IE Trade Policy 2008 1

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International Economics C. Brunnschweiler

12. Trade Policy: Part 1(Tariffs and Quotas)


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12. Trade Policy: Part 1


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12.1 Introduction

So far, we have contrasted autarky equilibrium with free trade equilibrium; both extremesvirtually unheard of in practice.

Usually, any country that engages in trade erects various barriers to control and restrict trade. Themost common barrier is a tax or tarifflevied on the importation of foreign goods (sometimes on

exports as well), followed by a quantitative restriction or quota, and other non-tariff barriers

(NTBs) such as subsidies.

Tariffs directly affect the price of imports and only indirectly the quantity via the effect ofprice increases on consumer and producer decisions.

Quotas are in a sense the opposite of tariffs, because they directly restrict the quantities ofimports and only indirectly affect prices through the artificial scarcity that the quantity

restriction creates.

Tariffs and quotas are similar in that they both ultimately restrict the quantity of importsand raise their domestic prices.

This chapter examines the policies that governments adopt towards international trade, as wellas looking at the effects of trade policies and the reasoning behind them.


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12.2 Tariffs

There are two main reasons why a government would choose to levy taxes on trade: Protect operations of domestic industries that compete with imports. In H-O framework for

example, restrictions would probably be more severe in sectors that intensively use scarce

factors. Most extreme tax would eliminate imports altogether (termed aprohibitive tariff).

Raise government revenues. Common practice in many developing countries, where taxinginternational trade at border is easier than collecting domestic income taxes. But tariffs used

to be main source of government income before introduction of income taxes in advanced

economies such as the U.S., as well.

12.3 Welfare loss from tariffs (SMOPEC) A SMOPEC can trade as much as it wants at fixed world pricesp*; tariffs will not affectp*, but they

will affect the equilibrium price ratio facing domestic consumers and producers.

Assume that pattern of comparative advantage is such that this country exports Yand importsX. Government places ad valorem tax of t on each unit of X imported into country. Because p* is

fixed, domestic price ofXwill rise by full amount of tax.


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Letp = px/pybe the domestic price ratio. Because exports are not taxed, domestic and world priceswill be related by px = px*(1+t) andpy= py* orp = p*(1+t). Because of import tariff on X, domesticprice ratio will be greater than world price ratio,p>p*.

-> Consumers pay and producers receive tariff-distorted domestic prices, rather than world prices.

Trade must balance at world price ratio, because country does business abroad at world priceratiop*. Equilibrium conditions are therefore given by:

MRS = MRT =p = p*(1+t)>p*

Balance-of-payments constraint: px*(Xc Xp)+ py*(Yc Yp) = 0 or p* = (Yc Yp) / (Xp Xc)

where subscriptspand cagain denote the amounts of a good produced and consumed, resp.

Domestic producers and consumers will equate domestic MRS in consumption and MRT inproduction to domestic price ratio, which is higher than world price ratio. However, domestic

production and consumption will be linked by world price ratio. Post-tariff equilibrium is given in Figure 15.1:

A is the autarky equilibrium, whereas Cf and Qf refer to free trade consumption andproduction points, resp.


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A tariff on imports of X willresult in production at point likeQtand consumption at point like

Ct

Points Qt and Ct are linked byworld price ratio as required by

balance-of-payments constraint

(see equations above); the two

points also satisfy the condition

that MRS=MRT>p*

Post-tariff welfare level Ut islower than free-trade welfare Uf

but higher than autarky level Ua.

Tariff causes production to move from free-trade point Qfback toward the autarky pointA. Tariff causes reduction in imports and also decline in exports, which must be true in

absence of change in world price ratio.


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New trade triangle is QtVCt. Exports of VQtunits of Yare worth VZunits ofXat domestic prices but VCtat world prices-> quantityZCtdepicts tariff revenue, measured in units of import goodX.

Assumption: government rebates tariff revenue to citizens in lump-sum fashion, allowing themto reach consumption point Ct.

In sum: Tariffs move the country back toward autarky by distorting domestic decision-making.

Because tariff makes X seem more valuable than it actually is, country specializes less in

comparative-advantage good and sacrifices some gains from specialization. Consumer prices

are also distorted, losing gains from exchange.

Loss in gains from trade reduces real national income from ONfto ONt. Finally, tariff redistributes income: production shift towards X will increase real income of

factor used intensively in the production of that good and reduce real income of the otherfactor (H-O, Stolper-Samuelson theorem). Losses shown in Figure 15.1 are shared unevenly:

because overall welfare falls with tariff, the factor used intensively in producing Ywill bear

welfare loss in excess of total welfare loss, while factor used intensively inXproduction gains.


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Figure 15.2 shows same effects with excess demand curves: SMOPEC excess demand curve Ex, foreign excess demand curve E*(perfectly elastic at free-

trade price ratiop*)

Free trade would lead to level ofimportsXf at world price ratio

Tariff on X will shift down excessdemand curve by tpercent to Ex, defined

by p(1+t) = p, where p is price along

original excess demand curve

the tariff reduces imports fromXf toXt,with exports correspondingly reduced to

p*Xt units of good Y

Domestic relative price in SMOPECbecomesp = p*(1+t), while tariff revenues

are given by the rectangle pp*TS,

measured in units of Y.


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12.4Tariffs, taxes, and distortions (SMOPEC)

We saw above that a tariff raises the price of consumers and producers. A tariff acts like a tax onconsumers and a subsidy to producers; a tariff has equivalent effect of consumption tax

combined with production subsidy!

Import tariffs and export taxes Import tariff onXis equivalent to export tax on Y. The import tariff onXleads topx > p*xwhilepy =

p*y, so thatp > p*. An export tax on Ymeans thatpy = py*(1 t)andpy < py*, whilepx = p*x, so that

againp > p*.

Thus, import tariff and export tax have same effect on domestic price ratio, and since that is theratio that matters, both have the same effect on production and consumption.

Export taxes and import tariffs are equivalent in that they tend to raise relative domestic price ofimports and lower relative domestic price of exports. Both tend to shift resources out of export

industries into import-competing industries.


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Export subsidies

Suppose that s is an ad valorem subsidy rate on exports of Y. Then * (1 )y yp p s= + and* */(1 )p p s p= + < . Then we have the following relationship (the balance-of-payments

constraint seen above still holds):

*

*1

p

MRS MRT p ps= = =


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Export subsidies are usually more welfare-decreasing than tariffs because they requiretaxpayers to fund them rather than

generating tax revenues

Export subsidy could even make economyworse off than under autarky if induced

production distortion were so large that

world price line emanating from distorted

production point Qs actually passed below

indifference curve Ua (see section 15.7 in

Markusen et al. for mathematical proof).


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Consumption taxes and production subsidies Suppose that government wants to increase production in import-competing sectorXrelative

to free-trade level (e.g. some minimum production level viewed as important for national

security, as in oil or gas or also steel production). What is least-cost way to do this?

Import tariff acts as tax on consumption as well as subsidy to production because it distortsboth consumer and producer prices, leading to both loss of gains from exchange and

specialization

Direct output subsidy (assumed to lead to same producer receipts per unit as import tariff)only distorts producer prices (i.e. increases producer price ofX), leading only to a loss in gains

from specialization.


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Outcome of production subsidy vs. import tariff shown in Figure 15.4: Import tariff onXshifts production from Qfto Qtand consumption from Cfto Ct, resulting in

welfare level Ut

Production subsidy on X again shiftsoutput to Qt , but consumption will be at

point Cs and utility at Us because

consumers can trade at world prices.


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Tariffs and distortions

So far we have assumed that there are no distortions in SMOPEC. If there are domesticdistortions, then tariffs could offset these and become welfare-increasing according to the

theory of the second best:

In the presence of multiple distortions such as domestic taxes or monopoly, welfare is notnecessarily imporved by removing a single distortion. Equivalently, in the presence of of

distortions, adding another distortion may be welfare-improving!

Example is the presence of a production subsidy on Yintroduced for political reasons, whichwould lead to distorted production and consumption as in chapter 9. The government could

probably improve welfare even without scrapping the subsidy by introducing an import tariff

on X: this would raise the domestic price of X and encourage its production, distorting

consumer prices and improving welfare even at fixed world prices. The tariff would influence

production in the opposite way to the subsidy. The effect of the tariff would then be to push

the economy back towards its efficient pattern of specialization.


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12.5 Tariffs and monopoly power

We now assume that were looking at a large country instead of the SMOPEC examined so far:world prices will be influenced by behavior of large country, i.e. the world price of the export

good will fall if it exports more, and rise in the opposite case

-> the more the country trades, the worse its terms of trade become (remember that the TOT

give relative prices of a countrys exports to itsimports).

Figure 15.6 shows two countries in a tradingsituation. hxE is Homes excess demand for

good Xandf

xE is Foreign excess demand for

X. In free trade, the equilibrium would be at

*

fp (see point F), with Home importing0

hX and

Foreign exporting 0fX .

Assume that Home imposes a tariff (eitherimport tariff onXor export tariff on Y):


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Homes excess demand curve shifts down to 'hxE , which causes the equilibrium world priceratio to fall to *tp (see point T) at the same time as the domestic price ratio in Home is driven

up top(point S; recall that *(1 )tp p t= + )

Restriction of imports in Home to level 1hX (and of foreign exports to 1fX ) is a move towardsautarky: the higher domestic price that distorts production and consumption decisionslowers welfare.

Tariff revenue is given by the area *tpp TS

However: fall in relative equilibrium world price of Homes export good Y from *fp to *tp represents a gain in Homes TOT! The welfare benefit from this favorable TOT effect would to

some extent mitigate the welfare loss from reduced trade.

Figure 15.7 shows the possibility that the positive TOT effect outweighs the negative tradeeffect from the tariff, making the home country better off with the tariff.


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Tariff lowers world price ratio from *fp to *tp ,resulting in post-tariff production and

consumption at tQ and tC , respectively.

Welfare increases from fU to tU .

Economic intuition: a country would like itsfirms to be perfectly competitive when selling

at home, but it would be beneficial for the

country overall to behave as a monopolist when

selling abroad. Because we assume that firmsare competitive, they cannot act in this way.

However, the government can bring the country to behave as a monopolist: the tariff causes

the country to restrict its output (exports) like a monopolist, and to restrict its demand

(imports) like a monopsonist, thereby moving prices in a countrys favor.

However, one countrys TOT gain is always anothers TOT loss: Foreign suffers a TOT loss, aswell as distortionary losses from the altered relative prices, which push resources out of its


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export sector and change consumption behavior.

Foreign could retaliate by imposing its own tariff on Homes exports in a process termed atrade war: this type of behavior is generally harmful to global welfare and would probably

leave both Home and Foreign worse off than in free trade.

In Figure 15.6, this retaliatory move would shift up Foreigns export-supply portion of fxE (i.e.the portion to the left of the vertical axis), which would further restrict trade and move the

TOT back against Home, possibly at the same world price ratio as with free trade but with

lower trade volumes. Both countries would be worse off.

Because of the very real possibility of foreign retaliation, it is difficult to derive anythingresembling an optimal tariff, which is usually based on the assumption that trade partners

will not react. However, if all countries were to pursue their own optimal strategy at the

same time, they would probably all be worse off! Quite often however, the mere threat of

retaliation will be enough to prevent a country from imposing its optimal tariff there is a

large strategic element to trade policy.


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tariffs, and finished goods have yet higher import taxes. This means that effective protection

for finished products is higher than nominal rates suggest! This is especially true in somelabor-intensive products, implying that the tariff structure is used as an implicit protection.

Tariff escalation is a substantial bone of contention between developed and developing

countries in trade negotiations.

Many developing countries arranged protective structures so that effective tariffs are farhigher than published tariffs, often with the goal of fostering growth in domestic

manufacturing through import substituting industrialization (e.g. Brazil during the 1970s-

80s). This policy was often accompanied by deliberate overvaluation of domestic currency, in

part to discourage exports of primary products and keep them for use by domestic

manufacturers.

For example, in 1969 Argentina was estimated to have nominal tariff rates of 63 percent onfinished textiles and 76 percent on woodworking industries. The associated effective rates of

protection (including trade barriers, taxes, and exchange-rate regime) were 832 percent and

1308 percent, resp.


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Table 15.1 provides further evidence of the discrepancy between nominal and effectiveprotection rates; although the estimates are not the most recent, substantial gaps still remainespecially in developing countries.


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Gains from trade with many goods, trade taxes, and subsidies

A simple condition permits us to extend the definition of gains from trade to a model withmany goods, some of which are taxed and some of which are subsidized:

if net trade tax revenue (the sum of all import and export tax revenues minus trade subsidy

payments) is positive, then the country is better off than in autarky. With other words: if trade

is, on average, taxed more than it is subsidizd, then there will be gains from trade (see

Markusen et al. section 15.7 for formal derivation).

A practical example of tariffs and export subsidies: Europes Common Agricultural Policy

From Krugman & Obstfeld (200&), chapter 8

[From the EUs homepage: The common agricultural policy is fundamental to the strength andcompetitiveness of EU farming and of the agri-food sector as a whole, with its 19 million jobs. The policy

ensures that farming and preservation of the environment go hand in hand. It helps develop theeconomic and social fabric of rural communities. It plays a vital role in confronting new challenges suchas climate change, water management, bioenergy and biodiversity]

Europes stepwise integration since the 1950s and the formation of what is today called theEuropean Union (EU) has had many effects, of which two of the largest are on trade policy. First, the


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members of the EU have removed all tariffs with respect to each other, creating a customs union.Second, the agricultural policy of the EU has developed into a massive export subsidy program.

The EUs Common Agricultural Program (CAP) began not as an export subsidy, but as an effort toguarantee high prices to European farmers by havign the EU buy agricultural products whenver theprices fell below specified support levels. To prevent this policy from drawign in large quantities ofimports, it was initially backed by tariffs that offset the difference between European and worldagricultural prices.

Since the 1970s, however, the support prices set by the EU have turned out to be so high that Europe,which would under free trade be an importer of most agricultural products, was producing morethan consumers were willing to buy. The result was that the EU found itself obliged to buy and storehuge quantities of food. At the end of 1985, European nations had stored 780000 tons of beef, 1.2million tons of butter, and 12 million tons of wheat. To avoid unlimited growth in these stockpiles,the EU turned to a policy of subsidizing exports to dispose of surplus production.

The policy works like the export subsidy we saw earlier: the EU subsidizes the export of the goodwhere it has a comparative disadvantage (meaning that it would import under free trade), shiftingproduction in that direction. The EU support price, however, is set not only above the world price p*that would prevail in its absence, but also above the higher autarky price. To export the resultingsurplus, an export subsidy is paid that offsets the difference between European and world prices.

The subsidizd exports themselves tend to depress world prices, increasing the required subsidy. Cost-benefit analysis would clearly show that the combined costs to European consumers and taxpayersexceed the benefits to producers.

Depsite the considerable net costs of the CAP to European consumers and taxpayers, the politicalstrength of farmers in the EU has been so large that the program has been difficult to rein in. One


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source of pressuer has come from the US and other food-exporting nations, who complain that theEUs export subsidies drive down the price of their own exports. The budgetary consequences of the

CAP have also posed concerns: in 2002, the CAP cost European taxpayers almost $50 billion without including the indirect cost to consumers. Government subsidies to farmers are equal toabout 36 percent of the value of farm output (twice the US figure, for example).

Recent reforms in the CAP represent an effort to reduce the distortion of incentives caused by pricesupport, while continuing to provide aid to farmers. [Reforms of 2003 have meant that farmers still

receive direct income payments to maintain income stability, but the link to production has beensevered. This aims at making agricultural production more market-oriented, reducing prices andproduction. In addition, farmers have to respect environmental, food safety, phytosanitary andanimal welfare standards. Farmers who fail to do this will face reductions in their direct payments.]

12.7 Quotas Start out by considering a SMOPEC. Figure 16.1 shows the home country, which imports x xC Q

units ofXat the fixed world price ratiop*.

Suppose Home imposes a quota on imports ofX, so that only QR units ofXcan be imported inevery period.

Quantitative restriction leads to artificial scarcity of X, which raises price of X for bothconsumers and producers, increasing the domestic price ratiop =MRT=MRS.


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Because cost of QR units of X on theworld market is still given by p*, a newpost-quota equilibrium can be found.

[Locate a trade triangle that is QR units

long on the X side but still has a

hypotenuse with slope p*. One endpointof the hypotenuse will be on the PPF, the

other on a community indifference curve,

so that slopes of two curves are the same,

given by p. New trade triangle shows

restricted level of X imports under quota

and amount of Yexports needed to pay for imports at world prices.]

Effects of import quota in Fig. 16.1 similar to those of import tariff in Fig. 15.1: quota lowersdomestic welfare, this time from fU to qU . Again, this move toward autarky will benefit the

scarce factor according to Stolper-Samuelson theorem.

qAC (i.e. distance from world price linep*to domestic price linep) gives difference in value of


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imports at world and domestic prices. In tariff case, this was the tax revenue. In quota case,

this is the quota rent: a lucky group of importers will get a permit to buy Xcheaply in Foreignand sell it at a premium in Home. We assume that this rent is used for consumption purposes,

leading to final equilibrium at qC .

Figure 16.2 shows the effects of import quotas in a SMOPEC using excess demand curves: Ex and E* are the Home and world excess demand curves for X, resp. In free trade, home

importsXfunits ofX at world pricep*.

Import quota QR distortshomes excess demand

curve to Exq, causing price of

Xto rise topin Home.

Figure 16.3 shows the samesituation for a large country: Exh and Exf are Home and

Foreign excess demand

curves. Initial imports in H


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are ofXhat world price p*, equal to exportsXfin Foreign.

Import quota QR in Home creates disequilibrium that leads to price and quantity changes in

both countries. Excess demand curve of H is now truncated at QR, at point Exq.

At free-trade price p* there is a surplus ofXin Foreign, which drives down price to *qp ; onthe other hand, theres a shortage ofXin Home, which drives up the (domestic) price top!

In new equilibrium, trade of X has been restricted to QR, its price fallen in F and risen in H.The gap between the prices

gives the rents (rectangle

*

qpp TS ) that accrue to those

who have the import permits.

Because H is a large country,the quota has TOT effects: if

quota rents stay in H, thenwelfare may rise, as long as

TOT from forcing down price


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of X in F offsets negative volume-of.trade effect.

The allocation of rents from import quotas can be done in different ways, includinggrandfathering or auctioning. Unfortunately, import quotas sometimes become political

favors and give rise to rent-seeking behavior, i.e. an activity - be it lobbying or bribery in

which real resources are (inefficiently) expended in the effort to acquire economically valuable

prizes. This possibility can make tariffs a less costly means of import protection.

Another mechanism for establishing a quota is for the importing country to request that theexporting country voluntarily restrict its exports through a voluntary export restraint(VER, also

known as a voluntary restraint agreement or VRA).

A VER leads to the allocation of quota rents among exporters in Foreign rather thanimporters in Home.

Welfare implications for Home with VER are always worse than under domestic importquota, because VER allows foreign country to collect and benefit from any quota rents. F

benefits from the positive TOT effect, while H suffers both a negative TOT effect and a

negative volume-of-trade effect.

For example, a study on three major U.S. VERs of 1980s in textiles and apparel, steel, and

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automobiles showed that around two-thirds of cost to consumers of trade restraints was

accounted by rents earned by foreigners, i.e. there was a transfer of income rather than a lossof efficiency.

Why are VERs used? Trade policy instruments are often used for political purposes to favorpowerful interest groups. To avoid retaliation from trade partners, VERs can both appease

domestic interest groups and foreign trade partners, with the added benefit of generally notviolating multilateral trade agreements since VERs are voluntary. There are also multilateral

VERs such as the Multi-Fiber Arrangement limiting textile exports from 22 countries until

2005.

An import quota in practice: U.S. sugar

From Krugman & Obstfeld (2006), chapter 8

The U.S. sugar problem is similar in its origins to the European agricultural problem: a domestic priceguarantee by the federal government has led to U.S. prices above world market levels. Unlike theEuropean Union, however, the domestic supply in the U.S. does not exceed domestic demand. Thusthe U.S. has been able to keep domestic prices at the target level with an import quota on sugar.

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A special feature of the import quota is that the rights to sell sugar in the U.S. are allocated toforeign governments, who then allocate these rights to their own residents. As a result, rents

generated by the sugar quota accrue to foreigners.In 2002, the quota restricted imports to app. 1.4 million tons; as a result, the price of sugar in the U.S.was more than twice the price in the outside world. According to an estimate which assumes thatthe U.S. sugar market does not have a major impact on the world price, free trade would more thandouble imports to 3.7 million tons.. The welfare effects of the import quota are estimated at around

US$2.468 billion. Part of the consumer loss represents a transfer to U.S. sugar producers, who gain aproducer surplus [the amount a producer gains from production by the difference between the pricehe actually receives and the price he would have been willing to sell at] of US$1.806 billion. Part ofthe loss represents the production distortion (US$0.247 billion) and the consumption distortion(US$0.052 billion). The rents to foreign governments that receive import rights amount to US$0.364billion. The net loss to the U.S. is given by the distortions plus the quota rents, a total of US$662

million per year most of this due to the fact that the quota rents accrue to foreign importers.The sugar quota illustrates in an extreme way the tendency of protection to provide benefits to asmall group of producers, each of whom receives a large benefit, at the expense of a large number ofconsumers, each of whom bears only a small cost. In this case, the yearly consumer loss amounts toonly US$8 per capita, or around US$30 for a typical family. Not surprisingly, the average American

voter is unaware that the sugar quota exists, and so there is little effective opposition.From the point of view of the sugar producers, however, the quota is a life-or-death issue. The U.S.sugar industry employs only about 38000 workers, so the producer gains from the quota representan implicit subsidy of about US$20000 per employee. It should be no surprise that sugar producersare very effectively mobilized in defense of their protection.

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A Voluntary Export Restraint in practice: Japanese autos

From Krugman & Obstfeld (2006), chapter 8

For much of the 1960s and 1970s, the U.S. auto industry was largely insulated from importcompetition by the difference in the kinds of cars bought by U.S. and foreign consumers. U.S. buyers,living in a large country with low gasoline taxes, preferred much larger cars than Europeans andJapanese, and, by and large, foreign firms had chosen not to challenge the U.S. in the large-carmarket.

In 1979, however, sharp oil price increases and temporary gasoline shortages caused the U.S. marketto shift abruptly toward smaller cars. Japanese producers, whose costs had been falling relative totheir U.S. competitors in any case, moved in to fill the new demand. As the Japanese market sharesoared and U.S. output fell, strong political forces in the U.S. demanded protection for the U.S.industry. Rather than act unilaterally and risk creating a trade war, the U.S. government asked the

Japanese government to limit its exports. The Japanese, fearing unilateral U.S. protectionistmeasures if they did not do so, agreed to limit their sales. The first agreement, in 1981, limitedJapanese exports to the U.S. to 1.68 million automobiles. A revision raised that total to 1.85 million in1984 to 1985. In 1985, the agreement was allowed to lapse.

The effects of this voluntary export restraint were complicated by several factors. First, Japanese andU.S. cars were clearly not perfect substitutes. Second, the Japanese industry to some extentresponded to the quota by upgrading its quality and selling larger autos with more features. Third,the auto industry is clearly not perfetly competitive. Nonetheless, the basic results were what thediscussion of VERs above would have predicted: the price of Japanese cars in the U.S. rose, with therent captured by Japanese firms. The U.S. government estimates the total costs to the U.S. at US$3.2billion in 1984, primarily in transfers to Japan rather than efficiency losses.

12 Trade Policy Part 131


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12.8Comparing the effects of tariffs and quotas Tariffs and quotas can potentially have very similar effects, as seen in Figures 15.1. and 16.1, the

main difference being that quotas generate rents, while tariffs generate tax revenues, which

can however be accounted for by the rent/revenue distribution mecahnism. Potential

equivalence shown in Figure 16.4. (similar to Fig. 16.2):

Exis free-trade excess demand curve forXin Home. Quota of QR will distort domestic

equilibrium to point E with Home

importing QR units of X at price p*,while its domestic price ratio rises to

p.

If tariff of rate / * 1t p p= isimposed instead (so that

*(1 )p p t= + ), excess demand curve

will shift down to Ext , and we again

12 Trade Policy: Part 132


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arrive at distorted equilibrium E

As long as quota rents and tariff revenues are distributed in the same way, the tariff and

quota will have identical economic effects.

However, tariffs and quotas do not always have equivalent effects; any perturbation to theworld price or domestic excess-demand curve will leave us with non-equivalent effect. We

examine three important situations in which they differ below. Quotas are rigid with respect to import quantities, so all changes must be absorbed by price

changes. Tariffs permit quantities of imports to change so that adjustment will occur in

quantities (and also in prices as well if the importing nation is large).

Economic Growth

Suppose that economic growth is associated with increases in the resource endowments ofcountry H, spcifically that the scarce factor grows larger.

According to the Rybczynski theorem, the impliction is that resources will be moved towardthe import-competing sector, making the economy more similar to the rest of the world and

moving the countrys excess demand curve down as the home autarky price moves toward the



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world pricep*.

Under a quota, the excess demand curve would shift down with growth and the quota-

distorted domestic price gradually fall towards p*as the relative scarcity of the imports falls

with economic growth.

Under an initially equivalent tariff, as scarce-factor growth pushes down the excessdemand curve, the tariff-distorted exces demand curve also falls, because it is the constanttariff rate that causes the excess demand curve to adjust (not a fixed quantity like in the

quota). The tariff will leave the domestic price the same at pbecause *(1 )p p t= + still holds,

but the level of imports will shrink.

In case of scarce-factor growth, the quota is actually preferable in welfare terms to the tariffbecause as growth proceeds, the quota becomes less binding, while the tariff prevents the

price from falling.

In case of abundant-factor growth, however, the quota would become increasingly bindingand domestic price would steadily rise, while under a tariff there would be rising imports at the

same domestic price; welfare losses would be lower with a tariff.



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Price fluctuations

In general, the domestic and foreign price ratios are related by

*(1 )p p t= +, with t>0.In case of

a tariff, tis the fixed ad valorem tariff rate. In case of a quota, we consider tto be an implicit

tariff rate that gives the difference between the foreign price and the price domestic

consumers are willing to pay, i.e. t is the percentage difference between the world and

domestic relative prices induced by the quota.

Suppose that a SMOPEC can choose between a tariff and a quota, and that the foreign excess-demand curve shifts up and down randomly (foreign price fluctuations).

Under a tariff, the domestic price ratio will fluctuate in proportion to the foreign pricefluctuation becacuse tis fixed.

Under a quota, tvaries inversely with the world price: an increase in the foreign pricep* willnarrow the gap between foreign and domestic price ratios. A decrease in p* will mean that

domestic importers are willing to bid more for the import licenses, and thus the implicit

tariff tis increased in value.

The quota provides better insulation from foreign price fluctuations, whereas the tariffprovides better insulation from fluctuations that are domestic in origin.



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Domestic monopoly

The contestable market hypothesis, stating that a firm will behave more competitively if itsmarket is contestable, implies that monopolists will behave differently under tariffs and

quotas.

A tariff leaves the domestic market contestable, albeit at higher tariff-distorted prices. Anymovement by a monopolist to restrict output and raise price above the current, tariff-distorted level will be offset by increasing amounts of imports from foreign competitors.

A quota, being a restriction on the quantity of sales on a market, destroys the contestabilityof a market. The monopolist can reduce output and raise prices without fear that additional

imports will flood the domestic market and force price back down.

In Figure 16.4, a domestic monopolist is able to restrict output, forcing the importingcountrys excess-demand curve (which reflects consumption minus production) to rise.

Suppose the extent of monopoly power allows a shift up of Ex to Ex; in this domestically

monopolized market, import prices will rise to pm when imports are artificially scarce due to

a quota of QR, but prices remain atpwith a tariff.

There is a possible double-distortion problem in the case of protection and imperfect



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competition. Under a monopoly, there is an undersupply of the monopoly good; under trade

protection, there tends to be an oversupply of the protected good. If a country switches from

tariff to quota, it is giving license to domestic monopolists to cut output and raise prices.

However, the lower levesl of monopoly output may simply compensate the distorted over-

production arising from protection, and the economy may see an overall improvement in

welfare.

IE Trade Policy 2008 1

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Transcript of IE Trade Policy 2008 1