© 2007 Pearson Addison-Wesley. All rights reserved Chapter 11 Diagram Analysis for IPE

11-2 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Commercial Policy as a second-best device Trade policy is the second best policy instrument. If the distortion comes from the production side, then the production policy itself (production subsidy) would be better. If the distortion comes from the consumption side, then the consumption policy itself would be better. The tariff can be used to help implement some social objective, but it proves frequently the second to best to some alternative policy instruments.

11-3 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Production Goals Suppose free-trade level of production is thought to be low. Two different strategies: tariffs on importable; or production subsidy on importable like food. Free-trade production is at A and consumption at B. If OJ level of food production must be undertaken, a tariff that raises food’s relative price at home to line 2 is sufficient. What is consumption behind this tariff wall? It should satisfy: (1) the consumption bundle must lie on an indifference curve whose slope reflects relative domestic prices; (2) it must have the same value as production point C at world price, that is point E.

11-4 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 11.3 Tariffs vs. Production Subsidies to Achieve a Production Goal

11-5 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Production Goals The restricted imports are EK, matched at world prices by clothing exports KC. Using production subsidy, production point is still at point C. World food prices are reflected in line HEC, parallel to line 1. Food producers receive the higher (subsidized) price shown by line 2. But now home consumers are free to buy at world price, and the best such point for them is H on curve y2. Y2 is higher that y1 in the case of tariffs.

11-6 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Evidence on U.S. Tariff Structure Next table shows the results of a simple test on the levels of protection that prevailed in the 1970s. Industries are ranked from the most protected to the least. The ranked list was divided into quarters. What is effective protection rate?

11-7 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Effective Rate of Protection The effective rate of protection measures how much protection a tariff or other trade policy provides domestic producers. –It represents the change in value that an industry adds to the production process when trade policy changes. –The change in value that an industry provides depends on the change in prices when trade policies change. –Effective rates of protection often differ from tariff rates because tariffs affect sectors other than the protected sector, a fact which affects the prices and value added for the protected sector.

11-8 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Effective Rate of Protection (cont.) For example, suppose that an automobile sells on the world market for $8000, and the parts that made it are worth $6000. –The value added of the auto production is $8000-$6000 Suppose that a country puts a 25% tariff on imported autos so that domestic auto assembly firms can now charge up to $10000 instead of $8000. Now auto assembly will occur if the value added is up to $10000-$6000.

11-9 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Effective Rate of Protection (cont.) The effective rate of protection for domestic auto assembly firms is the change in value added: ($ $2000)/$2000 = 100% In this case, the effective rate of protection is greater than the tariff rate.

11-10 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Table 11.1 Characteristics of Industries in Relation to Levels of Protection Given by U.S. Tariffs

11-11 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Does the tariff protect labor-intensive industries? The least-protected industries are indeed the least labor intensive. However, the most heavily protected industries are not very labor intensive. It does not confirm the prediction of the majority of voters that tariffs favor labor-intensive industries.

11-12 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Does the tariff protect low-skilled ? If the politicians aim in part to redistribute income to those poor, high tariffs should protect industries that employ low- skill and low-wage labor. Evidence: Low-wage industries do get the highest protection. However, their real income as consumers suffer seriously.

11-13 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Does the tariff protect small or big business? Theory conflicts. The lobbying model suggests that small industries can influence political decision at low cost, thus securing high protection. The collective decision suggest that high protection should go to large sellers. Evidence suggests that protection favors small establishments.

11-14 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Table 11.1 Characteristics of Industries in Relation to Levels of Protection Given by U.S. Tariffs

11-15 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Growth, Protection, and Welfare If a country devotes newly resources to its exportable sectors, the country’s terms of trade will tend to worsen. Immiserizing Growth But this is not true if the country is too small to affect world price of its export commodity. Why? Suppose a small country imposes tariff on its importable (food) like Figure Such a diversion of resources entails real income losses. Tariff in a small country cause dead-weight-loss.

11-16 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 3.3 Immiserizing Growth

11-17 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 10.4 The Effect of a Tariff on Imports

11-18 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Growth, Protection, and Welfare As this country grows, the more resources it devotes to the protected import-competing sector, the more its potential real income gains from growth are cut back. In the extreme case, growth at home could even result in a loss of welfare. Figure 11.4 illustrates these possibilities. Line 2 indicates world prices whereas line 1 shows domestic prices behind the tariff wall. With a tariff on food imports, line 1 showing domestic prices is flatter than line 2 which shows world prices.

11-19 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Growth, Protection, and Welfare A’ is the initial consumption point corresponding to production along TT’ at A. Now suppose tariff and world prices are unchanged, but the value of produced income at domestic prices rises by 25%. Consider difference cases for industries’ expansion. Point D: only the exportable sector expands 25%. The representative consumption point is at D’ which is the highest. Point B: fairly balanced expansion relative to point A. The consumption is at B’ which means real income increases. Growth has increased real income.

11-20 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 11.4 Growth with Protection

11-21 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Growth, Protection, and Welfare Point C and C’ is for expansion of pure import-competing industrial expansion. In the extreme case, if growth has been so biased in favor of importable (food), it would lower the real income. Therefore, growth to any of points B, C,D, and E shows a 25% increase in produced income at domestic price. But corresponding consumption points B’, C’, D’ and E’ are not equivalent.