Hard: Theory of Trade Policy Flashcards
Theory of second best tells us what?
B) so trade policy is not the best way to correct a distortion e.g a tariff has DWL losses b+d , and also can result Retaliation!!
So what should policies target ?
In most cases trade policy is welfare decreasing. But when one distortion already exists, trade policy can raise welfare (if offsets initial distortion)
B) directed as closely as possible at the distortions that need correcting (e.g addressing negative production externalities like pollution by addressing production like pigouvian taxes, not trade policy!)
So why use trade policy is rarely welfare improving? (5)
Protectionism of strategic (defence) or subsistence (agriculture) sectors, and infant industries.
Limit imports
Gov revenue, esp developing countries.
Political reasons - Stolper-samuelson magnification effect- if commodity price rises, return factor used intensely rises so owners of that factor benefit! so want protection!
Move profits to domestic producers
Partial equilbrium analysis of trade policy in a small open economy, meaning import supply is perfectly elastic at price Pw.
why is this significant
When considering optimal tariffs
t = 1/ε
so if ε infinite, optimal tariff for SOE is zero!
Tariffs subsidies and quotas have the same basic effects: (2)
(As expected!)
Imports fall and domestic production rise
However different effects on welfare (tariffs increase price for consumers and given to producers, subsidies only increase price given for producers, no change in CS for consumers)
Tariff diagram: mention welfare effects (CS,PS,DWL/trade divertion,Gov rev)
Pg16
DWL: b+d (trade diverted to less efficient domestic producers and total consumption falls)
Abcd loss in consumer surplus since prices rise
PS gain A
Gov rev C
Subsidy diagram , welfare effects (CS, PS, G, DWL/trade diversion)
Pg25
Shift down in supply curve. Now produce at q1.
Imports fall too from C₀ - q₀ to C₀-q₁
Price received by producers is Pw(1+s), but consumers still pay Pw.
CS: unchanged since still pay Pw
PS: rises by a
Gov expenditure: a+b (cost of subsidy)
DWL: b (trade diversion now as (efficient) importers replaced by less efficient domestic producers)
Quota diagram
Explain what happens
B) welfare effects
Similar effect to tariff - since limited supply means domestic can produce more and at a higher price!
Imports restricted to q₁ to c₁, which is equivalent to a tariff of t.
B)
Same welfare effects as tariff EXCEPT…
Instead of gov revenue from tariff, C represents quota rent
Max loss from lobbying for a quota is a+c
How can quota rents be allocated? (3)
Auctioned by government (gov revenue from selling people the right to import)
Import licenses given to domestic residents (allows them to import at world price and sell at higher domestic price)- so rents go to domestic welfare
Export licenses given to foreign residents - (foreign exports benefit from selling at the higher price) rents go to foreign welfare
Domestic welfare loss in diagram if rents are allocated by export licenses to foreigners
Bcd
So tariff increase price of imports for consumers AND producers, while subsidy keeps consumers price constant.
So prices faced by consumers are different. What does this mean in terms of bundles consumed
Different bundles are consumed for tariffs and subsidies, but although prices change, small country cannot affect world prices, so trade must still be balanced at original world price ratio
Recall in a small economy general equilibriu,
Tariff on imports X has the same effect as taxing exports Y
Imp: draw general equilibrium impact of a tariff compared to a subsidy
Then add tariff on imports of x pg 38.
B) then remember although prices change, small country cannot impact world prices, so world price ratio must have same slope!!!
New Pt (price ratio with tariff, which is steeper to show imports price rise)
Since more expensive, producers more incentive to produce more of X and less Y
B) draw parellel new PW slope. Now consume on a point on there
So consume on a point on new Pw.
where is consumption in case of a subsidy pg 40
where is consumption in case of a tariff pg 41
Subsidies do not impact CS, and so their IC is tangent to Pw.
B) with a tariff CS falls too (as have to pay higher prices), shift Pt outwards, and equilibrium is where IC is tangent to the new Pt
So tariff CIC is tangential to Pt, subsidy CIC tangential to Pw
So a tariff always reduces welfare for a small open economy. t = 1/ε (optimal tariff is 0 for SOE as ε is infinite)
But doesnt mean EVERYONE in the SOE is worse off. Which theory can explain this, and who benefits?
Stolper-Samuelson: commodity price and factor price (of the factor used intensely for the commodity that has risen) are positively linked.
In this case the commodity is the import (good x). So… (Px increase)
If import is capital-intensive, return to capital increases, so owners of capital benefit! (Will seek protection for the capital intensive good)
Imp: Now consider a large economy.
A large economy CAN benefit from trade policy e.g tariffs.
Explain
Large economies can influence world price.
When they impose a tariff, raises price of imports, thus reduces import demand, lowering world demand and world prices! (Monopsony power)
Since import less, domestic demand needs to be met elseway, so domestic producers put attention on domestic market rather than exporting, so supply of exports fall, increasing export price! (With optimal tariff, set domestic price = MC of importing)
Thus export price rises, import price falls - TOT gains.
