7 -- Case Study- Economic for Strategic decision

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Trade policies: how government make decisions

MBA 681 Economics for Strategic Decisions Prepared by Yun Wang

Outline 1. Partial equilibrium analysis of tariffs in a single industry: supply, demand, and trade

2. Costs and benefits of tariffs

3. Export subsidies

4. Import quotas

5. Voluntary export restraints

6. Local content requirements

Types of Tariffs • A tariff is a tax levied when a good is imported.

• A specific tariff is levied as a fixed charge for each unit of imported goods.

– For example, $3 per barrel of oil.

• An ad valorem tariff is levied as a fraction of the value of imported goods.

– For example, 25% tariff on the value of imported trucks.

Supply, Demand, and Trade in a Single Industry (1 of 4) • Consider how a tariff affects a single market, say that of

wheat.

• Suppose that in the absence of trade the price of wheat is higher in Home than it is in Foreign.

• With trade, wheat will be shipped from Foreign to Home until the price difference is eliminated.

Supply, Demand, and Trade in a Single Industry (2 of 4) • An import demand curve is the difference between the

quantity that Home consumers demand minus the quantity that Home producers supply, at each price.

• The Home import demand curve

MD = D − S

intercepts the price axis at PA and is downward sloping: – As price increases, the quantity of imports demanded

declines.

Figure 1 Deriving Home’s Import Demand Curve

As the price of the good increases, Home consumers demand less, while Home producers supply more, so that the demand for imports declines.

Supply, Demand, and Trade in a Single Industry (3 of 4) • An export supply curve is the difference between the

quantity that Foreign producers supply minus the quantity that Foreign consumers demand, at each price.

• The Foreign export supply curve    XS S D

intersects the price axis at AP and is upward sloping: – As price increases, the quantity of exports

supplied rises.

Figure 2 Deriving Foreign’s Export Supply Curve

As the price of the good rises, Foreign producers supply more while Foreign consumers demand less, so that the supply available for export rises.

Supply, Demand, and Trade in a Single Industry (4 of 4) • In equilibrium,

import demand = export supply,

home demand − home supply = foreign supply − foreign demand,

home demand + foreign demand = home supply + foreign supply,

world demand = world supply.

Figure 3 World Equilibrium

The equilibrium world price is where Home import demand (MD curve) equals Foreign export supply (XS curve).

Effects of a Tariff (1 of 4) • A tariff acts like a transportation cost, making sellers

unwilling to ship goods unless the Home price exceeds the Foreign price by the amount of the tariff:

 T TP t P

• A tariff makes the price rise in the Home market and fall in the Foreign market.

Figure 4 Effects of a Tariff

A tariff raises the price in Home while lowering the price in Foreign. The volume traded thus declines.

Effects of a Tariff (2 of 4) • Because the price in the Home market rises from PW

under free trade to PT with the tariff, – Home producers supply more and Home consumers

demand less, so – the quantity of imports falls from QW under free trade

to QT with the tariff.

Effects of a Tariff (3 of 4) • Because the price in the Foreign market falls from PW

under free trade to TP with the tariff,

– Foreign producers supply less, and Foreign consumers demand more, so

– the quantity of exports falls from QW to QT .

Effects of a Tariff (4 of 4) • The quantity of Home imports demanded equals the

quantity of Foreign exports supplied when  T TP P t

• The increase in the price in Home can be less than the amount of the tariff.

– Part of the effect of the tariff causes the Foreign export price to decline.

– But this effect is sometimes very small.

Effects of a Tariff in a Small Country • 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 Pw . – The price in the home market rises by the full amount

of the tariff, to PT = Pw + t .

Figure 5 A Tariff in a Small Country

When a country is small, a tariff it imposes cannot lower the foreign price of the good it imports. As a result, the price of the import rises from PW to PW + t and the quantity of imports demanded falls from D1 − S1 to D2 − S2.

Measuring the Amount of Protection (1 of 3) • The effective rate of protection measures how much

protection a tariff (or other trade policy) provides. – It represents the change in value that firms in an

industry add to the production process when trade policy changes, which depends on the change in prices the trade policy causes.

• Effective rates of protection often differ from tariff rates because tariffs affect sectors other than the protected sector, causing indirect effects on the prices and value added for the protected sector.

Measuring the Amount of Protection (2 of 3) • For example, suppose that automobiles sell in world

markets for $8,000, and they are made from factors of production worth $6,000.

– The value added of the production process is $8,000 − $6,000.

• Suppose that a country puts a 25% tariff on imported autos so that home auto assembly firms can now charge up to $10,000 instead of $8,000.

Measuring the Amount of Protection (3 of 3) • The effective rate of protection for home auto assembly

firms is the change in value added:

  

$4,000 $2,000 100%

$2,000

• In this case, the effective rate of protection is greater than the tariff rate.

Costs and Benefits of Tariffs • A tariff raises the price of a good in the importing country,

so it hurts consumers and benefits producers there.

• In addition, the government gains tariff revenue.

• How to measure these costs and benefits?

• Use the concepts of consumer surplus and producer surplus.

Consumer and Producer Surplus (1 of 2) • Consumer surplus measures the amount that consumers

gain from purchases by computing the difference in the price actually paid from the maximum price they would be willing to pay for each unit consumed.

– When price increases, the quantity demanded decreases as well as the consumer surplus.

Figure 6 Deriving Consumer Surplus from the Demand Curve

Consumer surplus on each unit sold is the difference between the actual price and what consumers would have been willing to pay.

Figure 7 Geometry of Consumer Surplus

Consumer surplus is equal to the area under the demand curve and above the price.

Consumer and Producer Surplus (2 of 2) • Producer surplus measures the amount that producers

gain from sales by computing the difference in the price received from the minimum price at which they would be willing to sell.

– When price increases, the quantity supplied increases as well as the producer surplus.

Figure 8 Geometry of Producer Surplus

Producer surplus is equal to the area above the supply curve and below the price.

Measuring the Costs and Benefits of Tariffs (1 of 4) • A tariff raises the price in the importing country:

– consumer surplus decreases (consumers worse off) – producer surplus increases (producers better off). – the government collects tariff revenue equal to the tariff

rate times the quantity of imports with the tariff.

    2 2T T Tt Q P P D S • Change in welfare due to the tariff is e − (b + d).

Figure 9 Costs and Benefits of a Tariff for the Importing Country

The costs and benefits to different groups can be represented as sums of the five areas a, b, c, d, and e.

Measuring the Costs and Benefits of Tariffs (2 of 4) • For a “large” country, whose imports and exports affect

world prices, the welfare effect of a tariff is ambiguous.

• The triangles b and d represent the efficiency loss. – The tariff distorts production and consumption

decisions: producers produce too much and consumers consume too little.

• The rectangle e represents the terms of trade gain. – The tariff lowers the Foreign price, allowing Home to

buy its imports cheaper.

Measuring the Costs and Benefits of Tariffs (3 of 4) • Part of government revenue (rectangle e) represents the

terms of trade gain, and part (rectangle c) represents some of the loss in consumer surplus.

– The government gains at the expense of consumers and foreigners.

• If the terms of trade gain exceed the efficiency loss, then national welfare will increase under a tariff, at the expense of foreign countries.

– However, foreign countries are apt to retaliate.

Figure 10 Net Welfare Effects of a Tariff

The colored triangles represent efficiency losses, while the rectangle represents a terms of trade gain.

Measuring the Costs and Benefits of Tariffs (4 of 4) • Tariffs can lead trading partners to retaliate with their own

tariffs, thus hurting exporters in the country that first adopted the tariff.

• Tariffs can be hard to remove and large tariffs may induce producers to engage in wasteful activities to avoid paying tariffs.

– Ford and Subaru install (then later remove) seats in vans and pickups trucks to avoid U.S. tariff on imports of light commercial trucks.

Export Subsidy (1 of 3) • An export subsidy can also be specific or ad valorem:

– A specific subsidy is a payment per unit exported. – An ad valorem subsidy is a payment as a proportion of

the value exported.

• An export subsidy raises the price in the exporting country, decreasing its consumer surplus (consumers worse off) and increasing its producer surplus (producers better off).

Tariffs for the Long Haul • Tariffs can induce producers to behave in creative —

though ultimately wasteful—ways in order to avoid them.

• Ford wants to avoid paying 25% tariff on light commercial trucks when imports its small commercial van from Europe.

– Ford installs rear windows, rear seats, and seat belts prior to shipping the vehicles to the United States in an attempt to be classified as passenger vehicles (and pay 2.5% tariff).

– Upon arrival, process reversed before delivery to dealers.

Export Subsidy (2 of 3) • Also, government revenue falls due to paying

 SS X for the export subsidy.

• An export subsidy lowers the price paid in importing countries    .S SP P S

• In contrast to a tariff, an export subsidy worsens the terms of trade by lowering the price of exports in world markets.

Figure 11 Effects of an Export Subsidy

An export subsidy raises prices in the exporting country while lowering them in the importing country.

Export Subsidy (3 of 3) • An export subsidy damages national welfare.

• The triangles b and d represent the efficiency loss. – The export subsidy distorts production and

consumption decisions: producers produce too much and consumers consume too little compared to the market outcome.

• The area b + c + d + f + g represents the cost of the subsidy paid by the government.

– The terms of trade decrease, because the price of exports falls.

Export Subsidy in Europe • The European Union’s Common Agricultural Policy sets

high prices for agricultural products and subsidizes exports to dispose of excess output.

– Subsidized exports reduce world prices of agricultural products.

• The cost of this policy for European taxpayers is almost $30 billion more than its benefits (in 2007). Subsidy payments are about 22% of the value of farm output.

– The EU has proposed that farmers receive direct payments independent of the amount of production to help lower EU prices and reduce production.

Figure 12 Europe’s Common Agricultural Policy

Agricultural prices are fixed not only above world market levels but also above the price that would clear the European market. An export subsidy is used to dispose of the resulting surplus.

Import Quota (1 of 2) • An import quota is a restriction on the quantity of a good

that may be imported.

• This restriction is usually enforced by issuing licenses or quota rights.

• A binding import quota will push up the price of the import because the quantity demanded will exceed the quantity supplied by Home producers and from imports.

Import Quota (2 of 2) • When a quota instead of a tariff is used to restrict imports,

the government receives no revenue. – Instead, the revenue from selling imports at high prices

goes to quota license holders. – These extra revenues are called quota rents.

An Import Quota in Practice: U.S. Sugar (1 of 4) • Imports of sugar into the United States limited and quota

rights passed out to foreign governments.

• Price of sugar in the United States has remained well above world prices.

• U.S. consumers are hurt by more than U.S. producers benefit; foreigners earn quota rents.

– Overall effect on national welfare negative.

An Import Quota in Practice: U.S. Sugar (2 of 4) • Under NAFTA, Mexico’s sugar exports were slowly

exempted from the quota restrictions and the U.S. sugar price premium decreased to its lowest level in over 25 years.

• U.S. sugar producers complained, and the U.S. Commerce Department sharply reduced Mexican sugar imports.

– Imposed a 64% anti-dumping tariff and then negotiated a suspension of the tariff in return for lower exports.

An Import Quota in Practice: U.S. Sugar (3 of 4) • With access to the world sugar market successfully

impeded, U.S. sugar prices have substantially risen again. – In 2015, that price was almost double the world price.

• For 2014, the sugar quota is estimated to: – cost consumers 3.5 billion ($11 per person or $30 for a

typical household), – generate producer surplus losses for food producers

who use refined sugar as an ingredient) of $909 million – for a total cost estimate of $4.4 billion. – benefit sugar producers $3.9 billion (mostly to refiners)

An Import Quota in Practice: U.S. Sugar (4 of 4) • Eliminating the sugar quota, by reducing the price of

sugar in the United States, would generate 17,000–20,000 new jobs in producing foods containing sugar.

– Far more than the 500-2,000 jobs that might be lost in the sugar industry.

– Would turn the United States from a net importer to a net exporter of sugar-containing foods.

• The sugar producers are better lobbyists than the sugar-containing food sector so this protection has been extended.

Figure 13 U.S. and World Raw Sugar Prices, 1989–2015

Source: U.S. Department of Agriculture.

Figure 14 Effects of the U.S. Import Quota on Sugar

The quota level Q raises the price of sugar in the United States above the world price (from PW to PQ). The higher price associated with the quota induces an increase in U.S. sugar production (from S1 to S2) and a reduction in U.S. sugar consumption (from D1 to D2).

Voluntary Export Restraint • A voluntary export restraint works like an import quota,

except that the quota is imposed by the exporting country rather than the importing country.

• These restraints are usually requested by the importing country.

• The profits or rents from this policy are earned by foreign governments or foreign producers.

– Foreigners sell a restricted quantity at an increased price.

A Voluntary Export Restraint in Practice (1 of 2) • In 1979, sharp oil price increases caused the U.S. market

to shift abruptly toward smaller cars.

• Japanese producers moved in to fill the increased demand faster than U.S. auto companies could come out with smaller, more fuel-efficient models.

• As the Japanese market share soared and U.S. output fell, strong political forces in the United States demanded protection.

• Rather than act unilaterally and risk creating a trade war, the U.S. government asked the Japanese government to limit its exports.

A Voluntary Export Restraint in Practice (2 of 2) • The Japanese, fearing unilateral U.S. protectionist

measures if they did not do so, agreed to limit their sales. – The first agreement, in 1981, limited Japanese

exports to the United States to 1.68 million automobiles.

– A revision raised that total to 1.85 million in 1984. – In 1985, the agreement was allowed to lapse.

• The price of Japanese cars in the United States rose, with the rent captured by Japanese firms.

• The total costs to the United States are estimated to have been $3.2 billion in 1984.

Local Content Requirement (1 of 4) • A local content requirement is a regulation that

requires a specified fraction of a final good to be produced domestically.

• It may be specified in value terms, by requiring that some minimum share of the value of a good represent home value added, or in physical units.

Local Content Requirement (2 of 4) • From the viewpoint of domestic producers of inputs,

a local content requirement provides protection in the same way that an import quota would.

• From the viewpoint of firms that must buy home inputs, however, the requirement does not place a strict limit on imports, but allows firms to import more if they also use more home parts.

Local Content Requirement (3 of 4) • Local content requirement provides neither government

revenue (as a tariff would) nor quota rents.

• Instead, the difference between the prices of home goods and imports is averaged into the price of the final good and is passed on to consumers.

Local Content Requirement (4 of 4) • Any public work project funded by the American Recovery

and Re-Investment Act of 2009 (ARRA) must use U.S. iron, steel, and manufactured goods (unless foreign bid more than 25% lower).

– The Bay Bridge linking San Francisco and Oakland did not use ARRA funding because some key components would have been 23% ($400 million) more expensive.

• Delays due to having to show that some items are unavailable from U.S. sources.

• Has triggered protectionist clauses that shut U.S. firms out of opportunities abroad.

Other Trade Policies • Export credit subsidies

– A subsidized loan to exporters – U.S. Export-Import Bank subsidizes loans to U.S.

exporters.

• Government procurement – Government agencies are obligated to purchase from

home suppliers, even when they charge higher prices (or have inferior quality) compared to foreign suppliers.

• Bureaucratic regulations (red tape) – Safety, health, quality, or customs regulations can act

as a form of protection and trade restriction.

The Effects of Trade Policy • For each trade policy, the price rises in the Home country

adopting the policy. – Home producers supply more and gain. – Home consumers demand less and lose.

• The world price falls when Home is a “large” country that affects world prices.

• Tariffs generate government revenue; export subsidies drain it; import quotas do not affect government revenue.

• All these trade policies create production and consumption distortions.

Table 1 Effects of Alternative Trade Policies

Policy Tariff Export Subsidy Import Quota Voluntary Export Restraint

Producer surplus

Increases Increases Increases Increases

Consumer surplus

Falls Falls Falls Falls

Government revenue

Increases Falls (government spending rises)

No change (rents to license holders)

No change (rents to foreigners)

Overall national welfare

Ambiguous (falls for small country)

Falls Ambiguous (falls for small country)

Falls

Summary (1 of 2) 1. A tariff increases the home price and the quantity

supplied and reduces the quantity demanded and the quantity traded; also decreases the world price when the country is “large.”

2. A quota does the same; an export subsidy does the same.

3. Tariffs generate government revenue; export subsidies drain it; import quotas are revenue neutral.

Summary (2 of 2) 4. The welfare effect of a tariff, quota, or export subsidy

can be measured by – efficiency loss from consumption and production

distortions. – terms of trade gain or loss.

5. With import quotas, voluntary export restraints, and local content requirements, the government of the importing country receives no revenue.

6. With voluntary export restraints and occasionally import quotas, quota rents go to foreigners.

Figure A.1 A Monopolist under Free Trade

The threat of import competition forces the monopolist to behave like a perfectly competitive industry.

Figure A.2 A Monopolist Protected by a Tariff

The tariff allows the monopolist to raise its price, but the price is still limited by the threat of imports.

Figure A.3 A Monopolist Protected by an Import Quota

The monopolist is now free to raise prices, knowing that the domestic price of imports will rise too.

Figure A.4 Comparing a Tariff and a Quota

A quota leads to lower domestic output and a higher price than a tariff that yields the same level of imports.