Trade Policy: Part 1 (Tariffs and Quotas)

International Economics

C. Brunnschweiler


12. Trade Policy: Part 1
• So far, we have contrasted autarky equilibrium with free trade equilibrium; both extremes virtually unheard of in practice. • Usually, any country that engages in trade erects various barriers to control and restrict trade. The most common barrier is a tax or tariff levied on the importation of foreign goods (sometimes on exports as well), followed by a quantitative restriction or quota, and other non-tariff barriers (NTBs) such as subsidies. Tariffs directly affect the price of imports and only indirectly the quantity via the effect of price increases on consumer and producer decisions. Quotas are in a sense the opposite of tariffs, because they directly restrict the quantities of imports and only indirectly affect prices through the artificial scarcity that the quantity restriction creates. Tariffs and quotas are similar in that they both ultimately restrict the quantity of imports and raise their domestic prices. • This chapter examines the policies that governments adopt towards international trade, as well as looking at the effects of trade policies and the reasoning behind them.
International Economics C. Brunnschweiler

12.1 Introduction


12. Trade Policy: Part 1
• There are two main reasons why a government would choose to levy taxes on trade: Protect operations of domestic industries that compete with imports. In H-O framework for example, restrictions would probably be more severe in sectors that intensively use scarce factors. Most extreme tax would eliminate imports altogether (termed a prohibitive tariff). Raise government revenues. Common practice in many developing countries, where taxing international trade at border is easier than collecting domestic income taxes. But tariffs used to be main source of government income before introduction of income taxes in advanced economies such as the U.S., as well.

12.2 Tariffs

12.3 Welfare loss from tariffs (SMOPEC)

• A SMOPEC can trade as much as it wants at fixed world prices p*; tariffs will not affect p*, but they will affect the equilibrium price ratio facing domestic consumers and producers. • Assume that pattern of comparative advantage is such that this country exports Y and imports X. • Government places ad valorem tax of t on each unit of X imported into country. Because p* is fixed, domestic price of X will rise by full amount of tax.
International Economics C. Brunnschweiler

Because exports are not taxed. Brunnschweiler . which is higher than world price ratio. resp. However. resp. Equilibrium conditions are therefore given by: MRS = MRT = p = p*(1+t) > p* Balance-of-payments constraint: px*(Xc – Xp)+ py*(Yc – Yp) = 0 or p* = (Yc – Yp) / (Xp – Xc) where subscripts p and c again denote the amounts of a good produced and consumed. domestic price ratio will be greater than world price ratio. Because of import tariff on X. because country does business abroad at world price ratio p*. rather than world prices. domestic production and consumption will be linked by world price ratio. • Trade must balance at world price ratio. • Post-tariff equilibrium is given in Figure 15. Trade Policy: Part 1 • Let p = px/py be the domestic price ratio.4 12. whereas Cf and Qf refer to free trade consumption and production points. -> Consumers pay and producers receive tariff-distorted domestic prices.1: A is the autarky equilibrium. p>p*. domestic and world prices will be related by px = px*(1+t) and py = py* or p = p*(1+t). • Domestic producers and consumers will equate domestic MRS in consumption and MRT in production to domestic price ratio. International Economics C.

the two points also satisfy the condition that MRS=MRT> p* Post-tariff welfare level Ut is lower than free-trade welfare Uf but higher than autarky level Ua. International Economics C. Tariff causes reduction in imports and also decline in exports. Brunnschweiler .5 12. Tariff causes production to move from free-trade point Qf back toward the autarky point A. Trade Policy: Part 1 A tariff on imports of X will result in production at point like Qt and consumption at point like Ct Points Qt and Ct are linked by world price ratio as required by balance-of-payments constraint (see equations above). which must be true in absence of change in world price ratio.

measured in units of import good X. Exports of VQt units of Y are worth VZ units of X at domestic prices but VCt at world prices -> quantity ZCt depicts tariff revenue. allowing them to reach consumption point Ct . Because tariff makes X seem more valuable than it actually is. losing gains from exchange. country specializes less in comparative-advantage good and sacrifices some gains from specialization. • In sum: Tariffs move the country back toward autarky by distorting domestic decision-making. while factor used intensively in X production gains.6 12.1 are shared unevenly: because overall welfare falls with tariff. Brunnschweiler . tariff redistributes income: production shift towards X will increase real income of factor used intensively in the production of that good and reduce real income of the other factor (H-O. International Economics C. Consumer prices are also distorted. Stolper-Samuelson theorem). the factor used intensively in producing Y will bear welfare loss in excess of total welfare loss. • Assumption: government rebates tariff revenue to citizens in lump-sum fashion. Trade Policy: Part 1 New trade triangle is Qt VCt . Finally. Loss in gains from trade reduces real national income from ONf to ONt . Losses shown in Figure 15.

where p is price along original excess demand curve the tariff reduces imports from Xf to Xt . defined by p’(1+t) = p. while tariff revenues are given by the rectangle pp*TS.7 12.2 shows same effects with excess demand curves: SMOPEC excess demand curve Ex. foreign excess demand curve E* (perfectly elastic at freetrade price ratio p*) Free trade would lead to level of imports Xf at world price ratio Tariff on X will shift down excess demand curve by t percent to E’x. with exports correspondingly reduced to p*Xt units of good Y Domestic relative price in SMOPEC becomes p = p*(1+t). International Economics C. Brunnschweiler . measured in units of Y. Trade Policy: Part 1 • Figure 15.

Both tend to shift resources out of export industries into import-competing industries. and since that is the ratio that matters. both have the same effect on production and consumption.4 Tariffs. A tariff acts like a tax on consumers and a subsidy to producers. and distortions (SMOPEC) International Economics C. import tariff and export tax have same effect on domestic price ratio. The import tariff on X leads to px > p*x while py = p*y.8 12. while px = p*x . taxes. • Export taxes and import tariffs are equivalent in that they tend to raise relative domestic price of imports and lower relative domestic price of exports. so that again p > p*. • Thus. 12. Brunnschweiler . An export tax on Y means that py = py*(1– t) and py < py*. a tariff has equivalent effect of consumption tax combined with production subsidy! Import tariffs and export taxes • Import tariff on X is equivalent to export tax on Y. Trade Policy: Part 1 • We saw above that a tariff raises the price of consumers and producers. so that p > p*.

9 12. tariff generates excessive production of Y International Economics C. Trade Policy: Part 1 Export subsidies * • Suppose that s is an ad valorem subsidy rate on exports of Y. where MRS in consumption equals distorted domestic price ratio Country trades more with rest of world (exports and imports increase). but welfare goes down from Uf to Us • Comparing the effects of an import tariff on X with those of an export subsidy on Y shows: Both policies distort allocation: subsidy generates excessive production of X. Then we have the following relationship (the balance-of-payments constraint seen above still holds): MRS = MRT = p = p* < p* 1+ s • The effects of an export subsidy are shown in Figure 15. the country produces more Y and less X (point Qs) than at the free trade equilibrium (point Qf) Real national income of 0Ns is smaller than in free trade (as with tariff) Consumption occurs at Cs. Then p y = p y (1 + s) and p = p* /(1 + s) < p* .3: Because of the export subsidy on Y. Brunnschweiler .

Trade Policy: Part 1 Export subsidies are usually more welfaredecreasing than tariffs because they require taxpayers to fund them rather than generating tax revenues Export subsidy could even make economy worse off than under autarky if induced production distortion were so large that world price line emanating from distorted production point Qs actually passed below indifference curve Ua (see section 15. for mathematical proof).10 12. Brunnschweiler .7 in Markusen et al. International Economics C.

as in oil or gas or also steel production).11 12. increases producer price of X).e. some minimum production level viewed as important for national security.g. International Economics C. leading to both loss of gains from exchange and specialization Direct output subsidy (assumed to lead to same producer receipts per unit as import tariff) only distorts producer prices (i. What is least-cost way to do this? Import tariff acts as tax on consumption as well as subsidy to production because it distorts both consumer and producer prices. Trade Policy: Part 1 Consumption taxes and production subsidies • Suppose that government wants to increase production in import-competing sector X relative to free-trade level (e. leading only to a loss in gains from specialization. Brunnschweiler .

import tariff shown in Figure 15. Brunnschweiler . Trade Policy: Part 1 • Outcome of production subsidy vs. but consumption will be at point Cs and utility at Us because consumers can trade at world prices. International Economics C. resulting in welfare level Ut Production subsidy on X again shifts output to Qt .4: Import tariff on X shifts production from Qf to Qt and consumption from Cf to Ct.12 12.

The tariff would influence production in the opposite way to the subsidy. Equivalently. then tariffs could offset these and become welfare-increasing according to the theory of the second best: In the presence of multiple distortions such as domestic taxes or monopoly. which would lead to distorted production and consumption as in chapter 9. welfare is not necessarily imporved by removing a single distortion. distorting consumer prices and improving welfare even at fixed world prices. If there are domestic distortions. Trade Policy: Part 1 Tariffs and distortions • So far we have assumed that there are no distortions in SMOPEC. Brunnschweiler . adding another distortion may be welfare-improving! • Example is the presence of a production subsidy on Y introduced for political reasons. The government could probably improve welfare even without scrapping the subsidy by introducing an import tariff on X: this would raise the domestic price of X and encourage its production. International Economics C. in the presence of of distortions. The effect of the tariff would then be to push the economy back towards its efficient pattern of specialization.13 12.

the worse its terms of trade become (remember that the TOT give relative prices of a country’s exports to its imports).6 shows two countries in a trading h situation. • Figure 15. In free trade. with Home importing X h and 0 Foreign exporting X f . Trade Policy: Part 1 • We now assume that we’re looking at a large country instead of the SMOPEC examined so far: world prices will be influenced by behavior of large country. Brunnschweiler . Ex is Home’s excess demand for f good X and Ex is Foreign’ excess demand for 12.5 Tariffs and monopoly power X.14 12. i. the equilibrium would be at 0 p* f (see point F). the world price of the export good will fall if it exports more.e. and rise in the opposite case -> the more the country trades. • Assume that Home imposes a tariff (either import tariff on X or export tariff on Y): International Economics C.

making the home country better off with the tariff. * Tariff revenue is given by the area ppt TS * * • However: fall in relative equilibrium world price of Home’s export good Y from p f to pt represents a gain in Home’s TOT! The welfare benefit from this favorable TOT effect would to some extent mitigate the welfare loss from reduced trade. • Figure 15. International Economics C.15 12. Brunnschweiler . Trade Policy: Part 1 Home’s excess demand curve shifts down to E xh' . which causes the equilibrium world price * ratio to fall to pt (see point T) at the same time as the domestic price ratio in Home is driven up to p (point S. recall that p = pt* (1 + t ) ) 1 1 Restriction of imports in Home to level X h (and of foreign exports to X f ) is a move towards autarky: the higher domestic price that distorts production and consumption decisions lowers welfare.7 shows the possibility that the positive TOT effect outweighs the negative trade effect from the tariff.

thereby moving prices in a country’s favor.16 12. • Economic intuition: a country would like its firms to be perfectly competitive when selling at home. Welfare increases from U f to U t . the government can bring the country to behave as a monopolist: the tariff causes the country to restrict its “output” (exports) like a monopolist. • However. they cannot act in this way. Trade Policy: Part 1 * * Tariff lowers world price ratio from p f to pt . as well as distortionary losses from the altered relative prices. one country’s TOT gain is always another’s TOT loss: Foreign suffers a TOT loss. Because we assume that firms are competitive. which push resources out of its International Economics C. and to restrict its “demand” (imports) like a monopsonist. resulting in post-tariff at Qt and production Ct . Brunnschweiler . but it would be beneficial for the country overall to behave as a monopolist when selling abroad. However. and consumption respectively.

International Economics C. Foreign could retaliate by imposing its own tariff on Home’s exports in a process termed a “trade war”: this type of behavior is generally harmful to global welfare and would probably leave both Home and Foreign worse off than in free trade. this retaliatory move would shift up Foreign’s export-supply portion of E xf (i. possibly at the same world price ratio as with free trade but with lower trade volumes. if all countries were to pursue their own “optimal” strategy at the same time. which would further restrict trade and move the TOT back against Home.17 12.6. Brunnschweiler . the portion to the left of the vertical axis). However. • Because of the very real possibility of foreign retaliation. Trade Policy: Part 1 export sector and change consumption behavior. they would probably all be worse off! Quite often however. In Figure 15. Both countries would be worse off. which is usually based on the assumption that trade partners will not react.e. the mere threat of retaliation will be enough to prevent a country from imposing its optimal tariff – there is a large strategic element to trade policy. it is difficult to derive anything resembling an “optimal tariff”.

Trade Policy: Part 1 • Discussion so far has implied that a tariff provides protection from imports.g. • In general. • Any tariff system will be a disadvantage to export industries. e. • Most commodities are produced with intermediate inputs which are themselves subject to trade taxes.6 Tariffs and effective protection . Brunnschweiler 12. a tax on imported steel would raise costs and lower output in automobile sector even if there were a protective tariff on cars. meaning that raw materials are allowed to be imported largely duty-free. • Developed countries often have a structure of escalating tariffs. and worse off as tariffs rise on imported inputs. which is reasonable for goods produced with nontraded primary inputs (e. thereby boosting domestic production of the protected good. which must sell at world prices: input tariffs will raise costs that may not be offset by export subsidies. while processed intermediates have higher International Economics C. labor and capital) and freely traded intermediates. The term effective protection refers to the fact that all such tariffs need to be taken into account in computing net protective effect of tariff structure.18 12. manufacturers are better off as tariffs rise on imports that compete with their outputs.g. Assumption is that tariff is only tax that directly affects costs and prices of the good.

The associated effective rates of protection (including trade barriers. often with the goal of fostering growth in domestic manufacturing through import substituting industrialization (e.19 12. • For example. implying that the tariff structure is used as an implicit protection. and finished goods have yet higher import taxes. and exchange-rate regime) were 832 percent and 1308 percent. Brunnschweiler . Brazil during the 1970s80s). International Economics C. in 1969 Argentina was estimated to have nominal tariff rates of 63 percent on finished textiles and 76 percent on woodworking industries. Trade Policy: Part 1 tariffs. Tariff escalation is a substantial bone of contention between developed and developing countries in trade negotiations. This policy was often accompanied by deliberate overvaluation of domestic currency. in part to discourage exports of primary products and keep them for use by domestic manufacturers. resp. • Many developing countries arranged protective structures so that effective tariffs are far higher than published tariffs.g. taxes. This means that effective protection for finished products is higher than nominal rates suggest! This is especially true in some labor-intensive products.

Trade Policy: Part 1 • Table 15.1 provides further evidence of the discrepancy between nominal and effective protection rates. substantial gaps still remain especially in developing countries. although the estimates are not the most recent. Brunnschweiler .20 12. International Economics C.

taxed more than it is subsidizd. The policy ensures that farming and preservation of the environment go hand in hand.21 12. with its 19 million jobs. section 15. and subsidies • A simple condition permits us to extend the definition of gains from trade to a model with many goods. then the country is better off than in autarky. bioenergy and biodiversity…] Europe’s stepwise integration since the 1950s and the formation of what is today called the European Union (EU) has had many effects.7 for formal derivation). the International Economics C. Brunnschweiler . With other words: if trade is. trade taxes. on average. It helps develop the economic and social fabric of rural communities. chapter 8 [From the EU’s homepage: “The common agricultural policy is fundamental to the strength and competitiveness of EU farming and of the agri-food sector as a whole. then there will be gains from trade (see Markusen et al. some of which are taxed and some of which are subsidized: if net trade tax revenue (the sum of all import and export tax revenues minus trade subsidy payments) is positive. First. A practical example of tariffs and export subsidies: Europe’s Common Agricultural Policy From Krugman & Obstfeld (200&). water management. It plays a vital role in confronting new challenges such as climate change. Trade Policy: Part 1 Gains from trade with many goods. of which two of the largest are on trade policy.

Second. an export subsidy is paid that offsets the difference between European and world prices. however. The result was that the EU found itself obliged to buy and store huge quantities of food. the political strength of farmers in the EU has been so large that the program has been difficult to rein in. To avoid unlimited growth in these stockpiles. Costbenefit analysis would clearly show that the combined costs to European consumers and taxpayers exceed the benefits to producers. To export the resulting surplus. Depsite the considerable net costs of the CAP to European consumers and taxpayers.2 million tons of butter. it was initially backed by tariffs that offset the difference between European and world agricultural prices. The subsidizd exports themselves tend to depress world prices. European nations had stored 780’000 tons of beef. The policy works like the export subsidy we saw earlier: the EU subsidizes the export of the good where it has a comparative disadvantage (meaning that it would import under free trade). however. 1. The EU support price. shifting production in that direction. the EU turned to a policy of subsidizing exports to dispose of surplus production. the agricultural policy of the EU has developed into a massive export subsidy program. At the end of 1985. creating a customs union. To prevent this policy from drawign in large quantities of imports. is set not only above the world price p* that would prevail in its absence. was producing more than consumers were willing to buy. but as an effort to guarantee high prices to European farmers by havign the EU buy agricultural products whenver the prices fell below specified support levels. Since the 1970s. Brunnschweiler . but also above the higher autarky price. which would under free trade be an importer of most agricultural products. Trade Policy: Part 1 members of the EU have removed all tariffs with respect to each other. and 12 million tons of wheat. One International Economics C. the support prices set by the EU have turned out to be so high that Europe. increasing the required subsidy. The EU’s Common Agricultural Program (CAP) began not as an export subsidy.22 12.

Quantitative restriction leads to artificial scarcity of X. food safety. [Reforms of 2003 have meant that farmers still receive direct income payments to maintain income stability. • Suppose Home imposes a quota on imports of X.] 12. so that only QR units of X can be imported in every period.7 Quotas • Start out by considering a SMOPEC.23 12. but the link to production has been severed. Farmers who fail to do this will face reductions in their direct payments. who complain that the EU’s export subsidies drive down the price of their own exports.1 shows the home country. while continuing to provide aid to farmers. The budgetary consequences of the CAP have also posed concerns: in 2002. Brunnschweiler . In addition. Figure 16. Recent reforms in the CAP represent an effort to reduce the distortion of incentives caused by price support. Government subsidies to farmers are equal to about 36 percent of the value of farm output (twice the US figure. This aims at making agricultural production more market-oriented. Trade Policy: Part 1 source of pressuer has come from the US and other food-exporting nations. phytosanitary and animal welfare standards. which raises price of X for both consumers and producers. increasing the domestic price ratio p =MRT=MRS. for example). farmers have to respect environmental. the CAP cost European taxpayers almost $50 billion – without including the indirect cost to consumers. which imports Cx − Qx units of X at the fixed world price ratio p*. reducing prices and production. International Economics C.

New trade triangle shows restricted level of X imports under quota and amount of Y exports needed to pay for imports at world prices. Brunnschweiler . so that slopes of two curves are the same. 16. given by p.] • Effects of import quota in Fig. Trade Policy: Part 1 Because cost of QR units of X on the world market is still given by p*.e. One endpoint of the hypotenuse will be on the PPF.1 similar to those of import tariff in Fig. the other on a community indifference curve. a new post-quota equilibrium can be found. this move toward autarky will benefit the scarce factor according to Stolper-Samuelson theorem. Again.1: quota lowers domestic welfare. distance from world price line p* to domestic price line p) gives difference in value of International Economics C. • ACq (i.24 12. 15. this time from U f to U q . [Locate a trade triangle that is QR units long on the X side but still has a hypotenuse with slope p*.

this is the quota rent: a lucky group of importers will get a permit to buy X cheaply in Foreign and sell it at a premium in Home. Import quota QR distorts home’s excess demand curve to Exq . Brunnschweiler . causing price of X to rise to p in Home. home imports Xf units of X at world price p*. Initial imports in H International Economics C. Trade Policy: Part 1 imports at world and domestic prices. In free trade. resp. In quota case. • Figure 16.3 shows the same situation for a large country: Exh and Exf are Home and Foreign excess demand curves. • Figure 16. We assume that this rent is used for consumption purposes. leading to final equilibrium at Cq .25 12. this was the tax revenue. In tariff case.2 shows the effects of import quotas in a SMOPEC using excess demand curves: Ex and E* are the Home and world excess demand curves for X.

Import quota QR in Home creates disequilibrium that leads to price and quantity changes in both countries. which drives up the (domestic) price to p! In new equilibrium. Because H is a large country. The gap between the prices gives the rents (rectangle pp* TS ) that accrue to those q who have the import permits. At free-trade price p* there is a surplus of X in Foreign. on the other hand. Excess demand curve of H is now truncated at QR. its price fallen in F and risen in H. as long as TOT from forcing down price International Economics C. Brunnschweiler . there’s a shortage of X in Home.26 12. which drives down price to pq * . Trade Policy: Part 1 are of Xh at world price p*. then welfare may rise. equal to exports Xf in Foreign. trade of X has been restricted to QR. at point Exq . the quota has TOT effects: if quota rents stay in H.

Trade Policy: Part 1 of X in F offsets negative volume-of. also known as a voluntary restraint agreement or VRA). while H suffers both a negative TOT effect and a negative volume-of-trade effect.S. because VER allows foreign country to collect and benefit from any quota rents. a study on three major U. Unfortunately. • The allocation of rents from import quotas can be done in different ways. Welfare implications for Home with VER are always worse than under domestic import quota. i. For example. VERs of 1980s – in textiles and apparel. an activity .e. and International Economics C. A VER leads to the allocation of quota rents among exporters in Foreign rather than importers in Home. import quotas sometimes become political favors and give rise to rent-seeking behavior.trade effect. including grandfathering or auctioning. This possibility can make tariffs a less costly means of import protection. Brunnschweiler .27 12. F benefits from the positive TOT effect. steel. • Another mechanism for establishing a quota is for the importing country to request that the exporting country voluntarily restrict its exports through a voluntary export restraint (VER.be it lobbying or bribery – in which real resources are (inefficiently) expended in the effort to acquire economically valuable “prizes”.

To avoid retaliation from trade partners.S. sugar From Krugman & Obstfeld (2006). Unlike the European Union. VERs can both appease domestic interest groups and foreign trade partners. Thus the U. An import quota in practice: U. There are also multilateral VERs such as the Multi-Fiber Arrangement limiting textile exports from 22 countries until 2005. with the added benefit of generally not violating multilateral trade agreements since VERs are voluntary.28 12.S. International Economics C. sugar problem is similar in its origins to the European agricultural problem: a domestic price guarantee by the federal government has led to U. chapter 8 The U. i. the domestic supply in the U.S. however. Trade Policy: Part 1 automobiles – showed that around two-thirds of cost to consumers of trade restraints was accounted by rents earned by foreigners. has been able to keep domestic prices at the target level with an import quota on sugar. there was a transfer of income rather than a loss of efficiency.S. • Why are VERs used? Trade policy instruments are often used for political purposes to favor powerful interest groups. Brunnschweiler .S.e. prices above world market levels. does not exceed domestic demand.

S. sugar producers.S.S.29 12. each of whom receives a large benefit.S. The sugar quota illustrates in an extreme way the tendency of protection to provide benefits to a small group of producers. the price of sugar in the U.S. In 2002. the quota restricted imports to app. In this case.806 billion. rents generated by the sugar quota accrue to foreigners. The net loss to the U. a total of US$662 million per year – most of this due to the fact that the quota rents accrue to foreign importers.247 billion) and the consumption distortion (US$0.364 billion. Trade Policy: Part 1 A special feature of the import quota is that the rights to sell sugar in the U. the yearly consumer loss amounts to only US$8 per capita. The U.7 million tons. Part of the loss represents the production distortion (US$0. however. It should be no surprise that sugar producers are very effectively mobilized in defense of their protection. The welfare effects of the import quota are estimated at around US$2.052 billion). Not surprisingly. so the producer gains from the quota represent an implicit subsidy of about US$20’000 per employee. who then allocate these rights to their own residents. free trade would more than double imports to 3. each of whom bears only a small cost. sugar market does not have a major impact on the world price. sugar industry employs only about 38’000 workers. the quota is a life-or-death issue. is given by the distortions plus the quota rents. who gain a producer surplus [the amount a producer gains from production by the difference between the price he actually receives and the price he would have been willing to sell at] of US$1.4 million tons. or around US$30 for a typical family. 1. The rents to foreign governments that receive import rights amount to US$0. the average American voter is unaware that the sugar quota exists.. From the point of view of the sugar producers. and so there is little effective opposition. Brunnschweiler . According to an estimate which assumes that the U.S. as a result. was more than twice the price in the outside world.468 billion. As a result. at the expense of a large number of consumers. Part of the consumer loss represents a transfer to U. are allocated to foreign governments. International Economics C.

Rather than act unilaterally and risk creating a trade war.S. and. Third. competitors in any case. at US$3. the auto industry is clearly not perfetly competitive. preferred much larger cars than Europeans and Japanese. with the rent captured by Japanese firms. The effects of this voluntary export restraint were complicated by several factors. by and large. protectionist measures if they did not do so.S.2 billion in 1984. however.S. buyers. output fell. government asked the Japanese government to limit its exports.85 million in 1984 to 1985. First.S. market to shift abruptly toward smaller cars. Brunnschweiler . A revision raised that total to 1. The U.S. U. foreign firms had chosen not to challenge the U. The first agreement. primarily in transfers to Japan rather than efficiency losses.68 million automobiles. auto industry was largely insulated from import competition by the difference in the kinds of cars bought by U. Nonetheless. the agreement was allowed to lapse. in the large-car market. government estimates the total costs to the U.S. cars were clearly not perfect substitutes.S. whose costs had been falling relative to their U. rose.S. the U. demanded protection for the U.S. the basic results were what the discussion of VERs above would have predicted: the price of Japanese cars in the U. Second. In 1985. to 1.S. Trade Policy: Part 1 A Voluntary Export Restraint in practice: Japanese autos From Krugman & Obstfeld (2006). in 1981.S.S. the U. chapter 8 For much of the 1960s and 1970s. and foreign consumers.S. fearing unilateral U. In 1979. living in a large country with low gasoline taxes. The Japanese. sharp oil price increases and temporary gasoline shortages caused the U. industry.S. agreed to limit their sales. Japanese and U. moved in to fill the new demand.S.30 12. As the Japanese market share soared and U. the Japanese industry to some extent responded to the quota by upgrading its quality and selling larger autos with more features. International Economics C.S. limited Japanese exports to the U. Japanese producers. strong political forces in the U.

(similar to Fig. the main difference being that quotas generate rents.1.4.1. as seen in Figures 15. 16. which can however be accounted for by the rent/revenue distribution mecahnism. while tariffs generate tax revenues. and we again International Economics C. while its domestic price ratio rises to p. Potential equivalence shown in Figure 16. Quota of QR will distort domestic equilibrium to point E with Home importing QR units of X at price p*. Brunnschweiler . excess demand curve will shift down to Ext . and 16.2): Ex is free-trade excess demand curve for X in Home.31 12. Trade Policy: Part 1 12. If tariff of rate imposed instead t = p / p * −1 is (so that p = p * (1 + t ) ).8 Comparing the effects of tariffs and quotas • Tariffs and quotas can potentially have very similar effects.

the impliction is that resources will be moved toward the import-competing sector. Brunnschweiler . Economic Growth • Suppose that economic growth is associated with increases in the resource endowments of country H. any perturbation to the world price or domestic excess-demand curve will leave us with non-equivalent effect. • According to the Rybczynski theorem. making the economy more similar to the rest of the world and moving the country’s excess demand curve down as the home autarky price moves toward the International Economics C. We examine three important situations in which they differ below. Trade Policy: Part 1 arrive at distorted equilibrium E As long as quota rents and tariff revenues are distributed in the same way. the tariff and quota will have identical economic effects. Tariffs permit quantities of imports to change so that adjustment will occur in quantities (and also in prices as well if the importing nation is large). so all changes must be absorbed by price changes. tariffs and quotas do not always have equivalent effects. • Quotas are rigid with respect to import quantities.32 12. • However. spcifically that the scarce factor grows larger.

Trade Policy: Part 1 world price p*. the quota is actually preferable in welfare terms to the tariff because as growth proceeds. because it is the constant tariff rate that causes the excess demand curve to adjust (not a fixed quantity like in the quota). The tariff will leave the domestic price the same at p because p = p * (1 + t ) still holds. Under an initially equivalent tariff. In case of abundant-factor growth.33 12. welfare losses would be lower with a tariff. Under a quota. while under a tariff there would be rising imports at the same domestic price. while the tariff prevents the price from falling. the quota becomes less binding. the excess demand curve would shift down with growth and the quotadistorted domestic price gradually fall towards p* as the relative scarcity of the imports falls with economic growth. the quota would become increasingly binding and domestic price would steadily rise. however. but the level of imports will shrink. In case of scarce-factor growth. the tariff-distorted exces demand curve also falls. International Economics C. as scarce-factor growth pushes down the excess demand curve. Brunnschweiler .

34 12. with t>0. Brunnschweiler . i. Under a tariff. International Economics C. Trade Policy: Part 1 Price fluctuations • In general. and thus the “implicit tariff” t is increased in value. t varies inversely with the world price: an increase in the foreign price p* will narrow the gap between foreign and domestic price ratios. In case of a tariff. Under a quota. • Suppose that a SMOPEC can choose between a tariff and a quota. A decrease in p* will mean that domestic importers are willing to bid more for the import licenses. t is the fixed ad valorem tariff rate. In case of a quota. The quota provides better insulation from foreign price fluctuations. the domestic and foreign price ratios are related by p = p * (1 + t ) . whereas the tariff provides better insulation from fluctuations that are domestic in origin. we consider t to be an “implicit tariff” rate that gives the difference between the foreign price and the price domestic consumers are willing to pay. and that the foreign excessdemand curve shifts up and down randomly (foreign price fluctuations).e. the domestic price ratio will fluctuate in proportion to the foreign price fluctuation becacuse t is fixed. t is the percentage difference between the world and domestic relative prices induced by the quota.

implies that monopolists will behave differently under tariffs and quotas. stating that a firm will behave more competitively if its market is contestable. in this domestically monopolized market. A tariff leaves the domestic market contestable. but prices remain at p with a tariff. Any movement by a monopolist to restrict output and raise price above the current. • There is a possible double-distortion problem in the case of protection and imperfect International Economics C. tariffdistorted level will be offset by increasing amounts of imports from foreign competitors. being a restriction on the quantity of sales on a market. import prices will rise to pm when imports are artificially scarce due to a quota of QR. The monopolist can reduce output and raise prices without fear that additional imports will flood the domestic market and force price back down. albeit at higher tariff-distorted prices.35 12. Trade Policy: Part 1 Domestic monopoly • The contestable market hypothesis. Suppose the extent of monopoly power allows a shift up of Ex to E’x. Brunnschweiler . In Figure 16. A quota.4. forcing the importing country’s excess-demand curve (which reflects consumption minus production) to rise. destroys the contestability of a market. a domestic monopolist is able to restrict output.

International Economics C. and the economy may see an overall improvement in welfare. there tends to be an oversupply of the protected good. However. the lower levesl of monopoly output may simply compensate the distorted overproduction arising from protection.36 12. Brunnschweiler . there is an undersupply of the monopoly good. Trade Policy: Part 1 competition. If a country switches from tariff to quota. under trade protection. Under a monopoly. it is giving license to domestic monopolists to cut output and raise prices.