Slides prepared by Thomas Bishop, edited by Mishelle Segui Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 8 The Instruments of Trade Policy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-2 Preview Partial equilibrium analysis of tariffs: supply, demand, and trade in a single industry Costs and benefits of tariffs

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-3 Introduction In the previous chapters we have answered the question “Why do nations trade?” Now: “What should a nation’s trade policy be?” In particular, we will try to answer questions like, “What trade policy should the US implement to protect its automobile industry?”

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-4 Types of Tariffs A tariff is a tax levied when a good is imported. The effect of the tariff is to raise the cost of shipping goods to a country A specific tariff is levied as a fixed charge for each unit of imported goods.  For example, $1 per kg of cheese An ad valorem tariff is levied as a fraction of the value of imported goods.  For example, 25% tariff on the value of imported cars.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-5 Types of Tariffs (cont.) What are the reasons for the US government to imposes tariffs? The importance of tariffs has declined over time, and instead new forms of protections have been implemented  Nontariff barriers Import quotas – limitations on the quantity of imports Export restraints – limitations on the quantity of exports

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-6 Supply, Demand, and Trade in a Single Industry Let’s analyze how tariffs affect the economy. Let’s construct a model measuring how a tariff affects a single market, say that of wheat. 2 countries: Home and Foreign  Both consume and produce wheat, which can be costlessly transported between countries Wheat is a simple competitive industry, in which the demand and the supply are functions of the market price

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-7 Supply, Demand, and Trade in a Single Industry (cont.) Not worry for exchange rates  Prices in both markets in terms of Home currency Trade will occur if prices are different in the absence of trade

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-8 Supply, Demand, and Trade in a Single Industry (cont.) Suppose that in the absence of trade the price of wheat in the foreign country is lower than that in the domestic country. What would the shippers in both countries do?

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-9 Supply, Demand, and Trade in a Single Industry (cont.)  With trade the foreign country will export: construct an export supply curve  With trade the domestic country will import: construct an import demand curve

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Supply, Demand, and Trade in a Single Industry (cont.) An export supply curve is the difference between the quantity that foreign producers supply minus the quantity that foreign consumers demand, at each price. An import demand curve is the difference between the quantity that domestic consumers demand minus the quantity that domestic producers supply, at each price.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Fig. 8-1: Deriving Home’s Import Demand Curve

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Supply, Demand, and Trade in a Single Industry (cont.) At P A, import demand is equal to zero Why is IM downward-sloping?

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Fig. 8-2: Deriving Foreign’s Export Supply Curve

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Supply, Demand, and Trade in a Single Industry (cont.) Why is XS upward-sloping? At P A, export supply is equal to zero

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Supply, Demand, and Trade in a Single Industry (cont.) World equilibrium occurs when Home import demand equals Foreign export supply In equilibrium, the quantities of import demand = export supply domestic demand – domestic supply = foreign supply – foreign demand In equilibrium, the quantities of world demand = world supply

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Fig. 8-3: World Equilibrium

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Effects of a Tariff A tariff can be viewed as an added cost of transportation. Why? The price of wheat will tend to rise in the domestic market. The price of wheat will tend to fall in the foreign market.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Effects of a Tariff (cont.) Until the price difference equals the tariff.  P T – P * T = t  P T = P * T + t  Introducing a tariff drives a wedge between the prices in the two markets

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Fig. 8-4: Effects of a Tariff

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Effects of a Tariff (cont.) Because the price in domestic markets rises (to P T )  domestic producers should supply more and domestic consumers should demand less.  The quantity of imports falls from Q W to Q T Because the price in foreign markets falls (to P * T )  foreign producers should supply less and foreign consumers should demand more.  The quantity of exports falls from Q W to Q T

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Effects of a Tariff (cont.) The quantity of domestic import demand equals the quantity of foreign export supply when P T – P * T = t In this case, the increase in the price of the good in the domestic country is less than the amount of the tariff.  But…

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Effects of a Tariff in a Small Country When a country is “infinitely small,” it has no effect on the foreign (world) price of a good  Therefore, the foreign price will not fall, but will remain at P w  The price in the domestic market, however, will rise to P T = P w + t

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Fig. 8-5: A Tariff in a Small Country