both producers (production distortion) and consumers (consumption distortion) that a tariff induces by making them to act as if imports were more expensive than they actually are.

15 2. Subsidy Export subsidy:
A payment for a firm or individual that exports goods abroad. It can be fixed (fixed payment per unit) or ad valorem (proportional to value of export). Exports subsidies encourage exporters to export more. From the individual exporter’s point of view, subsidies increase his/her export revenue. Well known examples: U.S. subsidy on cotton The European Common Agriculture Policy (CAP) For exporters, export subsidies increase revenue because for each unit exported, exporters receive a total revenue comprised of the international price of the good and the subsidy.

16 Benefits and costs of subsidy
Subsidized exporters benefit Foreign consumers benefit from low prices Foreign producers suffer from low prices Creates production distortion Creates consumption distortion Creates “terms of trade” loss for the subsidizing country The effect of export subsidies on prices is exactly the reverse of that of tariffs. If the exporting country is an influential player in the market of the good then export subsidy will lead to a fall in the international price of the good. Why? Because, the subsidy encourages the influential country to export more hence pushing down the international prices of the export good. So, for the exporter, the benefit of the subsidy is positive as long as the decline in the international prices of the good is less than the subsidy he/she receives. Just like a tariff, subsidies distort production and consumption incentives. Because of subsidies, exporters who might otherwise have not been able to compete in foreign markets could become major exporters and in fact could even drive out of market more efficient foreign producers. Hence, subsidies may allow less efficient producers to thrive at the expense of more efficient producers (i.e. production distortion). There is, thus, an efficiency loss. Subsidies also artificially lower the international price of a good making the subsidized good less cheaper for consumers thereby inducing them to buy more of the subsidized good than that supplied by more efficient foreign producers (i.e. consumption distortion). In addition to the efficiency cost, an export subsidy also leads to a “terms of trade” loss (i.e. a decline in export prices vis-à-vis import prices). See Handout: Asfaha, Samuel G Africa’s cotton crisis: Waiting for good news. South Bulletin - 108,

17 Other instruments of trade policy:
Import Quotas Restriction on quantity of imports Often enforced through import license Have the same effect as tariffs on domestic prices (hence production and consumption distortions) The implementation/enforcement of import quotas require issuing import licenses to some individuals or firms. Often, each individual or firm licensed to import the restricted good will have a quota, i.e. a maximum unit (such as number, weight, etc) of the good that can be imported per year. In some cases only government enterprises are licensed to import the good. Just like tariffs, import quotas limit quantity of imports hence push domestic prices higher than would otherwise be the case. As a result, consumers pay higher price for imports and demand less than would otherwise be the case (consumption distortion); and local producers also benefit from the higher prices and produces more than would be the case (production distortion). However, unlike in the case of imports, government earns no revenue from import quotas. Instead, the money that would have gone to governments in the form tariff revenue had tariffs instead of import quotas were levied now goes to the firms and individuals who held the right to import goods (i.e. the license holders). This profit is called quota rents. Both in the EU and the US import quotas have been the main trade instruments for sugar aimed at keeping domestic prices of sugar higher than international prices. The objective is to provide protection to domestic sugar producers from cheaper imported sugars. Both in the US and the EU, the right to sell sugars (the quotas) are allocated to foreign suppliers. Hence, the quota rents accrue to foreign suppliers. Case study: One of the oldest and most famous examples of trade protection was the United Kingdom’s Corn Law of The corn law, which was a total ban of importation of grains to England aimed at maintaining the French War era lucrative monopoly that farmers and landlords in Britain enjoyed. Read the handout on the one page handout on corn law in Annex *** and answer the following: What can you say about the politics of the adoption and repeal of the corn law? Map out the distributive effects of the corn law, i.e. who are the gainers and who are the losers? In what way would the advocates of the anti-corn law, namely middle-class manufactures, merchants, bankers and traders benefit from the repeal of the Corn Law?

18 Other instruments … Cont’d.
Voluntary export restraints Is a quota imposed on the side of the exporting (instead of importing) country. Often imposed by the request of the importing country - it thus is not truly voluntary. Exporting countries agree to it so as to not risk other worse forms of trade barriers such as import quotas or higher tariffs. It is discriminatory in its effect Voluntary export restraints (VER) are agreed between the importing and exporting countries. The importing countries request (actually put pressure) for VER so as to reduce competition from imports. The exporting countries often agree to restrict their own exports than risk sustaining worse terms from tariffs and/or quotas. In terms of its effect, VER has the same effect as that import quota with the import licenses assigned to foreign governments. Under VER, the quota rents go to the foreign suppliers. Examples include: Japan’s VER on its auto exports into the U.S. as a result of American pressure in the 1980s. Another well-known VER was the Multi – Fiber Arrangement (MFA) which restricted exports of textile and clothing to developed countries from 22 developing countries. The arrangement expired in 2005.

19 Other instruments … Cont’d
Local Content Requirements Requirement that some specific fraction of a good must be produced domestically Provides protection to local parts producers such as automobile parts etc. Was widely used as part of industrial policy The specific fraction could be stated in terms of physical units such as volumes etc. In other cases, it could be stated in terms of value-added in that some minimum share of the final price of a good need to represent domestic value-added. This policy was widely used in developing countries in order to promote industrial manufacturing. The policy provides protection to domestic parts producers by requiring suppliers to buy domestically certain amount per unit of each product they sell.

20 Other instruments … Cont’d
Export credit schemes Could take several forms. Two main forms are: Export loan - government institutions extend export credits directly, often in association with private financing. Export loan subsidy - Subsidized loan given to the foreign buyer by the exporting countries’ government operating indirectly to extend preferential refinancing and interest subsidies to private lenders. The objective of export credit schemes in their many forms is to assist domestic exporters by providing financing to foreign buyers. The risk on these credits, as well as on guarantees and insurance, is borne by the sponsoring government. To minimize the risk, governments put some form of restrictions on the amount of loans or subsidies allowed; and by excluding loans to some countries where risk of default is perceived to be high. Export credit schemes may give unfair trade advantages to domestic exporters against suppliers of competitive goods from other countries. Because the schemes “capture” buyers who would otherwise have preferred to buy the good from other suppliers.

21 Other instruments … Cont’d
Export credit schemes? What are their impact? To understand the effect, imagine this scenario: You have a shoe shop where you produce and sell a pair of shoe for $50. There is another shoe shop next to you which produces and sell an identical pair of shoes for 60$. Both you and your neighbours provide no loan and ask cash upfront for the sale of shoes. It is clear that you have a competitive advantage over your neighbour and it is sensible to believe that buyers prefer your shoes to your neighbours. Now, imagine that your neighbour has found a generous bank that could provide loans to her customers by paying her the full among of the shoes with the customers paying back the money in six months by paying $10 per month to the bank. Do you think that this will distort your competitive advantage? Now apply your analysis to the case of international trade where your neighbour is now your foreign competitor and the bank is her government?

22 Other instruments … Cont’d
National procurement May also be called government procurement, public tendering, public procurement etc … Purchases by government or regulated firms directed towards domestically produced goods and services. According to the World Trade Organization (WTO), government procurement is an important aspect of international trade accounting for considerable size of the procurement market (often 10-15 percent of GDP). By directing or restricting purchase of goods towards domestically produced goods, governments in their procurement decision can discriminate against imported goods.

23 Other instruments … Cont’d
Bureaucratic barriers Creating bureaucratic delays in customs clearance and other forms of administration barrier in order to discourage imports; Twisting laws, regulations and requirements in order to affect the internal sale, purchase, transportation and distribution of foreign goods.

24 Reflections What are the key policy instruments of trade policy in Indonesia? Could trade policy affect a country’s trade structure? Economic development? Employment and wages? How?

25 //

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