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Week 9 | Import Tariffs and Quota Under Perfect Competition Reading: Chapter 8 1. Why do governments sometimes apply a tariff on imported goods? 2. Why does the World Trade Organisation try to reduce the use of tariffs? 3. If the quantity of imports is restricted by a quota, how is it different from using a tariff? ECON847 INTERNATIONAL TRADE 1 Some Context (1) • In the previous weeks, we learned a variety of trade models. The primary proposition of all trade models is that trade brings net benefit to countries. • While the majority of economists think that free trade does more good than harm in general, governments around the world use a wide range of policies that ‘disrupt’ free trade. – Why? ECON847 INTERNATIONAL TRADE 2 Some Context (2) • In weeks 9-11 we discuss different trade policies and their impact on nations. • In weeks 9-10 we look at trade policies related to imports in the settings of perfect and imperfect competitions. These policy measures include: tariff, import quota, voluntary exports restraint (VER), anti-dumping duties. – Other import-related policies measures (we will not discuss): product standards, domestic content requirement, discriminatory government regulations. • In week 11 we look at trade policies related to exports, such as export subsidies and export tariffs, especially in the agricultural and high-tech industries. ECON847 INTERNATIONAL TRADE 3 Some Facts (1) • The world tariff level has been declining over the last fifty years. • In contrast, the use of non-tariff barriers have been rising (data are not shown here). ECON847 INTERNATIONAL TRADE 4 Some Facts (2) • Less developed countries tend to apply higher tariffs. Gerber, J. (2014), International Economics, 6th ed., Pearson. ECON847 INTERNATIONAL TRADE 5 Some Facts (3) • Tariffs tend to be higher in agriculture and textile/apparel than in manufacturing. • A lot of significant tariffs remaining in the US and Europe tend to be on agricultural products. • Averaged applied tariffs by sector and region in 2001 (percent, ad valorem equivalent) Source: Adapted from Table 1, Anderson, K. & W. Martin (2005), Agricultural trade reform and the Doha agenda, The World Economy, 28 ECON847 INTERNATIONAL TRADE 6 World Trade Organization (1) • How was the decline in the world tariff level possible? The short answer is international negotiations, e.g. via the WTO. • In 1947, shortly after the end of WW2, a group of 23 nations agreed to a set of provisional rules, known as General Agreement on Tariffs and Trade (GATT) to reduce trade barriers between nations. • In 1995, World Trade Organisation (WTO) was established as a result of the Uruguay Round, which supplants the GATT Secretariat and provides a formal institutional foundation for the GATT as an agreement. – Note that the GATT is simply an agreement, not a formal institution. • The WTO has 164 member countries (since July 2016). ECON847 INTERNATIONAL TRADE 7 World Trade Organization (2) • The WTO is the international institution that governs: – Provision of a forum for multilateral trade negotiations through ‘Rounds’ • Reductions in policy barriers • Tariffication of non-tariff policy barriers – Trade policy review mechanism – Dispute settlement procedures • The WTO has a larger coverage of trade issues than GATT. It also deals with: – Trade in service sectors with General Agreement on Trade in Services (GATS) – Intellectual properties with Agreement on Trade-Related Aspects of Intellectual Properties (TRIPS) ECON847 INTERNATIONAL TRADE 8 World Trade Organization (3) • The WTO is based on the following principles: – Non-discrimination between trade partners, i.e. the most-favoured nation (MFN) principle – National treatment of imported products • There are exceptions to the MFN principle: regional trade agreements are permitted. – Free trade areas in which a group of countries voluntarily agree to remove trade barriers between themselves (e.g. NAFTA) – Customs unions which are free-trade areas in which the countries also adopt identical tariffs between themselves and the rest of the world (e.g. EU) ECON847 INTERNATIONAL TRADE 9 World Trade Organization (4) • The GATT-WTO system uses two measures in order to achieve freer trade in the world. – Tariff round is a process where a large number of countries negotiate how and to what extent to reduce trade barriers. Thus far there have been nine trade rounds. – Tariff binding is a country’s commitment not to increase a tariff beyond the agreed level. • There are exceptions to tariff binding (and MFN): – Tariffs may be imposed in response to unfair trade practices such as dumping. – Countries can temporarily raise tariffs for certain products under the safeguard provision. ECON847 INTERNATIONAL TRADE 10 World Trade Organization (5) • GATT/WTO trade rounds: • The last round in Doha has not been successful. There have been multiple unsuccessful attempts to re-start the talk. • One of the reasons can be that the international trade is already quite free: the potential gains from this round is relatively low. ECON847 INTERNATIONAL TRADE 11 The Gains from Trade (1) • We analyse the effect of trade policies with the demand and supply framework. • Recall the concepts of consumer surplus (measure of consumer benefit) and producer surplus (measure of producer benefit). ECON847 INTERNATIONAL TRADE 12 The Gains from Trade (2) • Compare the situations without and with free trade. • Recall the concepts of consumer surplus and producer surplus. • Assume that Home’s no trade price is higher than the world price. • Free trade increases CS by (b + d), and decreases PS by (b). • Free trade brings Home a positive net effect (d). ECON847 INTERNATIONAL TRADE 13 The Gains from Trade (3) • Home’s demand for imports is illustrated by the red demand curve. ECON847 INTERNATIONAL TRADE 14 Effect of a Tariff for a Small Country (1) • Consider a small country: small enough not to affect the world price level. • Applying a tariff of t per unit of imports increases the import price from PW to PW + t. The domestic price also rises to PW + t. • This increases domestic quantity supplied from S1 to S2; and decreases quantity demanded from D1 to D2. ECON847 INTERNATIONAL TRADE 15 Effect of a Tariff for a Small Country (2) • The amount of imports fall from M1 = (D1 – S1) to M2 = (D2 – S2). ECON847 INTERNATIONAL TRADE 16 Effect of a Tariff for a Small Country (3) • The tariff decreases CS by (a + b + c + d), and increases PS by (a). • The government collects the tariff revenue (c). • The net welfare effect of a tariff is – (b + d). The tariff creates deadweight loss. • Note that this statement is based on one-dollar, one-vote metric: – Every dollar of gain or loss is just as important as every other dollar of gain or loss, regardless of who the gainers or losers are. ECON847 INTERNATIONAL TRADE 17 Effect of a Tariff for a Small Country (4) • The deadweight loss (b + d) has the following interpretation. • The area (b) is the production (efficiency) loss of the tariff: extra cost of shifting domestic resources towards the more expensive production. • The area (d) is the consumption loss of the tariff: the loss to the consumers in the importing nation due to the reduction in consumption. ECON847 INTERNATIONAL TRADE 18 Effect of a Tariff for a Small Country (5) • In sum, a small country suffers a loss from imposing a tariff. • Also, there are more losers (consumers) than winners (producers). • Then why do so many countries have tariffs (or other importrestricting measures) as a part of their trade policies? • One answer is that a developing country does not have any other source of government revenue. Import tariffs are ‘easy to collect’. ECON847 INTERNATIONAL TRADE 19 Effect of a Tariff for a Small Country (6) • Another reason is a problem of collective action in the group of consumers: removal of protection policy is in the collective interest but it is not in any individual consumer’s interest. – It is not worth spending time and effort to fight for removal of tariffs to save a few dollars in the supermarket. • That is, the producer group is more effective and wellorganised than the consumer group. – The loss per producer from removing a tariff is larger than the benefit per consumer. – It is more costly to organise a large group than a small group. ECON847 INTERNATIONAL TRADE 20 Effect of a Tariff for a Large Country (1) • The effect of a tariff is different if the tariff-imposing country is ‘large’: large enough to affect the world price level. • Let’s say, a large enough country imposes a tariff t per unit of imports. Then the following effects occur: – The domestic price rises, which is the same as the small country case. – The world price falls, because the foreign producers would fight to maintain sales by reducing their export prices as a response to a significant demand reduction in the large country. – As a result of the two opposite effects, the domestic price rises but by less than t. ECON847 INTERNATIONAL TRADE 21 Effect of a Tariff for a Large Country (2) • The tariff t per unit of imports would shift up the export supply curve from X* to X*+ t. – It is like foreign producers face higher production costs. • The domestic price rises from PW to P* + t; but the export price (before tariff) falls from PW to P*. ECON847 INTERNATIONAL TRADE 22 Effect of a Tariff for a Large Country (3) • The tariff decreases CS by (a + b + c + d), and increases PS by (a). • The government collects the tariff revenue (c + e). – The area (e) is the terms-of-trade gain due to reduction in the price of imports. ECON847 INTERNATIONAL TRADE 23 Effect of a Tariff for a Large Country (3) • The net welfare effect is (e – b – d), which could be both positive or negative. • This implies that it is possible for a large importing country to be better off with a tariff than under free trade: if the terms-of-trade gain (e) exceeds the deadweight loss (b + d). ECON847 INTERNATIONAL TRADE 24 Effect of a Tariff for a Large Country (4) • This implies that the ‘best’ tariff rate for a large importing country can be derived so that the area (e – b – d) is maximized. This best tariff rate is called the nationally optimal tariff. ECON847 INTERNATIONAL TRADE 25 Effect of a Quota on a Small Country (1) • Import quota is a quantity limit on imports. It is usually practiced by issuing import licences to individuals or firms. • Suppose a small country imposes a quota M2 (= D2 – S2). • The quota decreases imports from M1 to M2. • The quota increases the domestic price from PW to P2. Why? ECON847 INTERNATIONAL TRADE 26 Effect of a Quota on a Small Country (2) • The welfare effect of a quota is similar to that of a tariff. • The quota decreases CS by (a + b + c + d), and increases PS by (a). ECON847 INTERNATIONAL TRADE 27 Effect of a Quota on a Small Country (3) • The area (c) represents the quota rents: it equals the difference between the domestic price P2 and the world price Pw, times the quantity of imports M2. • The net effect of a quota on the country depends on who receive the quota rents. ECON847 INTERNATIONAL TRADE 28 Effect of a Quota on a Small Country (4) • The quota rents go to whoever hold the import licences. 1. The licences, hence the quota rents, can be allocated to home firms. – The net effect of a quota is – (b + d). 2. But, if there are more firms than the amount of licences available, firms may use up their resources up to (P2 – Pw) per unit of imports for rent-seeking in order to secure a licences. – – e.g. lobbying or bribery The net effect of a quota is – (b + c + d). ECON847 INTERNATIONAL TRADE 29 Effect of a Quota on a Small Country (5) 3. The government may auction off the licences. In this case, bidders would pay up to (P2 – Pw) per unit. The quota rents could end up with the government. – The net effect of a quota is – (b + d). 4. A voluntary export restraint (VER) may be imposed by the exporting country. In this case the quota rents go to the foreign exporters. – – – – In 1981, Japan agreed to limit its automobile exports to the US fearing stiffer protectionist measures from the US government. In 2013, China agreed to limit its solar panel exports to EU countries as a resolution to the trade dispute. VERs are rarely voluntary. The net effect of a quota is – (b + c + d). 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