Chapter 9 The Instruments of Trade Policy
Introduction So far we learned that: 1. Tariffs always lead to deadweight losses for small open economies 2. A large country can increase its welfare by using a tariff, but will make the other countries worst off by more than it gains (Beggar thy neighbor tariff). 3. The optimal tariff depends only the elasticity of Foreign export supply 1. When e x is low (export curve is very steep) the optimal tariff is high. 2. When e x is high (export curve is flat) the optimal tariff is low. ECON40710 University of Notre Dame 9-2
Introduction Road Map 1. Import quota small country 2. Export subsidy large country 3. Tariff and quota with domestic monopoly 4. Tariff with foreign monopoly ECON40710 University of Notre Dame 9-3
Import Quotas Small Country ECON40710 University of Notre Dame 9-4
Import Quotas Small Country We assume that the quota is binding imports would be higher in the absence of the quota (M2 < M1, the free trade level of imports) P2 Pw We now have a vertical export supply curve Because world prices are lower, consumers buy up to the amount of the quota in world markets Then turn to the domestic market The equilibrium price in the import market is P2 > Pw ECON40710 University of Notre Dame 9-5
Import Quotas Small Country At P2, the domestic supply (S2) is equal the demand (D2) The domestic supply is S2 = D2-M2, such that M2 = S2-D2 ECON40710 University of Notre Dame 9-6
Import Quotas Small Country For consumers and producer, the impact of the quota is the same as the equivalent import tariff: P2 = Pw+t Pw t = P 2 P w. The big difference is that the government does not collect revenue from tariff. ECON40710 University of Notre Dame 9-7
Import Quotas Small Country The difference between the world price (Pw) and the domestic price (P2) creates quota rents Suppose you buy a unit in the world market and sell it at home, you make profits. Those profits are called rents because they do not arise from production ECON40710 University of Notre Dame 9-8
Import Quotas Small Country Who gets the quota rent? Quota licenses are permits to import the quantity allowed under the quota system. The Home government has many options: Give licenses to domestic firms Auction the licenses Give licenses to foreign firms ECON40710 University of Notre Dame 9-9
Import Quotas Small Country 1. Home Firms get quota licenses The net effect on Home welfare due to the quota is then: Fall in consumer surplus -(a+b+c+d) Rise in producer surplus +a Quota rents earned at Home +c Net effect on Home welfare: -(b+d) This is the same DWL as with a tariff Revenue is collected by firms instead of the government. ECON40710 University of Notre Dame 9-10
Import Quotas Small Country 2. Auctioning the Quota The government of the importing country auction off the quota licenses. In a well-organized, competitive auction, the revenue collected should exactly equal the value of the rents. Fall in consumer surplus Rise in producer surplus +a Auction revenue earned at Home +c Net effect on Home welfare: -(a+b+c+d) -(b+d) This is the same loss as DWL as with a tariff. ECON40710 University of Notre Dame 9-11
Import Quotas Small Country 3. Voluntary Export Restraint The importing country gives authority for implementing the quota to the exporting government. In May 1981, with the American auto industry mired in recession, Japanese car makers agreed to limit exports of passenger cars to the United States. With VERs, quota rents are earned by foreign producers: Fall in consumer surplus -(a+b+c+d) Rise in producer surplus +a Net effect on Home welfare: -(b+c+d) This is a higher net loss than with a tariff. ECON40710 University of Notre Dame 9-12
Export Subsidy Large Country An export subsidy, S, is a payment to firms per unit exported. It is an inverse tariff. Suppose the export price is P* then: Foreign consumers pay P* Domestic firms receive P*+S ECON40710 University of Notre Dame 9-13
Export Subsidy Large Country World Price To study export, we need relabel the graph Home exports supply, X X is the supply of exports by Home: it gives optimal export for each world price P w Q w Foreign import demand, M* Exports M* is the demand for imports by foreign consumers: it gives optimal import for each world price. In equilibrium, import demand is equal to export supply which requires M*(P w ) = X(P w ) ECON40710 University of Notre Dame 9-14
Export Subsidy Large Country World Price Suppose that we introduce a subsidy S. P w P* S Home exports supply, X X - S Foreign import demand, M* Because the domestic government pays S, Foreign consumers would now have to pay only to buy Qw units. Pw S Q w Exports From the point of view of foreign consumers, X shifts down by the amount of the subsidy, S. ECON40710 University of Notre Dame 9-15
Export Subsidy Large Country Home Price D! (a) Home Market X 2 S World Price (b) World Market Home exports supply, X s P*+s P W X 1 s X s P* Foreign import demand, M* D 2 Quantity X 2 D 1 S 1 S 2 X 1 Exports ECON40710 University of Notre Dame 9-16
Export Subsidy Large Country The export subsidy leads to a reduction in world price (from P w to P*) However, the export subsidy raises the price in the exporting country from P w to P* + S To prevent (re)import at world price (P w ), import tariffs are usually in place ECON40710 University of Notre Dame 9-17
Export Subsidy Large Country Home Price P*+s P W P* D a S b d Consumer surplus falls by - (a+b) c e Producer surplus increases by + (a+b+c) Subsidy costs to government - (b+c+d+e) Net deadweight loss of -(b+d+e) An export subsidy leads to costs that D 2 D 1 S 1 S 2 Quantity exceed its (economic) benefits. ECON40710 University of Notre Dame 9-18
Imperfect Competition The results for the perfect competition case are useful benchmark. However, many industries are characterized by imperfect competition and a small number of producers. What is the impact of trade policy under imperfect competition? ECON40710 University of Notre Dame 9-19
Tariff and Quota with Domestic Monopoly Monopoly Model Suppose there is a single firm in the domestic market The demand, P(Q), is downward sloping must lower the price to sell more. Monopolist profits are maximized by choosing Q such that MR = MC: MR = P(Q) + P (Q)Q = MC ECON40710 University of Notre Dame 9-20
Tariff and Quota with Domestic Monopoly The MR curve is below the demand curve MR = P(Q) + P (Q)Q < P(Q) MC is increasing in Q decreasing returns to scale Monopolist charges prices above marginal costs P M > MC The monopolist charges more and produce less than perfectly competitive firms (P C, Q C ) ECON40710 University of Notre Dame 9-21
Tariff and Quota with Domestic Monopoly International trade Assume that: Home is a small economy. Foreign firms will supply any quantity to the domestic market at the world price: the export supply curve is flat at Pw. The world price is lower than the monopoly price: Home is an importer. ECON40710 University of Notre Dame 9-22
Tariff and Quota with Domestic Monopoly The monopolist can supply any quantity at the world price but cannot charge more than the world price consumer would switch to foreign goods. The monopolist now faces a perfectly elastic demand curve at the world price. Cannot affect the MR by changing Q (or equivalently P) This implies that MR = P W for any quantity sold. ECON40710 University of Notre Dame 9-23
Tariff and Quota with Domestic Monopoly As before, the monopolist maximizes profit by choosing Q such that MR = MC. Because MR = P W under free trade, this implies that: MC = P W Free trade eliminates the monopolist s ability to charge a price greater than its MC. ECON40710 University of Notre Dame 9-24
Tariff and Quota with Domestic Monopoly Profits are maximized at Q such that MR = MC. Under autarky (point A): P M > MC Under free trade (point B): P W = MC The monopoly price is lower and output higher under free-trade than in the closed economy ECON40710 University of Notre Dame 9-25
Tariff and Quota with Domestic Monopoly There is a difference between domestic demand and supply At the world price: The monopoly supplies S1 to the market Consumers demand D1 The increase in demand is greater than the increase in supply The difference is imported from Foreign (M1) ECON40710 University of Notre Dame 9-26
Tariff and Quota with Domestic Monopoly Trade Policy: Tariff Suppose Home imposes a tariff, t, on imports: Price at Home increases from P W to P W + t The foreign export supply curve shifts up to X* + t The Monopolist still faces a flat demand curve at P W + t To maximize profits, it will set MC = P W + t The import demand curve is not affected by the tariff ECON40710 University of Notre Dame 9-27
Tariff and Quota with Domestic Monopoly The tariff increases the price paid by domestic consumers. There is a decrease in demand from D1 to D2. Monopolist increases its supply from S1 to S2 Imports go down because supply goes up and demand goes down (M1 to M2). ECON40710 University of Notre Dame 9-28
Tariff and Quota with Domestic Monopoly What is the impact on welfare? The net effect on Home welfare is: ΔCS = -(a+b+c+d) ΔPS = +a ΔG = +c. ΔW = -(b+d) As with perfect competition, a tariff leads to a DWL for small countries. ECON40710 University of Notre Dame 9-29
Tariff and Quota with Domestic Monopoly Trade Policy: Quota Now we look at the effect of a quota We choose a quota that will give us the same level of imports as the tariff equivalent quota. Under a quota, the monopolist retains the ability to influence price The monopolist will never charge a price lower than the world price. Consumers buy from foreign firms first ECON40710 University of Notre Dame 9-30
Tariff and Quota with Domestic Monopoly The effective demand curve facing the Home monopolist under the quota is therefore the old demand curve minus the quota. D = D M2 The demand curve shifts left As usual profits are maximized by setting MR = MC (Point E) The monopolist charges P3 and produces S3. ECON40710 University of Notre Dame 9-31
Tariff and Quota with Domestic Monopoly By definition of equivalent quota the import is the same as before (D2 S2 = D3 S3). However, the monopoly price is higher and the quantity lower with the quota (point E) then under the equivalent tariff (point C). Quantity consumed is lower and average price higher Under imperfect competition, a quota is not equivalent to a tariff even though the level of import is the same under both policies. ECON40710 University of Notre Dame 9-32
Tariff and Quota with Domestic Monopoly We can also compare with free trade (point B). In our example, the monopoly price is higher and the quantity lower with the quota then under free trade (point B). This does not have to be the case (it depends on the slopes of the curves), but it is a possibility. Why is this finding important? ECON40710 University of Notre Dame 9-33
Tariff and Quota with Domestic Monopoly Trade policies are often implemented to protect an industry. The quantity produced at Home (and as a result employment) under the quota is lower than under free trade. The quota does not protect the industry. What is the impact on welfare? We don t compute it in details because it is difficult However, the DWL is higher then with a tariff because: Imports and world price are the same The monopolist charges a higher price and produce less ECON40710 University of Notre Dame 9-34
Tariff with Foreign Monopoly Suppose that the Foreign exporting firm is a monopoly. For simplicity, we assume no competing Home firm Home demand is supplied entirely by the foreign monopolist. The monopolist maximizes profits by setting MR = MC For simplicity, assume that the MC of production is constant A tariff is equivalent to an increase in the marginal cost for the exporter in the Home market MC = MC + t. ECON40710 University of Notre Dame 9-35
Tariff with Foreign Monopoly A tariff increases the MC In the new equilibrium, the quantity is lower and the price higher. ECON40710 University of Notre Dame 9-36
Tariff with Foreign Monopoly The consumer price increases by less than the tariff: P2 < P1 + t This happens because the MR curve is steeper than the demand curve: A given change in Q has a smaller impact on P(Q) than on MR(Q) This implies that the price received by the monopolist is now lower than before: P3 = P2 t < (P1 + t) t = P1 ECON40710 University of Notre Dame 9-37
Tariff with Foreign Monopoly The Foreign firm is making a strategic decision to absorb part of the tariff itself in order to maximize its profits. Since the Home country is paying a lower net-of-tariff price for its imports, it has experienced a terms-of-trade gain as a result of the tariff. Welfare will be higher with the tariff if the terms of trade effect is larger than the DWL. Home welfare is higher for a small tariff but then decreases as the tariff becomes large. This is similar to the impact of an import tariff for a large perfectly competitive economy. ECON40710 University of Notre Dame 9-38
Tariff with Foreign Monopoly ΔCS = (c+d) ΔPS = 0, there is no producer at Home ΔG = t X 2 = c + e ΔW = ΔCS + ΔPS + ΔG = e d ECON40710 University of Notre Dame 9-39
Tariff with Foreign Monopoly Import of Japanese Trucks To what extent do Foreign exporters absorb tariffs? In the 1980s, the United Automobile Workers applied to the ITC for protection -- It was determined that the recession was the primary cause of contraction in the auto industry so the case was rejected. At the time, most of the trucks were imported as cab/chassis with some final assembly needed. The category parts of trucks carried a 4% tariff rate Another category complete or unfinished trucks faced a tariff of 25% ECON40710 University of Notre Dame 9-40
Tariff with Foreign Monopoly The U.S. Customs Service reclassified some products in parts of trucks to complete or unfinished trucks to get the higher tariff. This reclassification raised the tariff rates on all Japanese trucks by 21%. By how much did the price rise? Of the 21% increase, only 12% was passed through to U.S. consumer prices 9% was absorbed by Japanese producers increase in US terms of trade. ECON40710 University of Notre Dame 9-41
Introduction Why do countries impose restrictions? 1. Easy way to raise revenue 2. A large country can tilt the terms of trade in its favor 3. Distortions: infant industry protection 4. Political economy: redistribute income across different groups in society ECON40710 University of Notre Dame 9-42
Conclusions A tariff on imports is the most commonly used trade policy. The impact of a tariff depends on the size of the country When the country is small, a tariff always leads to a DWL If a country is large enough, a small tariff may lead to a terms of trade effect high enough to increase welfare world welfare is always lower, however. In a large economy, we can compute an optimal tariff which maximizes welfare. It depends on the elasticity of demand. When the supply is not responsive to changes in price the optimal tariff is low. ECON40710 University of Notre Dame 9-43
Conclusions The impact of a quota depends on the structure of the industry Under perfect competition: Welfare effects are same as tariffs but generates quota rents instead of guaranteed government revenues. Quotas are more difficult to use efficiently because of rent seeking behavior. With imperfect competition Tariff and Quota are no longer equivalent policies: With a tariff, a Home monopolist cannot exercise its monopoly power. With a quota, the Home firm is able to charge a higher price because it enjoys a sheltered market. ECON40710 University of Notre Dame 9-44
Conclusions Countries sometimes use export subsidies, a payment to a firm that export. Welfare is always lower ECON40710 University of Notre Dame 9-45