Introduction

Gainers and Losers from Steel Tariffs

In March 2002 President George W. Bush, following a recommendation by the U.S. International Trade Commission, an independent federal agency that investigates trade matters, imposed a variety of tariffs on imports of steel into the United States. Ad valorem tariffs were imposed for three years, with some of them having a downward-sliding scale over the years, and the maximum tariff rate was 30 percent. The stated intent of the tariffs was to provide the U.S. steel industry with “breathing room” so that it could upgrade its equipment and reduce labor costs in order to become more competitive. Clearly, competitiveness had been slipping. Imports of steel products had risen from 18 percent of U.S. steel consumption in 1990 and 1991 to 31.4 percent in 1998, 27.7 percent in 1999, 28.7 percent in 2000, and 25.5 percent in 2001. The steel industry applauded the decision, but some politicians didn’t think that the import restrictions went far enough. For example, Senator Richard Durbin (D–IL) likened the actions to throwing a 30-foot rope to someone who was “drowning 40 feet offshore.” Foreign exporting countries protested the action. British Prime Minister Tony Blair said that the import restrictions were “unacceptable and wrong,” and Germany and China in particular registered strong objections. In addition, U.S. steel consumers faced sharply rising prices because of the tariffs, and they undertook such actions as hiring public relations firms and organizing protests. One firm in Illinois saw its steel input costs rise by more than 50 percent, and it had cut production by 15 percent. The objections by consumers are understandable in view of an estimate by Gary C. Hufbauer of the Peterson Institute for International Economics that, over the previous 30 years, various U.S. import protections had cost steel consumers $120 billion. The objections became so heated that the Bush administration soon implemented a number of exceptions to the tariff impositions and later repealed the tariffs. As with all tariffs, the steel case discussed here indicates that there are gainers and losers from actions that restrict international trade. The purpose of this chapter is to explore the effects of the tools of trade policy that were discussed in Chapter 13 on the nation that uses the tools. We thus examine the winners and losers when trade-distorting measures are undertaken and the net effects on the country. The initial or direct impact of a trade restriction takes place in the market of the commodity that is the focus of the specific instrument. When the analysis of a policy effect is confined to only one market and the subsequent or secondary effects on related markets are ignored, a partial equilibrium analysis is being conducted. While the most immediate and, very likely, the strongest effects are felt in the specific market for which the instrument is designed, it is important to remember the secondary effects. Because these secondary, or indirect, effects are often important, economists try to examine the effects of economic policy in a general equilibrium model. In this framework, the markets for all goods are analyzed simultaneously and the total direct and indirect effects of a particular policy are determined. Because both partial and general equilibrium impacts are useful for policy analysis, we will use both approaches to examine the effects of trade policy instruments. The first two sections are devoted to the analysis of trade restrictions in a partial equilibrium context, and the third section to an analysis in a general equilibrium framework. The central thrust of the chapter is that there is generally a net social cost to the country that employs trade restrictions, regardless of the type of instrument employed or the framework of analysis.

Trade Restrictions in a Partials Equilibrium Setting: The Small-Country Case

The Impact of an Import Tariff

First, let us examine the market in which an economically small (price-taker) country imports a product because the international price is less than the domestic equilibrium price in autarky (see Figure 1).2 Because the country can import all that it wishes at the international price (Pint), the domestic price (P0) equals the international price. If the small country imposes an import tariff, the domestic price of the foreign good increases by the amount of the tariff. With an ad valorem tariff, the domestic price now equals Pint(1 + t) = P1, where Pint is the international price and t is the ad valorem tariff rate. (With a specific tariff, the domestic price equals Pint + tspecific.) With the increase in domestic price from P0 to P1, domestic quantity supplied increases from QS0 to QS1, domestic quantity demanded falls from QD0 to QD1, and imports decline from (QD0 − QS0) to (QD1 − QS1). What is the net impact of these changes? Because the adoption of this policy involves both winners and losers, we must turn to devices that allow us to evaluate the costs and the benefits accruing to all those affected. To measure the effect of a tariff, we employ the concepts of consumer and producer surplus. The concept of consumer surplus refers to the area bounded by the demand curve on top and the market price below. It reflects the fact that all buyers pay the same market price regardless of what they might be willing to pay. Consequently, all those consumers who pay less (the market price) than they would be willing to pay (as represented by the height of the demand curve) are receiving a surplus [see Figure 2, panel (a)]. As market price rises, this consumer surplus falls; as price falls, consumer surplus increases.

In a similar vein, the concept of producer surplus refers to the area bounded on top by the market price and below by the supply curve. Because all producers receive the same market price, a surplus occurs for all units whose marginal cost of production (represented by the supply curve) is less than the market price received [see panel (b) of Figure 2]. Consequently, as price increases, producer surplus increases, and as market price falls, producer surplus decreases. A change in market price thus leads to a transfer of surplus between producers and consumers. With an increase in price, producer surplus is increased and consumer surplus is decreased. For a price decrease, surplus is transferred from producers to consumers. For our purposes, the changes in producer and consumer surplus that result from the tariff-induced price change are of interest. Let us now isolate the effects of a tariff on a market and estimate conceptually the various effects accruing to the winners and losers. The two actors who gain from the imposition of a tariff are producers and the government. In Figure 3, a 20 percent ad valorem tariff imposed on the market causes the domestic price to rise from $5 to $6, increasing producer surplus by trapezoid area ABCJ. At the same time, the government collects the tariff ($1) on each unit of the new level of imports; total receipts are represented by rectangular area KCFG. The losers from this policy are consumers who have to pay a higher price and consequently reduce their quantity demanded. This leads to a loss in consumer surplus equal to trapezoid area ABFH. What is the net effect of this tariff? Part of the loss in consumer surplus is transferred to the government (area KCFG) and part to producers (area ABCJ). This leaves two triangular areas, JCK and GFH, which reflect losses in consumer surplus that are not transferred to anyone. These areas are the deadweight losses of the tariff and represent the net cost to society of distorting the domestic free-trade market price. They can be viewed as efficiency losses resulting from the higher cost of domestic production on the margin (area JCK) and the loss in consumer surplus accompanying the tariff (area GFH) on the units consumers no longer choose to purchase. Because of the higher product price resulting from the tariff, consumers switch to alternative goods that bring lower marginal satisfaction per dollar.

These changes in consumer and producer surplus allow us to place a value on the impact of the tariff. For example, area ABFH (loss in consumer surplus with the tariff) is equal to the area of rectangle ABFG plus the area of triangle GFH. Similarly, the value of the gain in producer surplus is equal to the area of rectangle ABIJ plus the area of triangle JIC (which, because the lines are straight lines, equals the area of triangle JCK). The value of government revenue received is equal to the area of rectangle KCFG. Using the quantities and prices from Figure 3, the various effects are

There is thus a net cost to society of $25 due to the tariff (− $175 + $110 + $40). Care must be taken, however, in interpreting these precise values in a welfare context. Because one dollar of income may bring different utility to different individuals, it is difficult to determine the exact size of the welfare implications when real income is shifted between two parties, in this case from consumers to producers. In addition, part of the loss in consumer surplus may be offset by government use of the revenue, which affects consumers in a positive way. However, it is clear that there is a net efficiency cost to society whenever prices are distorted with a policy such as a tariff. From Chapter 6, we know that free trade page 285benefits society because the losers could be paid compensation and some income could still be “left over.” In reverse, the departure from free trade has reduced country welfare. 

The Impact of an Import Quota and a Subsidy to Import-Competing Production

The preceding analysis suggests that a tariff produces a net efficiency (welfare) loss, so the question arises, What are the effects of alternative trade policies such as quotas or producer subsidies? Might they be preferred to tariffs on economic efficiency and welfare grounds?

The Import Quota

As explained in Chapter 13, a quota operates by limiting the physical amount of the good or service imported. This reduces the quantity available to consumers, which in turn causes the domestic price to rise. The domestic price continues to rise until the quantity supplied domestically at the higher price plus the amount of the import allowed under the quota exactly equals the reduced quantity demanded. The quota thus restricts quantity supplied, causing price to adjust, in contrast to a tariff, which induces a quantity adjustment by fixing a higher domestic price. The market effects in the two cases are exactly the same. Return to Figure 3. The imposition of a 20 percent tariff caused the domestic price to rise to $6 and the quantity of imports to decline from 90 units to 40 units, as domestic quantity supplied increased and domestic quantity demanded decreased. The imposition of a quota of 40 units would have produced the very same result! With imports restricted to 40 units, the domestic price will rise and continue to rise until the combination of domestic quantity supplied and the quota-restricted imports equals quantity demanded. Thus, every quota has an equivalent tariff that produces the same market result, just as every tariff has an equivalent quota.3 While the market effects of tariffs and quotas are identical, the welfare implications are not. Since the price and quantity adjustments are the same under both instruments, the changes in producer surplus, consumer surplus, and the consequent deadweight efficiency losses are also the same. The government revenue effect is, however, not the same. With a tariff, the government receives revenue equal to the amount of the tariff per unit times the quantity of imports. No such tax is collected under a quota. In effect, the difference between the international price and the domestic price of the import good is an economic quota rent, which may accrue to the domestic importer/retailer, the foreign supplier/foreign government, or the home government or may be distributed among the three. Domestic importers/retailers will receive the rent if foreign suppliers do not organize to raise the export price or if the home government does not require that everyone importing the good buy a license from the government in order to do so. Foreign suppliers receive the quota rent if they behave in a noncompetitive, monopolistic manner and force up the price they charge the importing country’s buyers. However, it is also possible that the foreign government might step in and devise a scheme for allocating the supply of exports whereby it receives the quota rent; for example, the foreign government sells export licenses at a price equal to the difference between the international price and the domestic price in the quota-imposing country. If either foreign suppliers or the foreign government captures the rent, then the welfare loss to the home country is greater than it is with an equivalent home country tariff, since the previous tariff revenue now accrues to the foreign country. The mystery of what happens to the quota rent can be resolved to the quota-imposing government’s benefit if it sells licenses to those who wish to import the good at a price equal page 286to the difference between the international price and the higher (quota-distorted) domestic price. This generates government revenue equal to that achieved with the equivalent tariff. One way this might be accomplished is to have a competitive auction of import licenses. Potential importers should be willing to pay up to the difference between the international price and the expected domestic price to have the right to import. However, this kind of system, often called an auction quota system, will incur administrative costs that absorb productive resources and become additional deadweight losses. Again, the country welfare cost of the quota will likely exceed the welfare cost of the equivalent tariff, because these administrative costs are likely to be greater than those of the tariff.

Subsidy to an Import-Competing Industry

The static impact of a tariff and that of a quota on a market and welfare are essentially the same, except for the distribution of the quota rent. This conclusion does not hold for government subsidies paid to the import-competing domestic supplier. If the intent of the tariff or quota is to provide an incentive to increase domestic production and sales in the domestic market, then an equivalent domestic production result could be achieved by paying a sufficient per-unit subsidy to domestic producers, who are thereby induced to supply the same quantity at international prices that they were willing to provide at the higher tariff inclusive domestic price (see Figure 4). In effect, the subsidy shifts the domestic supply curve down vertically (in a parallel fashion) until it intersects the international price line at the same quantity that would occur were the tariff (or equivalent quota) in effect. With an equivalent subsidy, producers are equally as well off as when the tariff was in place. The subsidy not only provides them with an increase in producer surplus equal to that under the tariff or quota but also compensates them for the higher production cost on the additional production. The cost to the government (area ABCK) is equal to the quantity produced domestically (120 units) times the amount of the subsidy ($1) or $120. Note, however, that there is no change in the domestic market price; it remains equal to the international price in the case of a domestic producer subsidy. There is no loss in consumer surplus and no deadweight loss for consumers. The increased domestic production at a resource cost that exceeds international price on the margin leads, however, to a production-efficiency loss. This is equal to area JCK and is the amount by which the subsidy cost (ABCK) exceeds the increase in producer surplus (ABCJ). It can be viewed as the cost of moving from a lower-cost foreign supply to a higher-cost domestic supply on the margin.

From a welfare standpoint, the production subsidy certainly is more attractive than a tariff or quota. If the consumers are also the taxpayers, the cost of the subsidy ($120) is less than the loss in consumer surplus ($175) that results from either a tariff or a quota. To the extent that the consumers of the specific product are not the only taxpayers, then a subsidy is more equitable. From a cost-benefit perspective, the cost of protection of a domestic industry should be borne by those who receive the benefits of its larger output. If the protection of the industry is judged desirable for the public at large (e.g., because the industry is deemed to be valuable for national security), then the burden of the policy should be borne by the public at large and not by the subset of the public that consumes this product. Regardless of these last considerations, the subsidy to domestic import-competing producers has a lower welfare cost to the country as a whole than does the import tariff. In our numerical example, the net loss to society from the use of the subsidy is only $10 (triangle JCK) rather than the $25 associated with the tariff (triangle JCK plus triangle GFH in Figure 3). It is $10 because the increase in producer surplus of $110 (area ABCJ in Figure 4) is $10 less than the subsidy cost of $120 (area ABCK in Figure 4). Thus, in the steel example with which we began this chapter, the United States would have imposed upon itself a lower welfare cost if the domestic steel industry were further subsidized (which, in fact, it had been already by a mixture of federal as well as state and local government policies)4 rather than protected by the import tariffs. To illustrate the various effects, two economists from the Peterson Institute for International Economics, a Washington, DC, “think tank,” estimated (for 1990) the impact on U.S. consumers of tariff and quota restrictions on a number of products.5 Selected results for the annual loss of U.S. consumer surplus were as follows: benzenoid chemicals, $309 million; frozen concentrated orange juice, $281 million; softwood lumber, $459 million; dairy products, $1.2 billion; sugar, $1.4 billion; apparel, $21.2 billion; and textiles, $3.3 billion. Taking into account offsetting producer surplus and tariff revenue gains, the “net” welfare losses from the trade restrictions were smaller—“only” $10 billion in benzenoid chemicals, $35 million in frozen concentrated orange juice, $12 million in softwood lumber, $104 million in dairy products, $581 million in sugar, $7.7 billion in apparel, and $894 million in textiles. In mid-2015 prices those figures would be about 80 percent larger.

The Impact of Export Policies

The Impact of an Export Tax

We examine here the impact of three types of export policies—an export tax, export quota, and export subsidy—on the well-being of the country that is exporting the good. The imposition of an export tax, a levy on goods exported, leads to a decrease in the domestic price as producers seek to expand domestic sales to avoid paying the tax on exports. The domestic price (P0) falls until it equals the international price (Pint) minus the amount of the tax (see Figure 5). (Note that in the export situation the given international price is above the intersection of the home demand and supply curves.) When this occurs, gains and losses can again be measured using producer and consumer surplus. As domestic price falls and quantity supplied contracts, there is a reduction in producer surplus equal to the area of trapezoid ABFG. Part of this loss is transferred to domestic consumers through the lower price, producing an increase in consumer surplus equal to area ABCH. In addition, the government acquires tax revenue equal to area HJEG. Finally, areas CJH and GEF reflect deadweight efficiency losses that result from the price distortion. These areas represent losses in producer surplus that are not transferred to anyone in the economy. After summing up the effects of the export tax policy on the winners and the losers, the net effect on the economy is negative. It should be emphasized that the domestic supply and demand responses lead to a smaller level of exports (distance HG) after tax than before the tax (distance CF). Governments will thus overestimate the export tax revenue that will be received if they form their revenue expectation without fully accounting for the reduction in export quantity. The less elastic domestic supply and demand are, the smaller the impact of the tax on the quantity of exports and the greater the revenue earned by the government. The less elastic producer and consumer responses are, the smaller the deadweight efficiency losses. With the numbers indicated in the parentheses in the graph, producer surplus would thus fall by [($80 − $70)(90 − 0) + (1/2)($80 − $70)(100 − 90)] = $900 + $50 = $950; consumer surplus would rise by [($80 − $70)(30 − 0) + (1/2)($80 − $70)(40 − 30)] = $300 + $50 = $350; tax revenue would rise by ($80 − $70)(90 − 40) = $500; and the net result is (−)$950 + $350 + $500 = (−)$100. This $100 loss is equal to triangle CJH ($50) plus triangle GEF ($50).

Real Income Gains from Trade Liberalisation in Agriculture

One sector of most countries’ economies that gets substantial protection from import competition is the agricultural sector. Indeed, the disputes over liberalization in that sector caused a considerable delay in completing the Uruguay Round of trade negotiations in the late 1980s/early 1990s. Disagreements over agriculture also led to breakdowns in the Doha Round of negotiations that had begun in 2001, and, as of this writing, it is quite possible that the talks may not be successfully concluded. (See Chapter 16.) Because of the size and importance of the restrictions and interventions in agriculture, the welfare effects of liberalization in that sector can be substantial. Stephen Tokaricka (2008) of the International Monetary Fund surveyed various studies of the welfare effects of agricultural trade liberalization through removing tariffs and subsidies. He noted that removing tariffs will increase demand on world markets and thus will increase world prices of the affected goods. Likewise, removing production subsidies will tend to shift resources from agriculture to other sectors and thus also increase world prices. Therefore, net exporters of agricultural products tend to gain and net importers tend to lose from this liberalization. Overall, though, world economic efficiency will be increased due to resource allocation that is more in accordance with comparative advantage, and, hence, world real income will be enhanced. Two studies in his survey are briefly discussed here. One of them, by Thomas Hertel and Roman Keeney,b utilized a computer model with 2001 as the base year and with the world economy divided into 29 regions. Another study, by Tokarickc himself (2005), used 1997 as the base year and modeled 19 world regions and employed higher elasticities of trade responsiveness to price changes. Overall, the Hertel and Keeney model generated the results that agricultural trade liberalization would yield real income gains for high-income countries of $41.6 billion and gains for developing countries of $14.1 billion, giving a total world real income gain of $55.7 billion. Tokarick’s study, with his use of greater responsiveness of trade to price changes, yielded real income gains of $97.8 billion for high-income countries and $30.4 billion for developing countries– thus giving a world gain of $128.2 billion. Finally, in 2006 economist Scott Bradfordd estimated the welfare impact on the world as a whole of the removal of all nontariff and tariff barriers to trade in food products that are in place in eight developed countries—Australia, Canada, Germany, Italy, Japan, the Netherlands, the United Kingdom, and the United States. (This study’s estimates of the domestic price impacts of these barriers were discussed in Chapter 13, pages 276–77.) With the elimination of all such barriers by the eight countries, world welfare would increase by an amount equivalent to 0.73 percent of world GDP. This impact seems small in percentage terms, but it would be close to $600 billion. Almost three-quarters of the increase would accrue to the developed countries and the remainder to the developing countries. Although there are differences in these various estimates, the important point is that liberalization of agricultural/food trade could enhance world income by a substantial absolute amount. Welfare is indeed restricted by trade barriers. aStephen Tokarick, “Dispelling Some Misconceptions about Agricultural Trade Liberalization,” Journal of Economic Perspectives 22, no. 1 (Winter 2008), pp. 199–216. bThomas Hertel and Roman Keeney, “What Is at Stake? The Relative Importance of Import Barriers, Export Subsidies, and Domestic Support.” In Agricultural Trade Reform and the Doha Development Agenda, ed. by Kym Anderson and William Martin (Washington, DC: The World Bank, 2006), pp. 37–62. cStephen Tokarick, “Who Bears the Cost of Agricultural Support Policies in OECD Countries?” The World Economy 28, no. 4 (April 2005), pp. 573–93. dScott Bradford, “The Extent and Impact of Food Non-Tariff Barriers in Rich Countries,” Journal of International Agricultural Trade and Development 2, no. 1 (2006), pp. 149–50. In the extreme case the export quota of a commodity can be zero, such as in effect occurred when, in the 1970s, the U.S. Congress enacted a ban on U.S. exports of crude oil. page 290In this situation, there is no quota rent, the domestic price falls to the price at the intersection of D and S in Figure 5, and the loss of producer surplus clearly exceeds the gain in consumer surplus. At the time of this writing, there was pressure from several quarters for an end to the export ban.

The Impact of an Export Quota

If an export quota instead of an export tax is employed, the effects are similar to those of the export tax. However, the welfare impact of the two instruments may differ because, as with the import quota, no government revenue is necessarily collected. The recipient of the quota rent is unclear. The government in the exporting country can acquire the revenue by auctioning off export quotas. In a competitive market, exporters should be willing to pay up to the difference in price in the importing and exporting countries for the privilege to export (assuming no transaction costs). If this occurs, the revenue from the auction quota system will be equivalent to the revenue from an export tax. If this does not occur, exporters can organize and act like a single seller to acquire the quota rent by charging the importing country the market-clearing price. If foreign importing firms are organized, they have the potential to acquire the quota rent by buying the product at the market-clearing price in the exporting country and selling it at the higher market-clearing price at home. In our numerical example in Figure 5, the area HJEG ($500) would then be an additional loss to the exporting country. 

The Effects of an Export Subsidy

The final instrument considered is the export subsidy. Its use and the interest that it has sparked make it important to examine its effects. In Chapter 13, we noted that an export subsidy is in effect a negative export tax. Consequently, the effects of this instrument can be analyzed in a manner similar to that used with the export tax. In a small country, the imposition of the subsidy directly raises the price received by the producer for exported units of the product. For every unit exported, the producer receives the international price plus the subsidy. Producers are thus given the incentive to shift sales from the domestic to foreign markets to receive the government subsidy. The end result is that the export subsidy reduces the quantity sold in the domestic market, increases the price in the domestic market to where it equals the international price plus the subsidy, and increases the quantity supplied by producers as they respond to the higher price, leading finally to increased exports (assuming that the good is not imported). These demand and supply responses are evident in the partial equilibrium analysis for a small country (see Figure 6). The imposition of the export subsidy raises the domestic price, which was equal to P0 = Pint ($100) without the subsidy, to P1 = Pint + Sub ($100 + $10 = $110). The increase in price causes domestic quantity demanded to fall from Q1 (60 units) to Q3 (50 units), the quantity supplied to rise from Q2 (85 units) to Q4 (95 units), and the quantity of exports to increase from distance Q1Q2 (25 units) to distance Q3Q4 (45 units). These market adjustments to the export subsidy lead to a fall in domestic consumer surplus equal to area ABCJ and an increase in domestic producer surplus equal to area ABFH. Assuming that taxes pay for the subsidy program, the taxpayer cost of the subsidy program equals the amount of the per-unit subsidy times the new quantity of exports, area ECFG. Finally, the net social cost of the export subsidy is equal to the two deadweight triangles, ECJ and HFG. Area ECJ represents part of the transfer to producers, which is paid for twice—once by a loss in consumer surplus and once by the cost of the subsidy—and recaptured only once (by home producers). It can be thought of as a deadweight consumer/taxpayer loss. Triangle HFG is the usual production-efficiency loss that results from the less efficient domestic production shown by the movement from Q2 to Q4.6 page 291Using the numbers in parentheses in Figure 6, consumer surplus falls by [($110 − $100)(50 − 0) + (1/2)($110 − $100)(60 − 50)] = $500 + $50 = $550; producer surplus rises by [($110 − $100)(85 − 0) + (1/2)($110 − $100)(95 − 85)] = $850 + $50 = $900; the cost of the subsidy is ($110 − $100)(95 − 50) = $450; and the net social cost is −$550 + $900 − $450 = −$100. This loss is equal to the sum of triangles ECJ ($50) and HFG ($50).

The availability of the export subsidy leads to an increase in the domestic price from P0 to P1. With the increase in the domestic price, there is a loss in consumer surplus of ABCJ, a gain in producer surplus of ABFH, and deadweight losses to society of ECJ and HFG. The taxpayer cost of the subsidy program is ECFG. The subsidy expands production from Q2 to Q4 and increases exports from distance Q1Q2 to distance Q3Q4. 

Trade Restrictions in a Partial Equilibrium Setting: The Large-Country Case

Framework for Analysis

 To this point, we have been using the already familiar demand and supply curves for a good in a small country whose trade policies have no impact on the world price. We now turn to an examination of the effects of trade policies in the large-country setting, where an impact on world price does occur. To facilitate this discussion, we need to introduce a special demand curve and a special supply curve: (a) the demand for imports schedule, as distinct from the total demand page 292curve for a good, and (b) the supply of exports schedule, as distinct from the total supply curve of a good. The demand for imports schedule applies to a particular segment of the entire market for a good that is produced and consumed at home as well as imported, and the supply of exports applies to a particular segment of the entire market for a good that is produced and consumed at home as well as exported. The impact of trade policy hits directly on these particular market segments, which in turn have an impact on the entire market.

Demand for Imports Schedule

Figure 7, panel (a), portrays the demand and supply for a homogeneous good within a particular country. The good might be shirts and the country the United States. Demand curve Dh shows the quantity of shirts (whether made at home or abroad) that home consumers are willing to purchase at each particular price during a time period. Supply curve Sh shows the various quantities that domestic producers are willing to deliver to the market during this period at various possible prices. Remember that imports are simply home demand minus home supply. Thus, if the price of shirts is P0 ($40), consumers and domestic producers are both satisfied with quantity Q0 (20 units), so there is no need for imports. In deriving the demand for imports schedule in panel (b), the quantity of imports demanded at price P0 (= Pm0) is thus zero. However, suppose that the price in the United States is P1 ($36). At this price, home consumers want to purchase quantity Q2 (24) in panel (a), but home producers are only willing to supply quantity Q1 (16) at this lower and less profitable price. Thus, there is excess demand of (Q2 − Q1) over home supply, which yields a demand for imports of Qm1 (= Q2 − Q1 = 24 − 16 = 8), as plotted in panel (b) at price Pm1 (= P1 = $36). Similarly, at price P2 ($30), there is excess home demand of (Q4 − Q3 = 30 − 10), which page 293translates into a demand for imports of Qm2 ($20) at price Pm2 ($30). Finally, note that at price P3 ($20) in panel (a), all domestic production ceases. The quantity demanded of Q5 (40) is all excess demand, and Q5 equals Qm3 in panel (b). Note that the resulting Dm schedule is flatter than the Dh schedule. This means that the demand for imports schedule generally will be more elastic than the demand for the good itself, although it should be remembered that slope and elasticity are not identical terms. The greater elasticity reflects the response of both domestic supply and demand to the change in price. Finally, observe that Dm is identical to Dh at and below the price at which domestic production ceases. 

Supply of Exports Schedule

The simple rule to remember when deriving the supply of exports schedule for a country is that exports are equal to home production minus home consumption. The technique for obtaining the home supply of exports schedule for any good is analogous to that of the demand for imports schedule. Thus, schedule Sh in Figure 8, panel (a), shows the quantity of the good supplied by domestic producers at various market prices, while schedule Dh shows the quantities of the good home consumers are willing to buy at those prices. At P0 (= Px0 = $40), there is no export supply since consumers are willing to purchase all of the good produced by domestic firms. However, at higher price P1 ($46), there is excess supply at home, because the higher price has caused home consumers to purchase smaller quantities and home producers to offer more in the market. The excess supply at price P1 is (Q2 − Q1 = 26 − 14), which translates in panel (b) into quantity Qx1 (12) at price Px1 ($46). At the next-higher price, P2 ($52), there is a larger excess supply (Q4 − Q3 = 32 − 8); this amount is supplied to the world market as exports Qx2 (24) because home consumers are not purchasing that excess supply. Finally, all home production is supplied as exports at P3 ($60). Export supply schedule Sx is identical to home supply schedule Sh at and above P3. Note that Sx is flatter or more elastic than Sh up to price Px3 (which equals price P3), because an increase in price affects the quantity of exports supplied both through increased quantity supplied domestically and decreased quantity demanded. With these schedules now in hand, we can examine various trade policy instruments.

The Impact of an Import Tariff

Having explained how the import demand curve and export supply curve for large trading partners are obtained, we can now use these curves to demonstrate market equilibrium between two large countries. Market equilibrium is indicated by the international price where home import demand equals foreign export supply, that is, Dm = Sfx in panel (a) of Figure 9. Equilibrium quantity (exports = imports) is measured on the horizontal axis. Given this large-country equilibrium, let us examine how an import tariff affects the market. In Chapter 13, it was noted that tariffs can be specific or ad valorem in nature. The imposition of a specific duty is illustrated in Figure 9(b) and the ad valorem tariff in Figure 9(c). Curve Dm in each panel is the demand for imports schedule for this good, and the Sfx schedule is the supply schedule of foreign exports to this country. Prior to the imposition of the tariff, the equilibrium price is located at the intersection of these curves, at price Pm0, and the equilibrium quantity sold is quantity Qm0. When the specific tariff is imposed (e.g., $1 per unit of the good imported) in panel (b), the relevant supply of exports curve becomes S′fx instead of Sfx, as the schedule shifts up vertically at each quantity by $1 per unit. (Each quantity of exports supplied has a price that is $1 higher on S′fx than on Sfx.) Thus, the new supply of foreign exports schedule is parallel to the old schedule but above it at each quantity by the amount of the tax. As a consequence of the import tax, the market equilibrium is E′ rather than E. Consumers are now paying the higher price, Pm1, and purchasing the smaller quantity, Qm1. The foreign supplier of the good receives a lower price per unit—Pm2 rather than Pm0. The lower price is received by the foreign firm because, with page 295the tax in place, there is a smaller quantity purchased from the foreign firm and the price is bid down in this large-country setting, where the importing country can affect world prices by imposing the tariff. Finally, the difference between the price paid by consumers, Pm1, and the price received by the foreign producers, Pm2—or the distance (Pm1 − Pm2)—represents the tariff per unit of the goods imported. In this example, the total tariff revenue collected by the importing country’s government is represented by shaded area Pm2Pm1E′F. Part of this tariff revenue is paid economically by domestic consumers, area Pm0Pm1E′G, in that a higher price is paid over the free-trade price for each unit of the good imported. The other part of the tariff revenue is paid economically by the foreign exporter, area Pm2Pm0GF, in that the exporter receives a lower price than that under free trade for each unit exported. The extent to which the tariff is paid by one party or the other, the incidence of the tariff, depends importantly on the slope/elasticity of the Sfx schedule. If this supply of exports schedule were flatter or more elastic, more of the tax burden would be borne by the domestic consumer and less by the foreign producer. In the extreme case where the home (importing) country is a small country, Sfx would be represented by a horizontal line reflecting the given world price. S′fx would be parallel to and above Sfx by the vertical amount of the tariff per unit of the import. In this case, the tariff burden would be borne entirely by home consumers, since the world price (the price received by exporters) would not change with the imposition of the tariff. It can also be noted that the division of the tariff between the two parties depends on the slope of the Dm schedule. The flatter (or more elastic) the schedule other things being equal, the more the tariff is paid by the foreign producer rather than by the home consumer. The imposition of an ad valorem tariff is shown in Figure 9(c). The only difference in construction from the specific tariff in Figure 9(b) is that the new supply curve, S′fx, is no longer parallel to the free-trade supply curve Sfx. The new curve “pulls away” from the old curve at the higher prices because a constant percentage of a higher price is a larger absolute amount, and thus the new curve is plotted at greater distances above the old curve as we go up the vertical axis. In all other respects, the qualitative impacts in Figure 9, panel (c), are the same as in panel (b)—the new price paid by consumers is Pm1, the new price received by foreign producers is Pm2, the new quantity purchased in equilibrium is Qm1, and the tariff revenue collected is area Pm2Pm1E′F. In the small country, the entire negative welfare impact of the tariff is borne by consumers in the imposing-country market. In the large country, however, the impact of the tariff can be potentially shifted, at least in part, to the exporting country through a reduction in international price. The reduction in international price means of course that the domestic price inclusive of the tariff in the imposing (large) country is less than it would be if the international price had remained the same, the loss in consumer surplus is less, and the net cost of protection is less than that for a small country. To see why the welfare cost is less, let us turn to a two-country framework similar to that used with transportation costs in a large-country setting in Chapter 8 (pages 139–41). Figure 10 depicts this situation, in which two large countries are engaged in trade. Because country A [panel (a)] is the higher-cost producer of this commodity in autarky, it has an incentive to import the product, resulting in the import demand curve Dma in panel (b). Country B [panel (c)] is the low-cost producer and has an incentive to export the product, resulting in the supply of exports curve Sxb in panel (b). When they trade, countries A and B will arrive at an equilibrium international price, Pm0 (= $100 in our numerical example), which causes the desired quantity of imports into country A to be equal to the desired quantity of exports from country B (Qm0 = Qx0 = 30 units).

If country A now imposes a specific tariff of $10 on this product [a shift of Sxb to S′xb in panel (b)], the effect will be a rise in the price of the good above Pm0 by the amount of the tariff. When this happens, there will be an increase in the quantity supplied domestically by A’s producers, a decrease in the quantity demanded in country A, and a decrease in desired imports. As the quantity of imports desired by country A begins to fall, country B finds itself with an excess supply at Pm0 and begins to lower its domestic price. The new price in B leads to an increase in domestic quantity demanded, a decrease in quantity supplied, and a decrease in available exports. The reduction in country B’s export price means that the domestic tariff-inclusive price in country A begins to decline, stimulating greater purchases of imports. Ultimately, price will adjust concomitantly in both markets until the quantity of desired imports, Qm1 (17 units), in country A at the tariff-inclusive price, Pm1 ($106), is equal to the desired level of exports of country B, Qx1 (17 units), at its export (non-tariff-inclusive) price, Pm2 ($96). Prices in the two markets will always differ by the amount of the tariff (assuming no transportation costs). We can now analyze the welfare implications of the tariff.7 To the extent that the domestic price rises in tariff-imposing country A, there will be a loss in consumer surplus, a gain in producer surplus, a gain in government revenue, and the usual deadweight efficiency losses (triangles a and b in Figure 10). The deadweight losses will be less than they would have been if the domestic price in country A had risen by the full amount of the tariff, as it did in the small-country case. Notice also that the tariff revenue is now represented not by area c alone but by area c—paid by home consumers through a higher domestic page 297price—plus area fhij in panel (c)—paid by the exporting country’s producers, who receive a lower price for the good. In addition, the net effect of the tariff on country A’s welfare depends on the relative size of triangles a + b (deadweight losses) and rectangle fhij (a gain to A transferred from B because of the lower export price). If losses (a + b) are greater than the gain transferred from country B (area fhij), country A loses from the tariff. However, if losses (a + b) are smaller than the gain from area fhij, large country A can actually gain from the imposition of the tariff. This is more likely to occur when domestic demand and supply are more elastic in country A (the importing country) and demand and supply are less elastic in the exporting country. Similarly, a large country is less able to shift the cost of the tariff to the exporting country when domestic demand and supply are less elastic and the exporting country’s demand and supply are more elastic. In our numerical example in Figure 10, the deadweight loss area a has a value of 0.5($106 − $100)(66 − 60) = (1/2)($6)(6) = $18, and the deadweight loss area b has a value of 0.5($106 − $100)(90 − 83) = (1/2)($6)(7) = $21. The total deadweight loss is thus $18 + $21 = $39. However, area fhij of the tariff revenue (total tariff revenue equals area c plus area fhij) is acquired as a transfer from the exporting country B. This area fhij has a value of ($100 − $96)(74 − 57) = ($4)(17) = $68. Hence, the imposition of the tariff by large country A, with these particular numbers, has led to a net gain in welfare for A by the amount of $68 (the transfer from country B) − $39 (the deadweight losses) = $29. Another way to look at this result is through observing, in country A, the changes in consumer surplus, producer surplus, and tariff revenue. The change in consumer surplus in A because of the imposition of the tariff is −[($106 − $100)(83 − 0) + (1/2)($106 − $100)(90 − 83)] = −[$498 + $21] = −$519. The gain in producer surplus in country A is [($106 −$100) (60 − 0) + (1/2)($106 − $100)(66 − 60)] = $360 + $18 = $378. Finally, the total tariff revenue is area c [= ($106 − $100)(83 − 66)] plus area fhij [= ($100 − $96)(74 − 57)], or [$102 + $68] = $170 (i.e., the specific tariff of $10 per unit multiplied by the 17 units imported). Hence, the sum of the change in consumer surplus, the change in producer surplus, and the tariff revenue, is −$519 + $378 + $170 = + $29 (a gain). Keep in mind, though, that this gain is achieved at the expense of the trading partner country B, and subsequently there might well be retaliatory tariffs placed by B on products coming into B from country A. Also, the numbers easily could have been set up so that there was a loss for country A rather than a gain—a gain is by no means a certainty.

The Impact of an Import Quota

Just as in the small-country situation, an import quota in a large-country situation leads to price adjustments because of the reduced quantity of imports purchased by the importing country. Because the importing country is a large country, however, it has a noticeable effect on world demand for the product and hence reduces world price. The impact of the quota on the large importing country and the large exporting country (or the rest of the world) is illustrated in Figure 11. Graphically, the impact of the quota looks exactly like the impact of the tariff discussed in the previous section. The imposition of the import-reducing quota page 298leads to an increase in price in the importing country from Pm0 to Pm1 and to a decrease in price in the exporting country from Pm0 to Pm 2. These are the prices at which the level of desired exports by country B is equal to the import quota in country A. The impact of an “equivalent” quota on price and the level of trade is thus the same as the impact of the tariff discussed previously.

Turning to the welfare effects, there is a major difference between the tariff and the quota because no tariff revenue is collected with a quota. Thus, the question of what happens to the “quota rent” must be addressed before a welfare analysis can be completed. As in the small-country case, the quota rent can be captured (1) by the home government through the auctioning of import licenses, (2) by domestic importers/retailers that buy at the new international price (Pm2) and sell at the home price (Pm1), (3) by organized foreign producers that sell at the new price in the importing country (Pm1), (4) by exporting-country governments that auction off export licenses to their firms, or (5) by any combination of the first four. In a situation where the entire quota rent ends up in the importing country (the first two cases listed), the welfare impact is exactly the same as under the import tariff. The importing country incurs deadweight losses of triangles a and b and a positive transfer from abroad of rectangle fhij due to the reduced world price of the imports. The net effect of the quota is thus the sum of these two effects and can be positive or negative depending on their relative size; that is, the importing country can possibly benefit from the imposition of the quota because of the ability to influence world price. In the cases where the entire quota goes abroad (the third and fourth cases listed), the importing country not only incurs the deadweight losses a and b but also loses the rectangle c, which is effectively sent abroad through higher domestic import prices (Pm1 instead of Pm0). The impact of the quota on the importing country is thus clearly negative and equal to the sum of the three areas. Using the numbers in Figure 11 (the same as in Figure 10), the loss for country A would thus be area a ($18) plus area b ($21) plus area c ($102), a total loss of $141.page 299 The impact of the import quota on the exporting country can also be identified. In the cases where the entire quota rent goes to the importing country, the exporting country incurs deadweight losses of triangles ghf and ikj as well as the transfer rectangle fhij. The net welfare effect in this case is clearly negative. In the cases where the exporting country captures the entire quota rent, the deadweight losses are offset, at least in part, by the transfer from the importing country of rectangle c. Hence, should the exporting country be able to capture the quota rent, the net welfare effects will be positive whenever rectangle c is greater than the sum of the triangles ghf and ikj. Possible results for exporting country B can be illustrated by using the numbers in Figure 11. If the entire quota rent goes to importing country A, country B loses deadweight loss triangles ghf and ikj as well as the rectangle fhij. Area fhij was earlier calculated in Figure 10 to be $68. Area ghf has a value of (1/2)($100 − $96)(57 − 50) = (1/2)($4)(7) = $14. Area ikj has a value of (1/2)($100 − $96)(80 − 74) = (1/2)($4)(6) = $12. Thus, if the importing country captures the quota rent, the exporting country loses welfare of the amount ($68 + $14 + $12) = $94. Alternatively, this loss can be thought of, for the exporting country, as the amount by which country B’s loss of producer surplus (from the lower price and the smaller quantity sold) outweighs country B’s gain of consumer surplus (from the lower domestic price and greater domestic quantity consumed). The loss of producer surplus in panel (c) of Figure 10 is [($100 − $96)(74 − 0) + (1/2)($100 − $96)(80 − 74)] = $296 + $12 = $308. The gain in consumer surplus in exporting country B is [($100 − $96)(50 − 0) + (1/2)($100 − $96)(57 − 50)] = $200 + $14 = $214. Hence, the loss in producer surplus of $308 exceeds the gain in consumer surplus of $214 by $94, the net loss for country B. However, if exporting country B were able to capture the quota rent, it would not lose area fhij and it would gain area c from country A. Triangles ghf ($14) and ikj ($12) are still lost, but area c is a gain to be offset against those losses. With the numbers in Figure 11, area c = ($106 − $100)(83 − 66) = ($6)(17) = $102, and, hence, if B captures the quota rent, the country gains $102 (area c) − $14 (area ghf) − $12 (area ikj) = $76. To minimize any adverse welfare effect of foreign import protection on their economies, exporting countries have employed voluntary export restraints (VERs) to avoid the importing country’s actively utilizing tariffs or quotas to reduce imports. (VERs can be adopted at the behest of the importing country under the threat of an import quota if the VER is not used. This might occur if the importing country did not want to look like it was openly restricting trade by imposing an import quota—the VER looks less like the “fault” of the importing country.) The effect of an equivalent VER is graphically the same as that of the import quota described in Figure 11. The only difference is that the VER definitely allows the exporting country to capture the quota rent associated with the reduced trade. It thus results in an unambiguous welfare loss for the importing country and a possible welfare gain for the exporting country if the positive transfer effect from the importing country more than offsets the deadweight losses in the exporting country, as it did in our immediately preceding numerical example. However, it is important to note that the VER instrument was disallowed in 1994 by the Uruguay Round Trade Agreement.8 (See Chapter 16.)

The Impact of an Export Tax

The impact of a tax imposed by an exporting country is demonstrated in Figure 12 for two large countries. Graphically, it appears the same as the impact of a tariff and/or quota, discussed in the previous two sections, and we will use the same illustrative numbers as in Figures 10 and 11. The mechanism by which the export tax operates (a $10 per-unit export tax in our example) and the welfare effects on the two countries are, however, quite different.

With the imposition of the export tax, producers in the exporting country B are induced, as in the small-country case, to lower their domestic price and sell more at home to avoid paying the tax. This will take place until the difference between the price of the good in country B and the world price is equal to the export tax. As a result of the tax, exports decline due to both the increased local consumption and the reduced quantity supplied of the export good. Because this is a large-country setting, the reduced supply of exports on the world market results in an increase in the international price. Thus, the import price for country A rises from the initial nondistorted price of Pm0 ($100) to Pm1 ($106), and the price of

The Impact of an Export Subsidy

We now turn to the last policy to be examined in the large-country setting, the case of the export subsidy. This case is depicted in Figure 13. Starting with an illustrative no-subsidy price of $55, suppose firms now receive a per-unit payment of $10 when they export the good. Thus, domestic suppliers will sell to their own home market only if they receive a price equal to the revenue per unit (price plus subsidy) received by exporting. Assuming that no imports are allowed, the domestic price in the exporting country B rises, leading to a reduction in B’s consumption, an increase in B’s production, and an increase in B’s exports. Because country B is a large country, the increase in exports will lead to a fall in the world price. The price movements will continue until an import price (Pm1 = $49) in country A is reached at which the quantity of desired imports Qm1 (=15 − 6 = 9 units) is equal to the quantity of desired exports Qx1 of country B. The difference between Pm2 ($59) and Pm1 ($49) is the amount of the per-unit export subsidy, and the cost of the subsidy to the government of country B is (Pm2 − Pm1) × (Qx1). In our example, this cost is ($59 − $49)(16 − 7) = $90. Note that the presence of the export subsidy leads to a fall in the international price (from Pm0 to Pm1) and to an increase in imports (from Qm0 to Qm1) into country A as A’s production of the good declines and consumption of the good increases. Turning to the welfare effects in both countries, we observe that there is a net gain in the importing country A, which experiences net gains of triangles a and b as well as the rectangle c due to the fall in the international price. These three areas represent the amount by which the gain in consumer surplus in country A exceeds the loss of producer surplus in A. In the exporting country, the resulting increase in the domestic price from Pm0 to Pm2 leads page 303to deadweight losses of unshaded triangles f and g, if we assume that consumers are also the taxpayers who pay for the subsidy (just as in the small-country case). However, there is an additional cost to the exporting country associated with the fall in the international price. Even though the per-unit subsidy amounts to (Pm2 − Pm1), or $10, prices received by country B’s producers rise by only (Pm2 − Pm0), or $4, and the remainder of the subsidy, (Pm0 − Pm1), or $6, is transferred abroad to country A through lower prices. The total amount transferred is (Pm0 − Pm1) × (Qx1) and is depicted by the shaded rectangle h in panel (b) of Figure 13. The net welfare effect on the exporting country is thus the two deadweight losses coupled with the transfer abroad (also negative), or areas f, g, and h [= ($55 − $49)(9) = $54]. Thus, in the case of an export subsidy, being a large country results in an additional welfare loss that would not occur if the country were small. With our numbers, importing country A thus gains area a [= (1/2)($55 − $49)(8 − 6) = $6] plus area b [= (1/2)($55 − $49)(15 − 12) = $9] plus area c [= ($55 − $49)(12 − 8) = $24], or a total of $39. The exporting country B loses area f [= (1/2)($59 − $55)(10 − 7) = $6] plus area g [= (1/2)($59 − $55)(16 − 14) = $4] plus area h [= ($55 − $49)(16 − 7) = $54], for a total loss of $64. 

Trade Restrictions in a General Equilibrium Setting

The discussion of the effect of trade restrictions has to this point focused largely on the market of the particular good that is the target of the restriction in question. While this is a useful exercise, remember that as this market adjusts to the policy, other parts of the economy are also affected. Increased protection leads producers to reallocate resources to the protected industry and consumers to find substitutes for the now more expensive good. These economywide reverberations need to be taken into account if one is to assess fully the welfare impact of the trade restriction.

Protection in the Small-Country Case

To demonstrate the usefulness of the broader analysis of trade restrictions, let us return to the general equilibrium framework to demonstrate the gains from trade. This framework was discussed in Chapter 6. Assume that a small country is engaged in free trade (Figure 14). Initially, consumers are consuming at point C0, producers are producing at point B0, the country is exporting X0 of agricultural goods, and imports of textiles are equal to M0. Due to successful lobbying by the textile industry, an ad valorem import tariff is now imposed. In the small-country case, this increases the domestic price of textiles by t percent, and the domestic price of textiles becomes Ptex(1 + t). Domestic relative prices now become Pag/[Ptex(1 + t)], which are less than Pag /Ptex, the international relative prices. Producers see the increase in the relative price of textiles as a signal to produce more textiles (and consequently fewer agricultural goods) and adjust production until MCag /MCtex equals Pag/[Ptex(1 + t)]. This occurs when the flatter domestic price line is tangent to the production-possibilities frontier at point B1. This adjustment by producers represents a movement away from specialization and reduces the consumption possibilities available to the country from line (Pag/Ptex)0 to parallel line (Pag /Ptex)1. The adjustment in production thus leads to a reduction in real income and a consequent loss in welfare as consumers are forced to choose from smaller consumption possibilities along (Pag /Ptex)1 instead of (Pag /Ptex)0 and must therefore be on a lower indifference curve. page 304

Welfare Effects of Restrictive Rice Policies in Japan

A useful study of the welfare impacts of protecting a domestic industry through restricting imports and adopting other measures has been carried out by Australian economists James Fell and Donald MacLaren (2013). Japan has long been known and criticized for its large-scale aid to its rice farmers via various domestic measures and protective trade policies. Following the conclusion of the Uruguay Round of multilateral trade negotiations in 1994 (discussed in Chapter 16 of this text), Japan liberalized its restrictive policies to some extent in 2004–2005. As of that time, there were still several such policies in effect, however, including a production stipulation program to control the amount of domestic rice production, government purchases of rice to maintain about a one-million-tonnes stockpile of rice, and a tariff quota of 682,000 tonnes per year. (The metric measure “tonnes” is equal to 1,000 kilograms or roughly 2,200 pounds.) If imports are kept within the quota, there is no tariff but the government, which does the actual importing through a state enterprise, can add a markup of ¥292 per kg. when it sells the imported rice to the public; if imports exceed 682,000 tonnes, a “tariff” or markup of ¥341 per kg. is added to the world price when the rice is sold to the public in Japan. (As of this writing, the exchange rate is about ¥125 = $1.) The conceptual method used by Fell and MacLaren for calculating the welfare effects of the restrictions follows the methodological framework of this chapter. Taking into account the various government direct-support policies as well as the tariff quota system, Fell and MacLaren first construct the “tariff equivalent,” meaning that they express as a tariff rate the total impact of the various policies on raising the domestic price of rice above the world price. They then calculate, on the basis of a mathematical and econometric model, the effects on consumer surplus, producer surplus, and government spending of the removal of this tariff. From the analysis in this chapter, we would expect the elimination of the tariff to enhance consumer surplus and to have a negative impact on producer surplus. Government expenditure will fall as the stockpiling and other such programs are eliminated, and that decrease in spending can be thought of as a rise in revenue that can be regarded as now available for distribution to the economy to enhance well-being. The overall welfare effect of removing all of the restrictions is the sum of the change in consumer welfare (positive), the change in producer surplus (negative), and the fall in government spending (positive). An interesting aspect of the Fell-MacLaren paper is that they introduce some elements of realism that are not always included in studies that estimate the welfare effects of trade policies. First, they assume that Japan is a “large” country in the import of rice. This assumption means that, when Japan removes its protection against imports, the world price will rise as the new demand by Japanese consumers for imported rice bids up the landed price of the imports. (Of course, the domestic price of rice will fall with the removal of the restrictions.) Hence, the consumer welfare gain from elimination of import restrictions, other things equal, will not be as large as it would be if Japan were a “small” country in the import of rice. Second, Fell and MacLaren regard imported rice and domestically produced rice as being imperfect substitutes (i.e., the two goods are differentiated products such as discussed in Appendix A of this chapter). This treatment seems realistic, as there are indeed many varieties of rice produced in the world. Third, the authors allow for the fact that Japanese consumers may have a specific preference for (or bias toward) domestically produced rice over imported varieties of rice. (Such “home bias” in general was discussed in Chapter 9, page 161.) The various impacts of the removal of restrictions on rice were calculated for 2004, 2005, 2006, and 2007 with two different scenarios for each year—each scenario reflecting a different assumption regarding the elasticity of supply of imports to Japan. The smallest overall welfare gain from removal of the restrictions in the eight scenarios was ¥73 billion. This figure reflected the sum of a consumer welfare gain of ¥133 billion, a producer surplus loss of ¥118 billion, and a government expenditure reduction (welfare gain) of ¥58 billion. The largest Japanese welfare gain in the eight cases was ¥150 billion, comprised of a consumer surplus gain of ¥221 billion, a producer surplus loss of ¥191 billion, and a government expenditure reduction of ¥120 billion. Fell and MacLaren’s different calculations of the “tariff equivalent” of the various policies ranged from 105 percent to 204 percent. The assumption that Japan is a “large” country rather than a “small” country in the import of rice made for a large difference in results—for example, the ¥73 billion estimate of welfare gain indicated above would have become ¥1,645 billion if Japan had been treated as a small country rather than as a large country. Nevertheless, even with the large-country assumption, it is clear that welfare losses for Japan do occur because of the restrictive policies regarding rice. Source: James Fell and Donald MacLaren, “The Welfare Cost of Japanese Rice Policy with Home-Good Preference and an Endogenous Import Price,” Australian Journal of Agricultural and Resource Economics 57, no. 4 (October 2013), pp. 601–19.

Consumers must make a new consumption choice, given their lower level of real income. What point on the new consumption-possibilities frontier, (Pag /Ptex)1, will maximize their well-being in this tariff-distorted world? Because they face the same tariff-distorted prices as producers, they will try to find a point on the new consumption-possibilities line that represents an optimal consumption choice, given relative domestic prices. This will occur at a combination of agricultural goods and textiles that lies on (Pag /Ptex)1 and that results in MUag /MUtex = Pag /[Ptex(1 + t)]. This choice is indicated by point C1 in Figure 14. At C1 the slope of lower indifference curve IC1 is equal to the domestic price ratio that contains the tariff on textiles, Pag /[Ptex(1 + t)]. This is indicated by the tangency of IC1 to the dashed line at point C1. The tariff thus has a negative welfare impact on the country, represented by the shift from point C0 on indifference curve IC0 to point C1 on the community indifference curve IC1. The precise location of C1 on the world price line (Pag /Ptex)1 cannot be determined without more information on the height of the tariff and the exact shape of the indifference curves. All that can be concluded in this general presentation is that point C1 will be located somewhere on that world price line between point B1 (representing a prohibitive tariff) and point C2.10 page 306 The general equilibrium effects of a quota (not shown in Figure 14) are similar to those of the tariff as long as the quota rent remains in the country. This would be the case if the government auctions the quotas or if importers receive the quota rent. Because every tariff has an equivalent quota that produces the same change in relative domestic prices, the imposition of a quota leads to the same producer and consumer adjustments. The only static difference in the two instruments is that quotas fix quantities and let prices adjust to clear the market, whereas a tariff alters prices and lets quantities adjust. If, however, the exporting country receives the quota rent, for example, through the efforts of organized exporters or the imposition of a voluntary export restraint (VER), the result is different. The imposition of a VER has the impact of raising the price of the restricted good to the importing country, thus worsening the importing country’s terms of trade and leading to a position on an even lower indifference curve than did the tariff. It is useful at this juncture to contrast the effect of a tariff with that of a production subsidy to the import-competing industry. As indicated earlier, for every tariff, there is an equivalent production subsidy that causes domestic production to be the same as that under the tariff (see Figure 4 in this chapter). The subsidy leads to the same reduction in the gains from specialization and loss in real income. What is different, however, is that consumers continue to consume at international prices. The loss in real income means that consumers have to reduce consumption so that they are consuming on the new consumption-possibilities curve in Figure 14 (Pag /Ptex)1. However, because they continue to face international prices, they attempt to find the consumption point where an indifference curve is tangent to the new consumption-possibilities frontier. This tangency is indicated by point C2, which is on a higher indifference curve than C1. Again, if the government wishes to encourage production in the import-competing sector, it is preferable to do so by direct subsidization of producers rather than through price-distorting mechanisms such as tariffs. The smaller the negative effects of government intervention, the fewer the number of economic actors that are affected. With the subsidy, the distortion directly affects only producers, and the principal social cost of the subsidy is the loss in real income resulting from decreased specialization along the lines of comparative advantage.

Protection in the Large-Country Case

In the large-country case, the welfare impact of protection is less clear and concise. Because the large country can influence international prices by its own actions, the impact of a tariff is felt not only domestically but also internationally. With its tariff, the tariff-imposing country reduces both its import demand and export supply; that is, it is less willing to trade. Consequently, both the international demand for the import good and the world supply of the export good are reduced. Both effects cause the international terms of trade to change, increasing the price of the export good relative to the import good and improving the terms of trade of the tariff-imposing country. The overall reduction of welfare in the tariff-imposing country resulting from the smaller amount of trade is thus offset, at least in part, by improved terms of trade. It is possible that the effects of the terms of trade could more than offset the effect of the reduction in trade and leave the tariff-imposing country better off, assuming, of course, that its trading partners do not retaliate. (See the later discussion of the “optimum tariff rate” on pages 325–27 in Chapter 15). The general equilibrium effects of trade restrictions in the large-country case can be usefully examined through the use of offer curves. The offer curve concept was introduced in Chapter 7. To illustrate the impact of a tariff in such a framework, consider first the manner in which the curve shifts when a tariff is imposed. Figure 15 illustrates the offer curve for country I, which is exporting good B and importing good A. Remember that the curve was derived by plotting the willingness of the country to trade at alternative terms of trade. Curve 0I shows that country I is willing to export quantity 0B1 of good B and to page 307import quantity 0A1 of good A at TOT1. Similarly, at TOT2, the country is willing to export 0B2 and import 0A2. When a tariff is imposed, the country is less willing to trade at each terms of trade. At TOT1 on new offer curve 0I′, the country is willing to export only amount 0B′1 and to import only 0A′1. The willingness to trade at TOT2 is indicated in corresponding fashion. Thus, the offer curve shifts or pivots inward with the imposition of a tariff. The same shift or pivot can also represent an export tax as well as an import tariff, because both instruments indicate less willingness to trade at any terms of trade.

Consider the comparative impacts of tariffs and quotas. Figure 16 portrays the imposition of an import tariff along with the foreign offer curve. (Both countries I and II are large countries in these diagrams.) Prior to the tariff, the free-trade equilibrium is at point E with quantity 0B1 of good B exported from country I (and imported by country II) and quantity 0A1 of good A imported by country I (and exported by country II). With the imposition of the tariff, offer curve 0I′ rather than 0I becomes the relevant curve. The quantity of exports of country I falls to 0B2, and this quantity is exchanged for 0A2 of imports. Note also that the terms of trade improve for the tariff-imposing country, since TOT2 is steeper than TOT1. The offer curve analysis of import quotas and VERs is contained in Figure 17. In panel (a), the offer curve of country I with an import quota is identical to free-trade offer curve 0I until quota amount 0A2 is reached (equal to 0A2 in Figure 16). Then the offer curve ceases rising because no greater quantity of imports will be permitted, and the curve in its entirety becomes 0RI′ (horizontal line RA2 after point R). Like the import tariff, the quantity imported of good A is 0A2 at the new equilibrium E′, the quantity exported of good B is 0B2, and the terms of trade are TOT2.

The VER is shown in Figure 17, panel (b). Because it is the foreign country that is undertaking the measure, country II’s offer curve is the curve affected, not the offer curve of country I. Because country II can now export no more than 0A2, country II’s curve becomes horizontal at that quantity. Its offer curve in its entirety is 0SII′ rather than the free-trade curve 0II. The new equilibrium is at point E″. Country I still imports 0A2 of good A, but it now exports the larger amount (compared with the import tariff and the import quota) 0B3 of good B. Note also that the terms of trade have deteriorated for country I compared with the free-trade situation: they are now TOT3 rather than the original TOT1. In this two-country graph, the deterioration of country I’s terms of trade constitutes an improvement in those of country II. Clearly, country II prefers the VER to the import quota and the import tariff if the terms-of-trade impact is the only consideration.

Other Effects of Protection

We have examined the effect of protection from a direct static perspective using partial and general equilibrium analyses. Now we need to mention several other possible effects of protection. First, we need to reemphasize that restriction of imports is likely to lead to a reduction in exports of the tariff-imposing country. This takes place as soon as domestic resources are withdrawn from export production and used in the production of domestic import substitutes at the higher relative domestic price of these goods. Further, there is likely to be foreign country tariff and nontariff retaliation against the tariff-imposing country’s exports. Protection thus not only lowers real income in the imposing country but also redistributes it from export industries to import-competing industries. These shifts take place in the short run and reduce the incentive to invest in the affected export industries, contributing to reduced ability to export in the future. A reduced ability to export could be deadly to industries that rely on today’s investment in research and development to be competitive in the future. The subsequent slowing down of technological change in the comparative-advantage industries could be critical to efficiency and welfare in our increasingly interdependent world. Second, you will recall that trade restrictions have an impact on the distribution of income among the factors of production. With the imposition of a tariff in the Heckscher-Ohlin model, the scarce factor gains and the abundant factor loses. Or in the specific-factors model, the fixed factor in the import-competing industry (export industry) gains (loses), while the impact on the variable factor depends on consumption patterns. Income distribution effects are discussed further in Chapter 15. Third, the effect of protection in certain industries on total imports may be less than it appears if only the change in imports of the protected goods is examined. This would be the case if the increase in domestic production of the import-competing products required intermediate inputs that have to be imported. Then, while protection reduces imports of the targeted products, increased domestic production leads to increased importation of the required intermediate products. This is an often-ignored aspect of protection that turned out to be critical for a number of developing countries that were pursuing an import-substitution policy to reduce their total imports by producing the previously imported goods at home. Ignoring the indirect import requirement of the expanding import-competing sector contributed to serious mistakes in estimating the potential effectiveness of import-substitution strategies. It is also important not to ignore the possible effects of protection on foreign supply. History demonstrates that foreign suppliers will attempt to find ways to circumvent any kind of trade restriction, whether it be a tariff or nontariff barrier. Faced with the import barrier, foreign firms may devote even more time and resources to reducing costs of production in order to compete with domestic producers. The ultimate irony occurs when a portion of a quota rent is transferred to the foreign producer (either directly or indirectly through its government), which then uses it to make technological innovations and become an even stronger competitor. This took place in the U.S. textile and apparel industry and the automobile industry. Too often, protection seems to impair the pursuit of cost-reducing innovations in the imposing country while increasing the cost-reducing incentives in the exporting country. Unfortunately, this scenario leads over time to pleas for greater and greater protection from the already-protected industry. The increased levels of protection bring greater and greater net welfare losses to the trade-restricting country. page 310

Domestic Effects of the Sugar Quota System

The U.S. sugar industry has received protection since 1934. From 1934 to 1974, sugarcane and sugar beet growers were protected through import quotas, subsidy programs, and acreage restrictions. Since 1976, import tariffs, import fees, and quotas have been used fairly extensively. Most recently, the import limitation program consists of tariff-rate quotas, whereby a low tariff is placed on a first specified amount of imports, but the rate then rises as imports exceed that amount. The tariff-rate quota is set annually at 1.2 million tons and can be raised only under certain conditions. The effect of these restrictions on the industry has been substantial, causing the domestic U.S. price to be considerably above the world price. For example, in 1988 the average domestic price was $0.2212/pound and the world price was $0.1178/pound; that is, there was an equivalent tariff rate of 88 percent. In 1989, the world price was $0.1445/pound, and the average U.S. price was $0.2281/pound, an equivalent tariff rate of 58 percent. This protection cost consumers an estimated $1.2 billion in 1988, $1.1 billion in 1989, and $1.4 billion in 1990. The related net social losses from the program in those years were estimated at $242 million, $150 million, and $185 million, respectively. These estimates do not include any of the indirect or “downstream” effects on industries that use sugar as an input and whose costs of production were consequently higher as a result of sugar protection. A 2003 study (Beghin et al.) indicated that in 1998 sugarcane growers gained $307 million, sugar beet growers $650 million, and processors $89 million because of the program. Further, users of sugar lost $1.9 billion, and the deadweight losses associated with the program were put at $532 million. More recently the USITC in 2011 estimated the net welfare cost of the sugar program to be $49 million. In addition, an estimate by the Heritage Foundation is that, in 2013, each sugar farm in the United States received average annual revenue that was $310,000 greater than would have been the case without the protection given to the industry. Further, the consulting firm Agralytica estimated that U.S. sugar consumers, from 2002 through 2012, spent in a range of $1.45 billion to $4.24 billion more per year because of the restrictions, and 127,000 jobs were lost in the food manufacturing sector because of the higher cost of sugar (Heritage Foundation and Agralytica estimates given in Leonard).* The impact of protection, however, goes beyond the efficiency and distribution effects reflected in the above estimates. A 1990 Wall Street Journal article (see the sources for this box) focused on the state and local effects of the sugar program in a sugar beet–growing region of Minnesota. The higher prices for sugar gave farmers an incentive to shift land from other uses to the production of sugar beets, where they could earn up to four times what they could growing corn or wheat. However, the administration of the sugar program does not give everyone the opportunity to grow sugar beets. The sugar beet program is essentially administered through sugar processors. These sugar refiners are guaranteed a target price as long as they pay growers the support price.

Because there are no other restrictions, the amount of sugar beets that can be grown depends on the processing capacity of the local plant and the access of growers to the plant. In southern Minnesota, growers gained access to refining facilities by buying shares in the Southern Minnesota Beet Sugar Cooperative, which was founded in 1974. Without membership in the cooperative, growers had no place to sell sugar beets. Consequently, the benefits of the program accrued only to those few farmers who were members of the cooperative, and the program generated sizable impacts on local income distribution, land use, and consequently the entire social fabric of the community. Tensions rose every day as the “Beeters” sought to acquire more land from non–sugar beet growers and the evidence of their economic gains became even more visible. (It was estimated that large farmers reaped $100,000 to $200,000 in annual benefits from the sugar program.) Rural communities were wrenched apart. Families split over the issue, formerly good friends no longer met for coffee or spoke, churches and community organizations became divided, and vandalism against supporters and nonsupporters of the program occurred. The noneconomic social costs of price distortions like those introduced by the sugar program are too often ignored in policy analysis. For example greater health risks might occur from the fact that the higher domestic sugar price leads consumers to switch to sugar substitutes such as corn syrup. The social costs are, however, very real in communities such as Maynard, Minnesota. Removal of such price distortions would eventually lead to a return to land use consistent with unrestricted supply and demand considerations and would remove the source of the distribution distortion and community stress. Of course, new stresses would be introduced with changes in the distribution. The noneconomic personal and community costs that have already been incurred may, however, never be recouped.page 311 *In late summer 2015 the U.S. domestic price was about twice the world price. This implies an equivalent tariff rate of roughly 100 percent. Sources: U.S. International Trade Commission, The Economic Effects of Significant U.S. Import Restraints, Phase II: Agricultural Products and Natural Resources, USITC Publication 2314 (Washington, DC: U.S. Government Printing Office, September 1990), chap. 2, Fourth Update, 2004, USITC Publication 3701 (Washington, DC: June 2004), p. xvii, and Seventh Update, 2011, USITC Publication 4253 (Washington, DC: August 2011), p. x, obtained from www.usitc.gov; Bruce Ingersoll, “Small Minnesota Town Is Divided by Rancor over Sugar Policies,” The Wall Street Journal, June 26, 1990, pp. A1, A12; Gary C. Hufbauer and Kimberly A. Elliott, Measuring the Costs of Protection in the United States (Washington, DC: Institute for International Economics, 1994), pp. 79–81; John Beghin, Barbara El Osta, Jay R. Cherlow, and Samarendu Mohanty, “The Cost of the U.S. Sugar Program Revisited,” Contemporary Economic Policy 21, no. 1 (2003), p. 106, obtained from www.econpapers.repec.org; Bruce Odessey, “Bush Advisers View Sugar Program as Hurting U.S. Consumers,” obtained from www.usinfo.state.gov; U.S. Department of Agriculture, “U.S. Sugar Import Program,” obtained from www.fas.usda.gov; Carolyn Cui and Bill Tomson, “Sugar Surges as U.S. Acts to Boost Imports,” The Wall Street Journal, August 21–22, 2010, p. B1; Walter Williams, “Sweet Deals That Damage Our Health,” The Charlotte Observer, July 22, 2010, p. 13A. Burleigh C. W. Leonard, “U.S. Sugar Policy: Sweet for a Few, Sour for Most,” The Wall Street Journal, November 3, 2014, p. A15. Finally, new thinking about the effects of reducing or eliminating trade restrictions has emerged since the appearance of the Melitz (2003) model of trade. (See Chapter 10, pages 189–90) for a more complete discussion of this model.) The Melitz model centered on the phenomenon that there are some one-time fixed costs for a firm when engaging in exporting (e.g., learning about the characteristics of particular foreign markets, establishing product distribution channels abroad) as well as standard variable costs of exporting a unit of a good such as transportation costs and special packing costs. In the context of this model, a recent paper by George Alessandria and Horag Choi (2014) addressed the matter of eliminating trade restrictions. Basically, domestic firms are importing intermediate materials as part of their normal production process, and an elimination of all tariffs and other barriers to trade will thus reduce a firm’s imported input costs (and of course will reduce the landed price of any exports that the firm sells abroad if foreign countries also reduce or eliminate tariffs). With this reduction in input costs (as well as any increase abroad in sales of the firm’s goods), profits for the domestic firm are enlarged and a greater number of domestic firms will now find it attractive to cover the fixed/sunk costs of exporting. As a result, more firms begin to export, yielding gains from trade. Taking account of this new exporting resulting from the trade barrier reductions, it follows that any current trade restrictions in place are causing losses beyond the traditionally recognized ones because these additional trade gains have been foregone. With trade restrictions in place, there are fewer exporters in the country than would otherwise have been the case. page 312

Summary

This chapter has looked at the ways trade-restricting policies affect a country. Both the partial and general equilibrium approaches indicate that in the small-country case, restricting trade leaves the country less well-off. In the large-country case, trade restrictions can under certain conditions lead to an improvement in well-being for the country imposing the restrictions as long as the partner country does not retaliate. Retaliation and the resulting trade war leave everyone worse off. From the perspective of both cost and international policy, domestic subsidies remain the more desirable alternative if countries wish to assist import-competing industries. The subsidies also produce a domestic production distortion, but because they affect only producers, they are less costly to subsidy-financing consumers and have a smaller impact on the level of imports coming into the country than either tariffs or quotas.

Appendix A: The Impact of Protection in a Market of Non-Homogenous Goods

The analysis to this point has examined the welfare impact of trade policy–induced price distortions, assuming that the product on which the tariff is placed is a homogeneous good that can be represented with a single demand curve and price. However, if imperfect substitution exists between the foreign- and domestic-produced good, then the pretariff prices of the two products can be different and the single-market approach is inappropriate. With nonhomogeneous goods, the increase in the price of the foreign import resulting from the tariff causes consumers to increase their demand for the domestic substitute. This increase in demand leads in turn to an increase in price of the domestic good and a subsequent loss in consumer surplus, even though the tariff does not apply directly to it. An analysis of the impact of a tariff must take into account the indirect effects of the tariff both on related goods and the good upon which it is levied. This idea is developed in this appendix. (For elaboration, see U.S. International Trade Commission, 1989, chap. 2.) In the case of close but not perfect substitutes, we need to analyze the impact of the tariff in two markets, not just one. See Figure 18, where panel (a) describes the situation in the market for the domestic good and panel (b) describes the market for the imported good in this small-country case. Because the two goods are assumed to be close substitutes, the demand for each good is linked positively (the cross-price elasticity is positive) to the price of the other. Consequently, when the domestic price of one good changes, it leads to a change in demand for the other in the same direction. In Figure 18, panel (b), the imposition of a tariff on the foreign good raises its price on the domestic market from P′0 to P′1 = Pint(1 + t), simultaneously reducing the quantity demanded of the foreign good and causing the demand for the domestically produced good [panel (a)] to increase (a shift to the right of the demand curve Ddom to D′dom). With a normal upward-sloping domestic supply curve, the price of the domestic substitute increases, triggering an increase in demand for the foreign good (a rightward shift in the demand curve for the foreign product). The imposition of the initial tariff thus sets off demand shifts as the markets adjust to the price distortion. When the repercussions of the tariff have worked through the two demand curves, both curves will have shifted to the right, and the country will import an amount such as Q4 in panel (b), and there will be a higher price of the domestic good, P1, as shown in panel (a). Because the price has increased in both markets, two groups of consumers find that their consumer surplus has declined, not just one as with the homogeneous good.

Because both demand curves have shifted in the adjustment process, calculating the effects of the tariff distortion is not as straightforward as with homogeneous goods. The measure of the loss in consumer surplus differs according to the use of the pretariff demand curves or the after-tariff demand curves. Because of the joint market adjustments, measuring the loss in consumer surplus of the import good along pretariff demand curve Df ignores the cost to consumers who choose to switch to the import good because of the higher cost of the domestic substitute. Similarly, measuring the loss in consumer surplus along the tariff-ridden demand curve D′f overstates the loss in consumer surplus because it includes individuals who chose not to consume the import good—or to consume less of it—at the free-trade price but who would do so now. It is common practice to use an average of the estimates under each demand curve—that is, area abde in panel (b)—when measuring the loss in consumer surplus in the import market. A similar argument in the domestic market leads to the use of area a′b′e′d′ as the estimate of loss in consumer surplus due to the tariff on the foreign substitute. (It can be demonstrated theoretically that these are the appropriate measures of the loss in consumer surplus, assuming that the demand curves are linear and that there are no income effects, i.e., that the demand curves are “compensated” demand curves.) The effects of the tariff are a government revenue gain of abdf and a consumer deadweight loss of fde in the import good market. In the domestic market the consumer surplus loss a′b′e′d′ is equal exactly to the gain in producer surplus. An example of this kind of calculation with nonhomogeneous goods was provided by economist William R. Cline in 1990. For the U.S. textile industry in 1986, using the technique of this appendix, he calculated that the consumer welfare loss in the import market from import restrictions was $1,275 million (or $1.3 billion). Further, the consumer welfare loss in the market for domestically produced goods from those same import restrictions was $1,513 million (or $1.5 billion). In the domestic goods market, however, the transfer to producers was of course also $1,513 million, so there was no net social effect in the domestic goods market. In the import market, there was a tariff revenue gain of $488 million, and thus the net welfare effect in the import market (and therefore the net welfare effect for the United States as a whole) was a loss of $787 million (= $1,275 million − $488 million).   

Appendix B: The Impact of Trade Policy in the Large-Country Setting using Export Supply and Import Demand Curves

This appendix demonstrates the price, quantity, and welfare effects of trade policies using only the export supply/import demand diagram developed in the chapter. Thus, the demand and the supply curves within each country are not portrayed, although they are the bases for the export supply and import demand curves. We examine below the four basic instruments of trade policy—an import tariff, an import quota, an export tax, and an export subsidy.

The Impact of an Import Tariff

Figure 19 reproduces panel (b) of Figure 10 in this chapter with the relevant illustrative numbers. Recall that the imposition of this specific tariff causes the free-trade price, Pm0 ($100) to increase to Pm1 ($106) in the importing country and the quantity imported to fall from Qm0 (30 units) to Qm1 (17 units). The importing country’s government collects tariff revenue represented by the rectangle Pm2Pm1E′F [= ($106 − $96)(17) = $170], and the foreign supplier now receives price Pm2 ($96).

Consider the welfare effects on the tariff-imposing (home) country. The sum of areas a and b in Figure 10 conceptually equals the area of triangle GE′E in Figure 19 because the base of triangle GE′E (Qm0 − Qm1 = 30 − 17 = 13) equals the sum of the bases of triangles a and b in Figure 10; that is, the change in imports is the sum of the reduction in home consumption (base of triangle b = 7) and the increase in home production (base of triangle a = 6). The height of triangle GE′E in Figure 19 (Pm1 − Pm0 = $106 − $100 = $6) is the height of each of the triangles a and b in Figure 10. Further, the part of the tariff revenue paid by home consumers (area c in Figure 10) equals area Pm0Pm1E′G in Figure 19 [both are equal to ($106 − $100)(17) = $102], while the part of the tariff paid by the exporting country (area fhij in Figure 10) equals area Pm2Pm0GF in Figure 19 [both are equal to ($100 − $96)(17) = $68]. Thus, the net welfare effect in Figure 19 for the importing country is negative if deadweight loss triangle GE′E is greater than rectangle Pm2Pm0GF, and the net welfare effect is positive if the area GE′E is less than area Pm2Pm0GF. In our numerical example, because area GE′E = [(1/2)($106 − $100)(30 − 17)] = [(1/2)($6)(13)] = $39, and area Pm2Pm0GF = [($100 − $96)(17)] = [($4)(17)] = $68, there is a gain to the tariff-imposing country of ($68 − $39) = $29, just as occurred back in Figure 10.

The Impact of an Import Quota

To illustrate the imposition of an import quota in the demand for imports (Dm)–supply of foreign exports (Sfx) diagram, consider Figure 20. In free-trade equilibrium, quantity Qm0 (30 units) is imported at price Pm0 ($100). Now the government, under pressure from domestic import-competing suppliers, specifies that only amount Qm1 (17) of the good can be imported into the country. The effect of the quota is that, at quantity Qm1, a vertical line is erected (line Qm1FS′fx). The supply of exports schedule thus becomes RFS′fx, which is the normal supply of exports schedule from R to F (with point F occurring at quota amount Qm1) followed by the vertical segment indicating that no more imports can come in beyond quantity Qm1. The equilibrium position in the market with the quota in place is point E′ at equilibrium price Pm1 ($106). Thus, as with the tariff, the domestic price has been increased and the quantity has been decreased compared with equilibrium under free trade. The domestic consumer pays a higher price than that under free trade—the increase in price is represented by distance (Pm1 − Pm0 = $6)—and the foreign supplier receives a lower price than that under free trade; the decrease is represented by the distance (Pm0 − Pm2 = $4). Because there is a price divergence between what the consumer pays and what the producer receives for each unit of the import, the rectangle (quota rent) Pm2Pm1E′F in Figure 20 is available for someone (as discussed in the chapter).

What are the welfare effects on the home country of its import quota? In Figure 20 (as in Figure 19), triangle GE′E is the sum of the deadweight losses related to decreased home consumption and increased inefficient home production. However, if the government captures quota rent area Pm2Pm1E′F as revenue by selling import licenses, or if domestic importing firms capture it when the government does not sell licenses, then area Pm2Pm0GF is a transfer to the home country from foreign exporters. If this area is larger (smaller) than GE′E, the country will gain (lose) from the import quota. (Remember that we are assuming that trading partner countries do not retaliate.) In our numerical example, area GE′E = $39 and area Pm2Pm0GF = $68. But if the entire quota rent area, Pm2Pm1E′F, is captured by foreign suppliers or foreign governments with a rise in price of the good, the rent is captured by the exporting country. The net welfare effect of the quota would then be unambiguously worse than that of the tariff for the home (importing) country. The net welfare effect of the tariff was gain area Pm2Pm0GF ($68) minus loss area GE′E ($39); the net welfare effect of the quota if the foreign country captures the quota rent is a loss of both areas GE′E ($39) and Pm0Pm1E′G [($106 − $100 × 17) = $102]. (Note: area Pm2Pm0GF is not a loss from the departure from free trade because that area accrued to the foreign country under free trade as part of export receipts.) A VER is illustrated like the import quota in Figure 20 because the impact on domestic price and quantity of the import is the same. However, the important difference between the two instruments is that the quota rent area is now virtually certain to be captured by the foreign supplier or government. With the restricted quantity in place and under control of the exporting country, that country can raise the price up to Pm1. The welfare effect for the importing country from the VER is thus a loss equal to the loss from the import quota when the foreign exporters captured the quota rent. If foreign exporters do not capture the import quota rent, the loss to the importing country from the VER exceeds the loss from the import quota, which in turn could not be a loss smaller than that with a tariff. page 317

The Impact of an Export Tax

The impact of an export tax by the foreign country on the welfare of that exporting country can be analyzed in parallel fashion to an import tariff. (Hopefully this discussion is not getting too taxing!) Again, the tax can be specific or ad valorem in nature, but the basic principles are the same. Figure 21 illustrates the imposition of a specific export tax. The supply of exports schedule, Sfx, slopes upward and the demand schedule for imports, Dm, slopes downward in the usual fashion. Before the imposition of the tax, the market equilibrium is at point E with price Px0 and quantity Qx0. When the tax is levied, the supply of exports schedule shifts upward (a decrease in supply) to become S′fx. With the tax in place, the price of the export on the world market is Px1 ($106) and the quantity sold is Qx1 (17) at the new equilibrium point E′. The large, exporting country has thus been able to force up the world price to some extent because of the decrease in supply. However, the price that exporters receive after paying the tax falls to Px2 ($96) because, with less of the good exported, more is sold on their home market, driving down the domestic price. The exporting country’s government collects revenue of shaded area Px2Px1E′F[($106 − $96)(17) = $170] from the tax. Some of the revenue is economically paid by the importing-country buyer (area Px0Px1E′G [($106 − $100)(17) = $102]), and the remainder is paid by the producer (area Px2Px0GF) through receipt of lower revenues. The export tax hurts the exporting country’s producers, but its consumers gain through a reduced domestic price. This is opposite to the case of an import tariff by a country, where the importing country’s producers gain through the higher domestic price and its consumers are hurt. Let us now examine the welfare effects of this tax on the country imposing the tax, i.e., country B back in Figure 12 of this chapter. In Figure 21, the exporting country’s export price rises from Px0 to Px1. If import prices remain the same, then the terms of trade (Pexports/Pimports) will rise because of the export tax. Because of the improvement in the terms of trade, the welfare effect for the exporting country can be positive. In Figure 21, triangle FGE is the deadweight loss associated with the export tax; it corresponds conceptually to triangles ghf and ikj in Figure 12 in this chapter. It corresponds because the combined base of the two triangles in Figure 12 was the fall in exports, as is (Qx0 − Qx1 = 13) in Figure 21, and the price reduction was the old, pretax price minus the new domestic, after-tax price (Px0 − Px2 = $100 − $96), which equals (Pm0 − Pm2) in Figure 12. Potentially offsetting the deadweight losses from the export tax in Figure 21 is rectangular area Px0Px1E′G, the transfer of welfare as tax revenue to the government from importing country buyers of the export good. The large country will gain (lose) from the export tax if area Px0Px1E′G is larger (smaller) than area FGE.

The Impact of an Export Subsidy

An export subsidy is in effect a negative export tax, and the analytics of the two devices are similar. In Figure 22, the equilibrium in the export supply–import demand graph is initially at point E, with price Px0 ($55) and quantity exported Qx0. When the exporting-country government provides an export subsidy, say, of $10 per unit, the Sfx schedule shifts vertically downward (an increase in supply) to S′fx, which is shown as a parallel shift since we assume that a subsidy of a fixed monetary amount per unit exported is paid. The new price at which the exporter can sell the good is Px2 ($49), and the new equilibrium is at point E′ with quantity Qx1 (9 units). Because there is now a relatively greater incentive for the producer of the good to export rather than to sell in its domestic market, the reduced amount of the good in the exporting country causes the domestic price to rise to Px1. (With price Px1, the firm receives the same total amount per unit of sales in each market, because price Px1 equals export price Px2 plus the subsidy per unit received for exporting the good.) Thus, domestic consumers are injured when their producers receive an export subsidy. An additional possible source of injury to the exporting country is that the export subsidy (unlike the export tax or the import tariff) does not bring in revenue to the government. Rather, the subsidy requires government expenditure. The amount of subsidy required for export quantity Qx1 (9units) in Figure 22 is shaded area Px2Px1FE′, which is the amount of the subsidy per unit of exports [vertical distance E′F—equal to distance (Px1 − Px2)] times the number of units of the export (the horizontal distance from the origin to export quantity Qx1). Hence, the total subsidy cost is ($59 − $49)(9) = $90.