Problem Set 1: Trade Barriers under Perfect Competition - Answer Key

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1 ECO 6333: Trade Policy Spring 2019 Thomas Osang Problem Set 1: Trade Barriers under Perfect Competition - Answer Key Part I: The tariff could be either a specific tariff or an ad valorem tariff. Since the two foreign supply curves are parallel to each other, the free-trade supply curve can be regarded as having shifted up by a constant dollar amount at each quantity imported - hence it can be a specific tariff. However, since the free trade price stays constant for any quantity imported, adding vertically a given percentage of the free-trade price at each quantity also yields a parallel line above the free-trade supply curve by a constant dollar amount. Thus the tariff could also be ad-valorem in nature. Part II: 1. Industries and residents of a country who can benefit from protection are continuously seeking mechanisms by which their well-being can be enhanced. As tariffs have been reduced through international negotiations, these economic agents have sought to preserve their protected status by pushing for legislation and regulations regarding other barriers (NTBs) not covered by the negotiations. 2. Value added under free trade is 2000-( )=700. With tariffs imposed by the SOE, the price of good F becomes 2000(1+0.15)=2530. The price of input A becomes 800*(1+0.12)=896, the price of input B becomes 700*(1+0.1)=770. Value added under protection is thus ( )=864. ERP is thus ( )/700 = This means that the whole tariff structure (final plus intermediate tariffs) is more protectionist than the final good tariff by itself. The result implies that the return to the factors of production in the F industry as a whole has increased by 23.4% due to combined effect of all tariffs. As result, there would be an incentive for the (mobile) factors of production to enter this industry. The ERP is higher than the tariff on the final good due to the fact that the intermediate good tariffs are lower than the final good tariff. 3. The ERPs for the country s final goods industries will increase, meaning these production processes are protected to a greater extent than previously. Trading partners sending final goods to the country would regard this action as a move toward more protectionism. 1

2 4. The unweighted average nominal tariff is equal to: (0.50/5) (2.50/20) 10 = 1.3 = 0.13 = 13.0% 10 The weighted average nominal tariff is equal to: [0.15x x x x x x x140 + (0.50/5)x x250 + (2.50/20)x200]/3240 = 385 = = 11.88% The main problem with the unweighted-average tariff rate is that it does not take into account the relative importance of imports. If a country imports mostly goods with low (high) tariff rates, the unweightedaverage tariff would tend to overstate (understate) the height of a country s average tariff. The weighted-average tariff has a problem as well since it tends to understate the height of a country s average tariff. Why? Assuming similar demand elasticities across all imported goods, the goods with higher tariff rates tend to have lower import levels than those with relatively low tariffs. As a result, the low-tariff goods will have larger weights than the high-tariff products which in turn will tend to bias the weighted-average tariff downward. 2

3 Part III: 1. The winners are: Domestic producer surplus increases by 2000* *1.2*0.5 = 2580 Government receives tariff revenue equal to 200*1.2=240 The losers are: Domestic consumer surplus declines by 2500* *1.2*0.5 = 3060 The country s loss in welfare (equal to the DWL) is 300*1.2* *1.2*0.5=240 (alternatively: =240) 2. A SOE will always suffer a DWL (area γ) from a tariff with no offsetting gain. Hence, the country s welfare declines with a tariff. P P t d ExpS t P T γ ExpS T M t M T Q 3

4 A LOE can improve its welfare by restricting trade if it chooses a tariff that is not too large (the optimal tariff would be ideal), provided that the foreign export supply curve is sufficiently elastic (but not infinitely elastic) and that there is no retaliation by the foreign country. The graph below shows that a large tariff will reduce the LOE s welfare. P Exp t P t d P T γ Exp T P t δ Imp Q Since area δ is less than area γ, LOE s welfare declines. 4

5 Part IV: Table 1: Autarky, Trade, and Tariff Equilibrium: HC and FC Variable Home Country Foreign Country D A = S A 2 1 P A 6 2 import demand eq. P=6-1.2Q n/a export supply eq. n/a P=2+1.2Q P T M T = X T Welfare (W) in trade price with tariff M t = X t DWL due to tariff tariff transfer W due to tariff % change W due to tariff 2.4% -7.6% 8. The larger welfare loss in the foreign country is due to the fact that the FC is smaller than the HC. Just as smaller countries benefit more from free trade agreements than large economies, they tend to lose more (in percent of free trade welfare) from trade restrictions. 5