© 2007 Pearson Addison-Wesley. All rights reserved Chapter 10 Protection and the National Welfare.

© 2007 Pearson Addison-Wesley.All rights reserved

Chapter 10

Protection and the National Welfare

10-2Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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• Partial equilibrium analysis of tariffs: supply, demand and trade in a single industry

• Costs and benefits of tariffs

• Export subsidies

• Import quotas

• Voluntary export restraints

• Local content requirements


Import Tariffs and Export Subsidies

• Import tariffs are taxes levied on imports

• Export subsidies are payments given to domestic producers that export.

• Both policies influence the terms of trade and therefore national welfare.


Import Tariffs and Export Subsidies (cont.)

• Import tariffs and export subsidies drive a wedge between prices in world markets (or external prices) and prices in domestic markets (or internal prices).

• The terms of trade refers to the relative value of a country’s exports and a country’s imports.

– Since exports and imports are traded in world markets, the terms of trade measures external prices.


Import Tariffs and Distribution of Income Across Countries

• If the domestic country imposes a tariff on food imports, the price of food relative to price cloth that domestic citizens face is higher.

– Likewise, the price of cloth relative to the price of food that domestic consumers and producers pay is lower.

– Domestic producers will receive a lower relative price of cloth, and therefore will be more willing to switch to food production: the relative supply curve will shift.

– Domestic consumers will pay a lower relative price of cloth, and therefore be more willing to switch to cloth consumption: the relative demand curve will shift.


Import Tariffs and Distribution of Income Across Countries (cont.)


Import Tariffs and Distribution of Income Across Countries (cont.)

• When the domestic country imposes an import tariff, the terms of trade increases and the welfare of the country may increase.

• The magnitude of this effect depends on the size of the domestic country relative to the world economy.

– If the country is small part of the world economy, its tariff (or subsidy) policies will not have much effect on world relative supply and demand, and thus on the terms of trade.

– But for large countries, a tariff rate that maximizes national welfare at the expense of foreign countries may exist.


Export Subsidies and Distribution of Income Across Countries

• If the domestic country imposes a subsidy on cloth exports, the price of cloth relative to price food that domestic citizens face is higher.– Domestic producers will receive a higher relative price

of cloth, and therefore will be more willing to switch to cloth production: the relative supply curve will shift.

– Domestic consumers will pay a higher relative price of cloth, and therefore be more willing to switch to food consumption: the relative demand curve will shift.


Export Subsidies and Distribution of Income Across Countries (cont.)



• When the domestic country imposes an export subsidy, the terms of trade decreases and the welfare of the country decreases to the benefit of the foreign country.


Import Tariffs, Export Subsidies and Distribution of Income Across Countries

• The two country, two good model predicts that

– an import tariff by the domestic country can increase domestic welfare at the expense of the foreign country.

– an export subsidy by the domestic country reduces domestic welfare to the benefit of the foreign country.


Import Tariffs and Export Subsidies

• Export subsidies on a good decrease the relative world price of that good by increasing relative supply of that good and decreasing relative demand of that good.

• Import tariffs on a good decrease the relative world price of that good (and increase the relative world price of other goods) by increasing the relative supply of that good and decreasing the relative demand of that good.


Import Tariffs, Export Subsidies and Distribution of Income Within a Country

• Because of changes in relative prices, import tariffs and export subsidies have effects on income distribution among producers within a country.


Import Tariffs, Export Subsidies and Distribution of Income Within a Country (cont.)

• Generally, a domestic import tariff increases income for domestic import-competing producers by allowing the price of their goods to rise to match increased import prices, and it shifts resources away from the export sector.

• Generally, a domestic export subsidy increases income for domestic exporters, and it shifts resources away from the import-competing sector.


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.

• Let’s now analyze how tariffs affect the economy.


Supply, Demand and Trade in a Single Industry

• Let’s construct a model measuring how a tariff affects a single market, say that of wheat.

• Suppose that in the absence of trade the price of wheat in the foreign country is lower than that in the domestic country.

– With trade the foreign country will export: construct an export supply curve

– With trade the domestic country will import: construct an import demand curve


Supply, Demand and Trade in a Single Industry (cont.)

• An export supply curve is the difference between the quantity that foreign producers supply minus the quantity that foreign consumers demand, at each price.

• An import demand curve is the difference between the quantity that domestic consumers demand minus the quantity that domestic producers supply, at each price.



• In equilibrium,

import demand = export supply

domestic demand – domestic supply =

foreign supply – foreign demand

• In equilibrium,

world demand = world supply


The Effects of a Tariff

• A tariff acts as an added cost of transportation, making shippers unwilling to ship goods unless the price difference between the domestic and foreign markets exceeds the tariff.

• If shippers are unwilling to ship wheat, there is excess demand for wheat in the domestic market and excess supply in the foreign market.

– The price of wheat will tend to rise in the domestic market.

– The price of wheat will tend to fall in the foreign market.


The Effects of a Tariff (cont.)

• Thus, a tariff will make the price of a good rise in the domestic market and will make the price of a good fall in the foreign market, until the price difference equals the tariff.

PT – P*T = t

PT = P*T + t

The price of the good in foreign (world) markets should fall if there is a significant drop in the quantity demanded of the good caused by the domestic tariff.



• Because the price in domestic markets rises (to PT), domestic producers should supply more and domestic consumers should demand less.

– The quantity of imports falls from QW to QT

• Because the price in foreign markets falls (to P*T),

foreign producers should supply less and foreign consumers should demand more.

– The quantity of exports falls from QW to QT



• The quantity of domestic import demand equals the quantity of foreign export supply when PT – P*

T = t

• In this case, the increase in the price of the good in the domestic country is less than the amount of the tariff.

– Part of the tariff is reflected in a decline of the foreign country’s export price, and thus is not passed on to domestic consumers.

– “Pass-through” Tariff

– But this effect is often not very significant.


The Effects of a Tariff in a Small Country

• When a country is “small”, it has no effect on the foreign (world) price of a good, because its demand for the good is an insignificant part of world demand.

– Therefore, the foreign price will not fall, but will remain at Pw

– The price in the domestic market, however, will rise to PT = Pw + t


The Effects of a Tariff in a Small Country (cont.)


Effective Rate of Protection

• The effective rate of protection measures how much protection a tariff or other trade policy provides domestic producers.

– It represents the change in value that an industry adds to the production process when trade policy changes.

– The change in value that an industry provides depends on the change in prices when trade policies change.

– Effective rates of protection often differ from tariff rates because tariffs affect sectors other than the protected sector, a fact which affects the prices and value added for the protected sector.


Effective Rate of Protection (cont.)

• For example, suppose that an automobile sells on the world market for $8000, and the parts that made it are worth $6000.– The value added of the auto production is

$8000-$6000

• Suppose that a country puts a 25% tariff on imported autos so that domestic auto assembly firms can now charge up to $10000 instead of $8000.

• Now auto assembly will occur if the value added is up to $10000-$6000.


Effective Rate of Protection (cont.)

• The effective rate of protection for domestic auto assembly firms is the change in value added:

($4000 - $2000)/$2000 = 100%

• 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 we expect it to hurt consumers and benefit producers there.

• In addition, the government gains tariff revenue from a tariff.

• How to measure these costs and benefits?

• We use the concepts of consumer surplus and producer surplus.


Consumer Surplus

• Consumer surplus measures the amount that a consumer gains from a purchase by the difference in the price he pays from the price he would have been willing to pay.

– The price he would have been willing to pay is determined by a demand (willingness to buy) curve.

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


Consumer Surplus (cont.)


Producer Surplus

• Producer surplus measures the amount that a producer gains from a sale by the difference in the price he receives from the price he would have been willing to sell at.

– The price he would have been willing to sell at is determined by a supply (willingness to sell) curve.

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


Producer Surplus (cont.)


Costs and Benefits of Tariffs

• A tariff raises the price of a good in the importing country, making its consumer surplus decrease (making its consumers worse off) and making its producer surplus increase (making its producers better off).

• Also, government revenue will increase.


Costs and Benefits of Tariffs (cont.)



• For a “large” country that can affect foreign (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 compared to the market outcome.

• The rectangle e represents the terms of trade gain.

– The terms of trade increases because the tariff lowers foreign export (domestic import) prices.



• Government revenue from the tariff equals the tariff rate times the quantity of imports.– t = PT – P*

T – QT = D2 – S2

– Government revenue = t x QT = c + e

• Part of government revenue (rectangle e) represents the terms of trade gain, and part (rectangle c) represents part of the value of lost consumer surplus.– The government gains at the expense of consumers and

foreigners.



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

– However, this analysis assumes that the terms of trade does not change due to tariff changes by foreign countries (i.e., due to retaliation).


Figure 10.2 The Effect of a Tariff on Production


• The initial free-trade prices are shown by line 1; production is at A

• National income, measured in units of food, is OF.

• A tariff on imports of food raises the domestic relative price of food, as is shown by line 2.

• Resources are shifted into food, production moves to point B.

• At world prices national income in food units has been reduced to OD

• Line 3 is parallel to line 1.


Figure 10.3 The Effect of a Tariff on Demand


• Production remains at A on the right-angled TAT’ transformation schedule.

• A tariff raises the relative domestic price of food to line 2 (parallel to line 3 and 4).

• Food consumption falls by the substitution effect (from G to H) plus an income effect (from H to J)

• Distance EC measures the tariff revenue in terms of food.

• The trade triangle shrinks from GKA to JLA


Figure 10.4 The Effect of a Tariff on Imports


• A tariff raises the domestic relative price of food (shown by lines 2 and 3) above the fixed world price (shown by lines 1 and 4).

• Domestic production of food rises from A to B.

• Domestic consumption of food falls from G to J.

• The trade triangle shrinks form GKA to JLB.


Optimal Tariffs


Optimal Tariffs

• Then, we have:

)( dbe

d

dM

d

dP

d

dMP

d

dPM

2

1*

*

d

dMP

d

dPM *

*

XdM

dP

P

M

ddM

ddP

P

M /1

*

*/

*

*


Import Tariffs and Export Subsidies (cont.)

• Import tariffs and export subsidies drive a wedge between prices in world markets (or external prices) and prices in domestic markets (or internal prices).

• The terms of trade refers to the relative value of a country’s exports and a country’s imports.

– Since exports and imports are traded in world markets, the terms of trade measures external prices.


Meltzer Paradox

• World price Internal price

• Internal price decreases

(Pc/pf)w=3/5

(Pc/pf)w=3.1/5

(Pc/Pf)=3/5(1.2)=3/6

(Pc/Pf)=3.1/5(1.2)=3.1/6


Meltzer Paradox: Another Example

• World price Internal price

• Internal price increases

(Pc/pf)w=3/5

(Pc/pf)w=4/5

(Pc/Pf)=3/5(1.2)=3/6

(Pc/Pf)=4/5(1.2)=4/6


Metzler Paradox

• An import tariff has the direct effect of raising the internal relative import price.

• However, an import tariff might improve a country’s TOT so much—that is, raise the relative price of export good so much on the world markets.

• As a result, the internal relative price of the import good fall, or say, internal relative price of the export good increase.

• Then, a country is better off.


Export Subsidy

• An export subsidy can also be specific or ad valorem

– A specific subsidy is a payment per unit exported (Korean, 1960s).

– An ad valorem subsidy is a payment as a proportion of the value exported.

• An export subsidy raises the price of a good in the exporting country, making its consumer surplus decrease (making its consumers worse off) and making its producer surplus increase (making its producers better off).

• Also, government revenue will decrease.


Export Subsidy (cont.)

• An export subsidy raises the price of a good in the exporting country, while lowering it in foreign countries.

• Suppose A and B produce same products, if A exports to get higher price, and if domestic price doesn’t change, B will envy and export too

• At a result, no firm will supply the domestic market.

• Consumers have to pay Pw+s to get the exportable.

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


Export Subsidy for Small Country


• Consumption loss=a+b

• Production gain=a+b+c

• Government cost=b+c+d

• Deadweight Loss=b+d


Export Subsidy in Small & Large Country

• For small country, an export subsidy raises the price of a good in the exporting country.

• For large country, an export subsidy raises the price of a good in the exporting country, while lowering it in foreign countries.

• This is because the export subsidy makes domestic firm supply more to the foreign country.

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



• An export subsidy unambiguously produces a negative effect on national welfare.

• 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 compared to the market outcome.

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

– In addition, the terms of trade decreases, because the price of exports falls in foreign markets to P*

s.


Welfare Loss: Large vs. Small country

• For large country, its welfare loss is much larger than its counterpart for a small country.

• Deadweight loss in Large= (b+e)+(d+g)+f

• B+e in large=B in small: consumption distortion

• D+g in large=D in small: production distortion

• F is the extra loss in large country when compared to small country.

• Implication: for a large economy, it is unwise to use the export subsidy policy.


Export Subsidy in Europe

• The European Union’s Common Agricultural Policy sets high prices for agricultural products and subsidizes exports to dispose of excess production.

– The subsidized exports reduce world prices of agricultural products.

– Consider the determination of TOT

• The direct cost of this policy for European taxpayers is almost $50 billion.

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


Agricultural Export Subsidy

• The top four regimes:

• (1) EU, account for 90% in the world.

• (2) Switzerland, 5%

• (3) U.S. :2%

• (4) Norway 1%

• The agricultural export subsidy is scheduled to be terminated in 2013.


Export Subsidy in Europe (cont.)


Import Quota

• An import quota is a restriction on the quantity of a good that may be imported.

• This restriction is usually enforced by issuing licenses to domestic firms that import, or in some cases to foreign governments of exporting countries.

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


Import Quota (cont.)

• 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: either domestic firms or foreign governments.

– These extra revenues are called quota rents.


Quota under perfect competition


US Import Quota on Sugar


Quota Rent Allocations

• Direct offer to the importing firms: firms get benefit C.

• Indirect offer to the importing firms according to applications: firms get less benefit C.

• Public Auction: benefit=C.

• Grant to the exporting country


Why Quota but not tariffs?

• It is more direct . Under tariffs, maybe foreign exporters can lower their price to attract home to import more.

• WTO pressure. Tariffs vs NTBs

• Rich countries’ tariff is reduced from 40% to 3%.

• Pool countries’ tariff is reduced to 10%.

• Only some restrictions on the Tokyo round in 1979.


Two different effects of Import Quotas

• Equivalence of import tariff and import quota under perfect competition

• Non-equivalence of import tariff and import quota under imperfect competition

• Monopoly


Quota under perfect competition


Non-equivalence of tariff and quota


Monopolist under free trade

• Without trade, the monopolist set price at Pm and produce Qm to earn the extra profit according to MR=MC

• In the presence of free trade, price equals world price, and then it produces Qf, which is lower than Qm.


Monopoly with tariffs & Quotas


Monopoly with tariffs

• With tariff, the domestic price now is pw+t, which is still lower than the monopoly price.

• The domestic monopolist still cannot get the monopoly power.

• Consumers consume C2 and the firm produces Qt.

• Import M2.

• The deadweight loss is b+d


Monopoly with Quotas

• With quota Q=M2, home’s total demand minus the quota is the domestic residual demand.

• Such demand is supplied by the monopolist.

• Therefore, the monopolist can set a monopoly price at Pq, which is higher than the market price with tariff, Pw+t.

• Consumption is C3 and production is Qq.


Effect of change of domestic demand


Effect of change of domestic demand

• Before change, effect of quota equals that of tariff: Q=40, t=0.5

• Now if domestic demand increases, for this small country, foreign demand shifts to the right also.

• For tariff: import more, increase from 40 to 60, deadweight loss is k.

• But, suppose import quota keeps fixed at 40, then the excess demand will push up the domestic price to 2.

• However, this causes more deadweight loss, now is h+i+j+k, though the quota rent also increases.


Effect of change of world supply


Effect of change from world supply

• Small home country

• World price is 1, impose tariff t=0.5, it is the same as to impose quota 40.

• However, when foreign export supply increases, the foreign supply curve shifts right.

• The new world price is 0.5, domestic price is 1 given tariff is 0.5, then the deadweight loss is k.

• However, if quota is still fixed at 40, then the deadweight loss is i+j+k.

• Quota rent increases from (1.5-1)*40 to (1.5-0.5)*40.


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.

• However, 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.


Feenstra’s Research on VER

• Section 201: Domestic Tariffs are allowed if there is substantial injury by foreign’s tariffs.

• Substantial Cause: Tariffs are most important cause of injury to the domestic industry.

• In the early 1980, Paul Volcker uses tight monetary policy to contract the economy, interest rate increases, a strong dollar, and a deep recession beginning in January 1980.

• In June, 1980, the United Automobile Workers applied to the ITC for protection under section 201 U.S. trade laws.



• However, U.S. ITC deny their application to confirm that the U.S. recession was a more important cause of injury in autos than were increased imports.

• Then, several senates in the Midwestern states pursued import limits by other means.

• CARs—VER

• Trucks—Complete tariffs, chicken war with Germany

• Heavyweight Motorcycle—tariffs

• Japan agrees to voluntary restraint their export to the U.S.A



• On May 1,1981, 2 weeks before the hearing, Japan agree to restrict their export.

• 1981: 1.83 million• 1984: 2.02 million• 1992: 2.51 million• The VER was nearly exactly satisfied in early years, and

remain binding until 1987.• After that, however, actual imports were below the VER, so is

stopped in 1994.• Why? –Japan began assembling cars in the U.S.• Social Welfare Cost: $1034 per import car.


Local Content Requirement

• 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 domestic valued added, or in physical units.


Local Content Requirement (cont.)

• 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 domestic inputs, however, the requirement does not place a strict limit on imports, but allows firms to import more if they also use more domestic parts.


Local Content Requirement (cont.)

• Local content requirement provides neither government revenue (as a tariff would) nor quota rents.

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


Other Trade Policies

• Export credit subsidies– A subsidized loan to exporters

– US Export-Import Bank subsidizes loans to US exporters.

• Government procurement– Government agencies are obligated to purchase from domestic

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

• Bureaucratic regulations– Safety, health, quality or customs regulations can act as

a form of protection and trade restriction.


Government procurement

• If quantity of government procurement is less than the quantities produced by domestic firms in free trade, then there is no distortion on production and import

• However, when it is higher than domestic original production, this will raise domestic price.

• As a result, producer surplus increases

• But Government has to pay more.

• It has deadweight loss

• Import also decreases.



• In the absence of government procurement requirement, government buys S1, and import G-S1.

• In the presence of government procurement requirement, government buy G but pays Pd. Total cost=a+b.

• Producers gain=a

• Deadweight loss=b.

• Import decreases from M1 to M2 accordingly.


Summary

Tariff Export subsidy

Import quota Voluntary export

restraint

Producer surplus

Consumer surplus

Government net revenue

National welfare


Summary

Tariff Export subsidy

Import quota Voluntary export

restraint

Producer surplus

Consumer surplus

Government net revenue

National welfare

Increases IncreasesIncreases Increases

No change:rents to license holders

Increases Decreases

DecreasesDecreases Decreases Decreases

No change:rents to foreigners

Ambiguous,falls for smallcountry

Ambiguous,falls for smallcountry

DecreasesDecreases


Summary (cont.)

1. A tariff decreases the world price of the imported good when a country is “large”, increases the domestic price of the imported good and reduces the quantity traded.

2. A quota does the same.

3. An export subsidy decreases the world price of the exported good when a country is “large”, increases the domestic price of the exported good and increases the quantity produced.


Summary (cont.)

4. The welfare effect of a tariff, quota and export subsidy can be measured by:

– Efficiency loss from consumers and producers

– 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 10.1 Effects on Welfare and Government Revenue of Tariff on Individual Product


Figure 10.5 A Tariff Improves the Terms of Trade


Figure 10.6 Domestic Welfare Depends on the Tariff Rate


Figure 10.7 A Tariff and World Production


Figure 10.A.1 The Optimal Tariff


Figure 10.A.2 The Tariff May Not Protect


Figure 10.A.3 The Tariff Pulls Consumption Off the Contract Curve

© 2007 Pearson Addison-Wesley. All rights reserved Chapter 10 Protection and the National Welfare.

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Transcript of © 2007 Pearson Addison-Wesley. All rights reserved Chapter 10 Protection and the National Welfare.