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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
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• 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
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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
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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
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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?
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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
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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. 8-11
Fig. 8-1: Deriving Home’s Import Demand Curve
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Supply, Demand, and Trade in a Single Industry (cont.)
• At PA, import demand is equal to zero
• Why is IM downward-sloping?
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Fig. 8-2: Deriving Foreign’s Export Supply Curve
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Supply, Demand, and Trade in a Single Industry (cont.)
• Why is XS upward-sloping?
• At PA, export supply is equal to zero
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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
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Fig. 8-3: World Equilibrium
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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.
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The Effects of a Tariff (cont.)
• Until the price difference equals the tariff.
PT – P*T = t
PT = P*T + t
Introducing a tariff drives a wedge between the prices in the two markets
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Fig. 8-4: Effects of a Tariff
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The Effects of a Tariff (cont.)
• Because the price in domestic markets rises (to PT)
domestic producers should supply more and domestic consumers should demand less.
The quantity of imports falls from QW to QT
• 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 QW to QT
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The Effects of a Tariff (cont.)
• The quantity of domestic import demand equals the quantity of foreign export supply when PT – 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…
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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 Pw
The price in the domestic market, however, will rise to PT = Pw + t
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8-23
Fig. 8-5: A Tariff in a Small Country
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