slides2_trade_policy.pdf

# Introduction to international trade policy International trade is not entirely free due to the inherent presence of winners and losers, necessitating government intervention through various policy tools to manage and influence trade flows [3](#page=3). ### 1.1 Why trade is not free Economists often advocate for free trade, yet in reality, trade is not entirely free because there are individuals or groups who benefit from trade (winners) and those who are negatively impacted (losers). These "losers" often do not wish to accept their disadvantaged position, leading to pressure on governments to implement policies that alter trade outcomes. Consequently, agreements that are termed "free trade agreements" are more accurately described as "carefully managed trade agreements" [3](#page=3). ### 1.2 Government tools to influence trade Governments possess a wide array of instruments to manipulate international trade, which can involve restricting or promoting trade with partner countries. These tools form the trade policy toolkit used to regulate or affect the rules of international trade [3](#page=3) [5](#page=5). #### 1.2.1 The role of tariffs Tariffs are identified as the most widely known tool in the government's trade policy toolbox. The historical significance of tariffs in the United States is highlighted by the fact that at least two presidents, McKinley and Trump, have been characterized as "tariff men" [3](#page=3) [4](#page=4). #### 1.2.2 Other trade policy instruments Beyond tariffs, governments can employ a variety of other measures to influence trade. These include [5](#page=5): * **Quotas:** Limits on the quantity of specific goods that can be imported or exported [5](#page=5). * **Non-tariff measures:** A broad category of trade restrictions that do not involve direct taxes on imports or exports [5](#page=5). * **Local content requirements:** Regulations that mandate a certain percentage of a product's components or labor must be sourced domestically [5](#page=5). * **Subsidies:** Financial assistance provided by governments to domestic producers, which can make their goods more competitive internationally [5](#page=5). * **Voluntary export restrictions (VERs):** Agreements where an exporting country voluntarily limits the amount of a good it ships to another country [5](#page=5). * **Boycotts / bans:** Prohibitions on the trade of specific goods or with specific countries [5](#page=5). > **Tip:** Understanding the full range of these tools is crucial for analyzing trade disputes and the motivations behind international trade policies. Each tool has distinct economic and political implications. --- # Tariffs and their welfare analysis This section details how tariffs, a common trade policy tool, impact consumer surplus, producer surplus, government revenue, and lead to deadweight loss through a step-by-step welfare analysis [8](#page=8). ### 2.1 Tariffs as a trade policy tool Tariffs are taxes applied to the value of goods crossing a border or, alternatively, on each imported unit. They are a widely used tool in trade policy, with some countries employing high tariffs on specific products. For instance, Singapore heavily taxes alcohol, and Japan imposes significant tariffs on rice. Japan taxes the first 700,000 tons of rice entering the country at 0%, and subsequent imports are taxed at 2.3 USD per kilogram. Depending on the world price of rice, this can equate to a tariff of around 400% [6](#page=6) [7](#page=7). ### 2.2 Welfare analysis framework A welfare analysis quantifies the gains and losses for consumers and producers resulting from the imposition or removal of a tariff. This analysis typically proceeds in three steps [8](#page=8): 1. Measuring welfare without trade. 2. Measuring welfare with free trade. 3. Measuring welfare with trade and a tariff [8](#page=8). #### 2.2.1 Scenario #1: Welfare without trade In a closed economy, before any trade occurs, welfare is determined by domestic supply and demand [9](#page=9). * **Consumer Surplus:** Represented by the area below the demand curve and above the domestic price ($P_{home}$), consumer surplus reflects the gain consumers receive from purchasing goods at a price lower than their willingness to pay. This area is labeled 'A' on the graph. A lower price leads to a greater consumer surplus [9](#page=9). * **Producer Surplus:** Represented by the area above the supply curve and below the domestic price ($P_{home}$), producer surplus reflects the gains producers make from selling goods at a price higher than their marginal cost of production. This area is labeled 'B' on the graph. A higher price increases producer surplus [10](#page=10). * **Total Welfare:** In the absence of trade, total welfare is the sum of consumer surplus and producer surplus (Area A + Area B) [11](#page=11). #### 2.2.2 Scenario #2: Welfare with free trade When a country opens to international trade and the world price ($P_{world}$) is below the domestic price ($P_{home}$), imports become beneficial [12](#page=12). * **Consumer Gains:** Consumers benefit from the lower world price, increasing their consumer surplus. The demand curve shows willingness to pay, and the supply curve represents the marginal cost of production (#page=9, 10). With trade, the price falls to $P_{world}$, leading to an increase in quantity demanded and a decrease in quantity supplied domestically. This results in imports equal to the difference between quantity demanded and quantity supplied at $P_{world}$ [10](#page=10) [13](#page=13) [14](#page=14) [9](#page=9). * **Producer Losses:** Producers are negatively impacted by the lower world price, as they receive less revenue for their goods and may reduce production [13](#page=13). * **Total Welfare Increase:** The overall welfare of the country increases with free trade compared to autarky [13](#page=13). #### 2.2.3 Scenario #3: Welfare with trade and a tariff When a tariff ($\tau$) is imposed on imports, the domestic price rises from the world price ($P_{world}$) to $P_{home} = P_{world} + \tau$ (#page=16, 17). This tariff alters the welfare distribution [16](#page=16) [17](#page=17) [18](#page=18). * **Consumer Loss:** Consumers suffer a loss of surplus. This loss is composed of two parts: 1. **Price Effect:** Consumers pay a higher price for the units they continue to purchase, reducing their surplus on each unit. This corresponds to the area $P_{world}P_{home}cb$ in typical diagrams [19](#page=19). 2. **Volume Effect:** The higher price leads to a reduction in consumption as some consumers no longer find the product affordable given their willingness to pay. This is represented by the area $c b$ (or $dij$ due to symmetry as per ) between the demand curve and the new price, for the units no longer consumed [19](#page=19) [21](#page=21). The total consumer loss is represented by the area $P_{world}P_{home}fg$ (or $- (c+d+f+g)$ in labels from ). (#page=18, 19, 21) [18](#page=18) [19](#page=19) [21](#page=21). * **Producer Gain:** Producers benefit from the tariff. 1. **Price Effect:** Producers receive a higher price for the units they sell, increasing their surplus. This corresponds to the area $P_{world}P_{home}cd$ in typical diagrams [20](#page=20). 2. **Volume Effect:** The higher price incentivizes domestic producers to increase their output. This is represented by the area $cdj$ (or $+ (c+d+j)$ in labels from ) between the supply curve and the new price, for the additional units produced [18](#page=18) [20](#page=20). The total producer gain is represented by the area $P_{world}P_{home}dj$ (or $+ (c+d+j)$ in labels from ). (#page=18, 20, 21) [18](#page=18) [20](#page=20) [21](#page=21). * **Government Revenue:** The government collects revenue from the tariff. This revenue is equal to the tariff rate multiplied by the quantity of imports. In terms of the diagram, this is the area $P_{world}P_{home}hi$ (or $d+f+h+i$ in labels from ). (#page=18, 21) [18](#page=18) [21](#page=21). * **Deadweight Loss:** The net effect of a tariff is typically negative for a small country, meaning total welfare decreases. This loss arises from the combined "volume effects" on both consumers and producers, which are not offset by government revenue. It represents an inefficiency in resource allocation. The deadweight loss is quantified as the sum of the loss in consumer surplus from reduced consumption and the loss in producer surplus from reduced production that are not captured by the government or other parties (#page=18, 22). Specifically, it is the sum of the areas $dij$ and $fgh$ [18](#page=18) [22](#page=22). > **Tip:** The "volume effect" on the producer side, which leads to increased domestic production due to the tariff, is graphically represented by the area between the supply curve and the new price, for the increase in quantity supplied [21](#page=21). > **Tip:** The deadweight loss from a tariff is equal to the sum of the reduction in consumer surplus associated with the lost consumption and the reduction in producer surplus associated with the lost production, which are areas that are not gained by any other economic agent [22](#page=22). #### 2.2.4 Decomposing Welfare Changes The changes in consumer and producer surplus can be further broken down into a "price effect" and a "volume effect" (#page=19, 20) [19](#page=19) [20](#page=20). * **Consumer Surplus:** * **Price Effect:** The increase in price reduces the surplus on units that are still consumed [19](#page=19). * **Volume Effect:** The increase in price leads to fewer units being consumed, further reducing surplus [19](#page=19). * **Producer Surplus:** * **Price Effect:** The increase in price raises the surplus on units that are produced and sold [20](#page=20). * **Volume Effect:** The increase in price incentivizes producers to increase the quantity supplied, adding to their surplus [20](#page=20). #### 2.2.5 Net effect for a small country For a small country (one that does not influence world prices), the net effect of imposing a tariff is a decrease in total welfare. This net loss is equal to the deadweight loss, which is comprised of the two "volume effects" described earlier. The question of why countries impose tariffs, despite this welfare loss, remains an important consideration in trade policy discussions [22](#page=22). --- # Other trade policy tools Governments employ various instruments beyond tariffs to regulate international trade, including quotas, non-tariff measures (NTMs), and local content requirements [23](#page=23). ### 3.1 Quotas Import quotas function by imposing different tariff rates based on the volume of imports within a specified period. Typically, a lower tariff rate, $\tau_1$, applies to the first $X$ units of a good entering the country annually. Any subsequent units exceeding this threshold $X$ are subject to a significantly higher tariff rate, $\tau_2$ [23](#page=23). > **Example:** In Japan's rice market, the first 770,000 tons of imported rice face a tariff of $\tau_1 = 0\%$. However, all rice imports beyond this quota are subject to a tariff equivalent to $2.5$ dollars per kilogram, which translates to a substantial $\tau_2$ ranging from 400% to 700%, depending on the prevailing market price. This effectively deters significant rice imports beyond the stipulated quota [23](#page=23). ### 3.2 Non-tariff measures (NTMs) Non-tariff measures (NTMs) are trade policy instruments that, similar to tariffs, increase the final price for consumers by raising the cost of production rather than the cost of trading the product itself. A key distinction from tariffs is that governments collect no revenue from NTMs, as the increased costs are borne by producers. Despite this difference, NTMs share the fundamental impact of tariffs: they reduce trade volumes and lead to higher domestic prices [24](#page=24). NTMs can be quantified using various indices: * **Frequency index:** This metric indicates the proportion of products to which NTMs are applied [26](#page=26). * **Coverage ratio:** This measure quantifies the percentage of trade that is subject to NTMs [26](#page=26). > **Tip:** While NTMs and tariffs have similar impacts on consumers and trade, understanding the revenue implications is crucial for analyzing government policy objectives and fiscal outcomes. The economic impact of NTMs, specifically their effect on increasing prices, can also be estimated [27](#page=27). ### 3.3 Local content requirements Local content requirements (LCRs), also referred to as rules of origin, are a specific trade policy tool often utilized within regional trade agreements. These requirements stipulate that a certain percentage of a product's value added must originate from the participating countries for it to qualify for preferential tariff treatment [28](#page=28). > **Example:** Under agreements like the United States-Mexico-Canada (USMCA) agreement (formerly NAFTA), goods can move freely between the US, Mexico, and Canada without tariffs, but only if they are considered "mostly made" in one of these countries. A Canadian firm importing watches from Switzerland and then exporting them to the US would not qualify for duty-free status because the watches are manufactured in Switzerland, not North America. However, if the Canadian firm imports gold from Switzerland, uses it to manufacture jewelry in Canada where the imported gold constitutes 20% of the total cost and the remaining 80% is Canadian value-added, the jewelry would be considered "made in Canada" and could be exported to the US and Mexico duty-free [28](#page=28) [29](#page=29). The specific percentage for satisfying an LCR can vary significantly across different agreements and products. For instance, during the renegotiation of NAFTA, the US increased the local content requirement for cars from 62.5% to 75%, subsequently to 85%, with further increases to 90% anticipated by 2026. The primary objective of LCRs is to compel producers to source components from local suppliers, which are presumed to be potentially more cost-effective [30](#page=30). --- ## Common mistakes to avoid - Review all topics thoroughly before exams - Pay attention to formulas and key definitions - Practice with examples provided in each section - Don't memorize without understanding the underlying concepts

| Term | Definition | |------|------------| | Trade Policy | The set of rules and regulations that governments establish to govern international trade, influencing the flow of goods and services across borders. | | Free Trade Area (FTA) | A group of countries that have eliminated tariffs and other trade barriers among themselves, allowing for the free movement of goods and services, but maintaining independent trade policies with non-member countries. | | Tariffs | Taxes imposed by a government on imported goods or services, typically calculated as a percentage of the value of the good or on a per-unit basis, intended to protect domestic industries or generate revenue. | | Quotas | A government-imposed limit on the quantity of a particular good that can be imported into a country during a specified period. | | Non-tariff Measures (NTMs) | A broad category of trade restrictions that do not involve direct taxes on imports, such as quotas, import licensing, local content requirements, and technical regulations, which can increase the cost of imports. | | Local Content Requirement | A regulation that mandates a certain percentage of a product's value or components must originate from the domestic country to qualify for preferential treatment, such as tariff-free entry into a free trade area. | | Subsidies | Financial assistance provided by a government to domestic producers, which can distort international trade by making domestic goods cheaper or more competitive. | | Voluntary Export Restrictions (VERs) | Agreements where an exporting country voluntarily limits the amount of a commodity it exports to another country to avoid more stringent import restrictions. | | Boycotts / Bans | The refusal to buy or sell goods or services from a particular country or company, often for political or ethical reasons. | | Welfare Analysis | An economic method used to assess the impact of economic policies, such as tariffs, on the well-being of consumers, producers, and the government, by measuring changes in surplus. | | Consumer Surplus | The economic measure of the benefit consumers receive when they are willing to pay more for a good or service than they actually have to pay. | | Producer Surplus | The economic measure of the benefit producers receive when they sell a good or service for a higher price than the minimum price they would have been willing to accept. | | Deadweight Loss | A loss of economic efficiency that occurs when the equilibrium for a good or service is not achieved, often resulting from market distortions like tariffs, taxes, or subsidies. | | Price Effect | In the context of tariffs, the portion of the change in consumer or producer surplus that is directly attributable to the change in the price of a good. | | Volume Effect | In the context of tariffs, the portion of the change in consumer or producer surplus that is attributable to the change in the quantity of a good consumed or produced due to the price change. | | Rule of Origin | The criteria used to determine the national source of a product, crucial for implementing trade policies like tariffs, quotas, and preferential trade agreements. | | Import Quotas | A quantitative restriction imposed by a government on the volume of specific goods that can be imported into a country over a given period. | | Frequency Index (NTM) | A metric used to measure the prevalence of non-tariff measures (NTMs) by indicating the percentage of products in a country's tariff schedule to which NTMs apply. | | Coverage Ratio (NTM) | A metric used to measure the impact of non-tariff measures (NTMs) by indicating the percentage of a country's total trade that is subject to these measures. |