Trade policy under perfect competition

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1 Trade policy under perfect competition Sources: Feenstra Taylor. Eleni ILIOPULOS Paris 1 Class 6 E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 1 / 24

2 Aim of this lecture Understand the impact of trade barriers on walfare, consumption, production and the equilibirum. Apply the standard model of trade so as to understand the impact of trade barriers. Understand how import tari s act (both in a small and a large open economy) Understand how import quotas act References: Feenstra Taylor (2008), (Mucchielli Mayer (2005)). E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 2 / 24

3 Small open economy with free trade Back to consumer and producer surplus (see class 4!) E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 3 / 24

4 Import tari for the small economy E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 4 / 24

5 Import tari for the small economy A small country is one where its imports does not have any e ect on the world price.! the price charged to Home consumers will increase by the amount of the tari. With an import tari of t dollars, the export supply curve facing Home shifts up to X + t! P w + t, import quantity of M 2 because of higher price. Also,the quantity supplied at Home rises from S 1 to S 2. However, as rms increase the quantity produced, the marginal costs of production rise. The domestic price will equal the import price. Foreign exporters still receive the net of tari price, PW. These changes a ect producer and consumer surplus, and overall Home welfare. E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 5 / 24

6 Consumer surplus E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 6 / 24

7 Producer surplus E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 7 / 24

8 The gain of the Government E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 8 / 24

9 Net e ect and deadweight loss E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 9 / 24

10 Consumption Loss The triangle d also has a precise de nition. Due to the tari, the price increase from, PW to PW+t reduces quantity consumed at Home from D1 to D2. The area of the triangle can be interpreted as the drop in consumer surplus for those individuals who are no longer able to consume the units from D1 to D2 because of the higher price. We refer to this drop in consumer surplus as the consumption loss for the economy. E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 10 / 24

11 Production loss The base of b is the net increase in Home supply due to the tari, from S1 to S2. The height of this triangle is the increase in marginal costs due to the increase in supply. The fact that marginal costs are greater than world price means that this country is producing the extra supply ine ciently. Fewer resources would be used if imported rather than produced at home. The area of b is the production loss or e ciency loss due to producing at marginal costs above world price. E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 11 / 24

12 Net e ect and deadweight loss E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 12 / 24

13 Why are then tari s widely used? Tari s always lead to deadweight losses for small countries!most economists are opposed to them. Why then do so many countries use tari s? One idea is that developing countries do not have any other source of revenue. Import tari s are easy-to-collect (customs agents at major ports checking the goods crossing the borders). However, to the extent that developing countries recognize that tari s have a higher deadweight loss, we would expect that over time they will shift away from such easy-to-collect taxes. However, If the government cares more about producer surplus than consumer surplus, it might decide to use the tari despite the deadweight loss it incurs. E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 13 / 24

14 Large country E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 14 / 24

15 E ect of import tari s E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 15 / 24

16 Terms of trade Terms of trade is the ratio of export prices to import prices. In order to measure terms of trade, we want to use the net-of-tari import price, P*. Since P* is lower than P W, it follows that the Home terms of trade has increased/improved. We might expect, therefore, that the Home country gains from the tari E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 16 / 24

17 The deadweight loss at Home is (b + d), and the terms-of-trade gain is area e. E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 17 / 24

18 Welfare at Home The higher Home price makes consumers worse o, lowering consumer surplus (a+b+c+d). Home rms are better o with the higher price and increased surplus, a. Revenue collected from the tari equals the amount of the tari, t, times the new amount of imports, M 2, giving total revenue of (c + e). Fall in consumer surplus -(a+b+c+d) Rise in producer surplus +a Rise in government revenue +(c + e) Net e ect on Home welfare = (b+d) + (e)! The triangle (b+d) is the deadweight loss due to the tari. But notice, there is a source of gain, e, that o sets part of the loss. If e > (b + d), then Home is better o. If e < (b + d), then Home is worse o. E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 18 / 24

19 World Welfare and Foreign The Foreign loss, (e + f ) is the loss in Foreign producer surplus from selling fewer goods to Home at a lower price. The area e is the terms-of-trade gain for Home (equivalent terms-of-trade loss for Foreign). Extra deadweight loss in Foreign of f, giving a combined total greater than the bene ts to Home. Adding together the net loss to world welfare of (b+d+f). World deadweight loss! most economists oppose the use of tari s. Moreover, in a general eq. perspective, countries specialize in most protected sectors.."ine cient specialization"!! You loose the e ciency gains arising from specialization. E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 19 / 24

20 The optimal tari E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 20 / 24

21 Import quotas E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 21 / 24

22 Import quotas The import quota of M 2 < M 1 is imposed: quantity imported cannot exceed this amount.! Vertical supply curve, X: xes the import quantity at M 2. Demand at point C! Home price P 2. P 2 leads rms to increase the quantity supplied to S 2 and consumers to decrease their quantity demanded to D 2. For every level of import quota, there is an equivalent import tari!! The equivalent tari, would be: t = P 2 P W. E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 22 / 24

23 E ect on Welfare The rise in price from the quota! fall in consumer surplus:(a + b + c + d). The increase in price! gain in producer surplus: a. What changes with the quota is the area c which was government revenue under the tari. With a quota, whoever is actually importing the good will be able to earn c, the di erence between the world price and the higher Home price times the imports sold in the Home market. The di erence between these two prices is the rent associated with the quota. Area c represents the total quota rents. How to allocate the rent? E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 23 / 24

24 How to allocate the rent? 1 Giving the Quota to Home (import) Firms. This is the same loss we saw with a tari. 2 Rent Seeking: the waste of resources devoted to rent seeking could be as large as the value of the rents themselves, c.! loss: -(b+c+d) larger thean with tari s. 3 Auctioning the Quota. The revenue collected should equal the value of the rents!same loss as the tari. 4 Voluntary Export Restraint: the importing country can give authority for implementing the quota to the exporting government!quota rents are earned by foreign producers!higher loss than with a tari. E. ILIOPULOS (Paris 1) Trade policy under perfect competition Class 6 24 / 24

Chapter 9 1. Use Exhibit 3 to answer the following questions.

Chapter 9 1. Use Exhibit 3 to answer the following questions. Exhibit 3 a. If trade is not allowed, what is the equilibrium price and quantity in this market? Price = 4, quantity = 40 units. b. If trade