Chapter 9:The Instruments of Trade Policy

Basic Tariff Analysis

What is a Tariff?
Tariff is a tax levied when a good is imported.
Specific tariffs are levied as a fixed charge for each unit of goods imported(for ex. $
3 per barrel of oil).

Ad valorem Tariffs are taxes that are levied as a fraction of the value of the
imported goods (for ex. a 25% US tariff on imported trucks). Until the introduction
of income tax, U.S. government raised most of the revenue from tariffs.
Two purposes:
1) oldest form of trade policy and have traditionally been used as a source of govt.
revenue.
2)To protect particular domestic sectors.
United kingdom(the famous Corn Laws) to protect agriculture from import
competition.
Germany & USA (19th century) protected their industrial sectors by imposing tariffs
on manufacturing sectors.
 General Equilibrium Framework

Assume: 2 countries, Home and Foreign

Supply, Demand, Trade in a single country
• s
Import Demand
p
Curve (home)
p

pe Pe
Import demand curve
p2 p2

p1 p1

d MD

Q Q
 Foreign Export Supply curve

XS
p S
p
Export supply
curve
p2
p1

pe

Q Q
 World Equilibrium

• World equilibrium occurs when home import demand equals

foreign export supply
P XS

Pw

MD

Q
Qw
 A Tariff in a Small Economy
• When a country is small, a tariff it imposes cannot lower the
foreign price of the good it imports. As a result, the price of
the import rises from pw to pw+t, the quantity of imports
demanded falls from D1—S1 to D2—S2.

S
• a= domestic producer’s gain
• b=producer’s in efficiencloss
• Pw+t
105 c=govt. revenue
t a b c
• pw d d= consumer’s efficiency loss
100

• D b+d= net welfare loss

•

S1 S2 D2 D1
 Demand Schedule
• Consumer’s Surplus

• At P2 price CS= area a+b

• At P1 price CS= area a
a • Loss of consume’s surplus
P1w
+t
b
pw
2
 Supply Schedule
• Producer’s Surplus
S

p1
d
p2 c •
• At price p2 producer’s surplus= c
• At price p1 PS= area c+d
 Nominal and Effective Rate of Protection
The nominal rate of protection is the percentage tariff
imposed on imported good.

The effective rate of protection(ERP) is a measure of the

total effect of the entire structure on the value added per
unit of output in each industry, when both intermediate &
final goods are imported.

In other words, ERP means, the percentage change in

value added in each industry due to tariff protection.
ERP= (VT—Vw) / Vw where Vw : value added in the
sector at word prices
VT: value added in the
presence of trade policy(tariff)
• Tariffs may have different effects on diff. stages of
production of a good.

For ex : An automobile sells on the world market for

$8,000 (Pw) & parts out of which the automobile is made
sell for $ 6,000(Pw).

• Now compare two countries:

• One that wants to develop an auto assembly industry
• One that already has an assembly industry and wants to
develop a parts industry.

• To encourage a domestic auto industry, the first country

place a 25% tariff on imported autos, allowing domestic
assemblers to charge $ 10,000 instead of $8,000. What is
the ERP? Find out.
 Calculation of ERP
• First Country ERP on Auto industry (assembling) is 100% although NRP is
25%
25% tariff on $8000 means—$2000
– So Pw is $10000 (with tariff)
• VT (value added after tariff ) is ($10000—$6000)=$4000
• Vw (value added before tariff) is ($8000—$6000)=$2000
• (VT—Vw) / Vw $4000—$2000=$2000
(2000/2000)x100=100% ERP
Now, Second Country , to encourage domestic production of parts, imposes
a 10% tariff on imported parts.
• Cost of parts of domestic assemblers will rise from $6000 to $6600(10%
tariff).
• makes it less advantageous to assemble domestically.
• Find out the ERP
• Value added Before Tariff of assembled auto is 8000—
6000= 2000
• Value added after tariff on parts 8000—6600=1400
1400—2000= -600
Therefore,
ERP = (-600/ 2000)=-30%
• So, Positive protection t o parts manufacturers provides
negative effective protection to assembling auto
manufacturers at the rate of - 30%.
 Export Policy

• Export Subsidy: is a government policy to encourage

exports of goods and discourage sale of goods on the
domestic market through direct payments, low cost
loans, tax relief for exporters. Thus stimulates the
nation’s exports.

• Promoting exports has two goals:

• Hard currency earning means convertible currency that can be
used to import goods
• Encouraging firms and workers
 Downside
• Efficiency ---producing too much
• Effect on consumers-----paying higher domestic price
• Impact on domestic budget----tax payer has to pay
 Export Subsidy(small Economy)

• Impact on domestic economy

P
S

Pw+s
a b c d
Pw

Q1 Q2 Q3 Q4 Q
 Impact on Economy
• Producer Surplus increases= (a+b+c)
• Consumers Surplus decreases=(a+b)
• Cost of govt. subsidy (b+c+d). The tax payers have to pay
for that.
• [(a+b+c)]- [(a+b) + (b+c+d)]
• = a+b+c-a-b-b-c-d= -b-d
• =-(b+d)

• b and d represent consumption & production distortion

losses of the same kind that a tariff produces i.e,
• -(b+d) Deadweight Loss
 Europe’s Common Agricultural Policy(CAP)
• In 1957, six Western European nations –Germany,
France, Italy, Belgium, the Netherlands and Luxembourg
formed the European Economic Community. Now called
European Union. Overtime, more and more countries
decided to join. The union currently counts 27 EU
countries governing common economic, social, security
policies.

• Trade policy of EU—

• 1.The members of EU have removed all tariffs with
respect to each other. Thus creating customs union.
• 2.The Agricultural policy of EU has developed into a
massive export subsidy program.
• The EU’s Common Agricultural policy (CAP)began
not as an export subsidy but as an effort to
guarantee high prices to European farmers ----
• By having the EU buy agricultural products whenever the price
falls below the specified support levels.
• To prevent imports, it was backed by tariffs that offset the
difference between European and world agricultural prices.
• Since the 1970s, support price was set very high ---Europe was
producing more than the consumers were willing to buy.
• As a result, EU found itself obliged to buy & store quantities of
food. To avoid unlimited growth in these stockpiles, the EU
turned to a policy of subsidizing exports to dispose of surplus
production.
 EU’s export subsidy
abdc is cost of government subsidy
a S
Support b
price S1—D1 is amount of exports

EU price
Without
import

World c d
price D

D1 S1
 IMPORT QUOTAS
• Theory
• An Import quota is a direct restrictions on the quantity of
some good that may be imported. The restrictions are
usually enforced by issuing licenses to some group of
individuals or firms. Quotas, like other trade restrictions,
are typically used to benefit the producers of a good in
that economy.
• For example, the USA has a quota on imports of foreign
cheese. The only firms allowed to import cheese are
certain trading companies, each of which is allocated the
right to import a maximum number of pounds of cheese
each year; the size of each firm’s quota is based on the
amount of cheese it imported in the past.
 Domestic Price and Import Quota

• There is a misconception that import quotas

somehow limit imports without raising
domestic prices.
The truth is that an import quota always
raises the domestic price of imported good.
When imports are limited, the immediate
result is that at the initial price, the demand
for the good exceeds domestic supply plus
imports. This causes the price to bid up until
the market clears.
Diff. between Tariff and Import Quota
• An import quota will raise domestic prices by
the same amount as a tariff that imports to
the same level.
• The difference between a quota and a tariff is
that with that quota, government receives no
revenue. When a quota instead of a tariff is
used to restrict imports, the sum of money
that would have appeared with a tariff as
government revenue is collected by whoever
receives the import licenses.
 Quota Rents
The license holders are thus able to buy imports
and resell at a higher price in the domestic
market. The profit received by the holders of
import licenses are known as quota rents.
When imports are restricted by quota rather
than tariff, the cost is sometimes magnified by
a process known as rent seeking. In some
cases, individual and companies incur
substantial costs– in effect wasting some of
the economy’s productive resources– in an
effort to get import licenses.
 Chapter10:
Part 1: The Political Economy of Trade Policy

• Government intervention in international trade takes in

different forms of instruments that we discussed in previous
chapter. As we can well understand ( theoretically) that all
these instruments while implemented in international trade,
produce more costs than benefits.
• In practice, government policies reflect objectives that go
beyond simple measures of cost and benefit and
governments do not base their trade policy on economists’
cost-benefit calculations.
 The Case for Free Trade
• Since the time of Adam Smith, economists have
advocated free trade as an ideal towards which trade
policy should strive. Many economists believe free
trade produces additional gains beyond the
elimination of production & consumption distortion.
• In the modern world, tariff rates are generally low
and import quotas relatively rare. An estimate
(William Cline, Trade Policy and global Poverty, 2004
p180) shows, for the world as a whole, protection
costs less than 1% of GDP.
– The gains for free trade are somewhat smaller for
advanced economies such as United States and Europe
and somewhat larger for poorer “developing countries”.
 Additional Gains from Free Trade\

• 1.One kind of additional gain involves

economies of scale.
• Protected markets limit gains from external economies
of scale by inhibiting the concentration of industries.
• When economies of scale apply at the level of the
industry rather than at the level of individual firm, they
are called external economies. For examples, in the
United States, the semiconductor industry is
concentrated in California’s famous Silicon Valley; the
investment Banking industry is concentrated in New
York; the entertainment industry is concentrated in
Hollywood. External economies have played a key role
in India’s emergence as a major exporter of
information services, with a large part of this industry
still clustered in an around the city of Bangalore . Ref:
chap 8
 Cluster of Firms and efficiency
• Marshall argued 3 reasons:
– Why cluster of firms are more efficient than individual firms in
isolation:
• The ability of a cluster to support specialized suppliers;
• A geographically concentrated industry allows labor market pooling
• A geographically concentrated industry helps foster knowledge
spillovers

External economies drive a lot of trade both within and between

countries. For ex, New York exports financial services to the rest of the
united States, largely because external economies in the investment
industry have led to a concentration of financial firms in Manhattan.

Similarly, Britain exports financial services to the rest of Europe , largely

because those same external economies have led to a concentration of
financial firms in London.
Protected Firms & Internal economies of scale
• Protected markets lead -----
– too many firms to enter the protected industry. With a
proliferation of firms in narrow domestic markets, the
scale of production of each firm becomes inefficient.
– Some economists argue that the need to deter excessive
entry and the resulting inefficient scale of production is a
reason for free trade that goes beyond the standard cost-
benefit calculations.
– Another argument for free trade is that by providing
entrepreneurs with an incentive to seek new ways to
export or compete with imports, free trade offers more
opportunities for learning and innovation than are
provided by a system of ‘managed’ trade.
 Rent Seeking
When imports are restricted by quota rather than
tariff, the cost is sometimes magnified by a process
known as rent seeking. In some cases, individual and
companies incur substantial costs– in effect wasting
some of the economy’s productive resources– in an
effort to get import licenses.

The license holders are thus able to buy imports and

resell at a higher price in the domestic market. The
profit received by the holders of import licenses are
known as quota rents.
 Political Argument for Free Trade
A political argument for free trade reflects the fact that a
political commitment to free trade may be a good idea
in practice even though there may be better policies in
principle. Economists often argue that trade policies in
practice are dominated by special-interest politics
rather than by consideration of national costs and
benefits.
Economists can sometime show that in theory, a selective
set of tariffs and export subsidies could increase national
welfare, but that in reality, any government agency
attempting to pursue a sophisticated program of
intervention in trade would probably be captured by
interest groups and convert into a device for
redistributing income to politically influential sectors.
 Who Gets Protected
• Many Developing countries traditionally have protected
a wide range of manufacturing, in a policy known as
import-substituting industrialization.
• In advanced countries the range of protectionism is
much narrower; much protectionism is concentrated in
just two sectors: agriculture and clothing.
• Agriculture:
• In United States farmers are usually a well-organized
and politically powerful group that has been able in
many cases to achieve a very high rate of protection.
• In Europe’s CAP, the export subsidies in that program
mean that a number of agricultural products sell at two
or three times world prices.
• In Japan, the government has traditionally banned
imports of rice, thus driving up internal prices of the
country’s staple food to more than five times as high
as the world price.
• The United States is generally a food exporter. While
farmers have received considerable subsidies from
the federal government, the government’s
reluctance to pay money out directly has limited the
size of subsidies. As a result of govt. reluctance,
much of the protection in US is concentrated on
clothing industry.
 Protection on Clothing industry (in U.S.)
• The clothing industry is consists of two parts:
– Textile (spinning and weaving of cloth)
– And apparel (assembly of cloth into clothing)
• Apparel production is labor-intensive and the technology is relatively
simple. So high wage nation has comparative disadvantage where low
wage country has a comparative advantage.

Both industries (textile & apparel), but specially the apparel

industry, historically have been protected heavily through both
tariff and import quota. Until 2005, they were subject to the
Multi-Fiber Arrangement(MFA) which set both export and
import quotas for a large number of countries.
Uruguay Round trade agreement(signed in 1994) phased out the
MFA which took place in 2004. With the expiration of the MFA,
the cost of clothing protection and the overall costs of U.S.
protection fall sharply.
 Part 2: International Negotiation and Trade Policy
• It is often argued that it is difficult to devise trade
policies that raise national welfare and that trade policy
is often dominated by interest group politics.

Yet in fact from the mid-1930s until about 1980, the U.S.
and the other advanced countries gradually removed
tariffs and some other barriers to trade, and by so doing
aided a rapid increase in international integration. The
average U.S. tariff rate on dutiful imports rose sharply in
the early 1930s and then steadily declined.
Most economists believe this progressive trade
liberalization was highly beneficial. How was this
removal of tariffs politically possible?
• At least part of the answer is that the great post war
liberalization of trade was achieved through
international negotiation. That is governments
agreed to engage in mutual tariff reduction. These
agreements linked reduced protection for each
country’s import-competing industries to reduced
protection by other countries against that country’s
export industries.
• The Advantages of Negotiation
– There are at least two reasons why it is easier to lower
tariffs as part of a mutual agreement than to do so as a
unilateral policy.
• First: a mutual agreement helps mobilize support for freer trade
• Second: negotiated agreements on trade can help governments
avoid getting caught in destructive trade wars.
 International Trade Agreements: A Brief
History
• Internationally coordinated tariff reduction as a trade policy dates
back to the 1930s. In 1930, the U.S. passed a remarkably
irresponsible tariff law, the Smoot-Hawley Act. Under this act,
tariff rates rose steeply and U.s. trade fell sharply; some
economists argue that Smoot-Hawley Act helped deepen the great
depression.
• Within a few years , the U.S. administration proposed that tariff
needed to be reduced. To reduce tariff rates, tariff reduction
needed to be linked to some concrete benefits for exporters. The
U.S. would approach some country that was a major exporter of
some good– say sugar exporter– an offer to lower tariffs on sugar if
the country would lower its tariffs on some U.S. exports. In the
foreign country, attractiveness of the deal to foreign sugar exports
would balance the political influence of import-competing
interests. Such bilateral negotiations helped reduced the average
duty on U.S. imports from 59% in 1932 to 25% shortly after WW II.
 Negotiation
Bilateral negotiation, however, do not take full advantage of
international trade. For one thing, benefits from bilateral
negotiations may “spill over” to parties that had not made any
concessions.
• Multilateral negotiation, began soon after the end of world war II.
Originally the diplomats from the victorious Allies imagined such
negotiations, would take place under the auspices of a proposed
body called the ITO ( International Trade Organization), paralleling
the IMF and World Bank.
– In 1947 , unwilling to wait until the ITO was in place, a group of 23 countries
began trade negotiations under a provisional set of rules that became known
as the General Agreement on Tariffs and Trade or GATT. As it turned out, the
ITO was never established because it ran into several political opposition,
specially in the U.S.
– Officially the GATT was an agreement, not an organization– the countries
participating in the agreement was officially designated as “ contracting
parties” not members. In practice the GATT did maintain a permanent
“secretariat” in Geneva, which everyone referred to as “the GATT”.
 World Trade Organization(WTO)
• In 1995, the World Trade Organization(WTO) was established, finally
creating the formal organization envisaged 50 years earlier. However, the
GATT rules remain in force, and the basic logic of the system remains the
same.
– One way to think about the GATT-WTO approach to trade is to use a
mechanical analogy: It’s like a devise designed to push a heavy object,
the world economy, gradually up a slope – the path to free trade.
– The WTO officially commenced on 1st January 1995 under the Marrakesh
Agreement, signed by 123 nations on 15th April 1994 replacing the GATT,
which commenced in 1948. It is the largest international economic
organization in the world.
– The WTO deals with regulation of trade in goods, services and intellectual
property between participating countries by providing a framework for
negotiating trade agreements and dispute resolution process aimed at
enforcing participants’ adherence to WTO agreements, which are signed
by representatives of member governments and ratified by their
parliaments. Bangladesh has been a WTO member since 1 January 1995
and a member of GATT since 16 December 1972.
 MOST FAVOURED NATION(MFN)
• In international economic relations and international
politics, most favoured nation (MFN) is a status level of
treatment accorded by one state to another in international
trade. The term means the country which is the recipient of
this treatment must nominally receive equal trade
advantages as the “most favoured nation” by the country
granting such treatment(trade advantages include low tariffs
or high import quotas).
– In effect, a country that has been accorded MFN status may not be
treated less advantageously than any other country with MFN
status by the promising country. The members of WTO agree to
accord MFN status to each other. MFN is the cornerstones of WTO
trade law.
• Under the rules of WTO a member country is not allowed
to discriminate among trade partners and if a special status
is granted to one trade partner, the country is required to
extend it to all members of WTO.
 EXCEPTIONS OF MFN
• GATT members recognized in principle that the “most
favoured nation” should be relaxed to accommodate the
needs of developing countries, and the UN Conference
on Trade and Development (established in 1964) had
sought to extend preferential treatment to the exports
of the developing countries.
• Another challenge to the “most favoured nation”
principle has been posed by regional trade blocks such
as European Union and the North American Free Trade
Agreement(NAFTA), which have lowered or eliminated
tariffs among the members while maintaining tariff walls
between nations and the rest of the world. Trade
agreements usually allow for exceptions to allow for
regional economic integration.
 PREFERENTIAL TRADE AREA (PTA)
• A preferential trading area (preferential trade
agreement, PTA) is a trading block that gives preferential
access to certain products from the participating
countries. This is done by reducing tariffs but not
abolishing them completely. A PTA can be established
through a trade pact. It is the first stage of economic
integration. The line between a PTA and a free trade
area( FTA) may be blurred, as almost any PTA has a main
goal of becoming a FTA in accordance with the General
Agreement on Tariffs and trade.
• The GATT forbids preferential trading agreements in
general, as a violation of MFN principle, but allows them
if they lead to free trade between the agreeing countries.
 FREE TRADE AREA(FTA) & CUSTOMS UNION
• Two or more countries agreeing to establish free trade
can do so in one of two ways. They can establish a free
trade area in which each country’s goods can be shipped
to the other without tariffs but in which the countries set
tariffs against the outside world independently. The
North American Free Trade agreement (NAFTA)– which
establishes free trade among Canada, the United States
and Mexico---creates a free trade area. There is no
requirement in the agreement that, for example Canada
and Mexico have the same tariff rate on textiles from
China.
• OR, two or more countries can establish a customs union
in which the countries must agree on tariff rates. Ex,
European Union is full customs Union. All the countries
must agree to charge the same tariff rate on each
imported good.
 Free Trade Area versus Customs Union
• The difference between free trade area and customs union is, in brief, that
the first is politically straight forward but an administrative headache but
the second is just the opposite.
• A custom union requires that Germany, France, The Netherlands and all
other countries agree to charge the same tariffs. This is not easily done:
Countries are in effect ceding part of their sovereignty to a supranational
entity, the European Union.

NAFTA, while it permits Mexican goods to enter the United States without
tariffs and vice versa, it does not require that these two countries adopt a
common external tariff on goods they import from other countries.
This however, raises a different problem. Under NAFTA, a shirt
made by Mexican workers can be brought into the United States freely.
But suppose the United States wants to maintain high tariffs on shirts
imported from other countries, while Mexico does not impose similar
tariffs. What is to prevent someone from shipping a shirt from say,
Bangladesh to Mexico, then putting it on a truck bound for Chicago?
 Problem of NAFTA
• The answer is that even though the United States and Mexico may have
the free trade, goods shipped from Mexico to the United States must still
pass through a customs inspection. And they can enter the United States
without duty if they have documents proving that they are in fact Mexican
goods, not transshipped imports from third countries.
• But what is Mexican shirt? If a shirt comes from Bangladesh, but Mexican
sew on the buttons, does that make it Mexican? Probably not. But if
everything except the buttons were made in Mexico, it probably should
be considered Mexican.
• The point is that administering a free trade area that is not a customs
union requires not only that the countries continue to check goods at the
border, but that they specify an elaborate set of “rules of origin” that
determine whether a good is eligible to cross the border without paying a
tariff.
• As a result, free trade agreement like NAFTA impose a large burden of
paperwork, which may be significant obstacle to trade even when such
trade is in principle free.