1. Protectionism: How Nations Restrict Trade In a regime of Free Trade and free economic intercourse it would be of little consequence that iron lay on one side of a political frontier, and labor, coal, and blast furnaces on the other. But as it is, men have devised ways to impoverish themselves and one another; and prefer collective animosities to individual happiness. (John Maynard Keynes, 1920)

2. The Goals of this Chapter Use both partial equilibrium and general equilibrium models to explain the effects of tariffs. Use the general equilibrium model of a tariff to explain the important Lerner Symmetry Theorem. Extend the analysis to trade quotas, and demonstrate the similarities between tariffs and quotas. Describe some the many other ways in which governments restrict international trade. Introduce the concept of rent seeking and how it applies to trade policy from both a static and an growth perspective.

3. The Economics of a Tariff A tariff is simply a tax on imports An ad valorem tariff is a tax that is expressed as a percentage of the value of the import being taxed A specific tariff is an import tax expressed as a fixed dollar amount per unit of imports

4. The Economics of a Tariff The economic analysis of a tariff makes use of the two-country partial equilibrium model of trade. This model can be applied to trace the effects of a tariff on producers and consumers in the market for a traded good in both the exporting and importing countries.

5. The Economics of a Tariff First, we look at the effect of a tariff on the importing country. The domestic effects can be seen by looking at the two left-most diagrams in Figure 6.1. That is, look just at the Homeland market and the International Market.

6. The Economics of a Tariff Suppose an ad valorem tariff is applied to imports. Such a tariff is illustrated in the International Market diagram as an increase in the supply curve of imports. The effective decrease in foreign supply raises the Homeland price and reduces the quantity of imports.

7. The Economics of a Tariff The perspective from Abroad can be illustrated in the center and right-most diagrams of Figure 6.1. In Abroad, the tariff looks like a decrease in foreign demand. As a result, the price in Abroad declines, and the volume of exports falls.

8. The Economics of a Tariff: The Welfare Effects in Homeland and Abroad

9. The Economics of a Tariff: The Welfare Effects Prices rise in Homeland and fall in Abroad as the tariff drives a wedge between what exporters receive and importers pay. In the importing country, Homeland, consumers lose surplus equal to the areas A+b+C+d. In Abroad, the exporting country, producers lose surplus equal to the areas W+x+Y+z.

10. The Economics of a Tariff: The Welfare Effects The price rise in Homeland increases producer surplus by the area A. In Abroad, the fall in the price increases consumer surplus by the area W.

11. The Economics of a Tariff: The Welfare Effects Both countries suffer deadweight losses from the tariff because the volume of trade is reduces and prices are distorted. Homeland loses areas b+d Abroad loses areas x+z. The deadweight losses are equal to the same colored areas in the center International Market diagram.

12. The Economics of a Tariff: The Welfare Effects Total tariff revenue collected by Homeland’s government is equal to the sum of areas C and Y. Some of this tariff revenue, area C, comes out of the free trade consumer surplus. The rest of the tariff revenue comes out of the free trade producer surplus, namely area Y.

13. The two-country partial equilibrium model shows that a tariff by one country on the other’s exports causes: A transfer of welfare from domestic consumers to domestic producers in the importing country. A transfer of welfare from producers to consumers in the exporting country. A transfer of consumer surplus in the importing country to the importing country government in the form of tariff revenue. A transfer of producer surplus in the exporting country to the government of the importing country. Deadweight losses in both importing and exporting countries.

14. Example 6.2 The Gains and Losses from a Tariff Example 6.2 shows the welfare effects of a $3 specific tariff in a market that imports 8 million calculators with free trade. The welfare effects consist of changes in consumer surplus, producer surplus, and tariff revenue.

15. Example 6.2 The Gains and Losses from a Tariff For Homeland, the welfare effects of shifting from free trade in calculators to a $3 specific tariff are as follows: Homeland Consumer Surplus = – (A+b+C+d) = –$18.75 million Homeland Producer Surplus = + (A) = +$11.25 million Homeland Gov’t Tariff Revenue = + (C+Y)= +$ 6.00 million Net Welfare Change= Y ! b ! d= ! $ 1.50 million

16. Example 6.2 The Gains and Losses from a Tariff Abroad suffers a net loss that exceeds Homeland’s net gain by the total deadweight losses in both countries: Abroad’s Consumer Surplus = + (W)= + $11.25 million Abroad’s Producer Surplus = – (W+x+Y+z)= –$18.75 million Net Change = – Y– x – z= –$ 7.50 million The net loss for the world is: World deadweight losses= – (b+d+x+z)= –$ 9.0 million

17. How Much Protection Does a Tariff Really Provide? The true protection that a tariff provides to an industry is more accurately stated in terms of the industry’s value added. An effective tariff measures a nominal tariff’s effect on the value added of an industry. For example, if a tariff raises the price of a final good by 20 percent, and the industry adds half the product’s value, the effective tariff is 40 percent.

18. How Much Protection Does a Tariff Really Provide? A tariff on intermediate products can reduce an industry’s value added. That is, an effective tariff can be negative. In the example, if a government imposes a tariff on inputs while imposing no tariff on the final product, then the producers of final products will find their value added squeezed from $5,000 to $4,000.

19. A Tariff in the General Equilibrium Model An ad valorem tariff of t % on the import good X will raise the domestic price of X from the world price of P X to (1+t)P X. The world price line slope of –(P X /P Y ) increases to a tariff- distorted price line with a slope of –[(1+t)P X /P Y ]. Production shifts from P to P T, increasing X production and decreasing Y production. Welfare declines; only lower indifference curves are now attainable.

20. A Tariff in the General Equilibrium Model A tariff on imports of good X not only reduces imports and expands X industry output, but it also contracts output of Y and reduces exports. The X industry’s growing demand for resources raises the cost of resources for the Y industry, reducing that industry’s ability to produce and export. This result is known as the Lerner Symmetry Theorem, which states that any restraint on imports also effectively acts as a restraint on exports.

21. The Economics of a Quota The effects of a quota can be illustrated using the partial equilibrium model of imports and exports. Suppose the quota is set at half the free trade quantity of imports. From Homeland, the foreign supply curve looks like the kinked curve in the International Market on the right. With restricted imports, the Homeland price rises.

22. The Economics of a Quota From Abroad’s perspective, the quota creates a kinked foreign demand curve in the International Market. The domestic price in Abroad falls as the quantity exported is reduced to the quota level.

23. The Economics of a Quota The Full Welfare Effects in Homeland and Abroad

24. The Economics of a Quota The Full Welfare Effects By raising the price in Homeland, the quota increases Homeland producers’ surplus by the area A. In Abroad, the price falls and consumers gain surplus equal to the area W.

25. The Economics of a Quota The Full Welfare Effects The price rise in Homeland, the importing country, reduces consumer surplus by the areas A+b+C+d. In Abroad, the price decline there reduces producer surplus by the areas W+x+Y+z.

26. The Economics of a Quota The Full Welfare Effects The quota distorts prices and changes quantities from free trade levels, causing deadweight loses. In Homeland, the deadweight losses are b+d, equal to the same colored area in the center diagram. In Abroad, deadweight losses are x+z.

27. The Economics of a Quota The Full Welfare Effects The fundamental difference between a tariff and a quota is that a quota generates quota rent, not government revenue. This quota rent comes out of consumer surplus (area C) in the importing country and producer surplus (area Y) in the exporting country.

28. Example 6.3 The Gains and Losses from a Quota Example 6.3 shows the welfare effects of imposing quota of 2 million calculators on a market that imports 8 million calculators with free trade. The welfare effects consist of changes in consumer surplus, producer surplus, and quota rent.

29. Example 6.3 The Gains and Losses from a Quota If the rent accrues to domestic importers: Homeland Consumer Surplus = –(A+b+C+d) = –$18.75 million Homeland Producer Surplus = +(A) = +$11.25 million Homeland Quota Rent = +(C+Y)= +$ 6.0 million Net Change = Y!b!d= –$ 1.5 million

30. Example 6.3 The Gains and Losses from a Quota Abroad’s Consumer Surplus = +(W)= +$11.25 million Abroad’s Producer Surplus = –(W+x+Y+z)= –$18.75 million Abroad’s Quota Rent = 0= +$ 0.0 million Net Change= !Y!x!z= –$ 7.5 million World deadweight losses= –(b+d+x+z)= –$ 9.0 million

31. Example 6.3 The Gains and Losses from a Quota If the rent from Homeland’s quota accrues to foreign exporters: Homeland Consumer Surplus = – (A+b+C+d) = –$18.75 million Homeland Producer Surplus = + (A) = +$11.25 million Homeland Quota Rent = 0 = +$ 0.0 million Net Change = Y!b!d = –$ 7.5 million

32. Example 6.3 The Gains and Losses from a Quota Abroad’s Consumer Surplus = + (W) = +$11.25 million Abroad’s Producer Surplus = – (W+x+Y+z)= –$18.75 million Abroad’s Quota Rent = + (C+Y)= +$ 6.0 million Net Change= – (Y+x+z)= –$ 1.5 million World deadweight losses= – (b+d+x+z)= –$ 9.0 million

33. The Precise Welfare Effects of an Import Quota Depend on Who Gets the Rent When Abroad’s exporters are able to raise their prices and capture the quota rent, Abroad’s overall welfare loss is smaller, $1.5 million rather than $7.5 million. If it is importers that purchase overseas at lowered world prices and sell domestically at the higher prices, then Homeland gains the quota rent and reduces its overall welfare loss from the imposing the quota. Who ultimately gains the quota rent depends on who collects the difference between the higher price in Ho9meland and the lower price in Abroad.

34. The Equivalence of Tariffs and Quotas There is an equivalent tariff for any given quota, and vice versa. The areas representing transfers from one group to another and deadweight losses seem to be the same for equivalent tariffs and quotas. The only exception is the area C, which represents tariff revenue in the case of the tariff and quota rent in the case of the quota.

35. Some Differences between Tariffs and Quotas If demand shifts out, a tariff and quota that were equivalent will come to have very different price and welfare effects. Under a tariff, an increase in demand creates a new market equilibrium at c. Under a quota, an increase in demand creates a new market equilibrium at d.

36. Some Differences between Tariffs and Quotas Under a tariff, the price rises to to Pt, under a quota it rises to Pq. Under a tariff, the quantity imported rises from a to b, under a quota imports are unchanged. An increase in demand results in a greater gain in consumer surplus under a tariff. Deadweight loss is also less under a tariff, compare the smaller blue triangle with the quota’s red triangle.

37. Some Differences between Tariffs and Quotas A quota may also not ration rent opportunities as efficiently as a tariff. Consumers and producers along the green portions of the demand and supply curves should participate in the restricted trade. A quota could result in people at point B below the free trade price Pf getting import permits. Or, import permits may be denied to the lowest-cost suppliers and instead given to high-cost producers at point D.

38. The Costs of Costly Rent Seeking The costs of the resources used in rent seeking must be added to the costs of protection. Potential importers would be willing to spend some of the potential quota rent C to lobby policymakers to get the rent. If lobbying activities consume resources equal in value to half of the area C, then the total costs to the economy of the quota of bc would be equal to the deadweight losses b+d plus the blue half of C.

39. The Costs of Costly Rent Seeking Potential importers are not the only ones who engage in rent seeking. Consumers may wish to organize to protect themselves against rent-seeking producers. Consumers would be willing to spend up to the lost consumer surplus (A+b+C+d) to avoid the quota altogether. If lobbying costs consume half of the area A, then the darkly shaded area must also be added to the costs of protection.

40. Dynamic Rent Seeking: Obstructing Creative Destruction For the process of “creative destruction” to work, there must be destruction as well as creation. In a Schumpeterian environment of innovative competition, lobbying for protection against foreign competition may be motivated not by producers’ desire to increase producer surplus, but by the desire to slow the process of creative destruction and extend the period during which domestic innovators can reap profits. If such “dynamic” rent is successful, technological progress will slow, and welfare gains from economic growth will be lost.

41. Dynamic Rent Seeking: Obstructing Creative Destruction The welfare costs of obstructive dynamic rent seeking and the protection that it induces are potentially very large. The costs of dynamic rent seeking activity include the resources that are spent on obstructive activity rather than on the production of welfare-enhancing output. There are also the opportunity costs of lost future economic growth if the obstruction of competitive innovation is successful. Given the power of compounding, the opportunity cost of obstructing innovative activity can be enormous because the power of compounding magnifies even small changes in growth rates into large welfare changes.

42. Appendix: The complete analysis of a tariff in a general equilibrium model As shown earlier in the textbook, a tariff will tend to move production away from the free trade point P to a new production point P T, where the PPF is tangent to the tariff-distorted price ratio of (1+t)P X /P Y. Such a shift in production then points to a consumption equilibrium at C 1. But, the full effect of a tariff is more complex: there is also tariff revenue to account for.

43. The General Equilibrium Analysis of a Tariff The economy does not actually pay as much for X as consumers do because the tariff is paid the consumers’ own government, which presumably returns it to the citizens of the country in some form. Real income is therefore higher than the steeper price line, (1+t)P X /P Y, suggests.

44. The General Equilibrium Analysis of a Tariff Consumers face the price ratio (1+t)P X /P Y, so they take their income from producing P T and move toward the combination of X and Y given at point C 1. But, as consumers spend income earned to buy X goods equal to, say, ab, the government earns tariff revenue to provide goods or payments equal to an additional bc worth of X. Thus, in real income terms, consumers end up at a point c, instead of b.

45. The General Equilibrium Analysis of a Tariff Once at point c, consumers prefer the consumption point C 2, and they acquire more X. Tariff revenue increases, taking consumers to an even higher consumption possibilities frontier (CPF). The process stops at the point C 3, which is where consumer preferences reflect the tariff-distorted price ratio (1+t)P X /P Y but still lies on the CPF that reflects the real income generated by producing at P T.

46. The General Equilibrium Analysis of a Tariff In summary, consumption occurs at the point C T, where the indifference curve has the slope (1+t)P X /P Y. C T lies on CPL T, whose slope reflects the world price ratio but passes through the tariff- distorted production point P T. Thus, the tariff’s distorting effect on production implies that consumer and producer actions take the economy to the indifference curve I 2, not a higher one such as I 1.