International Trade Policies Under Perfect Competition · International Trade Policies Under Perfect Competition SURVEY OF INTERNATIONAL ECONOMICS Rafael López-Monti Department of

International Trade Policies

Under Perfect Competition

SURVEY OF INTERNATIONAL

ECONOMICS

Rafael López-MontiDepartment of Economics

George Washington University

[email protected]

Summer 2015(Econ 6280.20)

Required Reading:

Feenstra, R. and Taylor, A., International Economics (3e). Worth Publishers, CHAPTER 8

OR Feenstra, R. and Taylor, A., Essential of International Economics (3e). Worth Publishers, CHAPTER 7

* Material for teaching only. Please do not cite or circulate. Some typos might remain

2

INTERNATIONAL TRADE POLICIES

The Gains from Trade

Import Tariffs for a Small Country

Import Tariffs for a Large Country

Import Quotas

Export Subsidies

Export Tariffs

3


Recall: the consumer surplus from purchasing quantity D1 at price P1 is the area

below the demand curve and above that price. The consumer who purchases D2 is

willing to pay price P2 but has to pay only P1. The producer surplus from supplying

the quantity S1 at the price P1 is the area above the supply curve and below that

price. The supplier who supplies unit S0 has marginal costs of P0 but sells it for P1

4


Autarky (no-trade): home demand of D and supply of S, the no-trade equilibrium

is at point A, at the price PA producing Q0.

Free Trade: the world price is PW, so quantity demanded increases to D1 and

quantity supplied falls to S1. Since quantity demanded exceeds quantity supplied,

home imports D1 – S1, consumer surplus increases by the area (b + d), and

producer surplus falls by area b. The gains from trade are measured by area d.

Rise in consumer surplus: + (b + d)

Fall in producer surplus: − b

Net effect on Home welfare: + d

5

Import Tariffs

A tariff is a tax on imported goods

Types of tariffs:

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

goods. For example, $1 per kg of cheese

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

goods. For example, 25% tariff on the value of imported cars.

Tariffs raise the price of imported goods above the world

price by the amount of the tariff.

As a result, this will:

Reduce consumption, …

Increase production, and thereby …

Reduce the amount imported

6

of Steel

0 Quantity

of Steel

Domestic

supply

Domestic

demand

Imports

under free trade

Equilibrium

without trade

Price

before tariff

World

price

QS

QD

“Small Country” means that a country is too small to influence the world price


Home Price

7

of Steel

0 Quantity

of Steel

Domestic

supply

Domestic

demand

Price

after tariff Tariff

Imports

under free trade

Equilibrium

without trade

Price

before tariff

World

priceImports

with tariff

QS

QS

QD

QD

Effects of a Tariff on Prices and Quantities


Home Price

8

of Steel

0 Quantity

of Steel

Domestic

supply

Domestic

demand

Importsunder free trade

Equilibrium

without trade

Price

before tariff

World

price

QS

QD

Producer

surplus

before tariff

Consumer surplus

before tariff

Welfare under free trade


Home Price

9

A

B

of Steel

0 Quantity

of Steel

Domestic

supply

Domestic

demand

Price

after tariff Tariff


Equilibrium

without trade

Price

before tariff

World

priceImports

with tariff

QS

QS

QD

QD

Consumer surplus

after tariff

Consumer Surplus after Tariff


Home Price

10

C

G

of Steel

0 Quantity

of Steel

Domestic

supply

Domestic

demand

Price

after tariff Tariff


Equilibrium

without trade

Price

before tariff

World

price

QS

Imports

after tariff

QS

QD

QD

Producer

surplus

after tariff

Producer Surplus after Tariff


Home Price

11

E

of Steel

0 Quantity

of Steel

Domestic

supply

Domestic

demand

Price

after tariff Tariff

Imports

under free trade

Price

before tariff

World

price

QS

Imports

after tariff

QS

QD

QD

Tariff Revenue

Government’s Revenue from Tariff


Home Price

12

Effects of Tariff on Social Welfare

C

G

A

ED F

B

of Steel

0 Quantity

of Steel

Domestic Supply

Domestic

demand

Price

with tariff Tariff

Imports

without tariff

Price

without tariff

World

priceImports

after tariff

QS

QS

QD

QD

Deadweight Loss


Home Price

13

Consumers of the imported good are worse off

(compared to free trade)

Producers of the imported good are better off

The government gains some revenue

Total surplus decreases, because the loss to consumers

is larger than the gains to the producers and to the

government

The decrease in total surplus is called the deadweight

loss of the tariff.

Welfare Effects of a Tariff

14

As a result tariffs are the “third best”

The tariff can be thought of as the combination of a

consumption tax AND a production subsidy

The only rationale for a tariff is that “it helps producers”

But even that goal can be better achieved by using only

a production subsidy

That way, the bad effects of the consumption tax can be

avoided

Welfare Effects of a Tariff

15

of Steel

0 Quantity

of Steel

Domestic

supply

Domestic

demand

Consumption Tax

Imports

under free trade

Equilibrium

without trade

World

priceImports

after tax

= QS

QS

QD

Consumption Tax

Purchase price

after tax

Purchase price

before tax

QD

Home Price

16

of Steel

0 Quantity

of Steel

Consumption Tax

Imports

under free trade

Imports

after tax

= QS

QD

Consumption TaxAfter Tariff Consumption Tax

Change in Consumers’ Surplus -(C+D+E+F) -(C+D+E+F)

Change in Producers’ Surplus +C

Change in Government Income +E +C+D+E

Net Welfare Effect -(D+F) -F

Purchase price

before tax

DC

G

A

E F

B

Domestic

demand

Purchase price

after tax

QD

World

price

Domestic

supply

Equilibrium

without trade

Deadweight loss of

the consumption tax

QS

Home Price

17

When a small country imposes a consumption tax on

the imported good

Production is unchanged.

Consumption decreases.

Therefore, the amount imported decreases.

Consumers lose

Producers are unaffected

The government gains some tax revenue

The country as a whole is worse off

Welfare Effects of a Consumption Tax

18

of Steel

0 Quantity

of Steel

Domestic

supply

Domestic

demand

Production Subsidy

Imports

under free trade

World Price

Imports

after subsidy

QS

QS

QD Q

D=

Production Subsidy

Price sellers get

after subsidy

Price sellers get

before subsidy price buyers pay, with

or without the subsidy

Home Price

19

DC

G

A

E F

B

of Steel

0 Quantity

of Steel

Domestic

supply

Domestic

demand

Price

For sellers Production Subsidy


Price

For buyers

World

priceImports

with subsidy

QS

QS

QD

Deadweight Loss

QD

=

Production Subsidy

After

Tariff

Production

Subsidy

Change in Consumers’ Surplus -(C+D+E+F)

Change in Producers’ Surplus +C +C

Change in Government Income +E -(C+D)

Net Welfare Effect -(D+F) -D

Home Price

20

When a small country gives a subsidy to domestic

producers of an imported good

Consumers are unaffected

Producers gain (C), same as under the tariff

Taxpayers have to pay for the subsidy (CD)

Overall, the country is worse off (D).

Recall that under the tariff, the country suffered even more (DF)

Tariffs are “third best”

Welfare Effects of a Production Subsidy

21

Tariff = Consumption Tax + Production Subsidy

Comparative Welfare Loss

Destruction of value that is not compensated by a gain somewhere else : area F

Efficiency loss is another deadweight loss which occurs on the production side: area D

22

Why and How Are Tariffs Applied?

If a small country suffers a loss when it imposes a tariff, why do so

many have tariffs as part of their trade policies?

One answer is that a developing country does not have any other

source of government revenue. Import tariffs are “easy to collect.”

A second reason is politics. The benefits to producers (and their

workers) are typically more concentrated on specific firms and states

than the costs to consumers, which are spread nationwide.


23

A tariff may have effects that are less predictable and

harder to quantify

Retaliation by other countries: adds to the net loss of a tariff by

hurting export markets of other industries; can escalate rapidly

Innovation: tariffs reduce competitive pressures on domestic firms

and thus their incentives to innovate and improve the quality of

existing products

Rent seeking: any activity that uses resources in order to capture

more income without actually producing a good (e.g., firms hire

lobbyists to maintain tariff protection)

Potential Costs of Tariffs

24

C

G

A

E1D F

B

of Steel

0 Quantity

of Steel

Domestic

supply

Price

with tariff Tariff

Imports

without tariff

World price before tariff

QS

QS

QD

QD

World price after tariffDomesticdemand

E2

A large country can use tariffs to force down the price of its

imported good worldwide. This improves its terms of trade: the

ratio of export prices to import prices ( 𝑷𝑬𝑿𝑷𝑶 𝑷𝑰𝑴𝑷𝑶).

Import Tariffs for a Large Country

After Tariff

Change in Consumers’ Surplus -(C+D+E1+F)

Change in Producers’ Surplus +C

Change in Government Income +(E1+E2)

Net Welfare Effect +E2 - (D+F)

Home Price

E2 area represents the terms-of-trade gain

25

Optimal Tariff for a Large Importing Country

Optimal Tariff = 𝟏

𝑬𝑿∗ , where 𝑬𝑿

∗ is the elasticity of Foreign export supply

A tariff initially increases the importer’s welfare because the terms-of-trade

gain exceeds the deadweight loss until the optimal tariff at optimal level

(point C). After that, welfare falls. If the tariff is too large (greater than at B),

then welfare will fall below the free-trade level.

26

Take a Break

27

Import Quota

An import quota is a limit imposed by the domestic government on the

quantity of a good that can be produced abroad and sold domestically.

of Steel

0 Quantity

of Steel

Domestic

supply

Domestic

demand

Imports

without quota

Equilibrium

without trade

World

price

World

price

Price

without

quota

=

QD

QS

Home Price

28

The Effects of an Import Quota

An import quota is a limit imposed by the domestic government on the

quantity of a good that can be produced abroad and sold domestically.

of Steel

0 Quantity

of Steel

Domestic

supply

Domestic

supply

+

Import supply

Domestic

demand

Isolandian

price with

quota

Imports

without quota

Equilibrium

with quota

Equilibrium

without trade

Quota

Imports

with quota

QD

World

price

World

price

Price

without

quota

=

QS

QD

QS

Home Price

29

A

E'C

B

G

D E" F

Home Priceof Steel

0 Quantity

of Steel

Domestic

Supply

Domestic

supply

+

Import supply

Domestic

demand

Isolandian

price with

quota

Imports

without quota

Equilibrium

with quota

Equilibrium

without trade

Quota

Imports

with quota

QD

World

price

World

price

Price

without

quota

=

QS

QD

QS


30

Whoever is actually importing the good will be able to

earn the difference between the World Price and the

higher Price with quota by selling the imports in the Home

market.

We call the difference between these two prices the rent

associated with the quota, and hence the area (E’+E’’)

represents the total quota rents.

Next we examine the four possible ways that these quota

rents can be allocated.


31

1. Giving the Quota to Home Firms

Quota licenses (i.e., permits to import the quantity allowed under the

quota system) can be given to Home firms: With home firms earning the

rents (E’+E’’) , the net effect of the quota on Home welfare is

Fall in consumer surplus: − (C+D+E’+E’’+F)

Rise in producer surplus: + C

Quota rents earned at Home + (E’+E’’)

Net effect on Home welfare: − (D+F)


How to “capture” the Quota rents

32

2. Rent Seeking

If licenses for the imported chemicals are allocated in proportion to

each firm’s production of steel in the previous years, then the Home

firms will likely produce more steel than they can sell (and at lower

quality) just to obtain the import licenses for the following year.

Alternatively, firms might engage in bribery or other lobbying activities

to obtain the licenses.

These kinds of inefficient activities done to obtain quota licenses are

called rent seeking. If rent seeking occurs, the welfare loss due to the

quota would be



Net effect on Home welfare: − (D+F+E’+E’’)



33

3. Auctioning the Quota

A third possibility for allocating the rents that come from the quota is

for the government of the importing country to auction off the quota

licenses.

In a well-organized, competitive auction, the revenue collected should

exactly equal the value of the rents, so that area (E’+E’’) would be

earned by the Home government.

Using the auction method to allocate quota rents, the net loss in

domestic welfare due to the quota becomes



Auction revenue earned at Home + (E’+E’’)

Net effect on Home welfare: − (D+F)



34

4. “Voluntary” Export Restraint

The final possibility for allocating quota rents is for the government of

the importing country to give authority for implementing the quota to

the government of the exporting country.

Because the exporting country allocates the quota among its own

producers, this is sometimes called a “voluntary” export restraint

(VER), or a “voluntary” restraint agreement (VRA).

In the 1980s the United States used this type of arrangement to restrict

Japanese automobile imports.

In this case, the quota rents are earned by foreign producers, so the loss

in Home welfare equals





Net effect on Home welfare: − (D+F+E’+E’’)

35

Export Subsidy

Export Subsidies: the government gives to a particular domestic industry

subsidies and incentives to boost exports

Types:

Government grants low interest rate loans

U.S. Export-Import Bank (Exim Bank)

Tax breaks and tax abatements

WTO is against direct export subsidies, except agricultural subsidies and

developing countries that is developing an industry

Tariffication: economists convert import quotas and other non-tariff trade

barriers such as export subsidies into tariffs

A country could impose a countervailing duty

A tariff to nullify the effects of an export's country subsidy

Exporting country pays a tax to the importing country, nullifying the deadweight

losses

36

Export Subsidies in a Small Home Country

Demand

Supply

Quantity

Home

Price

Subsidy, per unitA

B C D E

F G HI

World Price

(Free Trade)

World Price + Subsidy

Exports

(Free Trade), X1

Exports

(with subsidy), X2

Autarky

37

Free Trade Export Subsidy

Consumers’ Surplus A+B+C A

Producers’ Surplus F+G+H+I B+C+D+F+G+H+I

Government Pays -(C+D+E)

Total Welfare A+B+C+F+G+H+I A+B+F+G+H+I-E

Policy Comparison : Welfare analysis

Exports actually rise as a result of the subsidy, from X1 to X2.

Net Welfare Effect = Export Subsidy – Free Trade

= (A+B+F+G+H+I-E) – A-B-C-F-G-H-I = -C-E = -(C+E)

As a result, the deadweight loss as a result of the subsidy is the

triangle (C+E)

38

Quantity

Price

Demand

Supply

Export Subsidy and

Import Tariff (CAP)

Imports under free trade

Exports after CAP

A

BC

D

E

F G H

I

Example: Europe’s Common Agricultural Policy

World Price + Subsidy

World Price

(Free Trade)

39

This table shows the agreements made at the 2005 WTO meeting in Hong Kong, which had as its

major focus the subsidies provided to agricultural products. This meeting was part of the Doha

Round of WTO negotiations, which have not yet been concluded.

TABLE (1 of 2) Agreements Made at the Hong Kong WTO Meeting, December 2005

WTO Goals on Agricultural Export Subsidies

40

TABLE (2 of 2) Agreements Made at the Hong Kong WTO Meeting, December 2005

WTO Goals on Agricultural Export Subsidies

41

Export Tariff in a Small Home Country

Demand

Supply

Quantity

Home

Price

Tariff per unitA

B C D E

F G HI

World Price

(Free Trade)

World Price -Tariff

Exports

(with Tariff), X2

Exports

(Free Trade), X1

Autarky

C’ E’

42

Free Trade Export Tariff

Consumers’ Surplus A A+B+C

Producers’ Surplus B+C+C’+D+E’+F+G+H+I F+G+H+I

Government Revenue +D

Total Welfare A+B+C+C’+D+E’+F+G+H+I A+B+C+F+G+H+I+D

Policy Comparison : Welfare analysis

Exports actually rise as a result of the subsidy, from X1 to X2.

Net Welfare Effect = Export Tariff – Free Trade

=(A+B+C+F+G+H+I+D) – A-B-C -C’-D-E’-F-G-H-I = -C’-E’ = -(C’+E’)

As a result, the deadweight loss as a result of the export tariff is the

triangle (C’+E’)

Documents

International Trade Policies Under Perfect Competition · International Trade Policies Under Perfect Competition SURVEY OF INTERNATIONAL ECONOMICS Rafael López-Monti Department of