International Economics I

(Econ 2081)

Chapter Three

International Trade and Commercial

Policy

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Empirically there is no nation that follows
free trade.
This chapter deals with:
◦ Cases for and against free trade
◦ Tariffs and non-tariff barriers
◦ Argument for protection
◦ Trade policy and economic welfare
◦ Optimal trade policy intervention
◦ Trade liberalization and issues of openness
◦ Import substitution versus export promotion

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3.1. Free Trade: Cases For and Against
3.1.1. The cases for free trade
In the reality it is rare to find a country
which is approaching completely free
trade.
Theoretical models suggest that free trade
will avoid the efficiency losses associated
with protection.

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The arguments for free trade include:
◦ Efficiency in production and consumption
◦ Economies of scale advantage
◦ Offers more opportunities for learning and
innovation.
◦ Higher productivity
◦ Avoid costs of rent-seeking
◦ Protection benefits special-interest politics

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3.1.2. The cases against free trade
Policies are being undertaken in the
interest of the nation as a whole.
◦ Activist trade policies increase the welfare of
the nation as a whole.
Arguments to justify the need of trade
policies include:
◦ Terms of trade benefit
◦ Domestic market failures

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3.2. Tariff and Non - Tariff Barriers
3.2.1. Tariff
Types and Measurements of Tariffs
Itis a tax or duty levied on the traded
commodity as it crosses a national boundary.
◦ Export tariff
◦ Import tariff
Tariff can be imposed in three forms:
◦ A specific tariff
◦ The ad valorem tariff
◦ A compound tariff
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Measurement of Tariffs
Unweighted-average tariff rate
◦ a simple average of the tariff.
Weighted-average tariff rate:
◦ each good’s tariff rate is weighted by the importance of
the good.
 prohibitive tariff
Nominal and the effective tariff rate
Nominal tariff rate
◦ Simply the rate listed in a country’s tariff
schedule

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Effective tariff rate (effective rate of
protection (ERP))
◦ Percentage change in the value added in an
industry because of the imposition of a tariff
structure.
◦ Indicator of the actual level of protection
◦ A more common formula for calculating the
ERP for any industry j using inputs selected as
i is 𝑡 𝑗 −σ 𝑖 𝑎 𝑖𝑗 𝑡 𝑖
𝐸𝑅𝑃𝑗 =
1− σ 𝑖 𝑎 𝑖𝑗

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Escalated tariff structure
Nominal tariff rates on imports of
manufactured goods are higher than
nominal tariff rates on intermediate inputs
and raw materials.
Rising rates that give greater protection to
intermediate and finished products than to
primary commodi­ties is called tariff
escalation.

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3.2.2. Non-Tariff Trade Barriers (NTBs)
Import Quota
◦ a certain physical amount of the good is
allowed.
Subsidies
◦ Providing domestic firms a cost advantage
◦ domestic subsidy
◦ export subsidy
Voluntary Export Restraints
◦ A quota on trade imposed from the exporting
country's side instead of the importer's.
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Local Content Requirements
◦ a regulation that requires that some specified
fraction of a final good be produced
domestically.
Government Procurement Provision
◦ Governments often extend preferences to
domestic suppliers in the form of buy-national
policies.
Dumping & Anti-dumping strategies
◦ A form of international price discrimination
◦ It occurs when foreign buyers are charged lower
prices than domestic buyers for an identical
product.
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Forms of dumping
Sporadic dumping (distress dumping)
◦ Occurs when a firm disposes of excess
inventories on foreign markets.
Predatory dumping
◦ Occurs when a producer temporarily reduces
the prices charged abroad to drive foreign
competitors out of business.
Persistent dumping
◦ Effort to maximize economic profits
Note: Anti dumping regulations
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3.3. Arguments for Protection
The reasons or the argument as to why
protection should be imposed.
◦ The Infant Industry Argument
◦ The terms-of-Trade argument
◦ Tariff to Reduce Aggregate Unemployment
◦ Tariff to Offset Foreign Dumping and Subsidy
◦ National Defense Argument for a Tariff
◦ Tariff to Improve the Balance of Trade

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3.4. Trade Policy and Economic Welfare
Can be conducted in two ways:
◦ The general equilibrium analysis
◦ The partial equilibrium analysis
 Consumer surplus
 Producer surplus
3.4.1. Welfare Effects of Tariff
Case 1: Small country case
◦ A price taker facing a constant world price

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Illustration
Price
H SD Good Y

g
E
9,500
e f
G
9,000 SDWT
a b c d F
8,000 SDW

DD

20 40 50 60 80
Quantity

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Effects of tariff impositions
The revenue effect
◦ Revenue collected by the government from the
imposition of tax on imports.
The redistribution effect
◦ Part of consumer surplus that is transferred to the
domestic producers
The protective effect
◦ The loss to the domestic economy because of
inefficiency in production.
The consumption effect
◦ The loss by the consumers duet to inefficiency in
consumption
 Dead weight loss (area B + D)
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Case 2: Large country case
Importing nation that is large enough to
influence the world price of the product.
SD
Price ($)

E SDWT
9600
SDW
8800
G
a b C d
8000 F
e
7800

DD

30 50 70 90 110 Quantity

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The welfare effects of tariff are thus :
◦ If e > (b + d), national welfare is increased
◦ If e < (b + d), national welfare is diminished
◦ If e = (b + d), national welfare remains
constant.

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3.4.2. Welfare Effect of Non-Tariff
Barriers
Quota
Price
H SD

g
E
9,500
e f
G
9,000 SDWQ
a b c d F
8,000 SDW

DD

20 40 50 60 80
Quantity

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Quota has an equivalent tariff that
produces the same market result, just as
every tariff has an equivalent quota.
While the market effect of tariffs and
quotas are identical, the welfare
implications are not.
◦ The government revenue effect is not the
same.
◦ Economic quota rent, which may accrue to the
domestic importer/retailer, the foreign
supplier, or the government or may be
distributed among the three.
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Subsidy to an import competing industry

Price S
S’

S a b d
PW

Q1 Q2 Q3 Q4
Quantity

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Export subsidies
Price S

PD PD = Pint + Sub
a b c d
Pint Pint

Q1 Q2 Q3 Q4
Quantity

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3.5. Optimal Trade Policy Intervention
Large nation can improve its terms of
trade by imposing a tariff on imports.
A nation thus optimizes its economic
welfare by imposing a tariff rate at which
the positive difference between the gain of
improving terms of trade and the loss of
declining import volume is maximized.
◦ Small tariff  small terms of trade gain and
small dead weight loss  net gain.
◦ High tariff  large terms of trade gain and
large dead weight loss  net loss.
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Illustration
Welfare

Free Trade

Autarky

O
Optimum Prohibitive Tariff
Tariff Tariff

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3.6. Trade Liberalization and Issues of
Openness
Trade liberalization, loosely defined as a
move towards freer trade through the
reduction of tariff and other barriers.
Critics of trade liberalization have blamed it
for a host of ills such as:
◦ rising unemployment and wage inequality in DCs,
◦ increased exploitation of workers in LDCs
◦ the de-industrialization and marginalization of
low-income countries,
◦ increasing poverty and global inequality, and
◦ degradation of the environment
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A basic proposition in international trade
theory states that free trade is superior to
protection because it allows a country to
fully exploit its comparative advantage.
◦ improved allocation of resources and
consequent gains in productive efficiency and
economic growth.
Two major extensions of this standard
proposition,
◦ Heckscher-Ohlin model and
◦ Stolper-Samuelson theorem

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The free trade position is one where
incentives are neutral between exports and
imports.
◦ Trade liberalization could thus be achieved
either by the reduction of tariffs or of any anti-
export bias through other means.
◦ Another element of trade liberalization is the
replacement of an instrument of trade control
by another that is less distorting of the
incentive structure.

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Ways in which the extent of trade
liberalization can be measured:
◦ Reduction in tariffs or the removal of
quantitative restrictions.
◦ Changes in relative prices
◦ Multiple criteria (1+2)
There has been considerable liberalization
of trade in the post Second World War
era.

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Factors behind this widespread trade
liberalization:
◦ Failure of the import-substitution policies
◦ Debt crisis of the early 1980s  stabilization and
structural adjustment programmes.
◦ Developments in the multilateral trading system.
Empirically, the static welfare losses
involved by trade protection vary
considerably.
Perhaps more importantly, trade openness is
statistically associated with higher growth

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Openness to Trade
Openness to trade has been a central
element of successful growth strategies.
However, the empirical relationship
between trade openness and economic
growth is not yet resolved.
Trade openness is the value of total trade
(imports plus exports) as a percentage of
GDP.

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The trade dependence index (also often
called the openness index) is a measure of
the importance of international trade in
the overall economy.
Openness of an economy is determined
by a large number of factors:
◦ trade restrictions like tariffs, nontariff barriers,
◦ foreign exchange regimes,
◦ non-trade policies and
◦ the structure of national economies

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3.7. Import Substitution versus Export
Promotion
A traditional way to approach the
complex issues of appropriate trade
policies for development is to set these
specific policies in the context of a
broader strategy of looking outward or
looking inward.

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In the words of Paul Streeten,
Outward-looking development policies
◦ “encourage not only free trade but also the
free movement of capital, workers, enterprises
and students . . . , the multinational enterprise,
and an open system of communications.”
Inward-looking development policies
◦ Greater self reliance can be accomplished only
if “you restrict trade, the movement of people,
and communications and if you keep out the
multinational enterprise, with its wrong
products and wrong want-stimulation and
hence its wrong technology.”
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A lively debate regarding these two
philosophical approaches has been carried
on in the development literature since the
1950s.
The distinction between these two
traditional trade-related development
strategies.
◦ Import substitution (IS)
 Initially production of previously imported simple
consumer goods.
 Second domestic production for a wider range of
more sophisticated manufactured items.

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 ◦ Export promotion (EP)
 Advocates the efficiency and growth benefits of free
trade and competition.
In practice, the distinction between IS and
EP strategies is much less pronounced
than many advocates would imply.
◦ Most developing economies have employed
both strategies

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-----End of Chapter Three-----

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