The Instruments of Trade Policy

Chapter 9
The Instruments
of Trade Policy
Preview
• Partial equilibrium analysis of tariffs in a

single industry: supply, demand, and trade
• Costs and benefits of tariffs
• Export subsidies
• Import quotas
• Voluntary export restraints
• Local content requirements
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Types of Tariffs
• A tariff is a tax levied when a good is

imported.
• A specific tariff is levied as a fixed charge
for each unit of imported goods.
– For example, $3 per barrel of oil.
• An ad valorem tariff is levied as a fraction

of the value of imported goods.
– For example, 25% tariff on the value of imported
trucks.

Supply, Demand, and Trade in a
Single Industry
• Consider how a tariff affects a single

market, say that of wheat.
• Suppose that in the absence of trade the
price of wheat is higher in Home than it is in
Foreign.
• With trade, wheat will be shipped from
Foreign to Home until the price difference is
eliminated.

Single Industry (cont.)
• An import demand curve is the difference

between the quantity that Home consumers
demand minus the quantity that Home
producers supply, at each price.
• The Home import demand curve
MD = D – S
intercepts the price axis at PA and is
downward sloping:
– As price increases, the quantity of imports
demanded declines.

Fig. 9-1: Deriving Home’s Import
Demand Curve

• An export supply curve is the difference

between the quantity that Foreign producers
supply minus the quantity that Foreign
consumers demand, at each price.
• The Foreign export supply curve
XS* = S* – D*
intersects the price axis at PA* and is
upward sloping:
– As price increases, the quantity of exports
supplied rises.

Fig. 9-2: Deriving Foreign’s
Export Supply Curve

• In equilibrium,
import demand = export supply,
home demand – home supply
= foreign supply – foreign demand,
home demand + foreign demand

= home supply + foreign supply,
world demand = world supply.

Fig. 9-3: World Equilibrium

Effects of a Tariff
• A tariff acts like a transportation cost,

making sellers unwilling to ship goods unless
the Home price exceeds the Foreign price by
the amount of the tariff:
PT – t = P T *
• A tariff makes the price rise in the Home
market and fall in the Foreign market.

Fig. 9-4: Effects of a Tariff

Effects of a Tariff (cont.)
• Because the price in the Home market rises

from PW under free trade to PT with the tariff,
– Home producers supply more and Home
consumers demand less, so
– the quantity of imports falls from QW under free
trade to QT with the tariff.

• Because the price in the Foreign market falls

from PW under free trade to PT* with the
tariff,
– Foreign producers supply less, and Foreign
consumers demand more, so
– the quantity of exports falls from QW to QT .

• The quantity of Home imports demanded

equals the quantity of Foreign exports
supplied when
PT – P T * = t
• The increase in the price in Home can be
less than the amount of the tariff.
– Part of the effect of the tariff causes the Foreign
export price to decline.
– But this effect is sometimes very small.

Effects of a Tariff in a Small Country
• When a country is “small,” it has no effect

on the foreign (world) price because its
demand is an insignificant part of world
demand for the good.
– The foreign price does not fall, but remains at
Pw .
– The price in the home market rises by the full
amount of the tariff, to PT = Pw + t .

Fig. 9-5: A Tariff in a Small
Country

Measuring the Amount of
Protection
• The effective rate of protection measures how
much protection a tariff (or other trade policy)
provides.
– It represents the change in value that firms in an industry
add to the production process when trade policy changes,
which depends on the change in prices the trade policy
causes.
• Effective rates of protection often differ from tariff

rates because tariffs affect sectors other than the
protected sector, causing indirect effects on the
prices and value added for the protected sector.

Protection (cont.)
• For example, suppose that automobiles sell in world

markets for $8,000, and they are made from factors
of production worth $6,000.
– The value added of the production process is
$8,000 – $6,000.
• Suppose that a country puts a 25% tariff on
imported autos so that home auto assembly firms
can now charge up to $10,000 instead of $8,000.

Protection (cont.)
• The effective rate of protection for home auto
assembly firms is the change in value added:
($4,000 – $2,000)/$2,000 = 100%
• In this case, the effective rate of protection is
greater than the tariff rate.

Costs and Benefits of Tariffs
• A tariff raises the price of a good in the

importing country, so it hurts consumers
and benefits producers there.
• In addition, the government gains tariff
revenue.
• How to measure these costs and benefits?
• Use the concepts of consumer surplus and
producer surplus.

Consumer and Producer Surplus
• Consumer surplus measures the amount

that consumers gain from purchases by
computing the difference in the price
actually paid from the maximum price they
would be willing to pay for each unit
consumed.
– When price increases, the quantity demanded
decreases as well as the consumer surplus.

Fig. 9-6: Deriving Consumer Surplus
from the Demand Curve

Fig. 9-7: Geometry of Consumer
Surplus

Consumer and Producer Surplus
(cont.)
• Producer surplus measures the amount

that producers gain from sales by computing
the difference in the price received from the
minimum price at which they would be
willing to sell.
– When price increases, the quantity supplied
increases as well as the producer surplus.

Fig. 9-8: Geometry of Producer
Surplus

Measuring the Costs and Benefits
of Tariffs
• A tariff raises the price in the importing country:
– consumer surplus decreases (consumers worse off)
– producer surplus increases (producers better off).
– the government collects tariff revenue equal to the tariff
rate times the quantity of imports with the tariff.
t QT = (PT –PT* ) (D2 – S2)
• Change in welfare due to the tariff is e – (b + d).

Fig. 9-9: Costs and Benefits of a Tariff
for the Importing Country

of Tariffs (cont.)
• For a “large” country, whose imports and exports
affect world prices, the welfare effect of a tariff is
ambiguous.
• The triangles b and d represent the efficiency
loss.
– The tariff distorts production and consumption decisions:
producers produce too much and consumers consume too
little.
• The rectangle e represents the terms of trade

gain.
– The tariff lowers the Foreign price, allowing Home to buy
its imports cheaper.

of Tariffs (cont.)
• Part of government revenue (rectangle e)

represents the terms of trade gain, and part
(rectangle c) represents some of the loss in
consumer surplus.
– The government gains at the expense of consumers and
foreigners.
• If the terms of trade gain exceed the efficiency

loss, then national welfare will increase under a
tariff, at the expense of foreign countries.
– However, foreign countries are apt to retaliate.

Fig. 9-10: Net Welfare Effects of a
Tariff

of Tariffs (cont.)
• Tariffs can lead trading partners to retaliate

with their own tariffs, thus hurting exporters
in the country that first adopted the tariff.
• Tariffs can be hard to remove and large
tariffs may induce producers to engage in
wasteful activities to avoid paying tariffs.
– Ford and Subaru install (then later remove)
seats in vans and pickups trucks to avoid U.S.
tariff on imports of light commercial trucks.

Export Subsidy
• An export subsidy can also be specific or ad

valorem:
– A specific subsidy is a payment per unit exported.
– An ad valorem subsidy is a payment as a proportion of the
value exported.
• An export subsidy raises the price in the exporting

country, decreasing its consumer surplus
(consumers worse off) and increasing its producer
surplus (producers better off).

Export Subsidy (cont.)
• Also, government revenue falls due to paying

s XS* for the export subsidy.
• An export subsidy lowers the price paid in importing
countries PS* = PS – s.
• In contrast to a tariff, an export subsidy worsens
the terms of trade by lowering the price of exports
in world markets.

Fig. 9-11: Effects of an Export Subsidy

Export Subsidy (cont.)
• An export subsidy damages national welfare.

• The triangles b and d represent the efficiency
loss.
– The export subsidy distorts production and consumption
decisions: producers produce too much and consumers
consume too little compared to the market outcome.
• The area b + c + d + f + g represents the cost of

the subsidy paid by the government.
– The terms of trade decrease, because the price of exports
falls.

Export Subsidy in Europe
• The European Union’s Common Agricultural Policy

sets high prices for agricultural products and
subsidizes exports to dispose of excess output.
– Subsidized exports reduce world prices of agricultural
products.
• The cost of this policy for European taxpayers is

almost $30 billion more than its benefits (in 2007).
Subsidy payments are about 22% of the value of
farm output.
– The EU has proposed that farmers receive direct payments
independent of the amount of production to help lower EU
prices and reduce production.

Fig. 9-12: Europe’s Common
Agricultural Policy

Import Quota
• An import quota is a restriction on the quantity of a

good that may be imported.
• This restriction is usually enforced by issuing
licenses or quota rights.
• A binding import quota will push up the price of the
import because the quantity demanded will exceed
the quantity supplied by Home producers and from
imports.

Import Quota (cont.)
• When a quota instead of a tariff is used to restrict

imports, the government receives no revenue.
– Instead, the revenue from selling imports at high prices
goes to quota license holders.
– These extra revenues are called quota rents.

Fig. 9-13: U.S. and World Raw Sugar
Prices in $ per ton, 1989–2011

Fig. 9-14: Effects of the U.S. Import
Quota on Sugar

Voluntary Export Restraint
• A voluntary export restraint works like an import

quota, except that the quota is imposed by the
exporting country rather than the importing
country.
• These restraints are usually requested by the
importing country.
• The profits or rents from this policy are earned by
foreign governments or foreign producers.
– Foreigners sell a restricted quantity at an increased price.

Local Content Requirement
• A local content requirement is a regulation that

requires a specified fraction of a final good to be
produced domestically.
• It may be specified in value terms, by requiring that
some minimum share of the value of a good
represent home value added, or in physical units.

(cont.)
• From the viewpoint of domestic producers of inputs,
a local content requirement provides protection in
the same way that an import quota would.
• From the viewpoint of firms that must buy home
inputs, however, the requirement does not place a
strict limit on imports, but allows firms to import
more if they also use more home parts.

(cont.)
• Local content requirement provides neither
government revenue (as a tariff would) nor quota
rents.
• Instead, the difference between the prices of home
goods and imports is averaged into the price of the
final good and is passed on to consumers.

(cont.)
• Any public work project funded by the American
Recovery and Re-Investment Act of 2009 (ARRA)
must use U.S. iron, steel, and manufactured goods
(unless foreign bid more than 25% lower).
– The Bay Bridge linking San Francisco and Oakland did not
use ARRA funding because some key components would
have been 23% ($400 million) more expensive.
• Delays due to having to show that some items are

unavailable from U.S. sources.
• Has triggered protectionist clauses that shut U.S.
firms out of opportunities abroad.

Other Trade Policies
• Export credit subsidies

– A subsidized loan to exporters
– U.S. Export-Import Bank subsidizes loans to U.S.
exporters.
• Government procurement
– Government agencies are obligated to purchase from home
suppliers, even when they charge higher prices
(or have inferior quality) compared to foreign suppliers.
• Bureaucratic regulations (red tape)
– Safety, health, quality, or customs regulations can act as
a form of protection and trade restriction.

The Effects of Trade Policy
• For each trade policy, the price rises in the Home

country adopting the policy.
– Home producers supply more and gain.
– Home consumers demand less and lose.
• The world price falls when Home is a “large”
country that affects world prices.
• Tariffs generate government revenue; export
subsidies drain it; import quotas do not affect
government revenue.
• All these trade policies create production and
consumption distortions.

Table 9-1: Effects of Alternative Trade
Policies

Summary
1. A tariff increases the home price and the quantity

supplied and reduces the quantity demanded and
the quantity traded; also decreases the world
price when the country is “large.”
2. A quota does the same; an export subsidy does
the same.
3. Tariffs generate government revenue; export
subsidies drain it; import quotas are revenue
neutral.

Summary (cont.)
4. The welfare effect of a tariff, quota, or export

subsidy can be measured by
– efficiency loss from consumption and production
distortions.
– terms of trade gain or loss.
5. With import quotas, voluntary export restraints,

and local content requirements, the government of
the importing country receives no revenue.
6. With voluntary export restraints and occasionally
import quotas, quota rents go to foreigners.

Chapter 9
Appendix: Tariffs
and Import
Quotas in the
Presence of
Monopoly
Fig. 9A-1: A Monopolist under Free
Trade

Fig. 9A-2: A Monopolist Protected by a
Tariff

Fig. 9A-3: A Monopolist Protected by
an Import Quota

Fig. 9A-4: Comparing a Tariff and a
Quota

The Instruments of Trade Policy

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Chapter 9

• Partial equilibrium analysis of tariffs in a

Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-2

• A tariff is a tax levied when a good is

• An ad valorem tariff is levied as a fraction

Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-3

• Consider how a tariff affects a single

Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-4

• An import demand curve is the difference

Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-5

Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-6

• An export supply curve is the difference

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home demand + foreign demand

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• A tariff acts like a transportation cost,

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• Because the price in the Home market rises

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• Because the price in the Foreign market falls

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• The quantity of Home imports demanded

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• When a country is “small,” it has no effect

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• Effective rates of protection often differ from tariff

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• For example, suppose that automobiles sell in world

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Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-20

• A tariff raises the price of a good in the

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• Consumer surplus measures the amount

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• Producer surplus measures the amount

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• Change in welfare due to the tariff is e – (b + d).

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• The rectangle e represents the terms of trade

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• Part of government revenue (rectangle e)

• If the terms of trade gain exceed the efficiency

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• Tariffs can lead trading partners to retaliate

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• An export subsidy can also be specific or ad

• An export subsidy raises the price in the exporting

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• Also, government revenue falls due to paying

Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-34