Trade policy instruments - tariffs

Question 1

What is a demand curve?

Answer 1

Demand curve describes the functional relationship between the price of a product and the quantity consumers would buy of that product.
Assuming consumers’ rational, utility maximizing behavior, the demand curve can be interpreted as ‘marginal utility’ function.

Question 2

What is marginal utility?

Answer 2

Marginal utility refers to how much utility (happiness) a consumer gets out of consuming one additional unit of the product.
A rational consumer therefore buys up to the point where the last one bought is just barely worth the price. The price reflects, thus, the marginal utility of consuming a little more.

Question 3

What is a supply curve?

Answer 3

Supply curve describes the functional relationship between the price of a product and the quantity producers would supply of that product.

Assuming producers’ rational, profit maximizing behavior, the supply curve can be interpreted as ‘marginal cost’ function.

Question 4

What is marginal cost?

Answer 4

Marginal cost referes to the cost added by producing one additional unit of a product or service.
A rational producer supplies up to the point where the marginal cost just equals the price.

Question 5

When will producers/consumers stop produce/buy?

Answer 5

Consumers (producers) buy (produce) up to the point where the marginal utility (marginal cost) equals the price.
For all units bought (produced) up to this point, the marginal utility (marginal cost) is above (below) the price.

Question 6

When will consumers/producers get a surplus? Please show this on a graph

Answer 6

For consumers, they get consumer surplus at any point where the price is below the marginal utility function.

For producers, they get producer surplus at any point where the price is above the marginal utility function.

For graph see p. 48

Question 7

Will a change in price both affect consumer and producer welfare?

Answer 7

Yes, one goes up and the other goes down.

Question 8

Please show and explain the direct effects of tariffs on the import demand curve

Answer 8

Without the possibility of imports, demand = supply at price p*
With the possibility of import, the amount of import will depend on the import price.
Two important assumptions:
- Imported and domestic goods are perfect substitutes.
- Import price fixes the domestic price.

As domestic consumers want to consume more than domestic producers are willing to produce at price p’’ or p’, the difference is met by imports.

graph p.41

Question 9

Please show and explain the direct effects of tariffs on the import supply curve

Answer 9

Supply of imports to Home is supply of exports from Foreign.

Equilibrium price in Foreign at p*.

In case the export price is higher than p* producers in Foreign have an incentive to produce more and export.

Note: Export price sets the price in Foreign. Producers in foreign have no incentive to produce less because they can sell their product via export.

graph p.49

Question 10

Explain and draw the workhorse diagram: MD – MS

Answer 10

Assuming imports and domestic production are perfect substitutes, the domestic price is fixed where demand and supply of import meet:

P_FT with FT = Free trade
- MD—MS diagram allows to determine the price and volume of imports.
- It does not allow to see impact on domestic consumers and producers.

graph p.42

Question 11

Please explain and draw a tariff analysis for a small country case

Answer 11

Small country: Domestic consumption and production and import have only negligible effects on world market conditions, specifically the good’s price.

Assumption: Imported good perfect substitutes from domestic good

P^w= world price of good, since no consumer would buy at a higher price is there is free trade.
Ad valorem tariff rate of t > 0.
Import tax = tPw
Price of the imported good: Pw+tPw
Short term: Consumers turn to the cheaper domestic products
Over time: Post tariff increase in the domestic product’s price up until Pd = Pw + tPw, because the domestic producers will not produce at a quantity to satisfy all consumers, thus excess demand drives prices up again.

As prices increase, consumers will buy less, which is called the consumption effect of the tariff.
Meanwhile, domestic producers are willing to supply more as prices rises, called the protective effect.

Revenue effect of the tariff: Government collects revenues

Graph p. 24 and 50

Question 12

What is ad valorem tariff?

Answer 12

ad valorem tariff = expressed as per cent of the imported good’s value / price

Question 13

Please explain and draw a welfare analysis for a small country case

Answer 13

Tariffs cause price changes, which causes welfare effects.

Consumers are generally worse of after a tariff is imposed - must pay higher prices

Domestic producers are better off
o Higher prices for the product
o Higher levels of employment and production
o Resulting in higher profits

Government is better off with a tariff (as long as it is not a prohibitive tariffs, cutting of all imports)
o Tariff revenue on imports

Tariffs redistribute welfare. From consumers to producers and government (there are winners and losers)
- Reduction in consumer welfare: Areas a+b+c+d
- Increase in producer welfare: Area a
- Increase in government welfare: Area c
- Dead-weight loss due to the tariff: Areas b + d

Graph p. 27 and 50

Question 14

Please explain and draw a tariff analysis for a large country case

Answer 14

Large country: Domestic consumption and production and import have a noticeable effect on world market conditions, specifically the good’s price.

Drop in imports after a tariff is imposed shifts the world demand curve and yields a reduction in world price.
Price of imported good falls from Pw to P1^w
Price of the domestic product only increases to P^d = P1^w + tP1^w

Consumer welfare loss: Areas a+b+c1+d
- Producer welfare gain: Area a
- Government welfare gain: Areas c1 + c2

Different from the small country case there may not be a net loss to society in terms of welfare. Because some of the welfare gain of the government is shouldered by the import partners – not by domestic consumers. If c2 > b + d, then the overall gain in domestic welfare is positive.

Question 15

What is a preferential trade agreement (PTA)?

Answer 15

It is an international treaty with restrictive membership. A PTA can take different forms such as free trade agreement or customs union.

It is unilateral trade preferences, including generalized system of preferences schemes (under which developed countries grant preferential tariffs to imports from developing countries), as well as other non-reciprocal preferential schemes granted a waiver by the general council.

Preferential agreements can be interpreted as a negative externality that PTA members impose on non-members.

Question 16

Mention some forms of PTA with deep integration

Answer 16

Fiscal union, monetary union and common market

Question 17

Mention some forms of PTA with shallow integration

Answer 17

Free trade agreements, and customs union

Question 18

What are the effects of PTA on welfare? include a graph

Answer 18

see. graph p.44

Question 19

Why use PTA?

Answer 19

market access for goods and services.
domestic policy anchoring
importation of good regulatory practices
supranational coordination to achieve regional policy goals.
export of regulatory standards by hegemos
foreign policy considerations

Question 20

What is a tariff?

Answer 20

A tariff is a form of tax imposed by a government on goods and services that are imported (or exported) across the country’s borders.
Tariffs raise the price of imported goods, which reduces demand for them and stimulates demand for domestic goods.
Tariffs can also lead to retaliation by trading partners, which can reduce overall trade and economic welfare.

Question 21

What is typically the effect of tariffs on welfare?

Answer 21

Welfare is redistributed. Typically:
o Consumers face a reduction in welfare
o Domestic producers face an increase in welfare
o Government faces an increase in welfare

Question 22

What is trade diversion?

Answer 22

It describes the redirection of trade from more efficient trade partners (exporters) to less efficient ones.

Both, tariffs and free trade agreements (or customs unions) may lead to trade diversion

Question 23

What is a trade deflection?

Answer 23

It is the rerouting of trade through a third country to avoid trade barriers imposed by the final destination country.

Free trade agreements may lead to trade deflection.

Question 24

What is Tariff escalation ?

Answer 24

Tariff escalation refers to the practice of imposing higher tariffs on processed or finished goods than on raw materials or intermediate goods.
Tariff escalation can discourage value-added activities in developing countries and limit their economic growth.

Question 25

What is the difference between discriminatory or non-discriminatory tariffs?

Answer 25

Discriminatory tariffs apply only to the goods of a particular nation or group of nations, while non-discriminatory tariffs apply to all goods of a certain category, regardless of their country of origin.

Question 26

Define the effective rate of protection (ERP)

Answer 26

The effective rate of protection (ERP) estimates the overall protection provided to domestic value-added production by a country’s entire tariff structure on imported final goods and intermediate goods in the production process.

The nominal rate of tariff on a final good may not be the same as the overall protection provided to domestic producers of the import substitute if the domestic production uses imported inputs subject to tariffs.

Question 27

What is a prohibitive tariff (small country example) ? Show it on a graph

Answer 27

A tariff that yields a price above P* is called prohibitive tariff. Here, the price of foreign goods rise above the equilibrium price in the domestic market, meaning that domestic suppliers would be willing to supply to cover all domestic demand.

Graph p. 24

Question 28

What are some unseen effects of tariffs in the small country example?

Answer 28

as firms increase output, additional labor is hired and employment in the protected industry will rise. Additional capital, raw materials, and other domestic resources will be drawn into the protected industry too.

Question 29

Whay is the optimal tariff?

Answer 29

There will often be at least one rate for which the tariff revenue extracted from the country’s trading partners more than compensates for the production-side and consumption-side inefficiencies it causes.
The one which maximizes the country’s net gain is called the optimal tariff.
However, the world as a whole loses when any country imposes an optimal tariff, because the tariff gains will be at the expense of consumers elsewhere. This can cause retaliation by these consumers.

Question 30

What is beggar-thy-neighbour trade Policies?

Answer 30

Beggar-thy-neighbor is a term used for a set of policies that a country enacts to address its economic woes that, in turn, actually worsen the economic problems of other countries.

unilaterally attractive but multilaterally destructive.

Trade policy decisions of one country affect the welfare of another country through an international externality (i.e. a cross-border effect).

Question 31

What is the two main effects of PTA? And explain them

Answer 31

trade creation and trade diversion.

The net balance between trade creation and trade diversion determines whether a PTA increases welfare for its members.

Trade creation occurs when imports from partners replace imports from more efficient outside producers. This increase welfare.
Trade diversion can harms members’ welfare, since trade is diverted from a more efficient exporter towards a less efficient one.

Question 32

Explain trade creation effects and draw it on a graph

Answer 32

see p. 30

Question 33

Explain trade diversion effects and draw it on a graph

Answer 33

see p.34

Question 34

What is the accumulation effect?

Answer 34

The accumulation effect considers how a PTA affects growth, determined by changes in physical capital and human capital or by changes in technology available to firms.

Question 35

What is the location effect?

Answer 35

The location effect looks at how the PTA may alter the distribution of economic activity within the PTA and thereby lead to inequality among member countries.
As trade costs decline, having close access to consumers becomes less important, and thus, firms would be drawn to “central” areas within the PTA.

Question 36

What does the “natural trading partners” hypothesis suggest?

Answer 36

The “natural trading partners” hypothesis suggests that preferential trade agreements (PTAs) between countries that trade extensively with each other are more likely and they should generally be expected to be trade creating.
PTAs formed between natural trading partners have lower costs compared to agreements between less trade-intensive countries.
If regional trade dominates due to high inter-continental transport costs, the formation of natural trading blocs within a region can improve welfare.

Question 37

What can help prevent trade deflection?

Answer 37

Rules of origin (RoOs) are necessary to verify the true origin of goods and prevent trade deflection.

Question 38

What is the consequence of restrictive RoOs ?

Answer 38

While RoOs can prevent trade deflection, they can also be used to protect industries, leading to trade diversion.

Restrictive RoOs may cause firms to engage in “supply switching” by using a more expensive intermediate good either from a domestic firm or a country in the PTA with lower restrictions, which can reduce the trade liberalizing impact of PTAs.
MNCs may switch their source of intermediate goods from a more efficient supplier in a non-member country to a less efficient supplier in a member country, resulting in trade diversion.

Question 39

Explain and draw the effect of MFN tariff on three countries in the context of open trade.

Answer 39

see p.36

Question 40

Explain and draw the effect of PTA on three countries in the context of open trade.

Answer 40

see p.36

Question 41

Explain and draw the welfare effects of PTA

Answer 41

see p.37

Question 42

What are the main effects of the US-China war?

Answer 42

Increases in bilateral trade costs such as those resulting from the ongoing trade war between US and China will result in lower trade, higher prices for consumers, and trade diversion effects.

US tariffs against China have resulted in a reduction in imports of the tariffed products by more than 25 percent. The decline was partly replaced by US imports from elsewhere (mainly Taiwan, Mexico, the EU and Viet Nam among others). Resulting in trade diversion effects.

The cost of the tariffs has been generally passed down to US consumers.

Chinese exporters may have started to bear part of the costs of the tariffs in the form of lower export prices.

Chinese firms may have only recently started to react to tariffs by reducing their export prices, thus absorbing part of the cost of the tariffs.

the US tariffs on China are economically hurting both countries. US losses are largely related to the higher prices for consumers, while China’s losses are related to significant export losses.