4.1.6 Restrictions on free trade

Question 1

Why do countries actively use commercial policy despite the well-known gains from trade?

Answer 1

To protect and promote industries (impact on M component of AD).

Question 2

What does commercial policy refer to?

Answer 2

• Deliberate government policies which aim to influence a country’s pattern of trade.
• Includes tariffs, quotas and a variety of non-tariff barriers.

Question 3

Tariff

Answer 3

Tax imposed on imports

Question 4

What is the intention behind tariffs?

Answer 4

To make foreign goods more expensive hence less price competitive than domestic goods.

Question 5

What may the tariff be?

Answer 5

A specific tax
An ad valorem tax

Question 6

A specific tax

Answer 6

A set amount levied on each unit of output.

Question 7

An ad valorem tax

Answer 7

A percentage of the product’s selling price.

Question 8

In the tariff diagram, why is Pw horizontal and below equilibrium?

Answer 8

The country does not have a comparative advantage in this good or service and therefore is a price taker at the world price.

Question 9

In the tariff diagram, what is shown before the tariff was imposed?

Answer 9

Before the tariff, domestic demand was at D1 and domestic supply is S1. S1 of this is supplied by domestic firms and the remainder (D1-S1) was imported, meaning they were more reliant on the world.

Question 10

In the tariff diagram, what is shown after the tariff is imposed?

Answer 10

After the tariff, price rises to Pw+T. This causes a contraction of domestic demand from D1 to D2. There is also an expansion of domestic supply from S1 to S2. There is a substantial fall in imports to (D2-S2).

Question 11

What is the welfare analysis of a tariff?

Answer 11

• Additional domestic producer surplus.
• Lost consumer surplus.
• Tariff revenue.
• Deadweight Welfare loss (DWL)

Question 12

Resource cost to society

Answer 12

DWL or Deadweight Welfare Loss as a result of domestic suppliers producing the product more expensively than overseas suppliers. So the tariff is inefficient as we haven’t seen a complete transfer of welfare between stakeholders.

Question 13

Evaluation of tariffs: How large is the tariff?

Answer 13

The bigger the tariff, the bigger the impact.

Question 14

Evaluation of tariffs: In some trading blocs, tariffs are common, not unilateral.

Answer 14

Means there is a larger impact as all members of the bloc impose the same tariff on countries. In the EU, common external tariffs are used and thus they have a larger impact.

Question 15

Evaluation of tariffs: If the supply and demand curves are more inelastic…

Answer 15

• The smaller the impact of the tariff on the volume of imports yet there is an identical impact on price.
• The greater the government tariff revenue.
• The smaller the deadweight loss to society.

Question 16

Quota

Answer 16

A limit on the volume of imports allowed into a country per year.

Question 17

What may the quota be?

Answer 17

• Quantitative restrictions
• Voluntary export restraints (VERs)

Question 18

What is the intention of quotas?

Answer 18

The intention is to restrict the flow of imports but without directly changing their prices (but of course indirectly, via constraining supply).

Question 19

In the quota diagram, what is shown before the quota is imposed?

Answer 19

Before the quota, domestic demand was at D1. S1 of this was supplied by domestic firms. The remainder (D1-S1) was imported.

Question 20

In the quota diagram, what is shown after the quota is imposed?

Answer 20

After the quota, total supply to this country will be given by S dom+quota. This is domestic supply plus the quota of imports allowed into the country, at any given price. Market price rises to Pq at which point demand contracts to D2, S2 is supplied by domestic firms and the remainder (D2-S2) is the agreed quota.

Question 21

What is the welfare analysis of a quota?

Answer 21

• Additional domestic producer surplus.
• Lost consumer surplus.
• Additional foreign producer surplus as foreign producers are granted a quota of D2-S2. They are willing to sell at Pw but sell at Pq.
• DWL as not all consumer surplus is reallocated.

Question 22

Why is there a resource cost to society (DWL)?

Answer 22

Since domestic suppliers produce the product more expensively than overseas suppliers.

Question 23

Evaluation of quotas: How large is the quota?

Answer 23

The larger the quota, the larger the impact.

Question 24

Evaluation of quotas: In some trading blocs, quotas are common, not unilateral.

Answer 24

Means there is a larger impact as all members of the bloc impose the same quota on countries. In the EU, common external quotas are used and thus they have a larger impact.

Question 25

Evaluation of quotas: If the supply and demand curves are more inelastic…

Answer 25

• The greater the rise in price but there is an identical impact on the volume of imports.
• The greater the increase in producer surplus to domestic firms.
• The greater the increase in producer surplus to foreign firms.
• The greater the deadweight loss to society.

Question 26

Export subsidy

Answer 26

A grant of money given by government to an industry, in order to lower prices and increase output for export.

Question 27

What is the intention behind using export subsidies?

Answer 27

To make domestic goods cheaper, hence more price competitive in foreign markets. This enables domestic firms to “dump” their goods in foreign markets (p<AC). This would drive competition out and allow them to dominate those foreign markets.

Question 28

In the export subsidy diagram, what is shown before the export subsidy is imposed?

Answer 28

Before the subsidy, domestic demand was at D1, of which S1 was being supplied by domestic firms. The remainder (D1-S1) was being supplied by RoW.

Question 29

In the export subsidy diagram, what is shown after the export subsidy is imposed?

Answer 29

After the subsidy, domestic supply curve shifts vertically downward by the amount of the subsidy. Domestic supply increases to S2. Number of domestic firms who can now compete with world price has risen by (S2-S1) (their quantity) and imports are squeezed from D1-S1 to D1-S2.

Question 30

What are the likely effects of the export subsidy on resource allocation?

Answer 30

• Promoting enhanced production of something that shouldn’t be produced more of so misallocation of resources.
• Distorts comparative advantage by making domestic firms appear more efficient and profitable so there will be a global misallocation of resources.

Question 31

Non-tariff barriers

Answer 31

Usually, these are rules and regulations that control the standard of products to be sold in a country.

Question 32

Examples of non-tariff barriers

Answer 32

Technical standards
Health and safety standards

Question 33

What is the grey area surrounding non-tariff barriers?

Answer 33

Entirely sensible and apply equally to both domestic and foreign goods?
A disguised restriction on international trade?

Question 34

One impact on an economy of a rise in protectionism is lower output and living standards.

Answer 34

Protectionist measures would block imports and force the domestic economy to be more self-sufficient. This would mean goods are no longer produced on the basis of comparative advantage, so production occurs at a higher opportunity cost. Accordingly, there is a fall in total world output, choice and living standards.

Question 35

Evaluation of lower output and living standards.

Answer 35

To evaluate, all depends on how far reaching the protectionist measures are. If tariffs and quotas are only applied to one or two strategic industries, while most others are still produced in accordance with CA, then the fall in output and living standards will be insignificant.

Question 36

One impact on an economy of a rise in protectionism is rise in price and loss of consumer surplus.

Answer 36

The tariff will raise the price of the good, leading to a contraction of demand, an expansion of domestic supply, hence a fall in imports from D1 - S1 to D2 - S2. (illustrate this fully with annotated diagram). The rise in price causes a loss of consumer surplus (CS), part of which goes to the government as tariff revenue (seen as tariff per unity quantity of imports). Part of the lost CS becomes additional producer surplus/rent - seen as additional area above the supply curve and below the price line. There there are two DWL areas. Firstly, the DWL of lost consumption, which occurs due to the contraction of demand. Secondly, there is a resource cost to society, as the tariff enables inefficient domestic firms to enter the market and compete with the world price.

Question 36

Evaluation of rise in price and loss of consumer surplus.

Answer 36

To evaluate, the significance of the tariffs impact will depend on PED and PES. In general, the steeper and more inelastic the S and D curves, the greater the government tariff revenue, and the smaller the DWL to society (as a rise in price will only lead to minimal rise in domestic supply and fall in demand). Further more, the impact on price and CS will depend on the size of the tariff. A 5-10% tariff is usually seen as insignificant and will have a very limited impact on consumer welfare. However, a 30-40% tariff will be more noticeable and damaging.

Question 37

One impact on the economy of a rise in protectionism is a rise in cost push inflation.

Answer 37

The tariff will raise the price of imported goods bought by domestic producers. This increases their cost of production, shifting the SRAS curve up / to the left and raising the price level from P1 to P2. The result is cost push inflation. (correctly labelled and fully annotated AD/AS diagram needed).

Question 38

Evaluation of rise in cost-push inflation

Answer 38

To evaluate, the impact on SRAS curve and price level depends on which imported goods are subject to protectionist measures. For example, tariffs on finished goods, only raises prices of the one product, limited impact of inflation. If the tariff is placed on raw materials, this will raise the cost of production for range of firms, so the impact on AS curve and price level will be greater.

Question 39

One impact on the economy of a rise in protectionism is a fall in unemployment.

Answer 39

The rise in the price of imports will cause import substitution, as demand switches away from foreign goods and towards domestic substitutes. This shifts AD curve to the right, and as real output rises from Y1 to Y2 the economy moves closer to full employment (YFE). (correctly labelled and fully annotated AD/AS diagram needed, specifically marking out YFE).

Question 40

Evaluation of a fall in unemployment.

Answer 40

However, the extent to which unemployment falls depends on the elasticity of the AS curve i.e. where we are in the business cycle.

Question 41

One impact on the economy of a rise in protectionism is an improvement in the balance of payments.

Answer 41

The tariff will cause import substitution, thereby reducing import expenditure.

Question 42

Evaluation of an improvement in the balance of payments

Answer 42

However, if other countries impose retaliatory tariffs, they may cause lower X, which would offset the positive effect of lower M. Hence in the LR, there may be very limited effect on the balance of payments.

Question 43

One impact on the economy of a rise in protectionism is greater income inequality.

Answer 43

Tariffs are indirect taxes (i.e. a tax on spending), making them regressive. That is, poorer households pay a larger proportion of their income in tariffs than richer households. For the UK, this would mean a rise in pverty and a fall in overall living standards.

Question 44

Evaluation of greater income inequality.

Answer 44

However, the greater income inequality can be mitigated to some extent if the government redistribute its tariff revenue to poorer households.

Question 45

What is the infant industry arguement?

Answer 45

Industries just starting up will consist of low volume producers who are short of experience. They lack the economies of scale and the benefits of learning by doing, held by foreign competitors who will clearly have a cost advantage over domestic firms. Hence tariff protection is required for a limited period until the domestic industry learns the ropes and grows large enough to be exposed to the full weight of international competition.