SPECIAL ISSUES IN INTERNATIONAL ECONOMICS

The economics of trade policy

Preliminary version

Academic Year 2024/2025 Instructor: Anna M. FALZONI

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 Where we are

 In previous lectures we have tried to answer the question “Why do

countries trade?” by presenting the most important trade models

 The Family Tree of Trade Models

 Now we try to answer the question “What should a country’s trade

policy be?”

 Should a country use a tariff or an import quota to protect its domestic industry
against foreign competition?
 Who will benefit and who will lose from a tariff or an import quota?
 Will the benefits outweigh the costs?

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 Why is trade policy important?

• Examples of tensions in the international economy related to trade

policy issues:

 trade war US – China (US places tariffs on China exports; China does the same
on US exports ….. )
 NAFTA renegotiation (US, Mexico, and Canada signed agreement November
2018, not yet ratified by all three)
 Brexit (exit of the United Kingdom from the European Union…..)

• But also sanctions related to the Russia – Ukraine war

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 Tariffs

The following slides are a selection based on professor Deardorff’s slides, course “Economics 340 – International Economics”

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 What Are Tariffs?

• Tariffs are Taxes on imports

• Two main types
– Ad valorem: % of value
– Specific: $ per unit
• How are they implemented?
– At the border, by customs officers
– They determine
• What good it is
• What price to use for ad valorem tariffs

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 Who Uses Tariffs?

• Virtually all countries

• How big are tariffs?
– In US, average only 2-3% (before Trump)
– In European Union, average 2% in 2020
– In developing countries, much higher, often around
20%
– Some particular tariffs are still much higher
– And President Trump has put tariffs of
• 25% on steel
• 10% on aluminum

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 Effects of Tariffs
• Easy to see from supply and demand
(partial equilibrium approach)
• Consider a good whose price would be
above the world price without trade
• We will look at two cases:
– Small country: Too small for its behavior to
matter for the world price
– Large country: Large enough (in market for
this good) that its behavior may change world
price

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Large country

8
9
Sunflower oil prices

Sunflower oil prices

12
Effects of Tariffs: Small Country

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 Effects of Tariffs: Small Country
P S
Autarky price
= Pa

Free trade
price = world
price = PW

Q S0 QD0 Q
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Effects of Tariffs: Small Country
P S
Effect on Price
Pa

PW+t

PW

Q S0 QD0 Q
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Effects of Tariffs: Small Country
P S
Effects on
Pa Quantities

PW+t

PW

Q S0 Q S1 QD1 QD0 Q
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 Effects of Tariffs: Small Country

• Why the price increase?

– On imports
• Tariff is simply added to the price paid to foreign
exporters
– On domestically produced goods
• Buyers don’t pay the tariff
• But if price stayed below PW+t, demand for the
domestically produced good would be greater than
supply
• This shortage would drive up price

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 Effects of Tariffs: Small Country
• Thus: what happens due to a tariff:
– Domestic price rises
(by full amount of tariff)
– Domestic output rises P
(Employment also rises in this industry) S
– Domestic demand falls
– Imports (=D−S) fall
– Suppliers gain
– Demanders lose
– Gov’t gets tariff revenue
– World sells less to us D
(but it doesn’t lose,
because we’re too small for it Q
to notice) 18
 Effects of Tariffs: Small Country

• How much do we gain and lose?

• Use changes in “consumer surplus” and
“producer surplus”

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 Reminder:
Change in Consumer Surplus

When price changes, Gain from price

P decrease, or loss
Consumers from price increase
– Gain from price
decrease
– Lose from price
increase
• By amount equal to D
area to the left of the
demand curve
Q
while…

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 Reminder:
Change in Producer Surplus

Producers
P S
– Gain from price
increase
– Lose from price
decrease
Gain from price
• By amount equal
increase, or loss
to area to the left
of the supply curve from price decrease
Q

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 Effects of Tariffs: Small Country

• Apply these to the effects we found for a

tariff
• Also note that the government (and thus
the taxpayer) of the country gets benefit of
tariff revenue

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Effects of Tariffs: Small Country
P S Effects on
Welfare
Pa Suppliers gain
+a

PW+t
a c
b d
PW

Q S0 Q S1 QD1 QD0 Q
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Effects of Tariffs: Small Country
P S Effects on
Welfare
Pa Demanders lose
–(a+b+c+d)

PW+t
a c
b d
PW

Q S0 Q S1 QD1 QD0 Q
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Effects of Tariffs: Small Country
P S Effects on
Welfare
Pa Government gains
+c

PW+t
a c
b d
PW

Q S0 Q S1 QD1 QD0 Q
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Effects of Tariffs: Small Country
P S Effects on
Welfare
Pa Net for country
−(b+d)

PW+t
a c Country
b d loses
PW
from
tariff
D

Q S0 Q S1 QD1 QD0 Q
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 Effects of Tariffs: Small Country
Summary: • Suppliers gain +a
• Demanders lose −(a+b+c+d)
• Government gains +c
• Net effect on country
Loss = −(b+d)
P S

Pa

PW+t
a b c d
PW

Q S 0 QS 1 QD1 QD0 Q
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 Effects of Tariffs: Small Country

• Dead Weight Loss

• Why? P S
• Because demanders
and suppliers both
are misled by the tariff
to behave as if the PW+t
good’s value were PW
PW+t, when in fact the
country can buy or D
sell it for PW.
Q

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 Clicker Question
In the graph, initial price is PW and quantities are
S0 and D0. A tariff t is then applied to imports.
For which demand curve is P
S
the dead-weight loss the
largest?
a) DA
b) DB PW+t

✓ c) DC PW
DC
DB
DA
S0 D0 Q
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 Clicker Question
Same graph.

For which demand curve is P

S
the loss to consumers the
largest?
✓ a) DA
b) DB PW+t

c) DC PW
DC
DB
DA
S0 D0 Q
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 Clicker Question
Same graph
How is this possible? If the
country loses more with DA P S
(dead-weight loss) but
consumers lose less, who
loses more?
a) Suppliers PW+t
Gains
✓ b) Government less, PW
DC
c) Foreigners actually
DB
DA
d) Other industries
S0 D0 Q
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 Effects of Tariffs: Large Country

• If the country is not small, but large, then

– when it reduces its imports of the good from
the world market
World Market
– the world price will fall. PW
SW
• Why?
PW0
– Because, with less
PW1
import demand by
large country, world DW0
demand shifts left. DW1 Q
W
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 Effects of Tariffs: Large Country

• Results due to tariff and fall in world price:

– Domestic price rises, but by less than the tariff
– Thus, compared to the same tariff in a small
country
• Output (and employment) rises by less
– Thus the benefit to suppliers is smaller
• Demand falls by less
– Thus the harm to demanders is smaller
• Imports fall by less
• Tariff revenue is larger (since imports fall less)
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Effects of Tariffs: Large Country
P S

PW0+t
PW1+t

PW0
PW1

Q S0 Q S1 QD1 QD0 Q
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Effects of Tariffs: Large Country
P S Effects of tariff
on Welfare
Suppliers gain
+a’
PW0+t
PW1+t
a’ c’
b’ d’
PW0 e’
PW1

Q S0 Q S1 QD1 QD0 Q
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Effects of Tariffs: Large Country
P S Effects of tariff
on Welfare
Demanders lose
–(a’+b’+c’+d’)
PW0+t
PW1+t
a’ c’
b’ d’
PW0 e’
PW1

Q S0 Q S1 QD1 QD0 Q
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Effects of Tariffs: Large Country
P S Effects of tariff
on Welfare
Government gains
+(c’+e’)
PW0+t
PW1+t
a’ c’
b’ d’
PW0 e’
PW1

Q S0 Q S1 QD1 QD0 Q
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Effects of Tariffs: Large Country
P S Effects of tariff
on Welfare
Net for country
+e’−(b’+d’)
PW0+t
PW1+t
a’ c’ Country
b’ d’
PW0 gains
e’
PW1 from tariff
if
D e’>(b’+d’)

Q S0 Q S1 QD1 QD0 Q
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 Effects of Tariffs: Large Country
Summary: • Suppliers gain +a’
• Demanders lose −(a’+b’+c’+d’)
• Government gains +(c’+e’)
• Net effect on country
P S Gain or Loss = +e’−(b’+d’)

a’ b’ c’ d’
e’
D
Q

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 Effects of Tariffs: Large Country

• This possibility of gain from a tariff goes

under several names:
– The “terms of trade” effect of a tariff
– The “monopoly” effect of a tariff
– The “optimal tariff”

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 Effects of Tariffs: Large Country

• The “Terms of Trade” Effect Pexports

– Definition:
TOT 
Pimports
A country’s “Terms of Trade” is
defined as the price of its exports
relative to its imports

– If TOT rises, the “terms of trade improves”

• because the country gets more imports in return for its
exports
– A tariff by a large country drives down the world price
of its imports
• and thus improves its terms of trade
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 Effects of Tariffs: Large Country

• The “monopoly” effect

- A monopoly firm increases its profit by
• Selling less to the market, and hence
• Raising the price that it gets
– A large country can increase its welfare by
• Buying less from the market (via a tariff), and
hence
• Lowering the price that it pays
– Note: Large country could also gain by
restricting exports, as OPEC has done with oil
(Not in recent years, but it
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keeps trying)
 Effects of Tariffs: Large Country

• The “optimal tariff” Example of a too large

– If a large country tariff:
uses a tariff that is P S

too large, it must

lose.
– Thus there is some
t
level of tariff that is
optimal D

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 Addenda on Tariffs
• Two more things:
1. The model we are using makes several
assumptions:
• Perfect competition:
– All buyers and sellers are too small, individually, to affect price
(even if the country is large). Answers could be different
otherwise
• Partial equilibrium
– Market is small part of large economy, so that effects on other
markets can be ignored
• Homogeneous products
– The imported good is a perfect substitute for domestically
produced good
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 Addenda on Tariffs

2. The large-country tariff

• Harms the other country (or rest of world)
• Lowers world welfare. Thus the rest-of-world loses
more than the tariff-levying country gains.
• The other country may retaliate with its own tariff.
Then both lose.

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Nontariff Barriers
 What Are NTBs?
• What Are They?
– Any institutional or policy arrangement that
interferes with trade, other than tariffs
– Term NTB is also used more broadly to
include policies that artificially expand trade
• e.g., Export subsidy
– Sometimes called “Nontariff Measures”
(NTMs)
• Main Types of NTB
– See outline above
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 Nontariff Barriers
Main Types of NTB

• Quotas
– Effects Equivalent to Tariffs
– Who Gets the Rents

• Other NTBs
– Tariff-Rate Quotas
– Voluntary Export Restraints (VERs)
– Government Procurement Regulations
– Customs Procedures
– Standards
– ……………..
• Subsidies

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 Quotas
• Definition: An import quota is a direct
restriction on the quantity of an import
– E.g., US might limit the imports of steel to
some number of tons per year
– Until Jan 1, 2005, US and EU had elaborate
import quotas on many textile and apparel
products from developing countries
– We still have quotas on many agricultural
products, e.g., sugar, cheddar cheese, dried
milk, etc
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 Quotas
• Effects of a quota
– If permitted quantity is above what would be
imported anyway, then no effect at all. (True
only with perfect competition)
– Otherwise, quota creates scarcity and raises
price
– Quota raises domestic price above world
price
• For market to clear, domestic price must rise to the
point that desired imports equal the quota
• See this with supply and demand
• But first note example of US quota on sugar..
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• Note that US price stayed mostly above the world price,
and was more stable
• But when world price spiked, then US price was
– just equal to the world price,
– not above as it would have been with a tariff
[Link]
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Effects of a Quota: Small Country
P S
Suppose quota
limits imports to
Pa this amount

Quota

PW

Q S0 QD0 Q
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Effects of a Quota: Small Country
P S
Suppose quota
limits imports to
Pa this amount

Quota
which is less than
initial imports
PW

D
Quota
Q S0 QD0 Q
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Effects of a Quota: Small Country
P S
Then price
must rise until
Pa D-S=Quota

PW

D
Quota
Q S0 QD0 Q
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Effects of a Quota: Small Country
P S
Thus price is…

Pa

PQ
Quota
PW

Q S0 QD0 Q
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Effects of a Quota: Small Country
P S
…and
quantities are
Pa

PQ

PW

Quota D

Q S0 Q S1 QD1 QD0 Q
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Effects of a Quota: Small Country
P S Effects on
Welfare
Pa Same as tariff,
except c

PQ
a c
b d
PW

Quota D

Q S0 Q S1 QD1 QD0 Q
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 Effects of a Quota: Small Country
P S
• Results
– Suppliers gain area +a PQ
a c
– Demanders lose area P b d
−(a+b+c+d) W

– Somebody gets area c, D

Q
but who?
• Area c is called “quota rents”
– It is the profit from buying at world price, PW,
and selling at higher domestic price, PQ
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 Effects of a Quota: Small Country
• Who gets quota rents?
• Depends on how quota is administered:
– First-come, first-served: Rents go to whoever gets
there before quota is exhausted
– Sell (or “auction”) import licenses: Rents go to
government as revenue from sale of licenses
– Give away import licenses to domestic people or
firms: those people or firms then get the rents
– Give away licenses to foreign firms or governments:
foreigners get the rents
• Most common is the last: Give away to
foreigners in proportion to their historical exports

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 Voluntary Export Restraint
• A voluntary export restraint works like an
import quota, except that the quota is imposed
by the exporting country rather than the
importing country.
• However, these restraints are usually requested
by the importing country.
• The profits or rents from this policy are earned
by foreign governments or foreign producers.
– Foreigners sell a restricted quantity at an increased
price.
 Effects of a Quota: Rent Seeking
• “Rent Seeking”
– Defined as the use of resources in effort to
get rents
– Examples
• Faster (thus more costly) transport to win race to
border for 1st-come-1st-served quota
• Lobbying legislators to get quota allocations
• Inefficient production intended to get quota
allocations based on market shares

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 Effects of a Quota
• Effects of quota compared to tariff
– Effects on price and quantity at a given time are the
same
• Hence “tariff equivalent”
– Effect on welfare is different if quota rents are lost to
rent seeking and/or accrue to foreigners:
• In that case, importing country loses more from quota than
from equivalent tariff
• What if country is large?
– Picture is also same as for tariff
– But if quota rent is lost or goes to foreigners,
importing country cannot gain
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 Effects of Quota: Large Country
(if Rent given to foreigners)
Summary: Domestic Country:
• Suppliers gain +a’
• Demanders lose −(a’+b’+c’+d’)
• Net effect on country = −(b’+c’+d’)
P S Foreign Country:
• License holders gain +(c’+e’)
• (Suppliers/Demanders also lose)

a’ b’ c’ d’
e’
D
Q

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 Effects of a Quota
• Other effects of a quota, not in model
– Quality upgrading
• Limited to a fixed quantity, foreign exporters seek
higher value by improving quality and charging
higher price
– Like a tariff, quota may induce foreign firms to
produce here
– Unlike a tariff, the quota becomes more
restrictive if foreign supply increases or world
price drops
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Effects of a Fall in World Price
P S

Pa

PQ
PT′
PW
PW′
Quota D

Q S0 Q S1 QD1 QD0 Q
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 Effects of a Fall in World Price
• Many things do not change:
– Domestic price
– Domestic quantity supplied
– Domestic quantity demanded
– Quantity of imports (fixed by quota)
• What does change?
– Tariff equivalent increases
– Rents from quota increase

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 Effects of a Rise in World Price
• If the rise is small, this is just the reverse of what
happened with a fall in world price
• But if the rise in world price is large enough, then
– The quota ceases to be binding
– Tariff equivalent of quota becomes, and stays, zero
– Domestic price becomes
• Equal to world price, and
• Rises with it
• This last is what we saw in the graph of the
price of sugar
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[Link]
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Effects of a Rise in World Price
P S

Pa

PQ’= PW′
PQ

PW

Quota D

Q S0 Q S1 QD1 QD0 Q
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 Subsidies
• Government assistance to producers
– Export subsidy: paid only for exports
– Domestic subsidy: paid for all production (but
still increases exports or reduces imports)
• Effect on the subsidizing country
– In competitive industries, country loses
– Subsidies usually are intended to benefit
producers, not country
– In non-competitive industries, result may be
different (Boeing-Airbus example)
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 Effects of a Subsidy
on Foreign Countries
• Effect, if
subsidizing country
World Market
is large, is to PW
reduce the world SW0
price of the
0 SW1
exported good PW
• Subsidy expands PW1
supply in
subsidizing country DW
(which is part of QW
SW0)
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 Effects of a Subsidy
on Foreign Countries
• Effects on other countries depend
direction of their trade:
– If they import the good, they gain
– If they export the good, they lose

See this in the following figures…

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 Effects of Export Subsidy:
on Foreign Importer
P S Effects on
Welfare
Suppliers lose
Demanders gain
Country gains
PW0 +(b+c+d)
a c
b d
PW1

Q S1 Q S0 QD0 QD1 Q
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 Effects of Export Subsidy:
on Foreign Exporter
P Effects on
S Welfare
Suppliers lose
PW0 Demanders gain
a c Country loses −c
PW1 b d

Q S0 Q S1 QD1 QD0 Q
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 Effects of a Subsidy
on Foreign Countries
• In both cases
– Foreign suppliers lose
– Foreign demanders gain
– Net effect on countries depends on
• Whether they are net importers or exporters
• Thus whether price change is improvement or worsening of
their terms of trade
• Optimal policy response for foreign countries
– Importers: Write “thank-you note” (Krugman)
– Exporters: Not much they can do

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 Subsidies: Are They Used?
• YES!!
• US, EU, Japan all have large subsidies on many
agricultural products
• These reduce world prices and hurt producers of
these products in developing countries
• Examples of US subsidies and whom they hurt:
– Corn: Mexico
– Sugar: Caribbean countries
– Cotton: Certain African countries

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