3. 4.1 Theories for Trade Protection
Infant Industry Argument
This argument contends that for free trade to be
meaningful, trading countries should temporarily
shield their newly developing industries from foreign
competition.
4. 4.1 Theories for Trade Protection
Some truths in the infant industry argument:
Once a protective tariff is imposed, it is very
difficult to remove, even after industrial maturity
has been achieved.
It is very difficult to determine which industries
will be capable of realizing comparative advantage
potential and thus merit protection.
The argument generally is not valid for mature,
industrialized countries.
There may be other ways of insulating a developing
industry from cutthroat competition. Rather than
adopt a protective tariff, the government could grant
a subsidy to the industry.
5. 4.1 Theories for Trade Protection
Terms of Trade Argument
In some cases, the terms of trade benefits of a tariff
outweigh its costs, so there is a terms-of-trade
argument for a tariff.
The terms of trade argument against free trade, then, is
intellectually impeccable but of doubtful usefulness.
In practice, it is emphasized more by economists as a
theoretical proposition than it is used by governments
as a justification for trade policy.
6. 4.1 Theories for Trade Protection
Domestic Market Failure Argument
Theory of the second best
When economists apply the theory of the second
best to trade policy, they argue that imperfections in
the internal functioning of an economy may justify
interfering in its external economic relations.
This argument accepts that international trade is not
the source of the problem but suggests nonetheless
that trade policy can provide at least a partial
solution.
7. 4.1 Theories for Trade Protection
Strategic Trade Policy
Because of the small number of firms, the assumption
of perfect competition does not apply. There are only a
few firms in effective competition in some industries.
This argument locates the market failure that justifies
government intervention in the lack of perfect
competition.
It is possible in principle for a government to alter the
rules of the game to shift these excess returns from
foreign to domestic firms.
9. 4.2 Tariffs
A tariff is simply a tax (duty) levied on a product
when it crosses national boundaries.
Import tariff v.s. Export tariff
Protective tariff v.s. Revenue tariff
Types of Tariffs
Specific Tariff
Ad Valorem Tariff
Compound Tariff
10. 4.2 Tariffs
Effective Rate of Protection (ERP)
the percentage change in the value added in an
industry because of the imposition of a tariff
structure by the country rather than the existence of
free trade.
11. 4.2 Tariffs
Calculation of ERP (Way I):
ERP = VA' -
VA
VA
VA- Value added with free trade
VA'- Value added under protection
12. 4.2 Tariffs
Calculation of ERP (Way II):
t a t
j i ij i
1
i ij
ERP
a
-
=
-
å
å
the free-trade value of input i
as a percentage of the free-trade value of the final good j
ij a -
the tariff rate on input i i t -
the tariff rate on the final good j j t -
summing over all the inputs i å -
13. 4.2 Tariffs
Three general rules about the relationship between
nominal rates and effective rates of protection:
If the nominal tariff rate on the final good is higher than the
weighted average nominal tariff rate on the inputs, then the
ERP will be higher than the nominal rate on the final goods;
If the nominal tariff rate on the final good is lower than the
weighted average nominal tariff rate on the inputs, then the
ERP will be lower than the nominal rate on the final goods;
If the nominal tariff rate on the final good is equal to the
weighted average nominal tariff rate on the inputs, then the
ERP will be equal to the nominal rate on the final goods.
14. 4.2 Tariffs
Two consequences of the effective rate calculation:
The degree of effective protection increases as the value
added by domestic producers declines.
In the formula, the higher the value of aij is, the greater the
effective protection rate for any given nominal tariff rate on
the final product will be.
A tariff on imports used in the production process reduces
the level of effective protection.
In the formula, as ti rises, the numerator of the formula
decreases and hence ERP decreases.
15. 4.2 Tariffs
Conclusion
when material inputs or intermediate products enter
a country at a very low duty while the final
imported commodity is protected by a high duty, the
result tends to be a high protection rate for the
domestic producers. The nominal tariff rate on
finished goods thus understates the effective rate of
protection.
But should a tariff be imposed on imported inputs
that exceeds that on the finished good, the nominal
tariff rate on the finished product would tend to
overstate its protective effect.
16. 4.2 Tariffs
Tariff Escalation
The tariff structures have generally been
characterized by rising rates that give greater
protection to intermediate and finished products than
to primary commodities.
The tariff structures of the industrialized countries
may indeed discourage the growth of processing,
thus hampering diversification into higher value-added
exports for the less developed countries,
worsening the potential competitive position of the
less-developed countries in the manufacturing and
processing sectors.
17. 4.2 Tariffs
Tariff Welfare Effects
Consumer Surplus
Consumer surplus refers to the difference between
the amount that buyers would be willing and able to
pay for a good and the actual amount they do pay.
Producer Surplus
Producer surplus is the revenue producers receive
over and above the minimum amount required to
induce them to supply the good.
19. 4.2 Tariffs
Trade Welfare Effect of Tariff in a Partial
Equilibrium Setting
The Small-Nation Case
20. 4.2 Tariffs
The redistributive effect (Area a)
the transfer of consumer surplus, in monetary terms, to the
domestic producers of the import-competing product.
The protective effect (Area b)
the loss to the domestic economy resulting from wasted
resources used to produce additional cloth at increasing unit
costs.
The domestic revenue effect (Area c)
the tariff proceeds paid by country A’s consumers to its
government.
The consumption effect (Area d)
arises from the decrease in consumption resulting from the
tariff's artificially increasing the price.
The deadweight loss (Areas b + d)
represents a real cost to a community, not a transfer to other
sectors of the economy.
21. 4.2 Tariffs
Welfare Cost of a Tariff Imposed by a Small Nation
Item Welfare Change (Area)
Change in consumer surplus −a −b −c −d
Change in producer surplus a
Change in government revenue c
Net welfare change −b −d
Levying an import tariff, therefore, reduces a small
country's welfare.
22. 4.2 Tariffs
The Large-Nation Case
International Free-Trade Equilibrium
The equilibrium world price is defined as the price at which the
quantity that consumers in Country A want to import is equal to
the quantity that producers in Country B want to export. In the
diagram, this price is denoted by PFT.
23. 4.2 Tariffs
The size of the tariff equals the difference between the price
consumers in country A pay for the product (PT) and the price
producers in country B receive (P'). That is, the per unit tariff
of t equals PT −P' .
24. 4.2 Tariffs
The redistributive effect (Area a)
the transfer of consumer surplus, in monetary terms, to the
domestic producers of the import-competing product.
The protective effect (Area b)
the loss to the domestic economy resulting from wasted
resources used to produce additional cloth at increasing unit costs.
The domestic revenue effect (Area c)
the tariff proceeds paid by country A’s consumers to its
government.
The consumption effect (Area d)
arises from the decrease in consumption resulting from the
tariff's artificially increasing the price.
The terms of trade effect (Area e)
the amount of the tariff revenue paid by foreigners because the
world price of their exports has fallen.
25. 4.2 Tariffs
The change in welfare in country A brought about by the
imposition of a tariff equals e−(b+d). This amount could
be positive or negative, depending on the relative sizes
of the two terms.
Optimal tariff : the tariff would be set to a level that
maximizes the area e−(b+d).
26. 4.2 Tariffs
Trade Welfare Effect of Tariff in a General
Equilibrium Setting
The Small-Nation Case
27. 4.2 Tariffs
The reduction in welfare comes from two
effects:
The economy no longer produces at a point that
maximizes the value of income at world prices. The
budget constraint that passes through B1 lies inside
the constraint passing through B0.
Consumers do not choose the welfare-maximizing
point on the budget constraint; they do not move up
to an indifference curve that is tangent to the
economy's actual budget constraint.
28. 4.2 Tariffs
The Large-Nation Case
With the imposition of a tariff, Country I’s offer curve OCI shifts
inward to OCI'.
29. 4.2 Tariffs
The Impact of a Tariff
The equilibrium quantity of exports falls from OB1 to OB2, and the
quantity of imports falls from OA1 to OA2. Country I’s terms of trade
improve from TOT1 to TOT2.
31. 4.3 Nontariff Trade Barriers
An Introduction to Nontariff Trade Barriers
Import Quota
An import quota is a physical restriction on the quantity of
goods that may be imported during a specific period; the
quota generally limits imports to a level below which
imports would occur under free-trade conditions.
A common practice to administer an import quota is for the
government to require an import license. Each license
specifies the volume of imports allowed, and the total
volume allowed should not exceed the quota.
Import quotas on manufactured goods have been outlawed
by the World Trade Organization.
32. 4.3 Nontariff Trade Barriers
Tariff-Rate Quota: A Two-Tier Tariff
a tariff-rate quota displays both tariff-like and
quota-like characteristics. This device allows a
specified number of goods to be imported at one
tariff rate (the within-quota tariff rate), whereas
any imports above this level face a higher tariff
rate (the over-quota tariff rate).
a tariff rate quota is a two-tier tariff.
33. 4.3 Nontariff Trade Barriers
Orderly Marketing Agreements
An orderly marketing agreement (OMA) is a market-sharing
pact negotiated by trading partners.
Its main purpose is to moderate the intensity of
international competition, allowing less efficient domestic
producers to participate in markets that would otherwise
have been lost to foreign producers who sell a superior
product at a lower price.
A typical OMA consists of voluntary quotas applied to
exports. These controls are known as voluntary export
restraints (VERs); they are sometimes supplemented by
backup import controls to ensure that the restraints are
effective.
34. 4.3 Nontariff Trade Barriers
Domestic Content Requirements
To limit the practice of outsourcing, organized labor has
lobbied for the use of domestic content requirements.
The effect of content requirements is to pressure both
domestic and foreign firms who sell products in the home
country to use domestic inputs (workers) in the production
of those products.
Manufacturers generally lobby against domestic content
requirements, because they prevent manufacturers from
obtaining inputs at the lowest cost, thus contributing to
higher product prices and loss of competitiveness.
35. 4.3 Nontariff Trade Barriers
Subsidies
National governments sometimes grant subsidies to their
producers to help improve their trade position.
Governmental subsidies assume a variety of forms,
including outright cash disbursements, tax concessions,
insurance arrangements, and loans at below-market interest
rates.
Two types of subsidies:
– a domestic subsidy which is sometimes granted to
producers of import-competing goods;
– an export subsidy which goes to producers of the goods
that are to be sold overseas.
36. 4.3 Nontariff Trade Barriers
Dumping
Dumping is recognized as a form of international price
discrimination.
It occurs when foreign buyers are charged lower prices
than domestic buyers for an identical product, after
allowing for transportation costs and tariff duties. Selling in
foreign markets at a price below the cost of production is
also considered dumping.
Commercial dumping is generally viewed as sporadic,
predatory, or persistent in nature. Each type is practiced
under different circumstances.
37. 4.3 Nontariff Trade Barriers
The effects of an Import Quota
In the absence of trade,
equilibrium would occur at
Point E with the domestic price
of cloth equaling P.
The free-trade equilibrium is
located at Point F, the domestic
price of cloth would fall to the
world price PW.
The imposition of the quota
changes the amount of cloth
supplied to the importing
country, a new equilibrium is
reached at G.
38. 4.3 Nontariff Trade Barriers
The country loses Areas b+c+d under a quota.
The redistributive effect (Area a)
The protective effect (Area b)
The domestic revenue effect (Area c)
Area c accrues to the foreign producers and makes
them more profitable.
The consumption effect (Area d)
The deadweight loss (Areas b + d)
39. 4.3 Nontariff Trade Barriers
Two methods available for a government or
community to capture Area c from foreign producers
under a quota.
–The domestic government could auction quotas to
importers in a free market. The limited quota
supply would go to those importers most in need
of the product who would pay the higher price.
–Convert the quota into an equivalent tariff.
40. 4.3 Nontariff Trade Barriers
Quota and equivalent tariff
The losses for consumers and community are much larger in
the case of a quota than in the case of a tariff when demand
increases.
41. 4.3 Nontariff Trade Barriers
The Effects of an Export Subsidy
Consumers lose Area a+b
in the form of higher taxes.
Producers gain Area a in
profits.
The cost to the community
is Area b, that is the
production deadweight
cost of the subsidy.
Subsidies are superior to
protection in another way:
they are more visible.
