Trade Policy, Tariffs and Social Welfare

Protective Effect (area b)

(1/2)(2)(1,000) = 1,000

4) Preservation of Home Market

"Buying American means the money stays here and does not go abroad and leaves the US wealthier" When we export goods and service abroad we obtain a flow of income that has a multiplier effect on our domestic economy

2) Employment

"We have to protect our domestic industry from foreign products produced by sweatshop foreign labor that works for low wages" This argument is frequently used by trade unions and was at the forefront of discussions over the NAFTA agreement Protectionism certainly does lead to a job saving and job creation within the protected industry. However, this comes at the expense of other industries. Protectionism generally shifts resources between industries and does not generally lead to a net creation of new jobs. If some workers can do the same job at twice the cost, why should we not retrain these workers to do a different job and to let the low skilled job go across the border? Protectionism is bad across industries. It leads to costly distortions and the mis-allocation of resources

There are many possible forms of Commercial Policy that can be implemented by a government in an economy. The main forms are:

(1) TARIFFS : which is a tax on imported items. Usually the tariff is a fixed percentage tax for each $ of imports. This is sometimes referred to as an AD VALOREM TARIFF and is the standard form of tariff in the US. For example the US imposes a tariff of 21% on come imported cotton tee shirts. Occasionally, there is a SPECIFIC TARIFF, which is a fixed amount on unit volume of goods traded regardless of $ value of the goods. also not that some countries impose tariffs on exports, e.g. Brazil with coffee exports. [compound tariff is both an ad valorem and a specific tariff] (2) Quotas: limits the volume of imports (3) Subsidies: government pays a domestic export industry (4) Non-tariff barriers: e.g. health and safety standards. Widely practiced by Japan

The area labeled "A", is considered to be DEADWEIGHT LOSS FROM INEFFICIENT PRODUCTION. The imposition of the tariff by the government raised the price and encouraged production to increase beyond the levels of efficiency. For example, the higher guaranteed price of coffee may have led to the formation of coffee producers in Michigan. Despite the lack of a helpful climate and other resources they have entered the market as producers in response to the higher guaranteed price resulting from the tariff. The are of Region A is,

(1/2)(1)(1,500-1,000) = 250 there is a corresponding loss of welfare from lost consumption given by region labelled "B". Some consumer's will be unwilling to consume at the artificially raised price and this area is calculated as, (1/2)(1)(2,400 - 2,200) = 100 A tariff always reducs welfare for a small open economy and in this case the reduction in welfare is seen to be 700 + 250 + 100 = 1,050

The results of the EU intervention has been to:

(a) raise the income of farmers in the EU (b) turn Europe into a large net exporter of food from having being a net importer (c) provide conflict with the US, Australia and Canada, (d) cost European consumers and the EU budget. It is estimated that the CAP costs the European countries about 1% of the GDP

(c) Provides a stable basis for trade. Each country must openly publish its tariff schedules, which are negotiated through GATT. An increase in an existing tariff or the introduction of a new tariff must be compensated for by the reduction or elimination of an existing tariff

(d) Promotes "fair" competition. Restricts dumping.

(e) Generally outlaws all quotas, except in the case of countries with Balance of Payments difficulties; and certain Lesser Developed Countries (LDCs)

(f) Provides a Waiver Clause, which allows a country to seek exemption from GATT obligations due to special circumstances or trade problems

(g) Regional Trade Agreements, GATT allows member countries to form preferential trading zones so long as they do not increase barriers to non members.

(h) Settles trade disputes

Common Market

(i) Free movement of goods and services among member countries (ii) Trade barriers to non members (iii) Free movement of factors of production (e.g. labor) across national borders within the economic bloc

To join the EU, a country must meet the COPENHAGEN CRITERIA, defined in 1993 as having

(i) stable democracy (ii) basic human rights (iii) the rule of law (iv) functioning market economy capable of competition with the EU, and (v) the acceptance of the obligations of membership, including EU law Four Western European countries that have chosen not to join the EU have partly committed to the EU's economy and regulations: Iceland, Liechtenstein and Norway are a part of the single market through the European Economic Area Switzerland has similar ties through bilateral treaties

Limitations of the Economic Argument

- Economists generally argue strongly for Free Trade, which is Welfare increasing in the models we have constructed. The model has assumed: (a) Perfect competition (b) have just considered one market at a time (c) have ignored income effects, where changes in income brought about by trade policies may lead to changed demand for competing or substitute goods (d) Consumers are price takers and it is assumed that the reduction in our demand will not effect the world price, Pw. This is sometimes known as the "Small Open Economy" Assumption, where a country's demand or supply is not large enough to change the ruling world price. Most of these assumptions can be modified and made increasingly realistic at the cost of increasing the complexity of the model. Free trade is not always allowed to occur due to the presence of monopolies and predatory pricing. Sometimes political power wins out and powerful industries and unions can lobby.

Regional Trade Agreements

-Deviates from the World Trade organization's guidelines by allowing discriminatory policies by blocs of countries

North American Free Trade Agreement (NAFTA)

-There is controversy on the benefits and costs of NAFTA -Mexico has seen its poverty rates fall and real income rise, even after accounting for the 1994-1995 economic crisis NAFTA appears to have been beneficial to business owners and elites in all three countries However, NAFTA has had negative impacts on farmers in Mexico who saw food prices fall based on cheap imports from highly subsidized US agribusiness negative impacts on US workers in manufacturing and assembly industries who lost jobs NAFTA is sometimes held responsible for the rising levels of inequality in both the USA and Mexico NAFTA has not been successful in closing the initial huge economic disparity between Mexico, USA, and Canada NAFTA has seen a dramatic increase in trade among the three nations between 1993-2004; which has coincided with increases in US trade worldwide NAFTA has not caused TRADE DIVERSION aside from a few select industries such as textiles and apparel, in which rules of origin negotiated in the agreement were specifically designed to make U.S. firms prefer Mexican manufacturers (and under current debate are: Trans Atlantic Trade and Investment Partnership (Trans Pacific Partnership)

Arguments for Protectionism

1) Patriotism "Be American. Buy American!" This argument is to raise barriers to foreign imported goods to persuade consumers to purchase more domestically produced goods. However, it will result in a welfare loss for the US as a whole. The welfare losses are paid by the consumer and transferred directly to businesses. It is probably "more American" to support policies that increase US welfare.

GATT Rounds of Talks

1949-1951 ; in the first two rounds world tariffs were dramatically reduced 1973-1979 ; the Tokyo Round; reduced tariffs by another 33%. Emphasized trade with DCs and environmental, health safeguards 1986; Uruguay Round; intellectual property rights 1990, Brussels, Belgium. Deadlocked talks between US and European Community over agriculture and services

(b) Protection through tariffs

Allows a certain degree of protection of domestic industries through the imposition of tariffs

Customs Union:

An agreement among two or more trading partners to remove all tariff and trade barriers between each other. Have external barriers against others

Global Village Argument

As citizens of the world we are members of a global village and should care about all the citizens of the world. Protecting US workers in one industry inevitably harms workers in lesser developed countries who find it harder to compete. This arguments is also valid for Globalization, which has lifted millions of folks in India, China and eastern Europe out of poverty and dramatically increased the GDP of these countries. At the same time, Globalization has caused unemployment and stagnant wage rates amongst unskilled workers in the US, Canada and western Europe.

Free Trade Area:

Association of trading nations where each member country agrees to remove all tariff and trade barriers among themselves; while having trading blocks to outsiders

Free Trade Situation

Assume a Small Open Economy World price of coffee is Pw = $2 Quantity demanded is Q^d = 3,000 - 200(2) = 2,600 Quantity supplied is Q^s = -500 + 500 (2) = 500 Imports = Qd-Qs = 2,600 - 500 = 2,100 consumers surplus is (1/2)(15-2)(2,600) = 16,900 Producers surplus is (1/2)(2-1)(500)=250 Welfare is 16,900 + 250 = 17,150

An economic model for the effects of quotas: the demand and supply functions for coffee in the US: Demand: Q^d = 3,000 - 200 P Supply: Q^s = -500 +500 P

Autarky situation P = 5 and Q = 2000 Consumer surplus: 10,000 Producer's surplus = 4,000

Bretton - Woods Conference

Conference at Bretton Woods, New Hampshire , US in 1944 Concerned with further reducing the extent of protectionism in the form of tariffs and quotas

Bretton - Woods Conference (cont)

Created the INTERNATIONAL MONETARY FUND (IMF) and a system of fixed exchange rates, similar to Gold Standard. The system lasted until 1972 when it irrevocably broke down and most countries began to have freely floating (free market determined) exchange rates. After 1972 the IMF began to look for a new role and eventually became involved with countries in debt and then transition economies

Economic Union

Extended the common market to all economic, social and political institutions The US is a monetary union, with all 50 states having the same currency, interest rates; so that there is a fixed exchange rate between the states

The EU has a COMMON AGRICULTURAL POLICY, (CAP) which consumes about 50% of its annual budget

Food prices in the EU are fixed above the market price at target price level which is determined each year. The EU keeps the price artificially above the market price by buying and storing surpluses Customs control ensure that imported food products do not enter the EU at a price below the target price Export surpluses allows the EU to unload surpluses at a competitive price compared to world prices.

General Agreement on Tariffs and Trade (GATT)

Founded in 1947 with its headquarters in Geneva, Switzerland GATT established rules and conduct for international trade negotiations

GATT (cont)

Generally GATT only allows export subsidies for agricultural goods Generally GATT only allows import quotas when imports threaten "market disruption" or a country facing "temporary" Balance of Payment difficulties

Quota Situation:

Government imposes a quota of a maximum of 700 Domestic supply is Q^sus = -500 + 500 P imported supply quota is Q^squota = 700 total supply curve is : Q^stotal = Q^sus + Q^squota = {-500 + 500P} + {700} = 200 + 500P the new equilibrium will occur where the original demand curve intersects with the new "total" supply curve. Hence, 3,000 - 200P = 200 + 500P 700P = 2,800 Hence P = 4 Q^d = 3,000 - 200(4) = 2,200 Q^sus = -500 + 500(4) = 1,500 consumer's surplus = (1/2)(15-4)(2,200) = 12,100 producer's surplus = (1/2)(4-1)(1,500) = 2,250 welfare = 12,100 + 2,250 = 14,350 this implies that there is a loss of welfare compared with free trade of 17,150 - 14,350 = 2,800 loss of consumer's surplus = 16,900 - 12,100 = 4,800 gain in producers's surplus = 2,250 - 250 = 2,000 Hence 2,000 of Consumer's surplus has been transferred to producer surplus; i.e a redistribution. The remaining 2,800 has been lost From carbaugh, pages 147 and 148, the loss of 4,800 consumers surplus has been divided into four areas, labeled a, b, c, and d. They have the following interpretations:

Gains from Trade

If the world price for coffee, given by Pws is Pw = $3, then it will be worthwhile for domestic consumers to buy imported coffee, since the world price is below the ruling domestic price. If the world price is used then the domestic demand is, Qd = 3,000-200(3) = 2,400 and the domestic supply is Qs= -500 + 500(3) = 1,000 Hence the shortfall in domestic production has to be made up by imports. The quantity of imports can be as the difference between the quantities demanded and supplied, Qd-Qs = 2,400 - 1,000 = 1,400 to calculate consumer's surplus we take the area (1/2)(15-3)(2,400) = 14,400 and for Producer's surplus (1/2)(3-1)(1,000) hence, consumer's surplus is now 14,400, which is a rise of 4,400 producers surplus is now only 1,000 which is a fall of 3,000 hence the net gain from trade is 4,400 - 3,000 = 1,400

An Economic Model of the Effects of a Tariff

In order to introduce the issues of commercial policy, it is convenient to start with some simple numerical examples that illustrate the various issues involved. This fictitious example is based on the demand and supply of coffee in the US. The specific demand and supply functions for coffee in the US are given by: Demand: Q^d = 3,000 - 200P Supply: Q^s = -500 + 500P where P is the price in $ of one thousand tons and Q^d represents the quantity demanded in thousand tons and Q^s represents the quantity supplied in thousand tons. not that generally demand and supply curves are downward and upward sloping curves respectively. For the sake of simplicity we are assuming in this example, that the functions are linear, i.e both straight lines

Inter War Attempts at Removing Tariffs

In the years 1934-1945 there were bilateral negotiations between the US and other countries to remove tariffs. The average import duty fell from 59% in 1934 to 25% in 1945

Issues Concerning the EU:

Initially the EU was essentially a customs union, which abolished tariffs and trade restrictions between its member countries and developed restrictions against outsiders. The restrictions on outsiders, took the form of common tariffs against imported goods from outside, so that for example, the US and Japan had to pay a CET (Common External Tariff) The EU is concerned with the development of economically disadvantaged areas of Europe. Traditionally, the EU has spent about 25% of its annual budget on such development

History of Protectionism [Smoot-Hawley Act]

Introduced in 1930, and imposed tariffs on a wide variety of goods; particularly agricultural products to protect US farmers. Helped to produce substantial tariff revenue. The average tariff rate was 53%

Reciprocal Trade Agreements Act in 1934

Most Favored Nation (MFN) Status introduced for general tariff reduction

(a) Trade without discrimination.

Most favored nation (MFN) clause; countries are obligated to grant to trading partners favorable terms in the application and administration of import and export duties

Great Depression:

Occurred between 1928/1929 to 1932/1933 when output and employment fell by about 33% in most industrialized economies The imposition of tariffs are generally considered to have worsened the depression Following the Smoot-Hawley legislation 25 countries retaliated with their own systems of tariffs. Some countries depreciated their currencies and others used Foreign Exchange control systems. By 1932 the US exports had declined by 66% Henry Ford had previously petitioned President Hoover in 1928 and advocated removing tariffs.

OECD

Or the Organization for Economic Cooperation and Development and is based in Paris, France. The OECD was formed at the end of World War II and was one of the outcomes of the Marshall Plan which channeled US aid to European countries at the end of the war

Economies of Scale

Protection in the form of a tariff leads to artificially high profits and encourages too many firms to enter the market. A smaller number of firms producing on a larger scale would be more efficient than a large number of small firms. Removing protection often deters inefficient entry and leads to lower costs of production. There is the immediate effect resulting from Free Trade of higher levels of domestic GDP and consumption. There are dynamic effects as the economy grows over time and/or becomes more efficient. Can import capital goods to improve technology. Open trade reduces the power of domestic monopolies and helps consumers. Trade expands markets Can increase the amount of savings to fund investment, so that savings are borrowed from other countries.

Protectionism

Protectionism is the use of commercial trade policy in the form of tariffs and quotas to restrict the amount of imported goods, and the use of subsidies to help domestic industries. There are many different justifications that are given for the use of protectionism. Many of these arguments appear to be logically unsound.

The Case for Restricting Trade

Tariffs raise government revenue. Tariffs protect domestic industry and employment in that industry. Tariffs are flexible as a policy tool and can be varied with each trading country. For example, the granting of MOST FAVORED NATION status to countries such as China. Hence can reward politically friendly countries.

Consumer's Surplus

The Consumer's Surplus at autarky is given by the shaded area below the Demand Curve Remember that the area of a triangle is, (1/2)(base)(height) hence the consumer's surplus is (1/2)(Qa)(Pa-P)=(1/2)(2,000)(15-5)=$10,000 the interpretation of the consumers surplus region is that it is the region where consumers welfare is increased due to the fact that more consumers pay less than they would have been willing to pay. That is the amount they are willing to pay to demand between Q = 0 and Q = 2,000, which is the level above the autarky price of $5

European Union (EU)

The EU is an economic and political community intended to make a single state or market with the same laws and with freedom of movement of labor and capital. The population of the EU is approximately 550,000 and has a GDP of almost $16,000bn and a per capita GDP of $30,000 The EU has a common trade policy, agricultural and fisheries policies, and a regional development policy In 1999 the EU introduced a common currency, known as the Euro, which by 2013 had been adopted by seventeen of the member states The EU represents its members in the World Trade Organization and plays an observational role at G8 summits. The EU has also developed a role in foreign policy, and in justice and home affairs. Twenty one EU countries are members of NATO Institutions such as the European Central Bank

Current composition of the EU:

The European Union is composed of 28 independent sovereign countries of: Austria, Belgium, Bulgaria, Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and United Kingdom [there are several official candidate countries which have applied for membership; namely the Republic of Macedonia and Turkey there are four more potential candidates which are all in the western Balkan and are: Albania, Bosnia and Herzegovina, Montenegro and Serbia

The case for free trade

The above example illustrates many of the aspects of the economic arguments for Free Trade. In particular, Free Trade is regarded as being: WELFARE INCREASING: imposing a tariff or quota leads to distortions in consumption and production and leads to a net loss in welfare.

3) Leveling the playing field for domestic industry

The argument is often expressed as, "Since so many foreign producers don't play fair we must use tariffs to level the playing field" However, tariffs and protectionism in general increased costs and reduces competition. For countries who don't "play fair"; the more effective route in the long run is to negotiate decreased trade barriers through GATT talks and in bilateral conferences

Autarky

The autarky price and quantity are determined at the equilibrium in the domestic market; i.e at the intersection of the demand and supply curves. On equating demand and supply, so that Q = Q^d - Q^s then, 3,000 - 200P = -500 +500P 3,500 = 700P P=3,500/700 = 5 which is the autarky equilibrium price. At a price of $5, the autarky quantity demanded is: Q = 3,000 - 200(5) = 2,000 as a check we can confirm that the quantity supplied is indeed: Q = -500 + 500(5) = 2,000

Producer's Surplus

The quantity of the Producer's Surplus at autarky, is given by the shaded area above the Supply curve. Hence the Producer's Surplus is calculated as, (1/2)(Qa)(Pa-P) = (1/2)(2,000)(5-1) = 4,000 the interpretation of the producer's surplus is that it is the region where producers welfare is increased due to the fact that they are able to supply at a higher price than necessary for them to produce the amount of coffee. That is they would be willing to supply between Q = 0 and Q = 2,000 at a lower price than the autarky price

Generalized System of Preferences (GSP)

allows the US to charge lower tariffs on goods from developing countries. The implementation of GSP rather than a full tariff will hopefully raise GNP in those countries and may lead to them buy more US exports. It is sometimes argued that the government should have more control over the volume and composition of trade for strategic and defense reasons Sometimes the concept of the Nominal Rate of Protection is used, which in percentage terms is 100(Tariff/Final Price). Note that the Effective Rate of Protection is another concept based on a value added calculation and is at least as high as for the Nominal Rate of Protection.

Redistributive Effect (area a)

is the area to the left of the demand curve under price of $4 and above $2; and represents the area or amount of surplus transferred from the consumer to the producer with the quota; i.e the gain in producer surplus. The amount of this effect is 2(500) + (2/2)(1,000) = 2,000

results of tariffs

now suppose that the government decides to impose a tax of $1 on imported coffee, so the world price of coffee becomes Pt = $4, where the symbol Pt denotes the price including the tariff. The new price Pt and where it intersects with the supply and demand curves is shown in figure 4. The increase in price from $3 to $4 leads to a reduction of consumer surplus and a corresponding increase in producer surplus -The imposition of the tariff and the subsequent increase in price leads to a large area, previously associated with consumer surplus, becoming an area of "lost welfare". This is a direct cost to consumers compared with the position under Free Trade the central block of this area labeled "C" has the interpretation of being Tariff Revenue to the Government. In this case it is $700, since (4-3)(2,200-1,500) = $700

From an overall social welfare perspective, the gain in consumer surplus is greater than the loss in producer surplus; so that trade has been worthwhile. The gains from trade are given by the areas (1/2)(5-3)(1,000) + (1/2)(5-3)(400) = 1,000 + 400 = 1,400

the general conclusion, or implication of this example, is that free trade is beneficial to the whole society, with consumers substantially benefiting to the extent it more than compensates for the loss of producer surplus

Consumption Effect (area d)

this corresponds to permanently lost consumer surplus which goes nowhere and is lost forever. The area in this case is (1/2)(2)(400) = 400 the sum of the redistributive effect, the protective effect, the revenue effect and the consumption effect all add to the lost consumer surplus of 4,800 however, only the protective effect, the revenue effect and the consumption effect add to lost welfare of 2,800 the redistributive effect has a positive benefit to US producers and the Revenue effect has a positive effect for the exporting nation. However, the protective effect and the consumption effect are deadweight losses.

Quota Revenue Effect (area c)

this corresponds to windfall profit or quota rent. The area in this example is (700)(2) = 1,400

European Free Trade Association (EFTA)

was started by the UK when they were denied access to the EU