International

Trade Policy

T.J. Joseph

Introduction• Classical trade theories advocate the economic gains

from free trade

• They show that free trade supports a higher level of domestic consumption and more efficient utilization of resources

• Also explain how free trade stimulates economic growth and the creation of wealth

• But the political reality of international trade is different

• Nations/Govts. Intervene in international trade to protect the interests of politically important groups

Instruments of Trade PolicyWhat should a nation’s trade policy be?

Different trade policies include:-

Tariffs

Non-tariff barriers

• Subsidies

• Quotas

• Voluntary Export Restraints

• Local Content Requirements

• Others

Tariff

• Simplest and the oldest form of trade policy

• It is a tax levied when a good is imported

• Purposes – to provide revenue to the Govt. and also to protect particular domestic sector

• Specific Tariff – Fixed charge for each unit of good imported

• Ad Valorem Tariff – levied as a fraction of the value of the imported goods

Trade in a Single IndustryAssume:-

• Two countries – Home and Foreign

• A single product – Wheat

• Free trade (no transportation cost)

• In each country supply and demand are functions of market prices

• Exchange rate remains same

Trade:

• Wheat will be exported from countries with low price to countries with high price, until the price differences get eliminated

• Suppose Home pricewheat > Foreign pricewheat

• Home imports and Foreign exports Wheat

• World Equilibrium reaches when Home import demand equals Foreign export supply, i.e.,

Home DD – Home SS = Foreign SS – Foreign DD

Home DD + Foreign DD = Home SS + Foreign SS

World DD = World SS

Costs and Benefit of a TariffEffect of a Tariff:

• Prices – rise in the importing country and falls in the exporting country

• Consumers – loss in the importing country and gain in the exporting country

Ex: tariffs on foodstuffs, cosmetics and chemicals cost the average Japanese consumer about $890 per year in 1989

• Producers – gain in the importing country and loss in the exporting country

• Government – gains revenue through tariff

Effect of a Tariff• Assume a import tariff of $t per unit of Wheat at Home

• For trade to take place, Home price should exceed at least by $t from that of Foreign price

Result – price in Home will rise and that in Foreign will fall

In Home;

• Consumers demand less, so fewer import demand

In Foreign;

• Producers get lower prices, so smaller export supply

Effects of Tariffs

• It reduce the overall efficiency of the world economy

– By encouraging domestic firms to produce productsat home which could have produced more efficientlyabroad

– Result in inefficient utilization of resources

Ex: car production in India before 1991

Measuring the Amount of Protection

• The principle objective of tariff is to protect domestic producers from the low prices due to import competition

• How much protection a tariff actually provides?

– Usually expressed as a percentage of free trade prices

– If tariff is an ad valorem, tariff rate itself should measure the amount of protection

The Effective Rate of ProtectionThe Effective Rate of Protection measures the percentage effect of the entire tariff structure on the value added per unit of output in each industry

• Tariff Structure

Tariff structure refers to the relationship among tariffs in related industries

• Value Added

Value added is the difference between the selling price and the cost of intermediate goods.

V = PA – Psa

The Effective Rate of Protection

ERP = (VT – VW ) / VW

ERP = Effective Rate of Protection

VT = Value Added with tariff

VW = Value added with free trade

Where,

VW – Value added in the sector at world prices

VT – Value added in the presence of trade policies

PA – World price of finished good

PC – World price of input component

tA – tariff rate on imported finished good

tC – tariff rate on input component

Provided tariffs does not affect world prices

The Effective Rate of Protection

The Effective Rate of Protection

The ERP can also be calculated using the following formula

ERP = (tA – atC ) / (1 – a)

Where,

tA - the nominal tariff on the imported finished good

a - the value of imported inputs as a share of the value of the final good under free trade

tC - the tariff on imported inputs used by the domestic producers.

Important!: Please refer the article by Frank Flatters for illustrative examples explaining the Effective Rates of Protection

Export Tariffs

• Levied on exports of a product from a country

• Less common than import tariffs

• Objectives:

1. To raise revenue for the government

2. To reduce exports from a sector, usually due to somepolitical reasons

Ex: China’s tariff on textile exports

Other Instruments of Trade Policy

Subsidies

• Subsidy is a payment to a domestic producer

• It can be in the form of cash grants, low-interest loans, tax breaks, and govt. equity

• Helps domestic producers compete against foreign imports and gaining export markets

Ex: Agricultural subsidies in U.S., Europe (43% of gross farm receipts. Almost $43 bn), Japan (62% of GFR), etc.

Effects of a Subsidy

• Domestic producers gain: increase in their international competitiveness

• The home country government loss

• Consumers loss: Govts. typically pay for subsidies by taxing individuals

• Advocates of Strategic Trade Policy (a section of New Trade Theory) favour subsidies to help domestic firms to achieve economies of scale

• Ex: Boeing got substantial U.S. govt. subsidies in the form of R&D grant

Effects of a Subsidy

• Mostly subsidies protect the inefficient and promote excess production

• Ex: Agriculture subsidies:

a. Allow inefficient farmers to stay in business

b. Encourage countries to overproduce

c. Encourage countries to produce products that can be produced more cheaply elsewhere and imported

d. Reduce international trade in agricultural products

Research shows that if advanced countries abandoned subsidies to farmers,

global trade in agricultural products would be 50% higher and the world as a

whole would be better off to the tune of $160 bn.

• A direct restriction on the quantity of some good that may be imported

• Restrictions are enforced through import licenses

• Import quotas are issued either to an individual or firm in the importing country or given directly to the government of exporting countries

Ex: (1) U.S. has quota on Cheese imports licensed to certain U.S. trading companies

(2) Sugar & textile imports in U.S. is given directly to the governments of exporting countries

Import Quotas

Effects of an Import Quota

• Raises the domestic price of the imported good

• Have the same effects of a tariff

• Revenue for government under quota system is the import license fee collected

• Quota Rents: The profits received by the holder of import license

• The recipient of Quota rents depend on who gets the rights to sell in the domestic market – whether domestic firm or government of exporting countries.

• A variant of import quota

• A VER is a quota on trade imposed from the exporting country’s side

• Generally imposed at the request of the importer

• It is like an import quota assigned to foreign govts.

Ex: limitation on auto exports to US enforced by Japanese automakers in 1981 (Max. 1.68 mn. vehicles per year)

Ex: the Multi-Fiber Agreement (MFA) that limits textile exports from 22 countries

Voluntary Export Restraints (VER)

Effects of a VER

• Foreign producers agree to VERs because they fear far more damaging punitive tariffs or import quotas

• VER – a way of making the best of a bad situation

• Benefits domestic producers by limiting import competition

• Domestic consumers are affected due to higher domestic price for the imported good (foreign supply is limited)

Ex: Study shows that due to import quotas, the price of sugar in US has been almost 40% greater than world price

• Very costly to an importing country than a tariff –revenue under a tariff becomes rent earned by foreigners

• A regulation that requires some specified fraction of a final good be produced domestically

• Widely used by the developing countries

• For the domestic producers of parts, this provides protection in the same way an import quota does

Ex: the Buy American Act specifies US govt agencies must give preferences to American products that uses at least 51% of the materials by value produced domestically

• Does not produce either government revenue or quota rent

Local Content Requirement

• Bureaucratic rules that are designed to make it difficult for imports to enter a country

Ex: Japan’s customs inspection on tulip bulbs from Netherland and courier packages of FedEx

France required that all imported videotape recorders arrive should go through a small customs entry point that was poorly staffed. The delays kept Japanese VCRs out of French market

Informal or Administrative Policies

• Dumping is variously defined as selling goods in a foreign market at below their cost of production or below their domestic market price

• Viewed as a method by which firms unload excess production in foreign markets

• Using substantial profits from their home markets to subsidize prices in a foreign market to drive indigenous competition out of that market

• Antidumping policies are designed to punish foreign firms that engage in dumping

• Antidumping duties are often called countervailing duties

Antidumping Policies

Summary

Tariff SubsidyImport Quota

VER

Producer surplus

rise rise rise rise

Consumer surplus

falls falls falls falls

Govt. Revenue

rise

Falls (Govt.

spending rises)

No change (Rent to license

holders)

No change (Rents to

foreigners)

Overall welfare

Ambiguous falls Ambiguous falls

THE POLITICAL ECONOMY OF TRADE POLICY

The Case for Government Intervention

Free Trade and Efficiency

The efficiency case of free trade

• Free trade eliminates distortions due to tariff and increase national welfare

• Protected markets fragment production internationally and reduce competition

• Too many firms in a narrow domestic market leads to inefficient scale of production

Political Arguments for Intervention• Protecting jobs and industries

• Protecting industries deemed important for national security

• Retaliation - use trade policy as a threat while bargaining for foreign market access or implement patent laws, etc.

• Protecting human rights of individuals in exporting countries

• Protecting consumers from “unsafe” products

Ex: European Union ban on the import of hormone-treated beef

Economic Arguments for Intervention• The infant industry argument

New manufacturing industries of developing countries cannot initially compete with well-developed industries in developed countries

• The New Trade Theory and Strategic Trade Policy

New Trade Theory argues that firms engage in international trade because they enjoy economies of scale mostly achieved through first-mover advantage

Some New Trade Theorists argue for strategic trade policy

• Their arguments have two components:

I. Govt. should provide subsidies to firms in newly emerging industries to help them achieve first-mover advantage (Ex: Boeing, LCDs by Japanese companies)

II. Govt. should intervene in industries to help domestic companies to overcome the barriers already created by the foreign firms enjoying first-mover advantage (Ex: Airbus)

“Trade policies in practice are dominated by special-interest politics rather than consideration of national costs and benefits”

National Welfare Argument against Free Trade

– Most trade policy measures are primarily to protect the income of particular interest groups

– “It is in the interest of the nation as a whole” - Politicians

– “Deviation from free trade reduces national welfare” - Economists

Discussion Questions

1. Do you think governments should consider human rights when granting preferential trading rights to countries?

2. Whose interests should be the paramount concern of government trade policy - the interests of producers or those of consumers?

References

1. Chapters 6, ‘International Business’ by

Charles W. Hill and Arun K. Jain, Tata McGraw

Hill publication.

2. Chapter 2, ‘International Business’ by Oded

Shenkar and Yadong Luo, Wiley publication.