Assignment 5...due today

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Lesson 6

Trade Policy

Types of Tariffs

Specific Tariff: levied as a fixed charge on each unit of an imported good

Ad Valorem Tariff: levied as fraction of the value of an imported good

Trade Policy Model

Partial equilibrium model

Consider the market for wheat in the Home and Foreign country

Domestic supply/demand determines the autarky wheat price in each country

Suppose Home autarky price greater than Foreign’s

Home imports wheat; Foreign exports wheat

Import Demand/Export Supply

As wheat price increases, Home demands less wheat imports

Import demand curve downward sloping

As wheat price increases, Foreign supplies more wheat exports

Export supply curve upward sloping

Import Demand/Export Supply (cont.)

Equilibrium condition: Import demand=Export supply

Determines world price of wheat

Home demand-Home supply=Foreign supply-Foreign demand

Home+Foreign Demand=Home+Foreign Supply

World Demand=World Supply

Tariff Incidence

Suppose specific tariff t placed on wheat imports

Import demand curve falls

World price of wheat falls, but by less than t

Exports/imports of wheat both fall by equal amounts

Tariff Incidence (cont.)

PW=pre-tariff world price

Pt=price with tariff in Home

Pt*=price with tariff in Foreign

Pt*=new world price

Pt=Pt*+t

Pt*<PW<Pt

Tariff Incidence (cont.)

Incidence Home: Pt-PW

Incidence Foreign: PW-Pt*

Pt-PW+PW-Pt*=Pt-Pt*=t

Small Country Case

If Home is small, reduction in Home import demand has negligible effect on world price (horizontal export supply curve)

Tariff incidence falls completely on Home country

Pt=PW+t

Pt*=PW

Welfare Analysis

Tariff raises price in importing country. In Home,

Consumers worse off

Producers better off

Government collects revenue

Can use cost/benefit analysis to see overall impact

Welfare Analysis (cont.)

Consumer surplus: amount a consumer gains from a purchase

Difference between max price would have been willing to pay and market price

Total CS=area above market price and below demand curve

Increases as market price decreases

Welfare Analysis (cont.)

Producer Surplus: amount a producer gains from a sale

Difference between market price and min price would have been willing to sell at

Total PS: area below the market price and above the supply curve

Increases as market price increases

Tariff effect: Large Import Country

consumer loss: a+b+c+d

producer gain: a

government revenue: c+e

Net loss=(a+b+c+d)-(a)-(c+e)=b+d-e

If e>(b+d), then net benefit

Tariff effect: Large Import Country (cont.)

b is production distortion loss

d is consumption distortion loss

b+d total efficiency loss

e is terms of trade gain

Note that e is absent in small country case

Tariff effect: Small Import Country (cont.)

Large importing country: tariff may result in net benefit for the country due to increase in terms of trade

Small importing country: tariff necessarily results in net loss since there is no terms of trade effect

Tariff effect: Export Country

consumer gain: a

producer loss: a+b+c+d

net loss: b+c+d

Happens due to tariff reducing world price of the export good

If world price unaffected (small importing country) then export country unaffected

Further Considerations

Tariffs can have additional costs:

retaliation by trade partners

hard to remove

wasteful activities to avoid paying the tariff

Cost/benefit analysis here only in monetary terms

In reality should consider which particular groups in country (rich/poor) gain or lose income from tariff

Export subsidy effect: Export Country

Export subsidy: payment to a firm or individual that ships a good abroad

Will increase export supply curve (shift to right) and lower the world price

Price increases in exporting country and decreases in importing country

Export subsidy effect: Export Country (cont.)

consumer loss: a+b

producer gain: a+b+c

government loss: b+c+d+e+f+g

overall loss: b+d+e+f+g

Export country definitely loses

Export subsidy effect: Export and Import Country

b is consumption distortion loss

d is production distortion loss

e+f+g is terms of trade loss

Notice that the importing country definitely gains due to the lower price for its import

Import Quota

Import Quota: direct restriction on the quantity of some good that might be imported

Has same effect on prices as an import tariff that leads to a quantity of imports equal to the quota quantity

Import Quota (cont.)

Quota Rents: whoever holds import license profits by buying import at world price and selling at the higher domestic price in importing country

This is equal to the revenue the government of the importing country receives under an equivalent tariff

Import Quota (cont.)

Comparison overall effect (for the country) of an equivalent quota and tariff depends on who has the import license

If it is domestic import firms then same overall effect as tariff

But commonly it is government of exporting country, which makes costs of quota much higher than equivalent tariff for the import country

Voluntary Export Restraints

Voluntary Export Restraints: quota on trade imposed from the exporter rather than the importer

Economically has same effect as import quota for which government of exporting country gets the license

Always more costly to importing country than a tariff that limits imports by the same amount

Indirect Tariff Costs: Chicken Tax

Western Europe in 60’s placed tariff on imports of US chicken

US retaliated with 25% tariff on imports of light commercial vehicles (imported into US by Volkswagen in Germany)

Japan replaced Volkswagen as producer of such vehicles, but US producers able to keep tariff in place

Indirect Tariff Costs: Chicken Tax (cont.)

Ford now produces a small commercial van in Europe the “transit connect”

2009 high gas prices increased US demand for this vehicle

Ford coverts van into passenger vehicle before shipping so it gets much lower 2.5% tariff

Then converts van back into a commercial van once it arrives in the US

Export Subsidy Costs: Europe’s Common Agricultural Policy

CAP guarantees certain price for EU farmers

If guaranteed price above domestic market price, supply>demand

Government has to buy surplus at guaranteed price

Resulted in massive stockpile of food in gov. storage by 1985

Export Subsidy Costs: Europe’s Common Agricultural Policy (cont.)

So wanted to give incentive for farmers to export surpluses, therefore turned to export subsidies

Of course depressed world price causing an even larger subsidy to be required

Cost to EU consumers exceeded benefits to farmers by $30 billion in 2007

Subsidy cost EU taxpayers $76 billion in 2009

Import Quota Costs: US Sugar

Rights are allocated to foreign governments who then resell them to their citizens

Given are projected impacts for 2013 for raw sugar quota

Restricted to imports to 3 million tons, resulting in US price 35% higher than world price

Import Quota Costs: US Sugar

Consumer surplus loss = $884 million

Producer surplus gain = $272 million

Production distortion loss = $68 million

Consumption distortion loss = $91 million

Import Quota Costs: US Sugar

Quota rents = $453 million

Net loss is quota rent plus efficiency losses = $612 million per year

Yearly consumer loss $3 per year

6,500 workers in sugar industry, so gain $42,000 per employee

Import Quota Costs: US Sugar

This is only effect of cost of raw sugar

Higher cost increases cost of refined sugar and results in job-loss in sugar using industries

For every job saved in farming, 3 are loss in confectionary manufacturing industries