The Instruments of Trade Policy: Part I, Tariffs

The Instruments of Trade Policy: Part I, Tariffs • INTERNATIONAL ECONOMICS,ECO 486 • Harmonized tariff schedule (HTS) of the United States:http://www.usitc.gov/taffairs.htm#HTS

Learning Objectives • Reprise the gains from trade • Analyze the welfare cost of tariffs • Determine the optimal tariff • Analyze export subsidies • Explain the effective rate of protection

Gains from Trade • Static Gains (PPF doesn’t shift) • Consumption gains • Production gains • Dynamic Gains (PPF does shift) • Trade expands resources • Trade may raise productivity • Political Gains

Consumption & Production Gains rF C B CIC2 A CIC1 TEXTILES, T (yards per year) CIC0 X 0 SOYBEANS, S (bushels per year)

Consumption & Production Gains PS/PT = rS=|slope of terms of trade line| rF C A to B shows consumption gains B to C shows production gains B CIC2 A CIC1 TEXTILES, T (yards per year) CIC0 X 0 SOYBEANS, S (bushels per year)

Dynamic Gains from Trade • Trade may speed economic growth

Dynamic Gains from Trade • Trade may speed economic growth • When more K goods are imported than produced in autarky, PPF shifts out. • Trade diffuses new technology. • Trade raises real income. Savings rise. • Free trade an effective anti-trust policy • Trade expands the market, allowing firms to exploit IRS. • When trade spurs development, decreasing-costs may occur.

Commercial Policy • Governments action that may change the composition and volume of trade flows • Tariffs • Quotas • Subsidies • Other non-tariff barriers • We’ll analyze the cost & benefits of these

Tariffs • Taxes on • Imports • Exports • Subsidies • Components -- See HTS • Ad valorem-- % of value • Specific -- flat fee per unit • Compound -- both

Positive Effects of Tariffs • Revenue Effect -- provide tax revenue • Protective Effect -- shelter domestic producers from foreign competition

Tariff Terminology • A pure-revenue tariff is one imposed on a good not produced domestically • A tariff on bananas imported to Iceland • A prohibitive tariff is one that is so high that none of the good is imported • no revenue is collected

Uses of Tariffs • Developing countries may rely on tariffs to provide tax revenue • Developed countries impose tariffs for their protective effect

Tariffs as tools of int’l policy • Most Favored Nation status, MFN • granted as a reward, withheld as a punishment • Generalized System of Preferences, GSP • Most developed countries have GSP as means of helping developing countries • access to markets of developed countries

Welfare Cost Analysis • Use (National) Supply and Demand • Partial equilibrium • One import or export good • Measure Changes in Consumer Surplus and Producer Surplus • Start with a small country • Its trade is too small to affect terms of trade

Gains from free trade -- imports 10 Price ($ per bushel of grapes) 6 3 2 0 4 1 7 10 Quantity (millions bushels of grapes per year)

Gains from free trade -- imports Domestic Supply of grapes 10 Price ($ per bushel of grapes) 6 a b c 3 World price of grapes 2 Domestic demand for grapes 0 4 1 7 10 Quantity (millions bushels of grapes per year)

Welfare of a Move to Free TradeA Small Country’s Imports

Gains from free trade -- exports 10 9 Price ($ per jar of honey) 6 2 0 4 1 7 10 Quantity (millions jars of honey per year)

Gains from free trade -- exports Domestic Supply of honey 10 9 World price of honey Price ($ per jar of honey) g e f 6 2 Domestic demand for honey 0 4 1 7 10 Quantity (millions jars of honey per year)

Welfare of a Move to Free TradeA Small Country’s Exports

Welfare Cost of a Tariffon Imports -- Small Country 10 Price ($ per bushel of grapes) 5 3 2 0 1 3 5 7 10 Quantity (millions bushels of grapes per year)

Welfare Cost of a Tariffon Imports -- Small Country Domestic Supply of grapes 10 Price ($ per bushel of grapes) World price + tariff $2/bu 5 c a d b 3 World price of grapes 2 Domestic demand for grapes 0 1 3 5 7 10 Quantity (millions bushels of grapes per year)

Welfare Cost of a Tariffon Imports -- Small Country Loss = 0.5 x tariff x change in imports

Welfare Cost of a TariffSmall Country Domestic Supply of grapes 10 Price ($ per bushel of grapes) World price + tariff $2/bu 5 c d b 3 World price of grapes 2 Domestic demand for grapes 0 1 3 5 7 10 Quantity (millions bushels of grapes per year)

Welfare Cost of a Tariffon Imports -- Small Country Domestic Supply of grapes 10 Price ($ per bushel of grapes) World price + tariff $2/bu 5 a2 c a1 d b 3 World price of grapes 2 Domestic demand for grapes 0 1 3 5 7 10 Quantity (millions bushels of grapes per year)

Export Tariff -- Small Country Domestic Supply of honey 10 9 Price ($ per jar of honey) 6 2 Domestic demand for honey 0 4 1 7 10 Quantity (millions jars of honey per year)

Export Tariff -- Small Country Domestic Supply of honey 10 9 PW d b c a Price ($ per jar of honey) PW -T 6 2 Domestic demand for honey 0 4 1 7 10 Quantity (millions jars of honey per year)

Welfare Cost -- Export TariffSmall Country Case

Int’l Free Trade Eq. Large Country Price ($ per lb.) PA PB 0 0 Quantity (lb. of Lobster per year)

Int’l Free Trade Eq. Large Country Price ($ per lb.) A’s Supply of L B’s Supply of L PA PFT PFT PB A’s demand for L B’s demand for L 0 0 Q1’ Q2’ Q1 Q2 Quantity (lb. of Lobster per year)

Import Demand Price ($ per lb.) Price ($ per lb.) A’s Supply of Lobster PA PA PFT PB PB A’s demand for Lobster 0 0 M = QD -QS Quantity (lb. of Lobster per year)

Import Demand Price ($ per lb.) Price ($ per lb.) A’s Supply of Lobster PA PA PFT PB PB A’s demand for imported lobster (excess demand); |slope| = rise/(sum of runs) A’s demand for Lobster 0 0 M = QD -QS Quantity (lb. of Lobster per year)

Export Supply Price ($ per lb.) B’s Supply of L PA PB PB B’s demand for L 0 0 QD QS X = QS -QD Quantity (lb. of Lobster per year)

Export Supply B’s Supply of exports, excess supply; slope = rise/(sum of runs) Price ($ per lb.) B’s Supply of L PA PB PB B’s demand for L 0 0 QD QS X = QS -QD Quantity (lb. of Lobster per year)

Price ($ per lb.) A’s Supply of Lobster PA PFT A’s demand for Lobster 0 Q1 Q2 Export Supply & Import Demand Price ($ per lb.) Export Supply, X PA PFT PFT PB Import Demand, M 0 0 M = Q2 -Q1 Quantity (lb. of Lobster per year)

Export Supply & Import Demand Price ($ per lb.) B’s Supply of L Export Supply, X PA PFT PFT PB PB Import Demand, M B’s demand for L 0 0 Q1’ Q2’ 0 M = Q2 -Q1 X = Q2‘ -Q1 ‘ Quantity (lb. of Lobster per year)

Optimal Tariffs • Large countries may force foreign producer to pay part of their tariff. • Because they are important customers, they force foreign suppliers to cut price. • The optimal tariff maximizes the net welfare change • Retaliation is likely to offset this gain

Equilibrium with a Tariff Large Country Price ($ per lb.) A’s Supply of L B’s Supply of L P” PFT PFT P’ P’ A’s demand for L B’s demand for L 0 0 Q1’ Q3’ Q4’ Q2’ Q1 Q3 Q4 Q2 Quantity (lb. of Lobster per year)

Equilibrium with a Tariff Large Country Price ($ per lb.) A’s Supply of L B’s Supply of L P” a c b d PFT PFT j i e h e P’ P’ A’s demand for L B’s demand for L 0 0 Q1’ Q3’ Q4’ Q2’ Q1 Q3 Q4 Q2 Quantity (lb. of Lobster per year)

A’s Welfare Cost -- Import TariffImposed by Large Country, A

B’s Welfare Cost from A’s TariffImport TariffImposed by A

The Instruments of Trade Policy: Part I, Tariffs