International Trade

The objective of this lecture is (a) to show the effect of free trade, (b) to analyse
the economic effects of protectionism and (c) to analyse a number of important
arguments for protectionism, including the dual sector model (distortions in the
factor markets). The general arguments here are an extension on chapters 16
and 17 of the main textbook, D. Ray Development Economics.

Free Trade

We can analyse free trade using either partial equilibrium analysis or general
equilibrium analysis. Partial equilibrium analysis looks at one industry only and
uses consumer and producer surplus to analyse welfare change. General
equilibrium analysis uses production possibility frontiers and indifference
curves to analyse the effects of free trade. Candidates can use either method in
the exam, unless the question specifically asks for one. Because the textbook
covers the model this lecture presents them very briefly.

Partial equilibrium analysis

Px Px

D D S

PB 0

c d

P* a b P*

PA0

X X

Country A Country B
Assume we have two countries, A and B. The pre-free trade (autarky) price in
country A is PA0 and in country B is PB0. When trade open up good X moves
from country A to country B, since price in A is lower than price in B. As
supply rises in B, price falls, and as it falls in A price rises, until we get a unique
international price, P*. Now sellers in country A do not have an incentive to sell
X to country B since they get the same price in their own country. Hence, this is
the new equilibrium with free trade. What are the welfare effects? Price in
country A will rise so consumers are worse off by area a, but producers gain
a+b, hence the country is better off by b. In country B the price falls, so
consumers are better off by c+d, but producers are worse off by d, hence the
country is better off by d. Note that in this analysis we do not care who gains
and who loses, we only care about the net effect. The net effect for both
countries is positive, hence free trade is good. Another important point to notice
is that this applies only to small countries. Small countries are countries that are
price-takers.

General equilibrium analysis

In general equilibrium analysis we consider both goods, X and Y. This analysis

presents only one of the countries. The other will have a similar experience but
specialises in the other good.

Y IC0 IC1

Y** E**

Y* E* E***

Px1/Py1

Px0/Py0

X** X* X
We start from autarkic position, E*, which shows consumption and production
under no trade, X*, Y*. Now trade open up. This country has comparative
advantage in good Y so specialises more in Y and trades. The new relative price
changes from Px0/Py0 to Px1/Py1, indicating that x becomes relatively cheaper.
Production is now at E** and consumption at E*** hence the country attains a
higher indifference curve IC1 where utility, U1 is higher than the autarkic level,
IC0 representing U0. This implies that free trade results in positive gains from
trade.

Protectionism
By protectionism we mean the use of trade instruments. In this lecture we look
at tariffs, quotas and voluntary export restraints (VERs).

Tariffs

Partial equilibrium of a tariff in a small economy

A tariff a is a tax on imports. It can be a specific tariff, where

Pt = Pw + t. Pt is the tariff-ridden price, Pw is the world price and t is the tariff.

Alternatively the tariff can be ad valorem (% of the price). In that case Pt = Pw
+ Pw t = (1+t) Pw. Partial equilibrium is when we analyse the effect of the tariff
using demand and supply curves. The small country is a price taker so faces a
perfectly elastic world supply curve. Initially domestic production is q0 and
consumption or demand is q1.

The effect of a tariff, as price rises from PW to Pt, is as follows:

1. Domestic consumers reduce their consumption from 0q1 to 0q3. q1q3 is

called the consumption effect.
2. Domestic producers increase their output from 0q0 to 0q2. q0q2 is called

the production effect.

3. The tariff reduces trade on imports from q0q1 to q2q3 (the increase in

domestic production plus the reduction in domestic consumption). This is

called the trade effect.
4. The tariff generates revenue for the government equal to t x q2q3.

D S

Pt’

Pt SW + t

PW a b c d SW

g f e

O q0 q2 q3 q1 x
Note that if the tariff is very high, i.e. Pt’, where demand equals supply, at the
new tariff ridden price there will be no trade; hence the revenue effect would be
zero. This is called a prohibitive tariff.

5. There is also a redistribution effect. Consumer welfare loss is a+b+c+d.

Area a is transferred to producers as extra producer surplus. c is
transferred to the government as tariff revenue.

Area b is the additional cost of producing q0q2 units over the previous cost (of
importing it) which was area f. In other words in this country producing q0q2
extra units cost b + f and in the rest of the world just area f.

Similarly, area d is the net loss to consumer surplus since q1q3 was previously
imported at a cost of area e but generated total consumer surplus of d + e. So
now consumers are denied its import and hence the surplus.

Tariff versus a domestic production subsidy

Assume the government wishes to protect domestic producers but maintain free
trade. This can be done via a subsidy to domestic producers.
Price

S’

Pt = PW + t SW + t

α β γ δ

PW SW

O q1 q3 q4 q2 Quantity

As before we start with free trade and import q1q2 units, produce 0q1 units and
consume 0q2 units. A tariff of amount ‘t’, increases price to Pt, reduces imports
to q3q4, reduces consumption to 0q4 and increases domestic production to 0q3.
Now assume we remove the tariff, which has resulted in net welfare loss of (β +
δ) and subsidize producers to produce 0q3. The subsidy shifts the supply curve
to S’.

Production subsidy costs are equal to (s * 0q3) which is (α + β). However, by

expanding output to 0q3, producers gain an extra producer surplus of α. Hence
the net welfare cost of the subsidy is β, i.e. α - (α + β) . This implies that a
subsidy to domestic producers to produce 0q3 units results in a smaller loss of
welfare than a tariff. Similarly, if the government wish to reduce the
consumption of this good to 0q4 then a consumption tax would result in a loss,
which is lower than the welfare loss of a tariff.

Hence for a small country, if the authorities have a domestic production or

consumption target in mind, it is always better to achieve it by using a subsidy
rather than a tariff. The welfare loss will be smaller.

THIS DOES NOT NECESSARILY APPLY TO A LARGE COUNTRY.

General equilibrium analysis in a small country

W IC0

P0 T'

W'

C0

P1 C1 W

W' IC1

T'

O X

Under free trade production is at P0 and consumption is at C0 and the terms of

trade is the slope of WW. This slope is (PX/PY)*. The authorities in the country
decide to impose a tariff on import of X. This raises the domestic price of X,
and hence the new relative domestic price become PtX/PY, which is higher than
(PX/PY)*, and is the slope of TT. This in turn raises the production of X and
reduces the production of Y. The new production point is now at P1. Where is
the new consumption point? To find this we need to draw a line parallel to WW
through P1. This is W'W'. The reason for this is that although we have a new
production point, we still need to trade at the unchanged relative price WW
internationally. The government imposes the tax once the good crosses the
border so only the domestic relative price is affected, obviously because of the
small country assumption. This implies that the new consumption point must be
somewhere along W'W'. Since the new relative price is PtX/PY the new
indifference curve must be tangential to a line parallel to TT and that tangency
point must be on W'W'. This is given by point C1tangntial to T'T'. Provided that
both X and Y are normal good this can only happen on a lower indifference
curve. Hence, the tariff reduces imports, and increases production of good X,
and export of good Y. If U0 represents the utility level at IC0 and U1 represents
the utility level at IC1, then the difference, U0 - U1 =ΔU, which is the loss of
welfare due to the tariff.

General equilibrium analysis in a large country

The crucial difference between a large and a small country is that by imposing a
tariff the large country increases production of X, therefore reduces import of X,
and this reduces the relative international price of X and hence the slope of
W'W' is now (PX/PY)**. Hence, we now get (PX/PY)**<(PX/PY)*<PtX/PY.
However, the large country still experiences a fall in welfare as C1 is on a lower
indifference curve than C0. In this case the welfare gain improvement of the
terms of trade (reduction in the international relative price of X) is less than the
welfare loss due to tariff.
 Y T

W IC0

P0 T'

W' C0

P1 C1 W

W' IC1

T'

O X

However, this need not be the case. It is possible for the terms of trade effect is
to be so large that the large country may gain from trade. This is shown in the
following diagram:
 Y

IC0 T' IC1

W' P0

P1 C1
W'

C0 W T'

T'

O X

In the above case the initial free trade consumption point is C0. The imposition
of the tariff reduces the international relative price of X so much that, given by
the slope of W'W', that at the same production point P, the large country can
now consume at C1, which is on a higher indifference curve, IC1. In this case the
positive effect of the reduction in the terms of trade for the large country is
greater than the negative welfare effect of the tariff so the large country gains
from the imposition of the tariff. Obviously, there will be a range of tariff
values/rates that can yield this result. The tariff value/rate that results in the
highest level of domestic welfare is called the optimum tariff. Optimum tariff
for small countries is zero. WE can assume, in general, that most developing
countries are small countries. However, some have large country power in some
goods, for example Chile in copper, etc.
Quotas
Quotas are a common example of non-tariff barriers. A quota is a quantitative
restriction on imports.

Consider the case of a tariff of t per unit of imports. This results in, as we have
discussed above, a welfare loss of (b+d). Notice that imports under this system
is given by q2q3 units or AB. Now assume we remove this tariff and replace it
by a quota = AB. Price falls to the world price but now domestic production
plus the quota (shown by S + quota), results in excess demand since Oq1 > Oq0
+ quota A’B’ (=AB). As a result of this excess demand the price of the product
will rise. This will continue to rise until Pq is reached so that domestic
production (supply) + quota = demand. Now Oq2 is produced, Oq3 consumed
and imports = AB. This implies that the quota has the same effect as a tariff that
lets in the same number of imports. The same in the sense that Pt = Pq and the
same output is produces and consumed. Notice that c’=b, hence the welfare
effect of the quota is exactly the same as that of an equivalent tariff. This in the
international trade literature is called tariff-quota equivalence. There are many
reasons to believe that tariffs and quotas are not equivalent but this is beyond
this course.
Price D S

S + quota

Pt A B SW + t

a b c c’ d

PW A’ B’ SW

0 q0 q2 q3 q1 Q

VERs

D S

Price

A B

Pq=PVER SW + t

a b c d

PW Sw

O q0 q2 q3 q1 Quantity

Imposition of a VER instead of a quota of AB, will raise the price to Pq so PVER
= Pq. However, note that, c, the tariff revenue under a tariff or the quota fee
under a quota, is now not collected by anyone inside the country. What happens
to it? The exporters can now sell each unit of the export inside this country at
price PVER = Pq, and hence the exporter gets area c. Hence, the total welfare cost
of VER to the country is (b+c+d), which is higher than the cost of a tariff or an
equivalent quota, (b+d).

If there is a higher welfare cost why allow it? Obviously the exporters prefer the
VER to a tariff or a quota. Since the VER is usually specified in quantity terms
the foreign suppliers can also substitute a higher value item (say a luxury car)
for a lower value one (a normal car). Also there is a ‘stick’ here. If not the VER,
the importing country may apply a tariff or a quota on imports.

Why might the importing country prefer it even though it imposes higher costs?
The simple reason is political economy. A VER was not, before WTO, against
GATT rules, hence it did not violate international trade rules. Also it is not
‘transparent’ i.e. it does not have to be passed by the parliament in the UK, or
the congress in the US or by the European Parliament, etc. Additionally, the
importing country put the blame of high prices on the exporter rather than
themselves.

The Case For Protection

1. The Infant Industry Argument
In this lecture we will consider the case of a 'pure infant'. This is when there is
no domestic production of the product before the introduction of the tariff (this
means that we cannot use the PPF for the pure case since in that vase there is
always a positive output of the good). However, this applies equally to a case
where there is a small domestic industry which is not necessarily efficient in
international trade. The European car manufacturing industry was referred to as
such a few years ago.

The first step is just like the tariff case. Initially domestic consumption is Oq0
and domestic production is zero, so the country imports Oq0.

P
D S

S1

Pt SW + t
a
b c d
PW e SW

O q1 q3 q2 q0 X

Now assume that the authorities decide that this good is important enough to be
produced in the country. They impose a tariff, which raises domestic price from
Pw to Pt. This in turn will increase domestic output from zero to Oq1 and reduces
domestic consumption to Oq2. Imports fall to q1q2. As we have seen previously
the welfare cost of this b + d.

In the case of the infant industry arguments there are two other effects. First
there are dynamic external economies of scale that reduces the average cost.
Secondly, there is learning effect (the time effect). The reason for this is that
managers and workers in this country did not know how to produce this good.
Over time they learn, and become better at it. This could be learning by doing
(learning from mistakes) or learning from others (usually in this case expats first
manage/run the production until locals learn enough to do it themselves). The
combined effect of these two implies that the average cost curve falls, and hence
the supply curve shifts to the right, to S1.

The Learning Effect

Average Cost

AC

Now the tariff can be removed. The price now falls to the world price so now
there is a domestic production of Oq3. Given that consumption is Oq0 and
imports are now q3q0. What is important here is that now, at the world price,
there is a positive domestic output. J S Mill proposed that if this is the case then
infant industry protection is justified. This is called the Mill test.

Bastable, however, argues that protection is costly so we need to do a cost

benefit analysis. At the new equilibrium there is now a new producer surplus
equal to e. Whether the country should protect this industry or not is a classic
case of cost-benefit analysis. The general textbook conclusion is that if e>b+d
then protect, otherwise do not. This is the Mill-Bastable test. This, however, is
very naive. The reason is that cost and benefits accrue at different times. The
correct analysis is as follows:

Assume the life of the project is 'm' years and we need to protect the industry
for 'n' years, after which the supply curve shifts. Obviously m>n. To calculate
the cost and benefits we need to calculate the discounted value of these costs
and benefits. The present value of costs is 𝑃𝑉 (𝐶𝑜𝑠𝑡𝑠) = 𝑃𝑉+, (𝑏 + 𝑑 ). The
7 ( )
present value of benefits is 𝑃𝑉 (𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠) = 𝑃𝑉,56 𝑒 . If PV(Benefits) is
greater than the PV(costs), use the tariff to protect the industry, otherwise do
not.

If 𝑃𝑉+, (𝑏 + 𝑑 )< 𝑃𝑉,56

7 ( )
𝑒 , then 𝑃𝑉+, (𝑏)< 𝑃𝑉,56
7 ( )
𝑒 . b is the only part of the
welfare cost that a private sector producer cares about so the question is why is
this good not produced already by a private sector producer, and therefore
requires protection to be produced? There are three arguments:

a. The government can make these calculations, but the private sector cannot (or
cannot do it correctly). Either the private sector does not have access to the right
information or they are not capable of making the analysis! Alternatively, there
are positive externalities that the private sector does not consider, but the
government would include as benefits. The problem is that more often than not
it is the other way round. The Concorde project is a good example. The
governments of France and the UK tried very hard to bring in the private sector,
but were not successful. The argument was that the project was too risky and
returns were uncertain. In fact, the private sector was correct. However, the two
governments had spent too much into the project to pull out. They also argued
that there were positive externalities of the technology. What these are, it is not
clear! The Concorde was a beautiful aircraft but was loss making for both BA
and Air France. Once BA decides to phase the out they received an offer from
Richard Branson, to buy them and use them for Virgin Air. The offer was
turned down!

b. There is a First-Mover-Disadvantage. This states that the first firm has to go

through the learning effect and bear the costs of learning until managers and
workers learn how to produce the good efficiently but additional firms can
poach those workers and managers. Two important points to bear in mind. The
first firm also may make profit, at least in the short run, before other firms enter,
and this compensates for the learning costs. This is the first mover advantage.
Secondly, if the problem is training costs, then the best policy is for the
government to subsidise training rather than distort relative prices across the
economy.

c. Capital markets may be imperfect. If this is the case there is a case for
protection, but not necessarily using tariffs. This either implies credit rationing
or high cost of borrowing, particularly for risky projects. In this case the
government should provide funds, underwrite loans, or subsidise interest
payments rather than using a tariff.

2. Distortions in the Commodity Market

Agriculture W T

P0 C1

C0 IC0

W' T'

Industry
This can happen if we have a domestic monopoly or an externality. Suppose the
agricultural sector produces food, but also uses fertilizers, which pollutes the
nearby rivers, therefore imposes a negative externality. Given the PPF and the
world relative price of agricultural versus industrial good, the slope of WW'
(PIndustrial/PAgricultural= PI/PA), production is at P0 but consumption is at C0, which
is below the PPF. Now assume we impose a tariff on the imports of the
industrial good. This changes the domestic price to 𝑃9: /PA and allows us to move
to IC1 and hence consumption goes to C1. This implies that the country gains
(moves to a higher indifference curve). Why? Because the negative effect of the
tariff is compensated by the positive effect of the reduction in externality. Note
that if the positive effect of externality reduction is less than negative effect of
the tariff we would end up on a lower indifference curve than IC0.
However, a tariff is not the best policy. The best policy is a tax on agriculture
and a subsidy to industry so that the private costs of transformation equals the
social cost. The subsidy will raise industrial output (X) and the tax will reduce
agricultural output (Y) but keeps international relative price of the commodities
intact so production moves to P* and consumption to C*. IC* is higher than IC0
and IC1, therefore welfare is maximised.
Y
W W'
IC*

C*

C0 P*
IC0

W W'

3. Distortions in the Factor Market: The Lewis Model

In development economics there is a very popular model called the Lewis Dual
Sector Model. This model assumes that the modern industrial sector, usually the
urban sector, pays a higher wage compared to the traditional rural sector (The
same analysis can be applied to union and non-union sector) This has the effect
of pushing in the PPF so the solid (red) PPF is the true one and the dotted PPF is
the actual (distorted) one.

The initial equilibrium production is P0 and consumption is C0. A tarif, will

change the domestic relative price to the slope of TT' and change production to
P1, and consumption to C1. Indifference IC1 is higher than IC0 so the country
gains by the imposition of the tariff (although this is not necessary). Is this the
best policy? No. A better policy is a subsidy to industry. This will not affect the
relative price (the domestic price will be the world price, or WW' is parallel to
WW). Production now goes to PS (production with subsidy) and consumption
goes to Cs. Consumption is now on a higher indifference curve than IC1 the
country is better off than the tariff case.

Y W T

P0 P1

IC0 IC1
C1
C0

W' T'

X
Is this the optimal policy? No.
 Y
W T

W' W''
IC*
P0
IC1
IC0 P1 C*
C1 CS
C0 ICS

W' T' P*
PS
W''

X
The optimal policy is to impose a tax on labour use in agriculture and a subsidy
on labour use in industry. This will shift the PPF to the (true) solid PPF.
Equilibrium will be at P* (production) and C* (consumption). We are now on
IC* which is higher than all other cases, hence this is the best policy.