Chapter 5: Trade Policy Flashcards
What is a tariff
Explain differences between a specific tariff and an ad valorem tariff
A tariff is a tax levied when a good is imported.
A specific tariff is levied as a fixed charge for each unit of imported goods: p=pW +t
An ad valorem tariff is an import tax expressed as a percentage of the international price of the good: p = pW (1 + t) t*100 is the percentage tariff rate
Partial equilibrium: Analysis of two large countries
What happen when there is an absence of trade
Foreign will export wheat to Home. Going from autarky to free trade raises the price of wheat in Foreign and lowers the price of wheat in Home until the price difference is eliminated.
What is the import demand curve
How to get the import demand curve
The import demand curve represents, for each price, the difference between the quantity demanded by Home consumers at that price and the quantity Home producers are willing to supply at the price.
MD = D(P) − S(P)
As price decreases, quantity of imports increases
What is the export supply curve
How to get the export supply curve
The export supply curve: represents, for each price, the difference between the quantity that Foreign producers are willing to supply at that price and the quantity demanded by Foreign consumers at that price.
XS∗ = S∗(P∗) − D∗(P∗)
As the price increases, export supply rises together
How to show the world equilibrium for two countries
import demand = export supply
D(P) - S(P) = S(P) - D (P)
world demand = world supply
D(P) + D(P) = S(P) + S (P)
What happens when there is the effect of the tariff
A tariff t acts like a transportation cost, making sellers unwilling to ship goods unless the Home price exceeds the Foreign price by the amount of the tariff: PT − t = PT*
Because of the tariff –> price increases from Pw to PT
When the price in home market increases from Pw to Pt with tariff. Import demand decreases from Qw to QT
Why can the increase in the price in Home can be less than the amount of the tariff.
If Home (country imposing tariff) is a large country –> the effect of the tariff will cause the foreign export price to decline
What happens if the importing country is a small one? How does this affect the foreign export price
If importing country is small, has no effect on the foreign (world price) as import demand takes up an insignificant portion of world demand
When small country impose import tariff, foreign price does not fall but stay at Pw. Price in domestic market rises by full amount of tariff to P(T) = Pw + T
What is Consumer surplus
Measured from area of maximum willingness to pay and price they actually paid
Consumer surplus measures the amount that consumers gain from purchases by computing the difference in the price actually paid from the maximum price they would be willing to pay for each unit consumed.
When price increases consumer surplus decreases
What is producer surplus
Producer surplus measures the amount that producers gain from sales by computing the difference in the price received from the minimum price at which they would be willing to sell.
When price increases –> producer surplus increases
What are the welfare effects of a tariff for a large country
CS Loss: a + b + c + d
PS gain: a
TR gain: c + e
NW gained: e - (b + d)
Why is it optimal for small country to set tariff = 0 and impose free trade
for small country, foreign price does not move down
CS Loss: a + b + c + d
PS gain: a
TR gain: c
NW gained: - (b + d) <0
therefore small country shld just set tariff = 0 impose free trade
What happens when there is a national welfare gain
If the terms of trade gain exceed the efficiency loss, then national welfare will increase under a tariff, at the expense of foreign countries.
However, foreign countries are apt to retaliate.
What does an improvement in country’s Term of trade mean
A reduction in the world relative price of its imports, or
An increase in the world relative price of its exports
What happens when the tariff is too large? Is there an optimum tariff
Large enough tariff ⇒ trade will cease (prohibitive tariff)
For graph:
Y axis: National welfare
X axis: tariff rate
At certain optimum tariff national welfare is maximised . Beyond prohibitive tariff rate trade will cease. National welfare at lowest
Potential costs of tariffs
If a country imposes tariffs on imports, trading partners are likely to retaliate by imposing their own tariffs on imports.
Tariffs can be politically hard to remove and large tariffs may induce producers to engage in wasteful activities to avoid paying tariffs.
Ford and Subaru install (then later remove) seats in vans and pickups trucks to avoid U.S. tariff on imports of light commercial trucks.
What is an import quota
An import quota is a restriction on the quantity of a good that may be imported.
An import quota restricts the quantity of imports directly, which increases the price of the good and protects local producers in the same way as a tariff.
The quantity restriction is usually enforced by issuing licenses or quota rights.
What happens when a quota instead of a tariff is being used to restrict imports
In this case, the government receives no revenue
Instead, the revenue from selling imports at high prices goes to quota license holders. The right to import is given through licenses to a group of people or firms.
The owner of this license buys the good to the world price and sells it at the domestic price. They make a profit (quota rents). Government can instead auction off the import liscences and obtain quota rents as government revenue
What is a tariff equivalent quota
For any tariff, there is an import quota that restricts the quantity of imports to exactly the same amount as the tariff.
The only difference is that the tariff revenue goes directly to the government, while the quota rents go to the quota holders (or to the government if the licenses are auctioned off).
What is an export subsidy
Export subsidy is a subsidy given to exporters of a particular good
When an export subsidy is imposed, domestic price Ps increases –> Lead to CS decreasing, PS increasing
Government needs to pay sXs* for the export subsidy
Export subsidy also worsens the terms of trade by lowering the price of exports in world markets
What are the effects of an export subsidy
Export subsidy lowers the price paid in importing countries Ps* = Ps - s
PS gained : A + B + C
CS loss: A + B
export subsidy cost : B + C + C + E + F + G
Since price of exports fall so TOT falls
What is a voluntary export restraint. Why is this bad for the importing country?
A voluntary export restraint (VER) works like an import quota, except that the quota is imposed by the exporting country rather than the importing country. Foreigners sell a restricted quantity at an increased price.
The effect is the same as an import quota but the difference is that the rents go to the exporting country (the firms with with the export licenses or the exporting country’s government if the export licenses are auctioned off) instead of the importer country.
VER is always worse than import quota since prices are now higher (due to restricted quantity) –> at the same time without obtaining any rents
What is the general equilibrium effect of a tariff in a small economy
Two goods: X and Y
tariff on good Y
What happens to relative price px/py
What happens to production, which produces more
With free trade, the country exports good X and imports good Y. The world relative price is at px/py, production in a country takes place at Y0 and consumption at C0
importing country impose a tariff on good y. Now domestic producers face relative price
px / (py(1+t)) Y
This causes country to produce less of good X and more of good
What happens to the budget constraint now?
How to find optimal consumption point
The budget constraint with the tariff has the same slope −pX /pY as the pre-tariff budget constraint but it goes through the new production point Y1.
This inward shift of the budget constraint is the production distortion.
The optimal consumption point C1 in the economy after it has imposed the tariff on good Y has to be at a point where the indifference curve has the slope
−pX / (pY (1 + t)) and it has to be within the budget constraint.
Indifference curve must intersect slope of −pX / (pY (1 + t)) –> give you new consumption point C1
What are the effects of the tariff on small economy (include consumption and production distortions)
The total distortions from imposing the tariff on good Y is the difference in utility from consuming at free trade consumption point C0 and tariff consumption point C1.
If there would have only been a production distortion, i.e. if the only distortion was the price that producers faces while consumers still paid the free trade price, consumption would have fallen to C2. The production distortion is therefore the difference in utility between C0 and C2.
But due to tariff, consumers face distorted price, thus consumption distortion is the difference in utility from C2 to C1
What are the effects of the tariff on small economy (include consumption and production distortions)
The total distortions from imposing the tariff on good Y is the difference in utility from consuming at free trade consumption point C0 and tariff consumption point C1.
If there would have only been a production distortion, i.e. if the only distortion was the price that producers faces while consumers still paid the free trade price, consumption would have fallen to C2. The production distortion is therefore the difference in utility between C0 and C2.
But due to tariff, consumers face distorted price, thus consumption distortion is the difference in utility from C2 to C1
