2. 1 Ch. 8: The Instruments of Trade Policy

3. 2 What Should A Nation’s Trade Policy Be? Should a nation protect a vital industry? Should a nation protect a vital industry? Who would benefit and who would lose? Who would benefit and who would lose? Would the benefits exceed the losses? Would the benefits exceed the losses? What kind of protection yields what kind of benefits and losses? What kind of protection yields what kind of benefits and losses? Import tariff Import tariff Import quota Import quota Export subsidy Export subsidy Voluntary export restraints Voluntary export restraints

4. 3 Tariffs Specific tariffs are $ amounts per unit, e.g. $15 per case of imported wine. Specific tariffs are $ amounts per unit, e.g. $15 per case of imported wine. Ad valorem tariff is percent of the value of the product imposed as tariff, e.g. 50% tariff on imported wine. Ad valorem tariff is percent of the value of the product imposed as tariff, e.g. 50% tariff on imported wine. Tariffs that were traditionally the main revenue of governments have declined in importance. Tariffs that were traditionally the main revenue of governments have declined in importance. Protection nowadays is through quotas, standards and export restraints. Protection nowadays is through quotas, standards and export restraints.

5. 4 Which Country Will Export Beef and Which Will Import? D S D S P beef Q Q Country ACountry B

6. 5 Country A’s Import Demand (High Cost Country) D S MD P beef Q Q Country A

7. 6 Country B’s Beef Export Supply (Low Cost Country) D S P beef Q Q Country B XS

8. 7 Equilibrium Price and Quantity in the World Market MD P beef Q Q Country B XS XS

9. 8 Imposing a Tariff D D S S Pw Pw Pt Pt* In a two-country world, imposing a tariff affects both parties. In this case, both countries are large countries: their behavior affects price. As a result, the tariff is shared by both: T=(Pt-Pw)+(Pw-Pt*) or T=Pt-Pt*.

10. 9 Tariff in a Small Country Pw S D Qd Qs Pt The definition of a small country is a country that cannot affect prices outside. In this case, the price effect of the tariff is solely on the small country.

11. 10 Effective Rate of Protection Suppose automobile companies use $3,000 worth of steel to produce a $10,000 worth of car. Suppose automobile companies use $3,000 worth of steel to produce a $10,000 worth of car. If US were to impose an import tariff on cars that raised the price to $12,500, can we say the protection was 25%? If US were to impose an import tariff on cars that raised the price to $12,500, can we say the protection was 25%? If US were to impose an import tariff on steel that raised the cost to car companies to $4,500, can we say the protection to steel was 50%? If US were to impose an import tariff on steel that raised the cost to car companies to $4,500, can we say the protection to steel was 50%?

12. 11 Effective Rate of Protection Before the tariff on cars, price was $10,000; afterwards, $12,500. Before the tariff on cars, price was $10,000; afterwards, $12,500. Before tariff, value added was $7,000; afterwards, $9,500. Before tariff, value added was $7,000; afterwards, $9,500. The effective rate of protection is (9500- 7000)/7000 or 2500/7000, which is 35.7%. The effective rate of protection is (9500- 7000)/7000 or 2500/7000, which is 35.7%.

13. 12 Effective Rate of Protection If steel had $3000 value added before and $4500 after the tariff, the effective rate of protection will be %50. If steel had $3000 value added before and $4500 after the tariff, the effective rate of protection will be %50. The impact on autos will be to reduce their value added from $7000 to $5500. The impact on autos will be to reduce their value added from $7000 to $5500. The effective rate of protection for the auto industry will be (5500-7000)/7000 or 1500/7000 or -21.4%. The effective rate of protection for the auto industry will be (5500-7000)/7000 or 1500/7000 or -21.4%.

14. 13 Costs and Benefits of a Tariff Tariff raises the price in the importing country. Tariff raises the price in the importing country. Producers gain. Producers gain. Consumers lose. Consumers lose. Government gains revenue. Government gains revenue. Tariff lowers the price in the exporting country. Tariff lowers the price in the exporting country. Producers lose. Producers lose. Consumers gain. Consumers gain.

15. 14 Consumer Surplus The market demand curve shows at each and every price how many units will be bought in the market. The market demand curve shows at each and every price how many units will be bought in the market. It also shows to sell a specific amount in the market, what the highest price should be. It also shows to sell a specific amount in the market, what the highest price should be. If a number of people are willing to pay that price and more, the product must have been worth to them that much. If a number of people are willing to pay that price and more, the product must have been worth to them that much. Some people were willing to pay more than the ongoing price. They have a windfall: consumer surplus. Some people were willing to pay more than the ongoing price. They have a windfall: consumer surplus.

16. 15 Consumer Surplus D Q P 127 $5.81 439 $3.54 The 127th unit can only be sold if the price were $5.81. All the previous units could be sold at higher prices. The people who paid $5.81 for those got a bargain. The windfall they got is equal to the triangle above the price.

17. 16 Consumer Surplus D Q 500 $3.54 $6.54 Calculate the consumer surplus. $2.54 667 Calculate the additional consumer surplus. $584 $750

18. 17 Producer Surplus Supply curve shows the amount brought to the market at each and every price. Supply curve shows the amount brought to the market at each and every price. In order to have more units brought to the market, the price has to rise to cover the increased cost of producing one more unit; i.e., MC is upward sloping. In order to have more units brought to the market, the price has to rise to cover the increased cost of producing one more unit; i.e., MC is upward sloping. If the cost of last unit sold just matches the price earned, the cost of previous units will be lower than the price. If the cost of last unit sold just matches the price earned, the cost of previous units will be lower than the price. The producers will earn profits on each previous unit. The producers will earn profits on each previous unit.

19. 18 Producer Surplus S 396 $4.07 In order to produce the 396th unit the price has to be at least $4.07. To produce more requires a higher price. All the units before 396 cost less than $4.07 to produce yet they are sold at $4.07. The producer surplus is the triangle between the price and the supply curve.

20. 19 Producer Surplus $1.50 $4.50 100 $7.50 200 Calculate the producer surplus at $4.50 and at $7.50. $450 $150

21. 20 Import Tariff in a Small Country Pw Q1 Q2 D S Pt Q3 Q4 Identify producer gain, government gain, and consumer loss.

22. 21 Import Tariff in a Small Country Consumer loss is greater than the gains of the producer and the government. Consumer loss is greater than the gains of the producer and the government. The efficiency (deadweight) loss is composed of production distortion and consumption distortion. The efficiency (deadweight) loss is composed of production distortion and consumption distortion. Production is distorted because high cost producers are allowed to produce instead of low cost producers. Production is distorted because high cost producers are allowed to produce instead of low cost producers. Consumption is distorted because consumers are forced to consume less at higher price. Consumption is distorted because consumers are forced to consume less at higher price.

23. 22 Import Tariff in a Large Country Pw Pt Pt* Q1Q2Q3 Q4 D S Terms of trade effect may compensate for the deadweight loss.

24. 23 Patrick Messerlin, Measuring the Cost of Protection in Europe, Institute of International Economics, 1999 as quoted in The Economist, May 24, 1999, p. 84. Average EU tariff on selected products, 1997

25. 24 European anti-dumping duties on selected products, 1997 Patrick Messerlin, Measuring the Cost of Protection in Europe, Institute of International Economics, 1999 as quoted in The Economist, May 24, 1999, p. 84.

26. 25 Export Subsidy in a Small Country Pw Ps Q1Q2Q3Q4 S D When there is no terms of trade effect, identify the welfare gains and losses. ab c d

27. 26 Export Subsidy in a Small Country There is no terms of trade effect. There is no terms of trade effect. Consumers lose a+b. Consumers lose a+b. Producers gain a+b+c. Producers gain a+b+c. Government “loses” b+c+d. Government “loses” b+c+d. Net loss b+d. Net loss b+d. Consumption distortion is b. Consumption distortion is b. Production distortion is d. Production distortion is d.

28. 27 Export Subsidy in a Large Country Ps Pw Ps* Negative terms of trade effect. Show welfare results.

29. 28 Export Subsidy in a Large Country Export price falls; negative terms of trade effect. Export price falls; negative terms of trade effect. Government subsidy is larger than in a small country case. Government subsidy is larger than in a small country case. Net loss is greater than the small country case. Net loss is greater than the small country case.

30. 29 EU’s Common Agricultural Policy EU countries are a net importer of agricultural products. EU countries are a net importer of agricultural products. To protect the incomes of the farmers initially support prices were established and import tariffs imposed to keep prices high. To protect the incomes of the farmers initially support prices were established and import tariffs imposed to keep prices high. The support prices are so high that it works as an export subsidy. The support prices are so high that it works as an export subsidy.

31. 30 EU’s Common Agricultural Policy Ps Pw Show benefit to farmers, cost to consumers and export subsidy.

32. 31 Common Agricultural Policy Over half of EU's budget goes to CAP. ( The Economist, May 8, 1999, p. 18.) Over half of EU's budget goes to CAP. ( The Economist, May 8, 1999, p. 18.) European beef farmers benefit from tariffs up to 125% on beef imports and from the ban on hormone-treated beef, which keeps out most American and Canadian produce. The cost is $14.6 billion a year in higher prices and taxes, or around $1.60 per kilo of beef. European beef farmers benefit from tariffs up to 125% on beef imports and from the ban on hormone-treated beef, which keeps out most American and Canadian produce. The cost is $14.6 billion a year in higher prices and taxes, or around $1.60 per kilo of beef. Patrick Messerlin, Measuring the Cost of Protection in Europe, Institute of International Economics, 1999 as quoted in The Economist, May 24, 1999, p. 84.

33. 32 Common Agricultural Policy European import restrictions more than double the price of many foods, such as milk, cheese and wheat. The duty on offal imports peaks at 826%. The cost of protecting European farming could be as much as 10-15% of value added in agriculture. European import restrictions more than double the price of many foods, such as milk, cheese and wheat. The duty on offal imports peaks at 826%. The cost of protecting European farming could be as much as 10-15% of value added in agriculture. Patrick Messerlin, Measuring the Cost of Protection in Europe, Institute of International Economics, 1999 as quoted in The Economist, May 24, 1999, p. 84.

34. 33 Patrick Messerlin, Measuring the Cost of Protection in Europe, Institute of International Economics, 1999 as quoted in The Economist, May 24, 1999, p. 84. Saving Jobs in EU Europe's costs of protection in 1999 was about 7% of EU's GDP - some $600 billion. Europe's costs of protection in 1999 was about 7% of EU's GDP - some $600 billion. With nearly 17 million Europeans out of work in 1999, politicians were susceptible to claims that competition from imports is costing jobs. With nearly 17 million Europeans out of work in 1999, politicians were susceptible to claims that competition from imports is costing jobs.

35. 34 Patrick Messerlin, Measuring the Cost of Protection in Europe, Institute of International Economics, 1999 as quoted in The Economist, May 24, 1999, p. 84. Saving Jobs in EU Protection in 22 heavily protected sectors safeguards only 200,000 jobs at a cost of $43 billion a year - or some $215,000 per job, enough to buy each lucky worker a new Rolls-Royce every year. Protection in 22 heavily protected sectors safeguards only 200,000 jobs at a cost of $43 billion a year - or some $215,000 per job, enough to buy each lucky worker a new Rolls-Royce every year. Since most workers in import-competing industries eventually find jobs elsewhere, the true number of jobs "saved" is tiny - and the annual cost of preserving them astronomical. Since most workers in import-competing industries eventually find jobs elsewhere, the true number of jobs "saved" is tiny - and the annual cost of preserving them astronomical.

36. 35 Protection in Industry in EU The average tariff (not effective tariff) on non- agricultural goods imported in 1997 was 5.1%. The average tariff (not effective tariff) on non- agricultural goods imported in 1997 was 5.1%. It excludes the impact of other import restrictions. For example, anti-dumping duties on "unfairly" cheap imports of products like steel, textiles and video recorders; quotas on imports from China and Russia; Japan's "voluntary" agreement to restrict its car exports all add to protection costs. It excludes the impact of other import restrictions. For example, anti-dumping duties on "unfairly" cheap imports of products like steel, textiles and video recorders; quotas on imports from China and Russia; Japan's "voluntary" agreement to restrict its car exports all add to protection costs. Patrick Messerlin, Measuring the Cost of Protection in Europe, Institute of International Economics, 1999 as quoted in The Economist, May 24, 1999, p. 84.

37. 36 Protection in Industry in EU Taking these into account, the true overall rate of industrial protection is at around 9% in 1997. The cost of that protection comes to as much as 8-12% of the value added in industry. Taking these into account, the true overall rate of industrial protection is at around 9% in 1997. The cost of that protection comes to as much as 8-12% of the value added in industry. Patrick Messerlin, Measuring the Cost of Protection in Europe, Institute of International Economics, 1999 as quoted in The Economist, May 24, 1999, p. 84.

38. 37 Protection in Services in EU A thicket of regulations whose costs cannot easily be estimated protects service sectors such as health care, telecommunications, financial services and airlines. But Mr. Messerlin estimates cost of protection could amount to 10- 15% of value added in services. A thicket of regulations whose costs cannot easily be estimated protects service sectors such as health care, telecommunications, financial services and airlines. But Mr. Messerlin estimates cost of protection could amount to 10- 15% of value added in services. Patrick Messerlin, Measuring the Cost of Protection in Europe, Institute of International Economics, 1999 as quoted in The Economist, May 24, 1999, p. 84

39. 38 Import Quota on Sugar in USA In 1990, US had import quota of 2.13 million tons on sugar; in 2002, it was 1.4 million tons. In 1990, US had import quota of 2.13 million tons on sugar; in 2002, it was 1.4 million tons. The world price of sugar was $280 per ton in 1990; it was $157.60 in 2002. The world price of sugar was $280 per ton in 1990; it was $157.60 in 2002. The quota raised the US price to $466/ton in 1990; in 2002, it was $417.40. The quota raised the US price to $466/ton in 1990; in 2002, it was $417.40. Given the demand curve and the local production of 5.14m tons at $280/ton, the quota created a shortage of 1.99m tons in 1990. Given the demand curve and the local production of 5.14m tons at $280/ton, the quota created a shortage of 1.99m tons in 1990. Price increase to $466 eliminated the shortage by providing domestic incentives to increase production to 6.32m tons in 1990. Price increase to $466 eliminated the shortage by providing domestic incentives to increase production to 6.32m tons in 1990. For 2002 results, see Figure 8-13 in the text. For 2002 results, see Figure 8-13 in the text.

40. 39 Import Quota on Sugar in USA, 1990 $466 $280 5.146.32 8.45 9.26 a = 186*5.14 + (186*1.18)/2 =$1066m b c=186* 2.13= $396 d b=.5*186*1.18=$110m d=.5*186*0.81=$75m

41. 40 Import Quota on Sugar in USA, 1990 Producer gains of $1066 million for 12,000 workers means a subsidy of $89,000 per worker. Producer gains of $1066 million for 12,000 workers means a subsidy of $89,000 per worker. Consumer loss is 1066+110+396+75 = $1647 million or $6 per capita. Consumer loss is 1066+110+396+75 = $1647 million or $6 per capita. If because of the quota 2500 extra people are employed in the industry, the cost of per job “saved” is $1,647,000,000/2,500 or $658,800. If because of the quota 2500 extra people are employed in the industry, the cost of per job “saved” is $1,647,000,000/2,500 or $658,800.

42. 41 Update on Sugar Quotas According to GAO, the cost to consumers in 1998 was $1.9 billion in higher prices. According to GAO, the cost to consumers in 1998 was $1.9 billion in higher prices. Artificially high prices led to overproduction where $1.4 million a month is paid by taxpayers to store one million pounds of sugar. Artificially high prices led to overproduction where $1.4 million a month is paid by taxpayers to store one million pounds of sugar. That is enough sugar to sweeten 180 billion donuts. That is enough sugar to sweeten 180 billion donuts. The chief beneficiaries are beet and cane growers. The chief beneficiaries are beet and cane growers. http://www.nytimes.com/2001/05/06/business/06SUGA.html?ex=990249498&ei=1&en=70dd040d727a9c94 Source:

43. 42 Update on Sugar Quotas The present program was put in place in 1981, during Reagan presidency. The present program was put in place in 1981, during Reagan presidency. In recent years, helped by technology and weather, production has exploded. In recent years, helped by technology and weather, production has exploded. A record 8.5 million tons of sugar was produced in the US in 1999. A record 8.5 million tons of sugar was produced in the US in 1999. Excess supply forced raw sugar price down to 18 cents/lb, lowest level in 20 years. Excess supply forced raw sugar price down to 18 cents/lb, lowest level in 20 years. The Agriculture Dept bought 132,000 tons in July 2000 at a cost of $54 million, 20 cents/lb. The Agriculture Dept bought 132,000 tons in July 2000 at a cost of $54 million, 20 cents/lb.

44. 43 Update on Sugar Quotas The largest producer of raw sugar, Flo-Sun of Palm Beach, FL, is owned by two Cuban exiles and are big donors to both Republican and Democratic parties. The largest producer of raw sugar, Flo-Sun of Palm Beach, FL, is owned by two Cuban exiles and are big donors to both Republican and Democratic parties. They want to restrict beet and cane production to control supply and limit imports of sugar. They want to restrict beet and cane production to control supply and limit imports of sugar. The US sugar supports provide direct payments by taxpayers to sugar growers. The US sugar supports provide direct payments by taxpayers to sugar growers.

45. 44 Update on Sugar Quotas Under 1994 Uruguay Round agreement, US is required to import about 1.1 million tons. Under 1994 Uruguay Round agreement, US is required to import about 1.1 million tons. NAFTA requires unlimited access to American market in 2008. NAFTA requires unlimited access to American market in 2008. In 2001, American officials claim 100,000 tons will be allowed in from Mexico. Mexicans claim the amount should be 500,000 tons. In 2001, American officials claim 100,000 tons will be allowed in from Mexico. Mexicans claim the amount should be 500,000 tons.

46. 45

47. 46 Voluntary Export Restraints (VER) Quotas imposed by the exporting country. Quotas imposed by the exporting country. It is similar the import quota where quota rents are reaped by the exporting country. It is similar the import quota where quota rents are reaped by the exporting country. Multi-Fiber Agreement on textiles and the Japanese auto VERs in early 1980s are examples. Multi-Fiber Agreement on textiles and the Japanese auto VERs in early 1980s are examples. According to the US government estimates Japanese VERs cost the US $3.2 billion in 1984. According to the US government estimates Japanese VERs cost the US $3.2 billion in 1984.

48. 47 Local Content Requirements Laws that require a fraction of the final good to be locally produced. Laws that require a fraction of the final good to be locally produced. It protects the local producers similar to an import quota. It protects the local producers similar to an import quota. The firms that are required to buy locally will have an increase in cost of production. The firms that are required to buy locally will have an increase in cost of production. Unlike an import quota, it does not restrict imports; the increased cost is passed to the consumers. Unlike an import quota, it does not restrict imports; the increased cost is passed to the consumers. Sometimes, local content laws accept exports by the firms to replace local content. Sometimes, local content laws accept exports by the firms to replace local content.

49. 48 Other Trade Policy Instruments Export credit subsidies: low interest loan given by the exporter to the importer. Export credit subsidies: low interest loan given by the exporter to the importer. National procurement: requirements that governments have to buy domestically produced goods. National procurement: requirements that governments have to buy domestically produced goods. Red-tape barriers: increasing health, safety or customs regulations to discourage imports. Red-tape barriers: increasing health, safety or customs regulations to discourage imports.

50. 49 Summary of Trade Policies