Unilateral Trade Policy

Unilateral Trade Policy
Professor Ralph Ossa

33501 International Commercial Policy
International Commercial Policy

Introduction
So far, we compared two extreme scenarios, autarky
and free trade, and concluded that countries are usually
better off under free trade.
But is free trade also a countrys optimal trade policy?
And why do governments engage in trade policy in
practice?
In this lecture we look at unilateral trade policy only. In
the next lecture we will then consider multilateral trade
negotiations.
2

Overview of trade policy instruments

Governments use a wide range of trade policy
instruments in practice. The most important ones are:
(i) import tariffs,
(ii) export subsidies,
(iii) import quotas,
(iv) voluntary export restraints, and
(v) local content requirements

Overview of trade policy instruments import

tariffs
Import tariffs are simply taxes on imported goods.
Governments usually impose one of two types of import
tariffs:
A specific tariff, i.e. a tariff charged per unit of imports,
say $1,000 per imported automobile.
An ad valorem tariff, i.e. a tariff charged per value of
imports, say $.1 per $1 worth of imported automobiles
(or simply 10 percent).
4


tariffs (cont.)
In the U.S., tariffs are relatively modest by international
standards. Currently, the U.S. average (ad valorem
equivalent) tariff is less than 2 percent.
However, this does not imply that U.S. tariffs are low in
all sectors. Indeed, the U.S. imposes much higher tariffs
in sectors such as clothing and apparel, leather and
footwear, and agriculture. Remember also our
discussion on antidumping duties.

Overview of trade policy instruments export

subsidies
Export subsidies are simply subsidies on exported
goods. Governments again usually impose one of two
types of export subsidies:
A specific export subsidy, i.e. a subsidy paid per unit of
exports, say $1,000 per exported automobile.
An ad valorem export subsidy, i.e. a subsidy paid per
value of exports, say $.1 per $1 worth of exported
automobiles (or simply 10 percent).
6

Overview of trade policy instruments export

subsidies (cont.)
In the U.S., export subsidies are mainly applied in
agriculture. An example is the Department of
Agricultures Dairy Export Incentive Program (DEIP).
The DEIP is designed to help exporters of dairy
products meet prevailing world prices for targeted dairy
products and destinations.
The E.U.s Common Agricultural Policy is another wellknown agricultural export subsidy program (more on
that later).
7


quotas
An import quota is a restriction on the quantity of a
good that may be imported.
This restriction is usually enforced through import
licenses. While these are usually issued to importers in
the importing country, they are also sometimes issued
to governments of exporting countries.
In the U.S., the quota on sugar imports is an example of
the latter kind. It restricts yearly sugar imports to
approximately 1.4 million tons.
8

Overview of trade policy instruments voluntary

export restraint
A voluntary export restraint (VER) is essentially an
export quota. Despite its name it is typically not fully
voluntary but instead requested by an importing country.
The Japanese VER on auto exports to the U.S. between
1981 and 1985 is perhaps the best known example. It
restricted Japanese auto exports to the U.S. to 1.68
million units initially and 1.85 million units eventually.

Overview of trade policy instruments local

content requirement
A local content requirement is a regulation that
requires a specific fraction of the final good to be
produced domestically. In may be specified in terms of
value or of physical units.
In the U.S., the Buy American Act is a good example. It
was originally passed in 1933 and requires government
agencies to give preference to U.S. firms in their
procurement. In particular, a bid by a foreign company
can only be accepted if it is a specified percentage
below the lowest bid by a U.S. firm.
10

Overview of trade policy instruments local

content requirement (cont.)
Also, American firms are not allowed to simply act as
sales agents for foreign firms. While American
products may contain some foreign parts, 51 percent of
the materials must be domestic.
This requirement can lead to some curious situations.
For example, the made in the USA buses bought in
1995 by the cities of Miami and Baltimore were really 49
percent made in Hungary.
11

Overview of the lecture

Unfortunately, we cannot discuss all effects of all these
trade policy instruments in detail.
We only analyze import tariffs and export subsidies in a
simple perfectly competitive environment:
(i) What is a countrys optimal import tariff? Why do
governments impose import tariffs in practice?
(ii) What is a countrys optimal export subsidy? Why do
governments impose export subsidies in practice?
12

Optimal import tariff basic framework

Consider an industry in which Home is an importer and
Foreign is an exporter.
It is useful to illustrate the (partial) equilibrium using
import demand and export supply curves.
Homes import demand curve measures the quantity
Homes consumers demand minus the quantity Homes
producers supply for any given Home price.
13

Optimal import tariff basic framework (cont.)
Price
No-trade
equilibrium
Price
S
PA
A'
Eachpointontheimport
demandcurveisapoint
thatcorrespondstoHome
importsatagivenHome
price
A
B
PW
D
S1Q0D1Quantity
14
Imports,M1
Importdemand
curve,M
M1Imports


Foreigns export supply curve measures the quantity
Foreigns producers supply minus the quantity Foreigns
consumers demand for any given Foreign price.
Home is typically referred to as small, if changes in
Homes import demand have only a negligible effect on
Foreigns price so that Foreigns export supply curve
facing Home is flat.
Home is typically referred to as large, if changes in
Homes import demand have a non-negligible effect on
Foreigns price so that Foreigns export supply curve
facing Home is upward sloping.
15

Price
No-trade
equilibrium
Case1:Homeissmall
Price
S
PA
A'
A
B
PW
D
S1Q0D1Quantity
16
Imports,M1
Foreignexport
supply,X*
Importdemand
curve,M
M1Imports

Price
No-trade
equilibrium
Case2:Homeislarge
Price
S
PA
A'
Foreignexport
supply,X*
A
B
PW
D
S1Q0D1Quantity
17
Imports,M1
Importdemand
curve,M
M1Imports


Consumer welfare can be measured by consumer
surplus, in this supply and demand framework.
Consumer surplus is given by the difference between
what consumers would be maximally willing to pay and
what they actually pay.
Graphically, it can be represented by the area below the
demand curve and above the price.
18

19


Producer welfare can be measured by producer
surplus in this supply and demand framework.
Producer surplus is given by the difference between
what producers would be minimally willing to charge
and what they actually charge. We can loosely refer to
this difference as profits.
Graphically, it can be represented by the area above the
supply curve and below the price.
20

21


Suppose now that Homes government imposes a
specific import tariff.
Notice that the tariff drives a wedge between the price in
Home and the price in Foreign.
For example, if the tariff is $1,000 per unit, PT = PT* +
1,000. In general, PT = PT* + t.
22

Optimal import tariff overview

The effects of Homes tariff differ in important ways
between the small country and the large country case
and we discuss both cases in turn.
First, we demonstrate that the optimal tariff of a small
country is zero.
Second, we show that the optimal tariff of a large
country is positive.
23

Optimal import tariff small country case

Homepricerisesbytheamount
ofthetariff
No-trade
equilibrium
Price
Price
S
Homesupplyincreasesand
Homedemanddecreases
importsfalltoM2
Foreignproducersstillreceive
thenet-of-tariffpricePW
PT=PW+t
PT*=PW
PW
X*+t
D
DD
S1S
2
2
1
M2
24
Quantity
Foreignexport
supply,X*
M
M2
M1
Imports

Optimal import tariff small country case (cont.)

No-trade
equilibrium
Thelossinconsumer
surplusduetothehigher
pricewiththetariffisequal
totheshadedarea(a+b+c
+d)
Price
S
A
PW+t
PW
D
S1S2D2D1Quantity
25
M2


No-trade
equilibrium
Thegaininproducer
surplusduetothehigher
pricewiththetariffisequal
totheshadedarea(a)
Price
S
A
PW+t
PW
D
S1S2D2D1Quantity
26
M2


No-trade
equilibrium
Thegainingovernment
revenueduetothetariffis
equaltotheshadedarea(c)
Price
S
Thisequalsthetariff,t,times
thequantityofimports,M2
PW+t
PW
D
S1S2D2D1Quantity
27
M2


The optimal tariff of a small country is therefore zero:
Fallinconsumersurplus
Riseinproducersurplus
Riseingovernmentrevenue
NeteffectonHomewelfare
-(a+b+c+d)
+(a)
+(c)
-(b+d)
The area (b+d) is referred to as deadweight loss or

efficiency loss. It arises because the tariff distorts
consumption and production decisions.
28


No-trade
equilibrium
(a)isatransferfrom
consumerstoproducers
Price
(c)isatransferfrom
consumerstothe
government
(b+d)isdeadweightloss
S
A
PW+t
PW
D
S1S2D2D1Quantity
29
M2


Thedeadweightlosscan
alsobeillustratedinthe
importdemandandexport
supplydiagram
Price
Deadweightloss
duetotariff,b+d
X*+t
X*
M
M2
30
M1
Imports

Optimal import tariff large country case

Homepricenowrisesbyless
thantheamountofthetariff
Price
Price
No-trade
equilibrium
Foreignproducersare
absorbingpartofthetariff
X*+t
S
A
PT*+t
PW
PT*
X*
C
B*
C*
M
S1S2D2D1Quantity
M2
M1
31
M2M1
Imports

Optimal import tariff large country case (cont.)
No-trade
equilibrium
Price
Price
X*+t
b+d
A
PT*+t
PW
PT*
X*
-(a+b+c+d)
+(a)
+(c+e)
-(b+d)+(e)
Riseingovernmentrevenue
B*
D
C*
M
S1S2D2D1Quantity
32
M2M1
Imports


The net effect on Home welfare is therefore ambiguous.
It is positive if e > b + d and negative if e < b + d.
On the one hand, there is again a deadweight loss (b
+ d) just as in the small country case. It again arises
because the tariff distorts Homes consumption and
production decisions.
But on the other hand, there is now also a terms-oftrade gain (e). It arises because the tariff lowers
Foreigns export prices.
33


It can be shown that the terms-of-trade gain dominates
the deadweight loss for a sufficiently small tariff so that
the optimal tariff of a large country is positive.
The derivation of this result is actually not too difficult. If
you are interested, you can take a look at the appendix
to chapter 9 in K-O.
34


Theoptimaltariffmaximizes
theimporterswelfare,pointC
Toohighofatariffwilldecrease
importerswelfareandcan
increasetothepointwhere
thereisnotrade
Termsoftradegain
exceedsdeadweight
loss
Importers
Welfare
FreeTrade
B'
B
A
NoTrade
35
Termsoftradegainis
lessthandeadweight
loss
Optimal
Tariff
Prohibitive
Tariff
Tariff


It turns out that the optimal tariff is just the inverse of the
elasticity of Foreign export supply:
Optimal tariff = 1/EX*
EX* is the percentage increase in the quantity exported
in response to a percentage increase in the world price
of the export.
Intuitively, the optimal tariff is decreasing in EX* since
Homes monopsony power in world markets is
decreasing in EX*.
36


As is easy to verify, Homes gain from a tariff comes
directly at Foreigns expense. This is because Homes
terms-of-trade gain is Foreigns terms-of-trade loss.
The optimal tariff is therefore a beggar-thy-neighbor
policy.
This observation will play a crucial role in our discussion
of trade negotiations next week.
37

Application U.S. steel tariff

This model can be used to estimate how costly tariffs
are in practice.
We illustrate this using the case of U.S. steel tariffs,
which were in place from March 2002 until December
2003. For simplicity, we consider only the small country
case.
Of course, this estimate is very rough since it relies on
many special assumptions (small country, no variety
effects, no productivity effects, etc.). However, it is a
useful starting point for more sophisticated calculations.
38

Application U.S. steel tariff (cont.)

During the 2000 presidential campaign, George W.
Bush promised to protect the U.S. steel industry. To
deliver on this promise, he requested that the
International Trade Commission (ITC) initiate a Section
201 investigation into the steel industry.
As we will discuss in more detail next week, Section 201
of the U.S. Trade Act of 1974 mirrors Article XIX of the
General Agreement on Tariffs and Trade (GATT),
known as the safeguard or escape clause. It allows a
temporary tariff to be used under certain circumstances.
39


After investigating, the ITC determined that the
conditions of section 201 and Article XIX were met and
recommended that tariffs be put in place to protect the
U.S. steel industry.
The tariffs recommended by the ITC varied across
products, ranging from 10 percent to 20 percent for the
first year and then falling over time so as to be
eliminated after three years. President Bush accepted
the ITCs recommendation but applied even higher
tariffs.
40

41


Knowing that U.S. trading partners would be upset by
this action, President Bush exempted some countries
from the tariffs on steel.
The countries exempted included Canada, Mexico,
Jordan, and Israel, all of which have free-trade
agreements with the U.S., and 100 small developing
countries that were exporting only a very small amount
of steel to the U.S..
42


RecallthattheDWLis
givenbytheareaofthe
triangle(b+d)
Price
Deadweightlossdue
tothetariff,b+d
PW(1+)
P=PW
DWL=PWM
PW
M
M2M1Imports
43
Inourcalculation,we
havetotakeintoaccount
thatthesteeltariffis
quotedasanadvalorem
tariff


It is convenient to first compute the DWL relative to the
import value in the year prior to March 2002:
DWL 1 PW M 1
=
= ( )(%M )
PW M1
2 PW M1
2
Since the most commonly used steel products had a

tariff of 30 percent in the year following March 2002, we
set = .3.
Since the quantity of steel imports in the year following
March 2002 was about 25 percent less than in the year
prior to March 2002, we set %M = -.25.
44


Hence, DWL = 1 ( )(%M ) = 1 (.3)(.25) = .0375
PW M
The welfare loss in the year after March 2002 was

therefore equal to around 3.75 percent of the import
value in the year prior to March 2002.
Since the import value in the year prior to March 2002
was equal to around $4.7 billion, the net welfare loss to
the U.S. economy in the year after March 2002 was
equal to around $176 million.
45

Import tariffs in practice

The above analysis suggests three motives for
governments to impose import tariffs:
(i) raising government revenue,
(ii) increasing producer welfare,
(iii) increasing overall welfare.
All these motives appear to be relevant in practice.
46

Import tariffs in practice raising government

revenue
Recall that one effect of an import tariff is to generate
government revenue.
While tariffs are more distortionary than income or
value-added taxes, they are also much easier to collect.
This makes them an attractive source of government
revenue especially for poor countries.
Even in the U.S., tariff revenue was the main source of
federal government revenue from the 1790s until the
1910s.
47

Import tariffs in practice raising government

revenue (cont.)
48

Import tariffs in practice increasing producer

welfare
Recall that another effect of an import tariff is to
increase producer welfare.
Producers are usually better organized politically than
consumers and therefore lobby the government more
effectively so that the government puts more weight on
producer surplus in its trade policy decisions.
One reason for this asymmetry is that the political
collective action problem is easier to overcome the
smaller is the number of benefitting individuals.
49

Import tariffs in practice increasing producer

welfare (cont.)
Most economists believe such special interest politics to
be at the heart of most trade policy decisions.
In a famous study, Princeton professor Penny Goldberg
and Yale professor Giovanni Maggi (1999) find that the
degree of import protection is systematically related to
campaign contributions in the U.S..
In particular, industries donating more generously tend
to receive more import protection in return.
50

Import tariffs in practice increasing overall

welfare
Recall that a small import tariff can also increase overall
welfare in the large country case.
While the optimal tariff argument is analytically
impeccable, most economists believed it to be of little
relevance in practice.
Very recent evidence provided by Chicago Booth
professor Christian Broda together with coauthors,
however, suggests that this is not the case.
51

Import tariffs in practice increasing overall

welfare (cont.)
For a sample of non-World Trade Organization (WTO)
member countries, Broda et al. (2009) find that import
tariffs are systematically related to export supply
elasticties.
In particular, import tariffs tend to be higher in
industries, which face a lower export supply elasticity,
just as predicted by the optimal tariff formula.
The reason they focus on non-WTO countries will
become apparent in the next lecture.
52

Optimal export subsidy basic framework

Consider now an industry in which Home is an exporter
and Foreign is an importer.
We can again illustrate the equilibrium in this industry
using import demand and export supply curves.
Analogous to our above discussion, Foreigns import
demand curve facing Home is flat if Home is a small
country and downward sloping if Home is a large
country.
53

Optimal export subsidy basic framework (cont.)

Case1:Homeissmall
Home
Price
World
Price
S
Homeexport
supply
B
PW
Foreignimport
demand
PA
A
D 1
54
X1
S1
Quantity
X1
Exports


Case2:Homeislarge
Home
Price
World
Price
S
Homeexport
supply
B
PW
Foreignimport
demand
PA
A
D 1
55
X1
S1
Quantity
X1
Exports


Suppose now that Homes government imposes a
specific export subsidy.
Notice that the subsidy again drives a wedge between
the price in Home and the price in Foreign.
For example, if the subsidy is $1,000 per unit, P*S = PS 1,000. In general, PS = PS* + s.
56

Optimal export subsidy overview

The effects of an export subsidy again differ between
the small country and the large country case.
However, the differences matter less for the overall
result.
In particular, the optimal export subsidy is zero in both
cases.
57

Optimal export subsidy small country case

Homepricerisesbytheamount
ofthesubsidy
Home
Price
World
Price
ForeignconsumersstillpayPW
Homesupplyincreasesand
Homedemanddecreases
exportsincreasetoX2
C
PS=PW+s
s
Xs
B
PS*=PW
PW
C'
s
D 2 D 1
58
X1
X2
S1 S2 Quantity
X1
X2
Exports


(cont.)
Home
Price
PW+s
s
b
a
World
Price
Totaldeadweight
loss,b+d
Xs
C
B
PW
C'
s
D 2 D 1
59
X2
S1 S2 Quantity
X1
X2
Exports


(cont.)
The optimal export subsidy of a small country is
therefore zero:
Fallingovernmentrevenue
-(a+b)
+(a+b+c)
-(b+c+d)
-(b+d)
The area (b+d) is again a deadweight loss arising

because of consumption and production distortions.
60

Optimal export subsidy large country case

Homepricenowrisesbyless
thantheamountofthesubsidy
Home
Price
World
Price
D
X2
PS*+s
s
Foreignconsumersare
absorbingpartofthesubsidy
Homeexports
supply,X
S
s
X1
Xs
PW
PS*
Foreign
import
demand,M*
D 2 D 1
61
S1 S2 Quantity
X1
X2
Exports

Optimal export subsidy large country case (cont.)

Fallingovernmentrevenue
Home
Price
D
PS*+s
s
PW
PS*
D 2 D 1
62
S1 S2 Quantity
-(a+b)
+(a+b+c)
-(b+c+d+e)
-(b+d+e)

Optimal export subsidy large country case (cont.)

The optimal export subsidy of a large country is
therefore also zero. The welfare costs are even larger
than for a small country because of an additional termsof-trade loss.
As is easy to verify, Foreign gains from Homes export
subsidy in this case. This is because Homes terms-oftrade loss is Foreigns terms-of-trade gain.
63

Application Europes CAP

The E.U.s Common Agricultural Policy (CAP) provides
financial support to European farmers at a massive
scale through a variety of policy instruments.
CAP expenditures were 49.8 billion in 2006,
accounting for 48 percent (!) of the E.U.s entire budget.
The CAP began as an effort to guarantee high prices to
European farmers by having the E.U. buy agricultural
products whenever the prices fell below specified
support levels.
64

Application Europes CAP (cont.)

To prevent this policy from drawing in large quantities of
imports, it was initially backed by tariffs that offset the
difference between European and world agricultural
prices.
The result was that the E.U. found itself obliged to store
huge quantities of food. At the end of 1985, European
nations had stored 780,000 tons of beef, 1.2 million tons
of butter, and 12 million tons of wheat.
65


To avoid unlimited growth in these stockpiles, the E.U.
turned to a policy of subsidizing exports to dispose of
surplus production.
In view of our analysis of export subsidies above, who
gained and lost from these export subsidies, assuming
(realistically) that the E.U. is a large country?
66


European farmers gained, European consumers lost,
and European governments had to incur the subsidy
costs. On balance, Europe lost from these export
subsidies.
Farmers in the rest of the world lost and consumers in
the rest of the world gained. On balance, the rest of the
world gained from these export subsidies.
The negative effect on farmers in developing countries
was often criticized.
67


Starting in 1992, the CAP has been reformed
substantially. It is now much less based on price
support and much more on direct payments to farmers,
which are often independent of the amount of
production.
Nevertheless, agricultural protectionism is still a highly
controversial issue in multilateral trade negotiations. In
fact, the Doha Round of trade negotiations is currently
suspended mainly because of disagreement over such
protectionism, as we will discuss in more detail next
week.
68

Export subsidies in practice

The above analysis suggests only one motive for
governments to impose export subsidies: raising
producer surplus as discussed in the case of import
tariffs.
While this is likely to be a critical driving force of
governments trade policy decisions, other motives for
export subsidies can arise in imperfectly competitive
environments. This is also the case for import tariffs.
Some of these other motives are discussed in the two
Krugman articles on the reading list.
69

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Unilateral Trade Policy

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Unilateral Trade Policy

Professor Ralph Ossa

International Commercial Policy

International Commercial Policy

Overview of trade policy instruments

International Commercial Policy

Overview of trade policy instruments import

International Commercial Policy

Overview of trade policy instruments import

International Commercial Policy

Overview of trade policy instruments export

International Commercial Policy

Overview of trade policy instruments export

International Commercial Policy

Overview of trade policy instruments import

International Commercial Policy

Overview of trade policy instruments voluntary

International Commercial Policy

Overview of trade policy instruments local

International Commercial Policy

Overview of trade policy instruments local

International Commercial Policy

Overview of the lecture

International Commercial Policy

Optimal import tariff basic framework

International Commercial Policy

Optimal import tariff basic framework (cont.)

International Commercial Policy

Optimal import tariff basic framework (cont.)

International Commercial Policy

Optimal import tariff basic framework (cont.)

International Commercial Policy

Optimal import tariff basic framework (cont.)

International Commercial Policy

Optimal import tariff basic framework (cont.)

International Commercial Policy

Optimal import tariff basic framework (cont.)

International Commercial Policy

Optimal import tariff basic framework (cont.)

International Commercial Policy

Optimal import tariff basic framework (cont.)

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Optimal import tariff small country case

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Optimal import tariff small country case (cont.)

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Optimal import tariff small country case (cont.)

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The area (b+d) is referred to as deadweight loss or

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