INTRODUCTION. In previous lecture: effects of various trade policies within a partial equilibrium framework

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1 INTRODUCTION In previous lecture: effects of various trade policies within a partial equilibrium framework INTERNATIONAL ECONOMICS ECON Today: changes in relative prices caused by the introduction of tariffs in one market are likely to have general equilibrium effects in other markets This lecture: LECTURE 9 TRADE POLICY: GENERAL EQUILIRIUM ANALYSIS * Focuses on the neo-classical model of trade (differences in tastes, technologies and factor endowments) * Considers the general equilibrium effects of the introduction of a tariff * Considers the arguments for protection Warning!! These lecture notes are to help students during the lectures. Reading these notes without attending lectures can be misleading. Estela Montado, University of ristol

2 Contents of today s lecture ) General equilibrium effects of a tariff: Small country ) General equilibrium effects of a tariff: Large country 3) Optimum Tariff 4) Arguments for protection ) General equilibrium effects of a tariff: Small country Preferences: indifference curves of the representative consumer Production Possibilities: characterised by PPF (summarizes the effect of both technology and factor endowments) Neo-classical Trade Model, two countries: home and foreign ; two goods: X and X Autarky Equilibrium (Fig. ) X A -(/p) X 3 4

3 Free Trade Equilibrium (Fig. ) World Welfare X Producer equilibrium in both countries (before trade) dx dx = < p p* F = dx* dx* C In equilibrium, home forgoes less units of good per unit of good produced than foreign -(/p F ) Choose good as the numeraire. Denote p the relative price of good in home and p* the price in foreign Assume home is a small economy. It faces a constant relative price for its imports of p* = p * F and constant relative price for its exports /p*=/p * F X MPL MPL = < p p* F = MPL* MPL* In equilibrium, the opportunity cost of producing good is lower in home than in foreign The world as a whole could have more of both goods if home increased production of good (its export good) and foreign reduced production of good (its import good). Trade would benefit both 5 6

4 Assume home imposes a tariff t on imports of good p < p * F.(+t) The production Cost in home (Fig. 3) X H I O -(/p F ) D J E G -(/p T ) Production cost of tariff: a country that levies a tariff produces a mix of goods worth less at international prices than the country is capable of producing X Free trade equilibrium Relative price of good is p = p * F Production at E OH value of domestic production in terms of imports at world prices OG value of domestic production in terms of exports at world prices Tariff-ridden equilibrium Relative price of good is p T = (+t).p * F Domestic production is D OI<OH value of domestic production in terms of imports OJ<OG value of domestic production in terms of exports Production cost of tariff IH production cost of tariff in terms of imports JG production cost of tariff in terms of exports 7 8

5 Consumer equilibrium in both countries dc dc = < p p* F = dc* dc* In equilibrium, consumer in home is willing to forgo less units of good (imported) to consume one more unit of good (exported) than the foreign consumer The consumption cost in home (Fig. 4) X N E A MU MU = < p p* F = MU* MU* Consumers in both countries would benefit from trade L -(/p F ) -(/p T ) However, tariffs introduce a distortion in consumption O P The representative consumer can afford a combination of goods less desirable than he can afford at international prices. This is the consumption cost of the tariff M X 9 0

6 Free trade equilibrium Relative price of good is p= p * F Consumption at E Tariff-ridden equilibrium LM relative price under the tariff p= p * F.(+t) Then, find on consumer s free trade budget constraint NP at which relative prices under the tariff LM are tangent to the consumer s indifference curve Point is where the consumers would choose to be given the free trade budget constraint NP and tariff-ridden relative price LM Consumption cost of tariff is on a lower indifference curve than E A is the cost of the tariff in terms of imports Next, examine general equilibrium effect of a tariff for a small country General equilibrium effect of a tariff: Small Country (Fig. 5) X Tariff revenue in terms of good O E C D Free trade equilibrium Equilibrium production at Equilibrium consumption at C Tariff-ridden equilibrium Equilibrium production at D Equilibrium consumption at E (p /p ) F (p /p ) T Trade reduced by tariff (imports and exports fall) X

7 ) General equilibrium effect of a tariff: Large Country When home is large, the tariff may lead to an improvement in the country s terms of trade (TOT) Net Welfare Gains from the Imposition of a Tariff (Fig. 7) X Under free trade, relative price of good p F = p * F If home imposes a tariff on imports, the equilibrium relative price of good decreases in foreign, p * T. This represents an improvement in TOT in home p * T < p * F Tariff revenue in terms of good C E D (p/p)t The relative price of good in home is p T = p * T (+t) (p /p ) * T (p /p ) F Assume the net effect of the tariff in home is to raise the domestic price. Then p T > p F Two situations can arise. ) A net welfare gain - the welfare gain from an improvement in the TOT in home exceeds the welfare costs in terms of the production and consumption distortion. (Fig. 7) ) A net welfare loss (Fig. 9) Free Trade equilibrium Relative price of good, p F = p * F Equilibrium in consumption at C Equilibrium in production at X 3 4

8 Tariff-ridden equilibrium Relative price of good in foreign falls p * T < p * F Relative price of good in home rises p T = p * T.(+t) Improvement of the terms of trade (fall in p * ) is sufficiently large, that when new tangency point between tariff-ridden equilibrium price line - p T = p * T.(+t) - and consumer s indifference curve, a higher indifference curve is reached than under free trade Note: welfare in home may either increase or decrease after the imposition of a tariff, depending on the relative size of the consumption and production distortions and the improvement in the terms of trade Tariffs and the Factor-Endowments Theory Recalling Heckscher-Ohlin Theorem: a country has a comparative advantage in the good whose production is relatively intensive in the country s relatively abundant factor A tariff raises the domestic price of the good that uses intensively the relatively scarce factor A tariff protects that industry which makes intensive use of the country s relatively scarce factor Stolper-Samuelson Theorem: a rise in the price of a good causes the price of the factor used intensively in the production of that good to rise in even greater proportion and the reward of the other factors falls A tariff increases the real income of the country s relatively scarce factor and reduces the real income of the country s relatively abundant factor 5 6

9 3) The Optimum Tariff The effects of a tariff on imports (Fig. 8) How are the relative prices in free trade and under the tariff determined? The offer curve traces out quantities of imports and exports a country is willing to buy and sell on the world market at all possible prices (see Krugman & Obstfeld Chapter 5 Appendix) Imports of good OC A HOME OC /p * T /p * F OC * A tariff increases the relative price of imports in home compared to the world market (it reduces the relative price of the export good in home ) Therefore, the offer curve for home shifts inwards. A tariff reduces the equilibrium quantity imported and exported by the home country at each relative price in world market. Exports of good The tariff leads to an inward shift in the offer curve of the home country Equilibrium world relative price of the export good (good ) rises (/p * T>/p * F). The terms of trade improve. Equilibrium exports and imports fall. There is a reduction in trade volumes 7 8

10 Optimal Tariff Argument A small tariff can be welfare improving For a sufficiently small tariff the welfare gains from the improved terms of trade are always larger than the welfare losses from consumption and production distortions (see Krugman & Obstfeld, Chapter 9 Appendix) Furthermore, one can solve for the value of the optimal tariff at which the welfare gains induced by the improved terms of trade are exactly offset by the welfare distortion losses Traditional trade theory suggests a large country can increase its welfare by using an import tariff to improve its terms of trade. An optimal tariff exists which maximises a country s welfare Assumption: foreign countries do not retaliate 5) Arguments for protection Static external economies It is argued that some industries may be characterised by external economies of scale and that this can justify protection Imperfect competition and strategic trade policy Allowing for imperfect competition introduces a new rationale for protection arising from strategic interaction between firms known as strategic trade policy. These policies attempt to improve performance by promoting particular exports or discourage imports Infant industry argument It is argued that a tariff is needed to protect an industry in its early stages of development so that firms may incur initial loses in an industry in order to reap the benefits of learning-by-doing later. This is a valid argument in the presence of market failures 9 0

11 Trade policy and domestic distortions It is argued that trade policy may have positive welfare effects because it offsets domestic distortions Profit-seeking activities Real resources could be employed in these activities and they constitute an additional cost of protection (i.e. tariff evasion, tariff-seeking lobbying, revenue-seeking lobbying, etc.) Tariff for a Large Country: welfare reducing effects (Fig.9) X Further traditional arguments Include tariffs to reduce unemployment, to offset foreign dumping, to offset foreign subsidies, to benefit a scarce factor of production, in national defence, to improve the balance of trade, to extract foreign monopoly s profits, to encourage better policy abroad Tariff revenue in terms of good E C D (p/p)t (These arguments may vary in their validity. See Krugman & Obstfeld, Chapters 0 & and Appleyard & Field, Chapters 5 & 6, for discussion) (p /p ) * T (p /p ) F X