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12. Trade Policy: Part 1 (Tariffs and Quotas)

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12. Trade Policy: Part 1

12.1

Introduction

So far, we have contrasted autarky equilibrium with free trade equilibrium; both extremes

virtually unheard of in practice. Usually, any country that engages in trade erects various barriers to control and restrict trade. The

most common barrier is a tax or tariff levied on the importation of foreign goods (sometimes on exports as well), followed by a quantitative restriction or quota, and other non-tariff barriers (NTBs) such as subsidies. Tariffs directly affect the price of imports and only indirectly the quantity via the effect of price increases on consumer and producer decisions. Quotas are in a sense the opposite of tariffs, because they directly restrict the quantities of imports and only indirectly affect prices through the artificial scarcity that the quantity restriction creates. Tariffs and quotas are similar in that they both ultimately restrict the quantity of imports and raise their domestic prices. This chapter examines the policies that governments adopt towards international trade, as well as looking at the effects of trade policies and the reasoning behind them.

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12. Trade Policy: Part 1

12.2

Tariffs

There are two main reasons why a government would choose to levy taxes on trade:

Protect operations of domestic industries that compete with imports. In H-O framework for

example, restrictions would probably be more severe in sectors that intensively use scarce factors. Most extreme tax would eliminate imports altogether (termed a prohibitive tariff). Raise government revenues. Common practice in many developing countries, where taxing international trade at border is easier than collecting domestic income taxes. But tariffs used to be main source of government income before introduction of income taxes in advanced economies such as the U.S., as well.

12.3

Welfare loss from tariffs (SMOPEC)

A SMOPEC can trade as much as it wants at fixed world prices p*; tariffs will not affect p*, but they

will affect the equilibrium price ratio facing domestic consumers and producers. Assume that pattern of comparative advantage is such that this country exports Y and imports X.

Government places ad valorem tax of t on each unit of X imported into country. Because p* is fixed, domestic price of X will rise by full amount of tax.

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12. Trade Policy: Part 1

Let p = p x /p y be the domestic price ratio. Because exports are not taxed, domestic and world prices

MRS = MRT = p = p*(1+t) > p*

will be related by p x = p x *(1+t) and p y = p y * or p = p*(1+t). Because of import tariff on X, domestic price ratio will be greater than world price ratio, p>p*. -> Consumers pay and producers receive tariff-distorted domestic prices, rather than world prices. Trade must balance at world price ratio, because country does business abroad at world price

ratio p*. Equilibrium conditions are therefore given by:

Balance-of-payments constraint:

p x *(X c – X p )+ p y *(Y c – Y p ) = 0

or

p* = (Y c – Y p ) / (X p – X c )

where subscripts p and c again denote the amounts of a good produced and consumed, resp. Domestic producers and consumers will equate domestic MRS in consumption and MRT in production to domestic price ratio, which is higher than world price ratio. However, domestic production and consumption will be linked by world price ratio.

Post-tariff equilibrium is given in Figure 15.1:

 

A is the autarky equilibrium, whereas C f and Q f refer to free trade consumption and production points, resp.

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12. Trade Policy: Part 1

A tariff on imports of X will result in production at point like Q t and consumption at point like

  • C t

Points Q t and

C t

are linked by

5 12. Trade Policy: Part 1 A tariff on imports of X will result in production

world price ratio as required by balance-of-payments constraint (see equations above); the two points also satisfy the condition that MRS=MRT> p* Post-tariff welfare level U t is lower than free-trade welfare U f but higher than autarky level U a . Tariff causes production to move from free-trade point Q f back toward the autarky point A.

Tariff causes reduction in imports and also decline in exports, which must be true in absence of change in world price ratio.

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12. Trade Policy: Part 1

New trade triangle is Q t VC t .

Exports of VQ t units of Y are worth VZ units of X at domestic prices but VC t at world prices -> quantity ZC t depicts tariff revenue, measured in units of import good X.

Assumption: government rebates tariff revenue to citizens in lump-sum fashion, allowing them

to reach consumption point C t . In sum:

Tariffs move the country back toward autarky by distorting domestic decision-making. Because tariff makes X seem more valuable than it actually is, country specializes less in comparative-advantage good and sacrifices some gains from specialization. Consumer prices are also distorted, losing gains from exchange. Loss in gains from trade reduces real national income from ON f to ON t . Finally, tariff redistributes income: production shift towards X will increase real income of factor used intensively in the production of that good and reduce real income of the other factor (H-O, Stolper-Samuelson theorem). Losses shown in Figure 15.1 are shared unevenly:

because overall welfare falls with tariff, the factor used intensively in producing Y will bear welfare loss in excess of total welfare loss, while factor used intensively in X production gains.

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12. Trade Policy: Part 1

Figure 15.2 shows same effects with excess demand curves:

SMOPEC excess demand curve E x , foreign excess demand curve E* (perfectly elastic at free- trade price ratio p*)

Free

trade

would

lead

to

level

of

imports X f at world price ratio Tariff on X will shift down excess demand curve by t percent to E’ x , defined by p’(1+t) = p, where p is price along original excess demand curve the tariff reduces imports from X f to X t , with exports correspondingly reduced to p*X t units of good Y Domestic relative price in SMOPEC becomes p = p*(1+t), while tariff revenues are given by the rectangle pp*TS, measured in units of Y.

7 12. Trade Policy: Part 1 • Figure 15.2 shows same effect s with excess demand

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12. Trade Policy: Part 1

12.4 Tariffs, taxes, and distortions (SMOPEC)

We saw above that a tariff raises the price of consumers and producers. A tariff acts like a tax on consumers and a subsidy to producers; a tariff has equivalent effect of consumption tax combined with production subsidy!

Import tariffs and export taxes

Import tariff on X is equivalent to export tax on Y. The import tariff on X leads to p x > p* x while p y =

p* y , so that p > p*. An export tax on Y means that p y

= p y *(1– t) and p y

< p y *, while p x = p* x , so that

again p > p*. Thus, import tariff and export tax have same effect on domestic price ratio, and since that is the

ratio that matters, both have the same effect on production and consumption. Export taxes and import tariffs are equivalent in that they tend to raise relative domestic price of imports and lower relative domestic price of exports. Both tend to shift resources out of export industries into import-competing industries.

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12. Trade Policy: Part 1

Export subsidies

Suppose

that

s

is

an

ad

valorem

subsidy

rate

on

exports

of

Y.

Then

*

pp

y

=

y

(1

+ s

)

and

*

pp = /(1 + s ) < p

*

Then

we

have

. constraint seen above still holds):

the

following

MRS MRT p

=

==

p *

1 + s

<

p *

relationship

(the

balance-of-payments

The effects of an export subsidy are shown in Figure 15.3:

Because of the export subsidy on Y, the country produces more Y and less X (point Q s ) than at the free trade equilibrium (point Q f ) Real national income of 0N s is smaller than in free trade (as with tariff) Consumption occurs at Cs, where MRS in consumption equals distorted domestic price ratio Country trades more with rest of world (exports and imports increase), but welfare goes down from U f to U s Comparing the effects of an import tariff on X with those of an export subsidy on Y shows:

Both policies distort allocation: subsidy generates excessive production of X, tariff generates excessive production of Y

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12. Trade Policy: Part 1

Export subsidies are usually more welfare- decreasing than tariffs because they require taxpayers to fund them rather than generating tax revenues Export subsidy could even make economy worse off than under autarky if induced production distortion were so large that world price line emanating from distorted production point Q s actually passed below indifference curve U a (see section 15.7 in Markusen et al. for mathematical proof).

10 12. Trade Policy: Part 1 Export subsidies are usually more welfare- decreasing than tariffs because

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12. Trade Policy: Part 1

Consumption taxes and production subsidies

Suppose that government wants to increase production in import-competing sector X relative to free-trade level (e.g. some minimum production level viewed as important for national security, as in oil or gas or also steel production). What is least-cost way to do this? Import tariff acts as tax on consumption as well as subsidy to production because it distorts both consumer and producer prices, leading to both loss of gains from exchange and specialization Direct output subsidy (assumed to lead to same producer receipts per unit as import tariff) only distorts producer prices (i.e. increases producer price of X), leading only to a loss in gains from specialization.

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12. Trade Policy: Part 1

Outcome of production subsidy vs. import tariff shown in Figure 15.4:

Import tariff on X shifts production from Q f to Q t and consumption from C f to C t , resulting in welfare level U t

Production subsidy on X

again

shifts

output to Q t , but consumption will be at

point

C s

and

utility

at

U s because

consumers can trade at world prices.

12 12. Trade Policy: Part 1 • Outcome of production subsidy vs. import tariff shown in

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12. Trade Policy: Part 1

Tariffs and distortions

So far we have assumed that there are no distortions in SMOPEC. If there are domestic distortions, then tariffs could offset these and become welfare-increasing according to the theory of the second best:

In the presence of multiple distortions such as domestic taxes or monopoly, welfare is not necessarily imporved by removing a single distortion. Equivalently, in the presence of of distortions, adding another distortion may be welfare-improving! Example is the presence of a production subsidy on Y introduced for political reasons, which would lead to distorted production and consumption as in chapter 9. The government could probably improve welfare even without scrapping the subsidy by introducing an import tariff on X: this would raise the domestic price of X and encourage its production, distorting consumer prices and improving welfare even at fixed world prices. The tariff would influence production in the opposite way to the subsidy. The effect of the tariff would then be to push the economy back towards its efficient pattern of specialization.

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12. Trade Policy: Part 1

  • 12.5 Tariffs and monopoly power

We now assume that we’re looking at a large country instead of the SMOPEC examined so far:

world prices will be influenced by behavior of large country, i.e. the world price of the export good will fall if it exports more, and rise in the opposite case -> the more the country trades, the worse its terms of trade become (remember that the TOT give relative prices of a country’s exports to its imports). Figure 15.6 shows two countries in a trading

situation. good X and

  • x is Home’s excess demand for

E

f

  • x is Foreign’ excess demand for

E

h

X. In free trade, the equilibrium would be at

*

p

f

(see point F), with Home importing

X

0

h

and

Foreign exporting

0

  • X f

.

Assume that Home imposes a tariff (either import tariff on X or export tariff on Y):

14 12. Trade Policy: Part 1 12.5 Tariffs and monopoly power • We now assume that

14 12. Trade Policy: Part 1 12.5 Tariffs and monopoly power • We now assume that

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C. Brunnschweiler

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12. Trade Policy: Part 1

Home’s excess demand curve shifts down to

E

h

x '

, which causes the equilibrium world price

ratio to fall to

p

*

t

(see point T) at the same time as the domestic price ratio in Home is driven

 

up to p (point S; recall that

p = p + t

*

)

)

 

t

(1

 

Restriction of imports in Home to level

X

1

(and of foreign exports to

X

1

) is a move towards

 

h

f

autarky: the higher domestic price that distorts production and consumption decisions lowers welfare.

 

*

 

pp TS

 
 

Tariff revenue is given by the area

t

However: fall in relative equilibrium world price of Home’s export good Y from

p

*

to

 

*

f

p

t

represents a gain in Home’s TOT! The welfare benefit from this favorable TOT effect would to some extent mitigate the welfare loss from reduced trade. Figure 15.7 shows the possibility that the positive TOT effect outweighs the negative trade effect from the tariff, making the home country better off with the tariff.

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12. Trade Policy: Part 1

Tariff lowers world price ratio from

*

p

f

to

p

*

t

,

resulting

in

post-tariff

production

and

consumption

at

Q

t

and

C

t

,

respectively.

Welfare increases from

U

f

to

U

t

.

16 12. Trade Policy: Part 1 Tariff lowers world price ratio from * p f to

Economic intuition: a country would like its firms to be perfectly competitive when selling at home, but it would be beneficial for the country overall to behave as a monopolist when selling abroad. Because we assume that firms are competitive, they cannot act in this way. However, the government can bring the country to behave as a monopolist: the tariff causes the country to restrict its “output” (exports) like a monopolist, and to restrict its “demand” (imports) like a monopsonist, thereby moving prices in a country’s favor. However, one country’s TOT gain is always another’s TOT loss: Foreign suffers a TOT loss, as well as distortionary losses from the altered relative prices, which push resources out of its

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12. Trade Policy: Part 1

export sector and change consumption behavior. Foreign could retaliate by imposing its own tariff on Home’s exports in a process termed a “trade war”: this type of behavior is generally harmful to global welfare and would probably leave both Home and Foreign worse off than in free trade.

In Figure 15.6, this retaliatory move would shift up Foreign’s export-supply portion of

E

f

x

(i.e.

the portion to the left of the vertical axis), which would further restrict trade and move the TOT back against Home, possibly at the same world price ratio as with free trade but with lower trade volumes. Both countries would be worse off.

Because of the very real possibility of foreign retaliation, it is difficult to derive anything resembling an “optimal tariff”, which is usually based on the assumption that trade partners will not react. However, if all countries were to pursue their own “optimal” strategy at the same time, they would probably all be worse off! Quite often however, the mere threat of retaliation will be enough to prevent a country from imposing its optimal tariff – there is a large strategic element to trade policy.

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12. Trade Policy: Part 1

12.6 Tariffs and effective protection

Discussion so far has implied that a tariff provides protection from imports, thereby boosting domestic production of the protected good. Assumption is that tariff is only tax that directly affects costs and prices of the good, which is reasonable for goods produced with nontraded primary inputs (e.g. labor and capital) and freely traded intermediates. Most commodities are produced with intermediate inputs which are themselves subject to trade taxes, e.g. a tax on imported steel would raise costs and lower output in automobile sector even if there were a protective tariff on cars. In general, manufacturers are better off as tariffs rise on imports that compete with their outputs, and worse off as tariffs rise on imported inputs. The term effective protection refers to the fact that all such tariffs need to be taken into account in computing net protective effect of tariff structure. Any tariff system will be a disadvantage to export industries, which must sell at world prices:

input tariffs will raise costs that may not be offset by export subsidies. Developed countries often have a structure of escalating tariffs, meaning that raw materials are allowed to be imported largely duty-free, while processed intermediates have higher

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12. Trade Policy: Part 1

tariffs, and finished goods have yet higher import taxes. This means that effective protection for finished products is higher than nominal rates suggest! This is especially true in some labor-intensive products, implying that the tariff structure is used as an implicit protection. Tariff escalation is a substantial bone of contention between developed and developing countries in trade negotiations. Many developing countries arranged protective structures so that effective tariffs are far higher than published tariffs, often with the goal of fostering growth in domestic manufacturing through import substituting industrialization (e.g. Brazil during the 1970s- 80s). This policy was often accompanied by deliberate overvaluation of domestic currency, in part to discourage exports of primary products and keep them for use by domestic manufacturers. For example, in 1969 Argentina was estimated to have nominal tariff rates of 63 percent on finished textiles and 76 percent on woodworking industries. The associated effective rates of protection (including trade barriers, taxes, and exchange-rate regime) were 832 percent and 1308 percent, resp.

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12. Trade Policy: Part 1

Table 15.1 provides further evidence of the discrepancy between nominal and effective protection rates; although the estimates are not the most recent, substantial gaps still remain especially in developing countries.

20 12. Trade Policy: Part 1 • Table 15.1 provides further evidence of th e discrepancy
20 12. Trade Policy: Part 1 • Table 15.1 provides further evidence of th e discrepancy

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12. Trade Policy: Part 1

Gains from trade with many goods, trade taxes, and subsidies

A simple condition permits us to extend the definition of gains from trade to a model with many goods, some of which are taxed and some of which are subsidized:

if net trade tax revenue (the sum of all import and export tax revenues minus trade subsidy payments) is positive, then the country is better off than in autarky. With other words: if trade is, on average, taxed more than it is subsidizd, then there will be gains from trade (see Markusen et al. section 15.7 for formal derivation).

A practical example of tariffs and export subsidies: Europe’s Common Agricultural Policy

From Krugman & Obstfeld (200&), chapter 8

[From the EU’s homepage: “The common agricultural policy is fundamental to the strength and competitiveness of EU farming and of the agri-food sector as a whole, with its 19 million jobs. The policy ensures that farming and preservation of the environment go hand in hand. It helps develop the economic and social fabric of rural communities. It plays a vital role in confronting new challenges such as climate change, water management, bioenergy and biodiversity…]

Europe’s stepwise integration since the 1950s and the formation of what is today called the European Union (EU) has had many effects, of which two of the largest are on trade policy. First, the

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12. Trade Policy: Part 1

members of the EU have removed all tariffs with respect to each other, creating a customs union. Second, the agricultural policy of the EU has developed into a massive export subsidy program.

The EU’s Common Agricultural Program (CAP) began not as an export subsidy, but as an effort to guarantee high prices to European farmers by havign the EU buy agricultural products whenver the prices fell below specified support levels. To prevent this policy from drawign in large quantities of imports, it was initially backed by tariffs that offset the difference between European and world agricultural prices.

Since the 1970s, however, the support prices set by the EU have turned out to be so high that Europe, which would under free trade be an importer of most agricultural products, was producing more than consumers were willing to buy. The result was that the EU found itself obliged to buy and store huge quantities of food. At the end of 1985, European nations had stored 780’000 tons of beef, 1.2 million tons of butter, and 12 million tons of wheat. To avoid unlimited growth in these stockpiles, the EU turned to a policy of subsidizing exports to dispose of surplus production.

The policy works like the export subsidy we saw earlier: the EU subsidizes the export of the good where it has a comparative disadvantage (meaning that it would import under free trade), shifting production in that direction. The EU support price, however, is set not only above the world price p* that would prevail in its absence, but also above the higher autarky price. To export the resulting surplus, an export subsidy is paid that offsets the difference between European and world prices. The subsidizd exports themselves tend to depress world prices, increasing the required subsidy. Cost- benefit analysis would clearly show that the combined costs to European consumers and taxpayers exceed the benefits to producers.

Depsite the considerable net costs of the CAP to European consumers and taxpayers, the political strength of farmers in the EU has been so large that the program has been difficult to rein in. One

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12. Trade Policy: Part 1

source of pressuer has come from the US and other food-exporting nations, who complain that the EU’s export subsidies drive down the price of their own exports. The budgetary consequences of the CAP have also posed concerns: in 2002, the CAP cost European taxpayers almost $50 billion – without including the indirect cost to consumers. Government subsidies to farmers are equal to about 36 percent of the value of farm output (twice the US figure, for example).

Recent reforms in the CAP represent an effort to reduce the distortion of incentives caused by price support, while continuing to provide aid to farmers. [Reforms of 2003 have meant that farmers still receive direct income payments to maintain income stability, but the link to production has been severed. This aims at making agricultural production more market-oriented, reducing prices and production. In addition, farmers have to respect environmental, food safety, phytosanitary and animal welfare standards. Farmers who fail to do this will face reductions in their direct payments.]

12.7 Quotas

Start out by considering a SMOPEC. Figure 16.1 shows the home country, which imports

C x
C
x

Q

x

units of X at the fixed world price ratio p*. Suppose Home imposes a quota on imports of X, so that only QR units of X can be imported in every period. Quantitative restriction leads to artificial scarcity of X, which raises price of X for both consumers and producers, increasing the domestic price ratio p =MRT=MRS.

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12. Trade Policy: Part 1

Because

cost

of

QR

units of

X

the

24 12. Trade Policy: Part 1 Because cost of QR units of X the on world

on

world market is still given by p*, a new post-quota equilibrium can be found. [Locate a trade triangle that is QR units long on the X side but still has a hypotenuse with slope p*. One endpoint of the hypotenuse will be on the PPF, the other on a community indifference curve, so that slopes of two curves are the same, given by p. New trade triangle shows restricted level of X imports under quota and amount of Y exports needed to pay for imports at world prices.]

Effects of import quota in Fig. 16.1 similar to those of import tariff in Fig. 15.1: quota lowers

domestic welfare, this time from

U

f

to

U

q

. Again, this move toward autarky will benefit the

scarce factor according to Stolper-Samuelson theorem.

AC

q

(i.e. distance from world price line p* to domestic price line p) gives difference in value of

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12. Trade Policy: Part 1

imports at world and domestic prices. In tariff case, this was the tax revenue. In quota case, this is the quota rent: a lucky group of importers will get a permit to buy X cheaply in Foreign and sell it at a premium in Home. We assume that this rent is used for consumption purposes,

leading to final equilibrium at

C

q

.

Figure 16.2 shows the effects of import quotas in a SMOPEC using excess demand curves:

E x and E* are the Home and world excess demand curves for X, resp. In free trade, home imports X f units of X at world price p*. Import quota QR distorts home’s excess demand curve to E xq , causing price of X to rise to p in Home. Figure 16.3 shows the same situation for a large country:

E x h and Foreign

f

E x

are Home and

excess demand

curves. Initial imports in

H

25 12. Trade Policy: Part 1 imports at world and domestic prices. In tari ff case,

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12. Trade Policy: Part 1

are of X h at world price p*, equal to exports X f in Foreign. Import quota QR in Home creates disequilibrium that leads to price and quantity changes in

both countries. Excess demand curve of H is now truncated at QR, at point E xq . At free-trade price p* there is a surplus of X in Foreign, which drives down price to

p

q

*

; on

the other hand, there’s a shortage of X in Home, which drives up the (domestic) price to p! In new equilibrium, trade of X has been restricted to QR, its price fallen in F and risen in H. The gap between the prices gives the rents (rectangle

*

pp

q

TS )

that accrue to

those

who have the import permits. Because H is a large country, the quota has TOT effects: if quota rents stay in H, then welfare may rise, as long as TOT from forcing down price

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12. Trade Policy: Part 1

of X in F offsets negative volume-of.trade effect. The allocation of rents from import quotas can be done in different ways, including grandfathering or auctioning. Unfortunately, import quotas sometimes become political favors and give rise to rent-seeking behavior, i.e. an activity - be it lobbying or bribery – in which real resources are (inefficiently) expended in the effort to acquire economically valuable “prizes”. This possibility can make tariffs a less costly means of import protection. Another mechanism for establishing a quota is for the importing country to request that the exporting country voluntarily restrict its exports through a voluntary export restraint (VER, also known as a voluntary restraint agreement or VRA). A VER leads to the allocation of quota rents among exporters in Foreign rather than importers in Home. Welfare implications for Home with VER are always worse than under domestic import quota, because VER allows foreign country to collect and benefit from any quota rents. F benefits from the positive TOT effect, while H suffers both a negative TOT effect and a negative volume-of-trade effect. For example, a study on three major U.S. VERs of 1980s – in textiles and apparel, steel, and

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12. Trade Policy: Part 1

automobiles – showed that around two-thirds of cost to consumers of trade restraints was accounted by rents earned by foreigners, i.e. ther e was a transfer of income rather than a loss of efficiency. Why are VERs used? Trade policy instruments are often used for political purposes to favor powerful interest groups. To avoid retaliation from trade partners, VERs can both appease domestic interest groups and foreign trade partners, with the added benefit of generally not violating multilateral trade agreements since VERs are voluntary. There are also multilateral VERs such as the Multi-Fiber Arrangement limiting textile exports from 22 countries until

2005.

An import quota in practice: U.S. sugar

From Krugman & Obstfeld (2006), chapter 8

The U.S. sugar problem is similar in its origins to the European agricultural problem: a domestic price guarantee by the federal government has led to U.S. prices above world market levels. Unlike the European Union, however, the domestic supply in the U.S. does not exceed domestic demand. Thus the U.S. has been able to keep domestic prices at the target level with an import quota on sugar.

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12. Trade Policy: Part 1

A special feature of the import quota is that the rights to sell sugar in the U.S. are allocated to foreign governments, who then allocate these rights to their own residents. As a result, rents generated by the sugar quota accrue to foreigners.

In 2002, the quota restricted imports to app. 1.4 million tons; as a result, the price of sugar in the U.S. was more than twice the price in the outside world. According to an estimate which assumes that the U.S. sugar market does not have a major impact on the world price, free trade would more than

double imports to 3.7 million tons

The welfare effects of the import quota are estimated at around

.. US$2.468 billion. Part of the consumer loss represents a transfer to U.S. sugar producers, who gain a producer surplus [the amount a producer gains from production by the difference between the price he actually receives and the price he would have been willing to sell at] of US$1.806 billion. Part of the loss represents the production distortion (US$0.247 billion) and the consumption distortion (US$0.052 billion). The rents to foreign governments that receive import rights amount to US$0.364 billion. The net loss to the U.S. is given by the distortions plus the quota rents, a total of US$662 million per year – most of this due to the fact that the quota rents accrue to foreign importers.

The sugar quota illustrates in an extreme way the tendency of protection to provide benefits to a small group of producers, each of whom receives a large benefit, at the expense of a large number of consumers, each of whom bears only a small cost. In this case, the yearly consumer loss amounts to only US$8 per capita, or around US$30 for a typical family. Not surprisingly, the average American voter is unaware that the sugar quota exists, and so there is little effective opposition.

From the point of view of the sugar producers, however, the quota is a life-or-death issue. The U.S. sugar industry employs only about 38’000 workers, so the producer gains from the quota represent an implicit subsidy of about US$20’000 per employee. It should be no surprise that sugar producers are very effectively mobilized in defense of their protection.

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A Voluntary Export Restraint in practice: Japanese autos

From Krugman & Obstfeld (2006), chapter 8

For much of the 1960s and 1970s, the U.S. auto industry was largely insulated from import competition by the difference in the kinds of cars bought by U.S. and foreign consumers. U.S. buyers, living in a large country with low gasoline taxes, preferred much larger cars than Europeans and Japanese, and, by and large, foreign firms had chosen not to challenge the U.S. in the large-car market.

In 1979, however, sharp oil price increases and temporary gasoline shortages caused the U.S. market to shift abruptly toward smaller cars. Japanese producers, whose costs had been falling relative to their U.S. competitors in any case, moved in to fill the new demand. As the Japanese market share soared and U.S. output fell, strong political forces in the U.S. demanded protection for the U.S. industry. Rather than act unilaterally and risk creating a trade war, the U.S. government asked the Japanese government to limit its exports. 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 U.S. to 1.68 million automobiles. A revision raised that total to 1.85 million in 1984 to 1985. In 1985, the agreement was allowed to lapse.

The effects of this voluntary export restraint were complicated by several factors. First, Japanese and U.S. cars were clearly not perfect substitutes. Second, the Japanese industry to some extent responded to the quota by upgrading its quality and selling larger autos with more features. Third, the auto industry is clearly not perfetly competitive. Nonetheless, the basic results were what the discussion of VERs above would have predicted: the price of Japanese cars in the U.S. rose, with the rent captured by Japanese firms. The U.S. government estimates the total costs to the U.S. at US$3.2 billion in 1984, primarily in transfers to Japan rather than efficiency losses.

30 12. Trade Policy: Part 1 A Voluntary Export Restraint in practice: Japanese autos From Krugman

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12. Trade Policy: Part 1

12.8 Comparing the effects of tariffs and quotas

Tariffs and quotas can potentially have very similar effects, as seen in Figures 15.1. and 16.1, the main difference being that quotas generate rents, while tariffs generate tax revenues, which can however be accounted for by the rent/revenue distribution mecahnism. Potential equivalence shown in Figure 16.4. (similar to Fig. 16.2):

E x is free-trade excess demand curve for X in Home. Quota of QR will distort domestic

31 12. Trade Policy: Part 1 12.8 Comparing the effects of tariffs and quotas • Tariffs

equilibrium

to

point

E

with

Home

importing QR units of

X

at

price p*,

while its domestic price ratio rises to

p.

If

tariff

of

rate

/

t = pp

*1

is

imposed

instead

(so

that

pp =

*(1 + t ) ), excess demand curve

will shift down to E xt , and we again

31 12. Trade Policy: Part 1 12.8 Comparing the effects of tariffs and quotas • Tariffs

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arrive at distorted equilibrium E As long as quota rents and tariff revenues are distributed in the same way, the tariff and quota will have identical economic effects. However, tariffs and quotas do not always have equivalent effects; any perturbation to the world price or domestic excess-demand curve will leave us with non-equivalent effect. We examine three important situations in which they differ below. Quotas are rigid with respect to import quantities, so all changes must be absorbed by price changes. Tariffs permit quantities of imports to change so that adjustment will occur in quantities (and also in prices as well if the importing nation is large).

Economic Growth

Suppose that economic growth is associated with increases in the resource endowments of country H, spcifically that the scarce factor grows larger. According to the Rybczynski theorem, the impliction is that resources will be moved toward the import-competing sector, making the economy more similar to the rest of the world and moving the country’s excess demand curve down as the home autarky price moves toward the

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world price p*. Under a quota, the excess demand curve would shift down with growth and the quota- distorted domestic price gradually fall towards p* as the relative scarcity of the imports falls with economic growth. Under an initially equivalent tariff, as scarce-factor growth pushes down the excess demand curve, the tariff-distorted exces demand curve also falls, because it is the constant tariff rate that causes the excess demand curve to adjust (not a fixed quantity like in the quota). The tariff will leave the domestic price the same at p because p = p *(1 + t ) still holds, but the level of imports will shrink. In case of scarce-factor growth, the quota is actually preferable in welfare terms to the tariff because as growth proceeds, the quota becomes less binding, while the tariff prevents the price from falling. In case of abundant-factor growth, however, the quota would become increasingly binding and domestic price would steadily rise, while under a tariff there would be rising imports at the same domestic price; welfare losses would be lower with a tariff.

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Price fluctuations

In general, the domestic and foreign price ratios are related by p = p *(1 + t ) , with t>0. In case of a tariff, t is the fixed ad valorem tariff rate. In case of a quota, we consider t to be an “implicit tariff” rate that gives the difference between the foreign price and the price domestic consumers are willing to pay, i.e. t is the percentage difference between the world and domestic relative prices induced by the quota.

Suppose that a SMOPEC can choose between a tariff and a quota, and that the foreign excess- demand curve shifts up and down ra ndomly (foreign price fluctuations). Under a tariff, the domestic price ratio will fluctuate in proportion to the foreign price fluctuation becacuse t is fixed. Under a quota, t varies inversely with the world price: an increase in the foreign price p* will narrow the gap between foreign and domestic price ratios. A decrease in p* will mean that domestic importers are willing to bid more for the import licenses, and thus the “implicit tariff” t is increased in value. The quota provides better insulation from foreign price fluctuations, whereas the tariff provides better insulation from fluctuations that are domestic in origin.

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Domestic monopoly The contestable market hypothesis, stating that a firm will behave more competitively if its market is contestable, implies that monopolists will behave differently under tariffs and quotas. A tariff leaves the domestic market contestable, albeit at higher tariff-distorted prices. Any movement by a monopolist to restrict output and raise price above the current, tariff- distorted level will be offset by increasing amounts of imports from foreign competitors. A quota, being a restriction on the quantity of sales on a market, destroys the contestability of a market. The monopolist can reduce output and raise prices without fear that additional imports will flood the domestic market and force price back down. In Figure 16.4, a domestic monopolist is able to restrict output, forcing the importing country’s excess-demand curve (which reflects consumption minus production) to rise. Suppose the extent of monopoly power allows a shift up of E x to E’ x ; in this domestically monopolized market, import prices will rise to pm when imports are artificially scarce due to a quota of QR, but prices remain at p with a tariff. There is a possible double-distortion problem in the case of protection and imperfect

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competition. Under a monopoly, there is an undersupply of the monopoly good; under trade protection, there tends to be an oversupply of the protected good. If a country switches from tariff to quota, it is giving license to domestic monopolists to cut output and raise prices. However, the lower levesl of monopoly output may simply compensate the distorted over- production arising from protection, and the economy may see an overall improvement in welfare.