International Economics I
(Econ 2081)
Chapter Three
International Trade and
Commercial Policy
Habtemariam
A. 1
Empirically there is no nation
that follows free trade.
This chapter deals with:
◦ Cases for and against free trade
◦ Tariffs and non-tariff barriers
◦ Argument for protection
◦ Trade policy and economic welfare
◦ Optimal trade policy intervention
◦ Trade liberalization and issues of
openness
◦ Import substitution versus export
promotion
Habtemariam A. 2
3.1. Free Trade: Cases For and Against
3.1.1. The cases for free trade
Question: What is free trade?
Free trade refers to a situation where a
government does not attempt to influence
through quotas or duties what its citizens
can buy from another country or what they
can produce and sell to another country.
In the reality it is rare to find a country
which is approaching completely free trade.
Theoretical models suggest that free trade
will avoid the efficiency losses associated
with protection.
Habtemariam A. 3
Question: Why is it beneficial for countries to engage in
free trade?
The theories of Smith, Ricardo and Heckscher-Ohlin
show why it is beneficial for a country to engage in
international trade even for products it is able to
produce for itself
International trade allows a country to specialize in the
manufacture and export of products that can be
produced most efficiently in that country, and import
products that can be produced more efficiently in other
countries
The arguments for free trade include:
◦ Efficiency in production and consumption
◦ Economies of scale advantage
◦ Offers more opportunities for learning and
innovation.
◦ Higher productivity
◦ Avoid costs of rent-seeking
◦ Protection benefits special-interest politics
Habtemariam A. 4
3.1.2. The cases against free
trade
Policies are being undertaken in
the interest of the nation as a
whole.
◦ Activist trade policies increase the
welfare of the nation as a whole.
Arguments to justify the need of
trade policies include:
◦ Terms of trade benefit
◦ Domestic market failures
Habtemariam A. 5
3.2. Tariff and Non - Tariff
Barriers
3.2.1. Tariff
Types and Measurements of Tariffs
It is a tax or duty levied on the
traded commodity as it crosses a
national boundary.
◦ Export tariff
◦ Import tariff
Tariff can be imposed in three forms:
◦ A specific tariff
◦ The ad valorem tariff
◦ A compound tariff
Habtemariam A. 6
◦ Specific tariffs
Taxes that are levied as a fixed
charge for each unit of goods
imported
Example: A specific tariff of $10 on
each imported bicycle with an
international price of $100 means
that customs officials collect the
fixed sum of $10.
◦ Ad valorem tariffs
Taxes that are levied as a fraction of
the value of the imported goods
Example: A 20% ad valorem tariff
Habtemariam A. 7
◦ A compound duty (tariff) is a
combination of an ad valorem
and a specific tariff.
◦ Modern governments usually
prefer to protect domestic
industries through a variety of
nontariff barriers, such as:
Import quotas
Limit the quantity of imports
Export restraints
Limit the quantity of exports
Habtemariam A. 8
Measurement of Tariffs
Unweighted-average tariff rate
◦ a simple average of the tariff.
Weighted-average tariff rate:
◦ each good’s tariff rate is weighted by the
importance of the good.
prohibitive tariff
Nominal and the effective tariff
rate
Nominal tariff rate
◦ Simply the rate listed in a country’s
tariff schedule.
Habtemariam A. 9
Effectivetariff rate (effective rate of
protection (ERP))
◦ Percentage change in the value added in an
industry because of the imposition of a tariff
structure.
◦ Indicator of the actual level of protection
◦ A more common formula for calculating the
𝑡𝑗 −σ𝑖 𝑎𝑖𝑗𝑡𝑖
ERP for any industry j using inputs selected as i
𝐸𝑅𝑃 =
𝑗
1− σ𝑖 𝑎𝑖𝑗
is:
Where = free trade value of input i as a
percentage of the free trade value of the
final good j.
tj and ti = tariff rates on the final good
and on any input i, respectively
Habtemariam A. 1
Escalated tariff structure
Nominal tariff rates on imports of
manufactured goods are higher
than nominal tariff rates on
intermediate inputs and raw
materials.
Rising rates that give greater
protection to intermediate and
finished products than to primary
commodities is called tariff
escalation.
Habtemariam A. 1
3.2.2. Non-Tariff Trade Barriers
(NTBs)
Import Quota
◦ a certain physical amount of the good
is allowed.
Subsidies
◦ Providing domestic firms a cost
advantage
◦ domestic subsidy
◦ export subsidy
Voluntary Export Restraints
◦ A quota on trade imposed from the
exporting country's side instead
Habtemariam A. of the
12
Voluntary Export Restraints
◦ A voluntary export restraint
(VER) is an export quota
administered by the exporting
country.
It is also known as a voluntary
restraint agreement (VRA).
◦ VERs are imposed at the request of
the importer and are agreed to by
the exporter to forestall other trade
restrictions.
Habtemariam A. 13
Local Content Requirements
◦ a regulation that requires that some
specified fraction of a final good be
produced domestically.
Government Procurement Provision
◦ Governments often extend preferences
to domestic suppliers in the form of buy-
national policies.
Dumping & Anti-dumping strategies
◦A form of international price
discrimination
◦ It occurs when foreign buyers are
charged lower prices than domestic
buyers for an identical product.
Habtemariam A. 14
Forms of dumping
Sporadicdumping (distress
dumping)
◦ Occurs when a firm disposes of excess
inventories on foreign markets.
Predatory dumping
◦ Occurs when a producer temporarily
reduces the prices charged abroad to
drive foreign competitors out of
business.
Persistent dumping
◦ Effort to maximize economic profits
Note: Anti dumping regulations
Habtemariam A. 15
3.3. Arguments for
Protection
The reasons or the argument as to
why protection should be imposed.
◦ The Infant Industry Argument
◦ The terms-of-Trade argument
◦ Tariff to Reduce Aggregate
Unemployment
◦ Tariff to Offset Foreign Dumping and
Subsidy
◦ National Defense Argument for a Tariff
◦ Tariff to Improve the Balance of Trade
Habtemariam A. 16
3.4. Trade Policy and Economic
Welfare
Can be conducted in two ways:
◦ The general equilibrium analysis
◦ The partial equilibrium analysis
Consumer surplus
Producer surplus
3.4.1. Welfare Effects of Tariff
Case 1: Small country case
◦ A price taker facing a constant world
price
Habtemariam A. 17
Illustration
Price
H SD Good Y
g
E
9,500
e f
G
9,000 SDWT
a b c d F
8,000 SDW
DD
20 40 50 60 80
Quantity
Habtemariam A. 18
Effects of tariff impositions
The revenue effect
◦Revenue collected by the
government from the imposition
of tax on imports. Area c.
The redistribution effect
◦Part of consumer surplus that is
transferred to the domestic
producers. Area a, taken from
consumers and transferred to
producers.
Habtemariam A. 19
The protective effect
◦ The loss to the domestic economy because of
inefficiency in production. Area b
The consumption effect
◦ The loss by the consumers due to inefficiency
in consumption. Area d.
Dead weight loss (area b + d)
Imposition of tariff by a small nation
results in overall loss of welfare equal to:
area (b + d). This is because it can not
influence the term of trade (tot).
Habtemariam A. 20
Case 2: Large country case
Importing nation that is large
enough to influence the world
price of the product. S D
Price ($)
E SDWT
9600
SDW
8800
G
a b C d
8000 F
e
7800
DD
30 50 70 90 110 Quantity
Habtemariam A. 21
If importing country imposes
a tariff on imports, price of
import commodity will
increase. This results in a
decrease in quantity
demanded.
This will force the exporter to
reduce its price, not to lose
its customers in the
importing country.
Habtemariam A. 22
Thus, the tariff incidence is
shared between consumers and
exporting firms.
The welfare of the large
importing country rises when the
country shifts some of the tariff
to exporter firms via export price
reduction.
Thus, the term of trade improves
for the importing country at the
expense of exporter country.
Habtemariam A. 23
Area ‘a’ represents the
redistributive effect. It is
transferred from domestic
consumers to domestic producers.
Area ‘ b+d’ is dead weight loss,
the deterioration of national
welfare, because of reduction in
consumption and an ineffecient
use of resources.
Area ‘c+e’ –shows tariff revenue
effect.
Habtemariam A. 24
Thus, the revenue effect of an
import tariff in the large nation
case includes two components.
That is, area ‘c’ that is shifted from
domestic consumers to the tariff
levying government.
Area ‘e’, the tariff revenue
extracted from foreign producers in
the form of a lower supply price.
Area ‘e’ is called the term of trade
effect.
Habtemariam A. 25
The welfare effects of tariff are
thus :
◦If e > (b + d), national welfare
is increased
◦If e < (b + d), national welfare
is diminished
◦If e = (b + d), national welfare
remains constant.
Habtemariam A. 26
3.4.2. Welfare Effect of Non-
Tariff Barriers
Quota
Price
H SD
g
E
9,500
e f
G
9,000 SDWQ
a b c d F
8,000 SDW
DD
20 40 50 60 80
Quantity
Habtemariam A. 27
Quota has an equivalent tariff
that produces the same market
result, just as every tariff has an
equivalent quota.
While the market effect of tariffs
and quotas are identical, the
welfare implications are not.
◦ The government revenue effect is
not the same.
◦ Economic quota rent, which may
accrue to the domestic
importer/retailer, the foreign
supplier, or the government
Habtemariam A.
or may 28
The change in producer surplus,
consumer surplus, and the dead weight
loss are the same with the case of tariff.
In the case of tariff, area ‘c’ represents
government revenue; no such tax is
collected under a quota.
The difference between the international
price and the domestic price of imported
good is an economic rent, which may
accrue to the domestic importer/retailer,
the foreign supplier, or government or
may be distributed among the three.
Habtemariam A. 29
Domestic importers/retailers will
receive the rent if foreign
suppliers do not recognize to
raise the export price or if
government does not sill import
licenses.
Foreign suppliers receive the rent
if they behave in monopolistic
manner.
Government may benefit if it sells
licenses.
Habtemariam A. 30
Subsidy to an import competing
industry
Price S
S’
S a b d
PW
Q1 Q2 Q3 Q4
Quantity
Habtemariam A. 31
Subsidy to an import competing
industry
If a unit subsidy of s amount
is given, supply shifts from s
to s’.
Because the price of the
product remains unchanged
at Pw, the loss to consumers’
surplus does not occur.
The amount of subsidy is
area a+b.
Habtemariam A. 32
Area ‘a’ is a pure transfer
from taxpayer to producers.
Area ‘b’ is dead weight loss.
Since the subsidy does not
reduce consumption, there is
no a dead weight loss of area
d.
Thus, production subsidy is
preferred to a tariff on
welfare [Link] A. 33
Export subsidies
Price S
PD PD = Pint + Sub
a b c d
Pint Pint
Q1 Q2 Q3 Q4
Quantity
Habtemariam A. 34
Export subsidies
In a small country, the imposition of the
subsidy raises the price received by the
producer for exported units of the product,
which is equal to international price plus
subsidy.
As a result:
Export subsidy reduces the quantity sold in
the domestic market.
Increase the price in the domestic market
Increases the quantity supplied by producers
as they respond to the higher price.
The total dead weight loss due to export
subsidy is area b+d.
Habtemariam A. 35
3.5. Optimal Trade Policy
Intervention
Large nation can improve its terms
of trade by imposing a tariff on
imports.
A nation thus optimizes its economic
welfare by imposing a tariff rate at
which the positive difference
between the gain of improving terms
of trade and the loss of declining
import volume is maximized.
◦ Small tariff small terms of trade gain
and small dead weight loss net gain.
◦ High tariff large terms of trade gain
and large dead weight Habtemariam
loss netA. loss. 36
Illustration
Welfare
Free Trade
Autarky
O
Optimum Prohibitive Tariff
Tariff Tariff
Habtemariam A. 37
3.6. Trade Liberalization and
Issues of Openness
Trade liberalization, loosely defined as a
move towards freer trade through the
reduction of tariff and other barriers.
It is a major move towards Globalization.
Critics of trade liberalization have blamed
it for a host of ills such as:
◦ rising unemployment and wage inequality in
DCs,
◦ increased exploitation of workers in LDCs
◦ the de-industrialization and marginalization of
low-income countries,
◦ increasing poverty and global inequality, and
◦ degradation of the environment.
Habtemariam A. 38
A basic proposition in international
trade theory states that free trade
is superior to protection because it
allows a country to fully exploit its
comparative advantage.
◦ improved allocation of resources and
consequent gains in productive
efficiency and economic growth.
Two major extensions of this
standard proposition,
◦ Heckscher-Ohlin model and
◦ Stolper-Samuelson theorem
Habtemariam A. 39
The Heckscher-Ohlin model says that it is
determined by a country’s relative factor
endowment.
The Stolper-Samuelson theorem states that
free trade will increase the demand for
unskilled labour in the labour-abundant
countries and also raise wages once any
labour surplus is eliminated. Conversely, the
demand for skilled labour will rise in the
capital- (and by extension skill- ) intensive
countries. The demand for, and wages of,
unskilled labour will, at the same time, fall.
Habtemariam A. 40
The free trade position is one
where incentives are neutral
between exports and imports.
◦ Trade liberalization could thus be
achieved either by the reduction of
tariffs or of any anti-export bias
through other means.
◦ Another element of trade
liberalization is the replacement of
an instrument of trade control by
another that is less distorting of the
incentive structure.
Habtemariam A. 41
Ways in which the extent of trade
liberalization can be measured:
◦ Reduction in tariffs or the removal of
quantitative restrictions.
◦ Changes in relative prices
◦ Multiple criteria (1+2)
There has been considerable
liberalization of trade in the post
Second World War era.
Habtemariam A. 42
Factors behind this widespread trade
liberalization:
◦ Failure of the import-substitution policies
◦ Debt crisis of the early 1980s
stabilization and structural adjustment
programmes.
◦ Developments in the multilateral trading
system.
Empirically, the static welfare losses
involved by trade protection vary
considerably.
Perhaps more importantly, trade
openness is statistically associated
with higher growth Habtemariam A. 43
Openness to Trade
Openness to trade has been a
central element of successful
growth strategies.
However, the empirical
relationship between trade
openness and economic growth is
not yet resolved.
Trade openness is the value of
total trade (imports plus exports)
as a percentage of GDP.
Habtemariam A. 44
The trade dependence index (also often called
the openness index) is a measure of the
importance of international trade in the overall
economy.
A high index value is often interpreted as
indicating a more open economy although the
index is biased by other factors, including
economic size.
Openness of an economy is determined by a
large number of factors:
◦ trade restrictions like tariffs, nontariff
barriers,
◦ foreign exchange regimes,
◦ non-trade policies and
◦ the structure of national economies
◦ It is possible that an open and liberalized
Habtemariam A. 45
3.7. Import Substitution versus
Export Promotion
A traditional way to approach the
complex issues of appropriate
trade policies for development is
to set these specific policies in
the context of a broader strategy
of looking outward or looking
inward.
Habtemariam A. 46
In the words of Paul Streeten,
Outward-looking development policies
◦ “encourage not only free trade but also the
free movement of capital, workers,
enterprises and students . . . , the
multinational enterprise, and an open system
of communications.”
Inward-looking development policies
◦ Greater self reliance can be accomplished
only if “you restrict trade, the movement of
people, and communications and if you keep
out the multinational enterprise, with its
wrong products and wrong want-stimulation
and hence its wrong technology.”
Habtemariam A. 47
A lively debate regarding these two
philosophical approaches has been
carried on in the development
literature since the 1950s.
The distinction between these two
traditional trade-related
development strategies.
◦ Import substitution (IS)
Initially production of previously
imported simple consumer goods.
Second domestic production for a
wider range of more sophisticated
manufactured items.
Habtemariam A. 48
Import-Substituting
Industrialization
Import-substituting
industrialization was a trade
policy adopted by many low- and
middle-income countries before
the 1980s.
Thepolicy aimed to encourage
domestic industries by limiting
competing imports.
Habtemariam A. 49
The principal justification of this policy was/is
the infant industry argument:
◦ Countries may have a potential
comparative advantage in some industries,
but these industries cannot initially
compete with well-established industries in
other countries.
◦ To allow these industries to establish
themselves, governments should
temporarily support them until they have
grown strong enough to compete
internationally.
Habtemariam A. 50
Problems with the
Infant Industry Argument
1. It may be wasteful to support
industries now that will have a
comparative advantage in the future.
2. With protection, infant industries may
never “grow up” or become
competitive.
3. There is no justification for
government intervention unless there
is a market failure that prevents the
private sector from investing in the
infant industry. Habtemariam A. 51
Problems with the
Export promotion argument
Export promotion: looking outward free trade
and competition.
◦ Export promotion (EP)
Advocates the efficiency and growth benefits
of free trade and competition.
◦ Primary-commodity export expansion, limited
demand
Low income elasticities
Low population growth rates in developed
economies
Decline in prices of primary goods, implies
low revenue (some periods of price spikes,
including recent years, but very long-run
trend has been downward) Habtemariam A. 52
Lack of success with international
commodity agreements
Development of synthetic
substitutes
Agricultural subsidies in developed
nations.
In practice, the distinction
between IS and EP strategies is
much less pronounced than many
advocates would imply.
◦ Most developing economies have
employed both strategies
Habtemariam A. 53
-----End of Chapter Three-----
Habtemariam A. 54