International Economics

Ch#8 The Instruments of Trade Policy

Question#1:

Home's demand curve for wheat is

D = 100 - 20P.
Its supply curve is
5 = 20 + 20P.
Derive and graph Home's import demand schedule. What would the price of wheat be in the
absence of trade?

Answer:

Import demand is given by the equation MD(P) = S(P) − D(P) = 80 − 40P. The absence of trade is
the equivalent to import demand being zero, which happens at P = 2. The graph is seen below.

Figure : Trade Market for Wheat

Question#2:

Now add Foreign, which has a demand curve and a supply curve
D* = 80 - 20P,
S* = 40 + 20P.
a. Derive and graph Foreign's export supply curve and find the price of wheat that would
prevail in Foreign in the absence of trade.
b. Now allow Foreign and Home to trade with each other, at zero transportation cost.Find
and graph the equilibrium under free trade. What is the world price? What is the volume of
trade?

Answer:

a. Foreign’s export supply curve is given by: XS∗(P) = S∗(P)− D∗(P) = −40 + 40P. The
absence of trade is equivalent to export supply being zero, which occurs at P∗ = 1. The
graph is included in the above figure

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b. When they are allowed to trade, there is no distortion in prices so we have a common
world price of P w = P = P∗. In order to find equilibrium, we set import demand equal to
export supply giving:
MD(P) = XS∗(P∗) ⇒ 80 − 40P w = −40 + 40P w ⇒ P w = 1.5
At this world price we have MD(1.5) = XS∗(1.5) = 20.

Question#3:

Home imposes a specific tariff of 0.5 on wheat imports.

a. Determine and graph the effects of the tariff on the following: (1) the price of
wheat in each country; (2) the quantity of wheat supplied and demanded in each country; (3)
the volume of trade.
b. Determine the effect of the tariff on the welfare of each of the following groups:
(1) Home import-competing producers; (2) Home consumers; (3) the Home government.
c. Show graphically and calculate the terms of trade gain, the efficiency loss, and the total
effect on welfare of the tariff.

Answer:

a. The tariff causes a wedge to be placed between prices seen between the two countries,
so we now have P = P∗ + 5. Setting export supply equal to import demand, we get:
MD(P∗ + 5) = XS∗(P∗) ⇒ 80 − 40(P∗ + 0.5) = −40 + 40P∗ ⇒ P∗ = 1.25 ⇒ P = 1.75.
At these prices production in each country is given by the following:

Table 1: Quantity of Wheat Supplied and Demanded in Each Country.

Supply. Demand

Home (P = 1.75) 55. 65

Foreign (P∗ = 1.25) 65 55
The volume of trade is given by:
MD(1.75) = XS∗(1.25) = 10

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The effects on the trade market are given in the graph below

b. Home import-competing producers are better off because they have less foreign
competition, which means both price and quantity of good produced domestically
increases. Home consumers are worse off because they now have to pay a higher price.
The home government benefits in that they now have additional tariff revenue.

c.

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From this figure we can see the areas that were referred to in the answer to part (e). Producers
gain area a, consumers lose areas a, b, c, d, and the government receives tax revenue c and e.
We can calculate the areas with some simple geometry. Recall, before the tariff, total trade was
20 bushels of wheat, but now it is 10. Also, notice the height of both triangles b and d is 0.25.
Therefore, we have:
b + d =1/2* (20 − 10) × 0.25 = 1.25
e = 10 × 0.25 = 2.5
⇒ e − b − d = 1.25.
Therefore, the overall welfare effect is positive. These numbers also tell us the efficiency loss
and the terms of trade gain. Efficiency loss is defined as the loss caused by the tariff in the
market, or triangles b + d = 1.25. The terms of trade gain is defined as the additional gain
created by the distortion on the market, or rectangle e = 2.5.

Question#4:

Suppose that Foreign had been a much larger country, with domestic demand D* =
800 - 200P, 5* = 400 + 200P. (Notice that this implies that the Foreign price of wheat in the
absence of trade would have been the same as in problem 2.) Recalculate the free trade
equilibrium and the effects of a 0.5 specific tariff by Home. Relate the difference in results to
the discussion of the "small country" case in the text.

Answer:

With the larger foreign country, export supply is given by:

XS∗(P) = −400 + 400P.

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Therefore the free trade equilibrium is given by:

MD(P w) = XS(P w) ⇒ 80 − 40P w = −400 + 400P w ⇒ P w ≈ 1.09.
Now, with a tariff of 5 imposed by home, the new equilibrium is given by:
MD(P∗ + 5) = XS(P∗) ⇒ 60 − 40P∗ = −400 + 400P∗ ⇒ P∗ ≈ 1.05 ⇒ P ≈ 1.55.
We can further recalculate the net welfare effects by focusing on the terms of trade gain minus
the efficiency loss, given below.
b + d =1/2× (1.55 − 1.09) × (36.4 − 18) = 4.232
e = (1.09 − 1.05) × (18) = 0.72
⇒ e − b − d = −3.512.
From the above calculations we see that there is now an overall welfare loss from imposing the
tariff.
This is because being a small country implies there is less effect on the world market. A small
country has less influence over the world and the terms of trade gains are smaller. Even further,
the home market will be most effected with higher prices, increasing the efficiency loss

Question#5:

The aircraft industry in Europe receives aid from several governments, aqcording to some
estimates equal to 20 percent of the purchase price of each aircraft. For example, an airplane
that sells for $50 million may have cost $60 million to produce, with the difference made up
by European governments. At the same time, approximately half the purchase price of a
"European" aircraft represents the cost of components purchased from other countries
(including the United States). If these estimates are correct, what is the effective rate of
protection received by European . aircraft producers?

Answer:

The concept of effective rate of protection usually applies to tariffs. However, I guess it could
also be applied to subsidies. In your example, the "effective" rate of protection provided by the
subsidies would be twice the "nominal" rate, i.e. 40% instead of 20%. This is because the
European value added is only half of the final sales price. European value added is the sales
price less the cost of components purchased outside Europe. The cost of these components
amount to 50% of the final sales price.

Question#6:

Return to the example of problem 2. Starting from free trade, assume that Foreign offers
exporters a subsidy of 0.5 per unit. Calculate the effects on the price in each country and on
welfare, both of individual groups and of the economy as a whole, in both countries.

Answer:

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An export subsidy lowers consumer surplus and raises producer surplus in the exporter market.
An export subsidy raises producer surplus in the export market and lowers it in the import
country market. National welfare falls when a large country implements an export subsidy.
National welfare in the importing country rises when a large exporting country implements an
export subsidy. An export subsidy of any size will reduce world production and consumption
efficiency and thus cause world welfare to fall.

Question#7:

The nation of Acirema is "small," unable to affect world prices. It imports peanuts at the price
of $10 per bag.

The demand curve is

D = 400 - 10P.
The supply curve is
S = 50 + 5P.
Determine the free trade equilibrium. Then calculate and graph the following effects of an
import quota that limits imports to 50 bags.
a. The increase in the domestic price
b. The quota rents
c. The consumption distortion loss
d. The production distortion loss

Answer:

MD = 400 – 10P – (50 + 5P) = 400 – 10P – 50 – 5P = 350 – 15P

At a price of $10 per bag of peanuts,

350 – 15 X 10 = 200.

Acirema imports 200 bags of peanuts. A quota limiting the import of peanuts to 50 bags has the
following effects:

a. The increase in the domestic price. Set MD = 50 to find the post-quota price: 350 – 15P
= 50. The price of peanuts rises to $20 per bag.
b. The quota rents. The quota rents are ($20 - $10) x 50 = $500.
c. The consumption distortion loss. The consumption distortion loss is 0.5 x 100 bags x $10
per bag = $500
d. The production distortion loss. The production distortion

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Ch#9 The Political Economy of Trade Policy

Q#1 "For a small country like the Philippines, a move to free trade would have huge
advantages. It would let consumers and producers make their choices based on the real costs
of goods, not artificial prices determined by government policy; it would allow escape from
the confines of a narrow domestic market; it would open new horizons for entrepreneurship;
and, most important, it would help to clean up domestic politics." Separate out and identify
the arguments for free trade in this statement.

Answer
The arguments for free trade in this quote include:
• Free trade allows consumers and producers to make decisions based upon the marginal cost
and benefits associated with a good when costs and prices are undistorted by government
policy.
• The Philippines is "small," so it will have little scope for influencing world prices and capturing
welfare gains through an improvement of its terms of trade.
• "Escaping the confines of a narrow domestic market" allows possible gains through
economies of scale in production.
• Free trade "opens new horizons for entrepreneurship."
• Special interests may dictate trade policy for their own ends rather than for the general

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welfare. Free trade policies may aid in halting corruption where these special interests exert
undue or disproportionate influence on public policy.

Q#2 Which of the following are potentially valid arguments for tariffs or export subsidies, and
which are not (explain your answers)?

a. "The more oil the United States imports, the higher the price of oil will go in the next world
shortage."

b. "The growing exports of off-season fruit from Chile, which now accounts for 80 percent of
the U.S. supply of such produce as winter grapes, are contributing to sharply falling prices of
these former luxury goods."
c. "U.S. farm exports don't just mean higher incomes for farmers-—they mean higher income
for everyone who sells goods and services to the U.S. farm sector."
d. "Semiconductors are the crude oil to technology; if we don't produce our own chips, the
flow of information that is crucial to every industry that uses microelectronics will be
impaired."
e. "The real price of timber has fallen 40 percent, and thousands of timber workers have been
forced to look for other jobs."

Answer

a. This is potentially a valid argument for a tariff, since it is based on an assumed ability of the
United States to affect world prices -- that is, it is a version of the optimal tariff argument. If the
United States is concerned about higher world prices in the future, it could use policies which
encourage the accumulation of oil inventories and minimize the potential for future adverse
shocks.

b. Sharply falling prices benefit U.S. consumers, and since these are off-season grapes and do
not compete with the supplies from U.S. producers, the domestic producers are not hurt. There
is no reason to keep a luxury good expensive.

c. The higher income of farmers due to export subsidies and the potentially higher income to
those who sell goods and services to the farmers comes at the expense of consumers and
taxpayers. Unless there is some domestic market failure, an export subsidy always produces
more costs than benefits. Indeed, if the goal of policy is to stimulate the demand for the
associated goods and services, policies should be targeted directly at these goals.
d. There may be external economies associated with the domestic production of
semiconductors. This is a potentially a valid argument. But the gains to producers of protecting
the semiconductor industry must as always be weighed against the higher costs to consumers
and other industries which pervasively use the chips. A welltargeted policy instrument would be

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a production subsidy. This has the advantage of directly dealing with the externalities
associated with domestic chip production.

e. Thousands of homebuyers as consumers (as well as workers who build the homes for which
the timber was bought) have benefited from the cheaper imported timber. If the goal of policy
is to soften the blow to timber workers, a more efficient policy would be direct payments to
timber workers in order to aid their relocation.

Q#3 A small country can import a good at a world price of 10 per unit. The domestic supply
curve of the good is

S = 50 + 5P

The demand curve is

.D= 400 - 10P

In addition, each unit of production yields a marginal social benefit of 10.

a. Calculate the total effect on welfare of a tariff of 5 per unit levied on imports.
b. Calculate the total effect of a production subsidy of 5 per unit.
c. Why does the production subsidy produce a greater gain in welfare than the tariff?
d. What would the optimal production subsidy be? Without tariffs, the country produces 100
units and consumes 300 units, thus importing 200 units.

Answer

Without tariffs, the country produces 100 units and consumes 300 units, thus importing 200
units.

a. A tariff of 5 per unit leads to production of 125 units and consumption of 250 units.The
increase in welfare is the increase due to higher production of 25 x 10 minus the losses
to consumer and producer surplus of (25 x 5)/2 and (50 x 5)/2, respectively, leading to a
net gain of 62.5.
b. A production subsidy of 5 leads to a new supply curve of S = 50 + 5 x(P+5).Consumption
stays at 300, production rises to 125, and the increase in welfare equals the benefits
from greater production minus the production distortion costs, 25 x 10 -(25 x 5)/2 =
187.5.
c. The production subsidy is a better targeted policy than the import tariff since it directly
affects the decisions which reflect a divergence between social and private costs while
leaving other decisions unaffected. The tariff has a double-edged function as both a
production subsidy and a consumption tax.

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b. The best policy is to have producers fully internalize the externality by providing a
subsidy of 10 per unit. The new supply curve will then be S = 50 + 5 x(P+10), production
will be 150 units, and the welfare gain from this policy will be 50 x 10 -(10 x 50)/2 =250.

Q#4. Suppose that demand and supply are exactly as described in problem 3 but there is no
marginal social benefit to production. However, for political reasons the government counts a
dollar's worth of gain to producers as being worth $2 of either consumer gain or government
revenue. Calculate the effects on the government's objective of a tariff of 5 per unit

Answer

The government's objective is to maximize consumers surplus plus its own revenue plus twice
the amount of producers surplus. A tariff of 5 per unit improves producers surplus by 562.5,
worsen consumers surplus by 1375, and leads to government revenue of 625. The tariff results
in an increase in the government's objective function of 375.

Q#5. "There is no point in the United States complaining about trade policies'in Japan
andEurope. Each country has a right to do whatever is in its own best interest. Instead of
complaining about foreign trade policies, the United States should let other countries go their
own way, and give up our own prejudices about free trade and follow suit."Discuss both the
economics and the political economy of this viewpoint.
Answer

The United States has a legitimate interest in the trade policies of other countries, just as other
countries have a legitimate interest in U.S. activities. The reason is that uncoordinated trade
policies are likely to be inferior to those based on negotiations. By negotiating with each other,
governments are better able both to resist pressure from domestic interest groups and to avoid
trade wars of the kind illustrated by the Prisoners' Dilemma example in the text.
Q#6. Which of the following actions would be legal under GATT, and which would not?
a. A U.S. tariff of 20 percent against any country that exports more than twice as much to the
United States as it imports in return.
b. A subsidy to U.S. wheat exports, aimed at recapturing some of the markets lost to the
European Union.
c. A U.S. tariff on Canadian lumber exports, not matched by equivalent reductions on other
tariffs.
d. A Canadian tax on lumber exports, agreed to at the demand of the United States to placate
U.S. lumber producers.
e. A program of subsidized research and development in areas related to hightechnology
goods such as electronics and semiconductors.

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f. Special government assistance for workers who lose their jobs because of import
competition.

Answer

a. While tariffs are legal, the United States is obliged to offer compensation for
anyunilateral tariff increase by reducing other tariffs to compensate the affected
exporting country.
b. Export subsidies on agricultural products are legal under GATT.
c. This is not legal under GATT because the United States is not offering compensating
reductions in other tariffs on Canadian goods. Interestingly, in the late 1980s, U.S.
efforts to protect the shakes and shingles industry were met with an outcry and
Canadian threats of a trade war. These protectionist efforts by the United States were
rescinded.
d. This is legal under GATT since the action is taken by Canada on its own exports.
e. This is legal under GATT since it does not involve any direct export subsidies.
f. This is legal under GATT and, in fact, may help increase the benefits from trade.
Q#7. As a result of political and economic liberalization in Eastern Europe, there has
been widespread speculation that Eastern European nations such as Poland and
Hungary may join the European Union. Discuss the potential economic costs of such
an expansion of the European Union, from the point of view of (1) Western Europe;(2)
Eastern Europe; and (3) other nations.
Answer
The potential economic costs associated with the entrance of Poland and Hungary
intoan expanded EU depend largely on whether their membership results in trade
creationor trade diversion. In particular, Poland and Hungary will gain if they engage in
new trade with Western Europe although they might lose if trade within the European
Union simply replaces trade which had been occurring with Eastern bloc
countries.Furthermore, both of these nations will face at least higher structural
unemployment during the transition period. Some of the negative effects on workers
might be lessened if labor mobility is permitted across borders. The Western nations
should also be concerned on the trade creation versus trade diversion aspects of the
entry of Poland and Hungary. For distributional and political reasons, they may be
concerned about whether the prices of their own products will be driven down by
competition or whether the entrants will simply bring to the Western markets an
expanded variety of products and scope for additional scale economies of production.
Workers in Western markets may be concerned that inflows of foreign labor drive down
wages, although, as we have observed in previous chapters, the nominal wage shifts
should be considered in light of changes in the prices of consumption goods. Countries

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outside of the EU, such as the United States and Japan, would express concern if the
supplies of products to the EU by Poland and Hungary substitute for goods previously
supplied by the United States and Japan. The large outsiders, however, could reap
substantial positive gains from having expanded access to the consumers of Poland and
Hungary.

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