Trade Policy Global Trade and Finance Prof. Bryson, Marriott School
A tariff is a tax, usually ad valorem (“on the value” or some percentage of the estimated market value of a commodity). • It is imposed as a commodity crosses the frontier of the importing country.
The Two Functions of Tariffs First, they create revenues Second, they hinder foreign competition.
Trade Before Tariffs • Because the world price is below the domestic price, imports are equal to the shortage between Dd and Sd at the world price. Sd World Price Dd Imports
Tariffs • Now, this country imposes a tariff, Pw plus tariff World Price and the price rises from Pw to Pw + Tariff.
Tariffs • We get the famous areas a,b,c, and d. Wp plus tariff a b c d World Price Imports after tariff Imports before tariff
Consumers lose areas a+b+c+d in consumer’s surplus as the tariff raises the price. Wp plus tariff a b c d World Price Producers gain Area A Smaller than what consumers lost
Net national loss from the quota: areas b and d. These are losses in consumer surplus not offset by gains made elsewhere. Government collects area c as tariff revenues Wp plus tariff a b c d World Price
b is the “Production effect.” This is a deadweight loss. Consumers purchases are shifted to the more expensive, less-efficient domestically produced product. Wp plus tariff a b c d World Price d is the “consumption effect,” also deadweight loss, resulting from the reduction in consumption due to the higher price.
So the net national welfare loss is b + d. Wp plus tariff a b c d World Price
More about b and d • The net losses, b and d, don’t appear very large, but • 1% of US GNP is still well over $100 billion • Net national loss is substantially less than consumer loss.
More about b and d • There is also an administrative cost to a tariff (part of c must be added to b and d). • Protection has dynamic (technological effects). • Stagnation.
Import Quotas • Historically, as tariffs decrease through the efforts of GATT/WTO, other barriers replace them. This has gone on since the early 1950s. • Import Quotas, a most popular substitute for tariffs, are limits on the total Q of imports permitted.
Import Quotas • With quotas, importing countries have absolute assurance about import quantities. • With tariffs, countries have less control over import volumes, since foreign exporters can cut prices to increase sales when they face tariffs.
Quotas • Analytically speaking, quotas are not better and are usually worse than tariffs. • Total market supply is the domestic supply curve plus the fixed quota at all prices above the world price. Sd Sd + Quota Imports, limited to the Quota, simply shift the S curve out. Pw Quantities are determined by the Intersection of D and Sd + Quota. Imports after Dd Imports before quota
But stop! Let’s compare this to a tariff and we will notice they are almost identical analyses.
Tariffs and Quotas Compared • This country has imposed a tariff. How would a quota look? Sd Sd + Quota Wp plus tariff World Price Just add the quota to the supply curve
Quotas • Once again, we have the same net economic welfare situation illustrated by the areas in the strip abcd diagram Sd Sd + Quota a b c d Pw Dd
Consumers lose areas a+b+c+d in consumer’s surplus, Sd Sd + quota Equilibrium price with quota where Dd = Sd + quota a b c d World Price
Producers gain area a. Sd Sd + quota a b c d
Government could collect area c auctioning import licenses. Sd Sd + quota Equilibrium price with quota where Dd = Sd + quota a b c d World Price
Net national loss from the quota:at least areas b and d. Sd Sd + quota Equilibrium price with quota where Dd = Sd + quota a b c d World Price
b is the “Production effect.” This is a deadweight loss. Consumers purchases are shifted to the more expensive, less-efficient domestically produced product. Sd Sd + quota a b c d d is the “consumption effect,” also deadweight loss, resulting from the reduction in consumption due to the higher price.
Additional Quota Problems • First, the quota can create domestic and foreign monopoly power. • The domestic firm may have very high prices, and limited competing imports don’t force prices down.
Additional Quota Problems • The foreign producers can tacitly collude and charge the domestic monopoly price.
Additional Quota Problems Second, efficiency depends on how the rights to import are distributed. Import licenses can be allocated as follows: 1. by competing auctions (generates same as tariff revenues. 2. by sales (or bribes) by corrupt customs officials
Additional Quota Problems 3. by fixed favoritism – some arbitrary method, e.g., on the basis of pre-quota sales proportions 4. by resource-using application procedures. Use the bureaucratic method, viz., queues.
Voluntary Export Restraints • Here, a major exporting partner is warned to restrict its sales in your country voluntarily.
Voluntary Export Restraints • The importing country says: “As you invade our market, you had better restrain yourself voluntarily, or our parliament will cream you with tariffs or quotas.”
Voluntary Export Restraints • President Reagan did this with Japanese auto exporters. • Unwittingly, this is like saying, “You had better behave like a monopolist in our market!” (Restrict your output and do what you will with your price.)
VER’s, Quotas, and Free Trade, See Figure 8.2 in the text • A VER is, in effect, like a quota. • Let’s compare the VER, quota, and free trade.
VER’s, Quotas, and Free Trade, • Free Trade Fs= foreign supply of Ms Fs Dm = demand for imports Dm Small Country Large country (w/monopsony power) With free trade, both countries enjoy same consumers surplus With free trade, both cases enjoy the same producers surplus.
VER’s, Quotas, and Free Trade With a quota, the small country loses consumer surplus, but can get the yellow area by auctioning import licenses. • Using a Quota Fs= foreign supply of Ms Fs Dm = demand for imports Dm Small Country Large country (with monopsony power) With a quota, the large country gains the larger yellow box.
VER’s, Quotas, and Free Trade • Using a Quota Fs= foreign supply of Ms Fs Dm = demand for imports Dm Small Country Large country (with monopsony power) With a quota, the exporter loses the larger green area of producer surplus.
VER’s, Quotas, and Free Trade • A VER is, in effect, like a quota. • Let’s compare the three types of protection • VER, • quota, and • free trade.
With a VER, the large country is like the small one, except it gives its larger yellow box to the foreign monopolist. • Using a VER Fs= foreign supply of Ms Fs Dm = demand for imports Dm Small Country Large country (with monopsony power) With a VER, the small country loses consumer surplus. It gives the yellow box to the foreign monopolist.
Trade and Historical Societies • Contrast the cases of the USSR and China • The case of the Lamanites and Nephites THE BOOK OF HELAMAN, CHAPTER 6 The righteous Lamanites preach to the wicked Nephites—Both peoples prosper during an era of peace and plenty— 7 And behold, there was peace in all the land, insomuch that the Nephites did go into whatsoever part of the land they would, whether among the Nephites or the Lamanites.8 And it came to pass that the Lamanites did also go whithersoever they would, whether it were among the Lamanites or among the Nephites; and thus they did have free intercourse one with another, to buy• and to sell, and to get gain, according to their desire.9 And it came to pass that they became exceedingly rich, both the Lamanites and the Nephites; and they did have an exceeding plenty of gold•, and of silver, and of all manner of precious metals, both in the land south and in the land north.
10 Now the land south was called Lehi• and the land north was called Mulek•, which was after the son• of Zedekiah; for the Lord did bring Mulek into the land north, and Lehi into the land south. 11 And behold, there was all manner of gold in both these lands, and of silver, and of precious ore of every kind; and there were also curious workmen, who did work all kinds of ore and did refine it; and thus they did become rich. 12 They did raise grain in abundance, both in the north and in the south; and they did flourish exceedingly, both in the north and in the south. And they did multiply and wax exceedingly strong in the land. And they did raise many flocks and herds, yea, many fatlings.
13 Behold their women did toil and spin, and did make all manner of cloth•, of fine-twined linen and cloth of every kind, to clothe their nakedness. And thus the sixty and fourth year did pass away in peace.14 And in the *sixty and fifth year they did also have great joy and peace, yea, much preaching and many prophecies concerning that which was to come. And thus passed away the sixty and fifth year. And what was the result?
How well did the Nephites handle their wealth? 17 For behold, the Lord had blessed them so long with the riches of the world that they had not been stirred up to anger, to wars, nor to bloodshed; therefore they began to set their hearts upon their riches; yea, they began to seek to get gain that they might be lifted up one above another; therefore they began to commit secret• murders, and to rob and to plunder, that they might get gain. 18 And now behold, those murderers and plunderers were a band who had been formed by Kishkumen and Gadianton•.