Chapter 5: Trade Policy

Question 1

What is a tariff

Explain differences between a specific tariff and an ad valorem tariff

Answer 1

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

Question 2

Partial equilibrium: Analysis of two large countries

What happen when there is an absence of trade

Answer 2

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.

Question 3

What is the import demand curve

How to get the import demand curve

Answer 3

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

Question 4

What is the export supply curve

How to get the export supply curve

Answer 4

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

Question 5

How to show the world equilibrium for two countries

Answer 5

import demand = export supply

D(P) - S(P) = S(P) - D (P)

world demand = world supply

D(P) + D(P) = S(P) + S (P)

Question 6

What happens when there is the effect of the tariff

Answer 6

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

Question 7

Why can the increase in the price in Home can be less than the amount of the tariff.

Answer 7

If Home (country imposing tariff) is a large country –> the effect of the tariff will cause the foreign export price to decline

Question 8

What happens if the importing country is a small one? How does this affect the foreign export price

Answer 8

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

Question 9

What is Consumer surplus

Answer 9

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

Question 10

What is producer surplus

Answer 10

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

Question 11

What are the welfare effects of a tariff for a large country

Answer 11

CS Loss: a + b + c + d
PS gain: a
TR gain: c + e

NW gained: e - (b + d)

Question 12

Why is it optimal for small country to set tariff = 0 and impose free trade

Answer 12

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

Question 13

What happens when there is a national welfare gain

Answer 13

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.

Question 14

What does an improvement in country’s Term of trade mean

Answer 14

􏰀 A reduction in the world relative price of its imports, or

􏰀 An increase in the world relative price of its exports

Question 15

What happens when the tariff is too large? Is there an optimum tariff

Answer 15

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

Question 16

Potential costs of tariffs

Answer 16

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.

Question 17

What is an import quota

Answer 17

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.

Question 18

What happens when a quota instead of a tariff is being used to restrict imports

Answer 18

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

Question 19

What is a tariff equivalent quota

Answer 19

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).

Question 20

What is an export subsidy

Answer 20

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

Question 21

What are the effects of an export subsidy

Answer 21

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

Question 22

What is a voluntary export restraint. Why is this bad for the importing country?

Answer 22

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

Question 23

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

Answer 23

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

Question 24

What happens to the budget constraint now?

How to find optimal consumption point

Answer 24

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

Question 25

What are the effects of the tariff on small economy (include consumption and production distortions)

Answer 25

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

Question 25

What are the effects of the tariff on small economy (include consumption and production distortions)

Answer 25

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