Instruments of Trade Policy

Financial Management MBA Programme

University of Coburg, December 2019
Alba Patozi
Introduction
• So far we have considered the determinants and effects of
international trade:
• Classical trade theory
• New Trade theory
• Now we are going to turn to trade policy:
• What are the effects of trade policies?
• How do domestic and trade policy interact?
Trade and Domestic Policies
• Trade policies are policies which directly influence trade flows.
• Examples are trade tariffs, import quotas, voluntary export restraints
and export subsidies.
• However, also domestic policies, such as production subsidy, for
example will have an impact on trade flows.
• Today we will analyze the effects of trade policy in classical trade
theory models.
Outline
• Trade policy in partial equilibrium
• Domestic policies and trade policy
Partial Equilibrium Analysis
• We first examine the effects of trade policy in just one market.
• The industry is too small to affect factor prices that are therefore taken as
given and left out of the analysis.
• We therefore do not consider the indirect (general equilibrium) effects.
• Welfare changes will be measured with the help of consumer and producer
surplus.
• Consumer surplus is the area underneath the demand curve and above the
equilibrium price.
• Producer surplus is the area above the supply curve and below the
equilibrium price.
Model’s assumptions
• Economic Environment
• Two countries (Home and Foreign)
• One homogeneous commodity (bananas)
• Perfect competition
• In the absence of trade the price of bananas is lower in Foreign than
in Home,
• We will use excess supply and demand curves to derive the world
market price of bananas.
Import demand and Export Subsidy
• In autarky, the home price 𝑃! is assumed to be higher than the
foreign price 𝑃!∗
• Hence, with trade: Home country imports bananas, so we have to
construct a home import demand curve. Foreign country exports
bananas, so we have to construct a foreign export supply curve.
Home import demand
• Home excess (or import) demand: MD = D – S.
• 0 at 𝑃! and downward sloping: As price increases, the quantity of
imports demanded declines.
Foreign Export Supply
• Foreign excess (or export) supply: XS* = S*- D*.
• 0 at 𝑃!∗ and upward sloping: As price increases, the quantity of
exports supplied rises.
World Market Equilibrium
• World market equilibrium: World demand = World Supply.
• Import Demand = Export Supply
Import Tariff
• What happens when the importing country imposes a tariff?
• A specific tariff is levied as a fixed charge for each unit of imported
goods.
• For example, £1 per kg of cheese.
• An ad valorem tariff is levied as a fraction of the value of imported
goods.
• For example, 25% tariff on the value of imported cars.
“Small” Country
• What if the home country is too small to affect world prices?
• When a country is “small’, it has no effect on the foreign (world) price
because its demand is an insignificant part of world demand for the
good.
• The foreign price does not fall, but remains at 𝑃#
• The price in the home market rises by the full amount of the tariff, to
𝑃$ = 𝑃# + 𝑡 , where t is the amount of the tariff.
Small Country Tariff Equilibrium
Welfare Impact of Tariff
• Import tariff raises the home price, so it hurts home consumers and
benefits home producers.
• In addition, the government gains tariff revenue.
• To measure and compare these gains and losses, we use the concept of
consumer surplus and producer surplus.
• Welfare analysis for home:
• Consumer surplus
• Producer surplus
• Government revenue
• Net Welfare Impact
Consumer Surplus
Consumer Surplus: The difference between the maximum price
consumers are willing to pay and the actual price. The maximum price
consumers are willing to pay is determined by the demand curve.
Producer Surplus
Producer Surplus: The difference between the actual price and the
minimum price producers are willing to accept for each unit sold. The
minimum price producers are willing to accept is determined by the
supply curve.
Welfare Impact of tariff: Small Country
Optimum Tariff Large Country
Optimum Tariff: Large Country
Optimum Tariff: Large Country
Optimum Tariff: Large Country
• For a ‘large’ country, whose imports and exports affect world prices, the
welfare effect of a tariff is ambiguous.
• Triangles b and d: Efficiency loss
• The tariff distorts production and consumption decisions: producers
produce too much and consumers consume too little.
• Rectangle e: Terms of trade gain: The tariff lowers the Foreign price,
allowing Home to buy its imports cheaper. Edgeworth (1894)
• If ToT gain > Efficiency loss, then national welfare will increase under a
tariff, at the expense of foreign countries.
• The large country can choose the tariff that maximizes its net welfare gain.
That is the Optimum Tariff argument.
Empirical Evidence
• Broda, Limao, Weinstein (2008): Countries that are not members of
the WTO set higher tariffs.
• Typical country sets tariffs 9% points higher in goods with high market
power relative to those with low market power. This large effect is of
similar magnitude to the average tariffs in the data.
Summary of Instruments
• The optimal trade policy in a competitive economy is in general free
trade.
• The only exception is the optimum tariff argument, however, this
depends on no retaliation by the foreign country.
Political Economy of Trade Policy
• The case for free trade:
• The case against free trade
The case for free trade
• Four arguments in favor of free trade:
ØAllocative efficiency: recourses are more efficiently allocated when
market prices are not distorted through trade policy.
ØEconomies of scale: a large integrated market allows industries to
produce at low average costs
ØImperfect competition: free trade reduces firms’ market power,
increases product variety and allows only the most productive firms
to survive.
ØRent seeking: trade restrictions generate rents and resources shifted
from productive to unproductive rent-seeking activities.
Against Free Trade
• Terms of trade and the optimum tariff
• Domestic market failures
(Unemployed resources, externalities, undefined property rights,
incomplete information)
• Infant industry and import substituting industrialization
• Economies of scale and export led industrialization
• Imperfect competition and strategic trade policy
Terms of trade and Retaliation
• The terms of trade logic implies a large country may have an incentive
to impose an import tariff or an export tax unilaterally.
• But it assumes that other countries do not retaliate by enacting their
own trade decisions.
• If this happens, the outcome is a ‘trade war’.
• The likely outcome is a ‘trade war’ where all countries competitively
enact trade restrictions and end up being worse off than with free
trade.
Trade wars and Trade Talks
• A trade war results when each country has a unilateral incentive to
impose trade restriction, regardless of what other countries do
• In a trade war, all countries enact trade restrictions even if it is in the
interest of all countries to have free trade
• Multilateral negotiations help avoid trade wars. This is the logic of the
World Trade Organization (WTO)
• The point can be illustrated by a simple example with two countries:
US and Japan
Trade Wars and Trade Talks
• If trade is free, both countries achieve a welfare level equal to 10. Joint
welfare is 20.
• If a country restricts trade unilaterally and the other country does not
react, the protecting country gets 20 and the other gets -10. Joint
welfare is 10.
• If the other country reacts, both countries get -5. Joint welfare is -10.
Trade wars
• The non-cooperative (Nash) equilibrium is a situation in which neither
country wants to change its decision given the decision of the other country
• The only outcome with this property is Protection – Protection (’trade war’)
• Both countries get -5 and joint welfare is -10
Trade talks
• If countries cooperate, they agree on the choices that maximize joint
welfare
• The only outcome with this property is Free Trade- Free Trade (‘trade talk’)
• Both countries get 10 and joint welfare is 20
 What has the GAAT/WTO done?
• Tomz, Goldstein and River
2007 (AER): Trade between
two formal GATT members if
62% higher than trade
between pairs of
nonparticipants.
• Gravity equation (includes
e.g. distance, common
language) and date and year
fixed effects in column (5)
N = 234, 597, 𝑅 % = 0.84
Summary
• The aggregate gains from trade and their cross-country distribution
determine the case for/against free trade.
• With retaliation, trade agreements provide a way to overcome terms
of trade externalities.
Taking Stock
What determines the pattern of trade? (Who trades with whom, what and
how much?)
Answer: Comparative Advantage from factors and technologies, Economies
of Scale and Love of Variety.
What are the effects of international trade on economic welfare?
Answer : Welfare gains from trade, Income Distribution.
What are the effects of trade policies?
Answer: Optimum tariff, WTO, Protection.
How do domestic policies interact with trade and trade policies?
Answer: Industrial policy, inequality.
Outstanding issues: Impact of FDI, New sources of inequality, Market power
of trades.