Chapter 9: The Instruments of Trade Policy

Tariff: Tax levied when a good is imported Goal = raise cost of shipping

Special Tariff: Fixed charges for each unit of good imported

Ad Valorem Tariff: A fraction of the value of the imported goods

  • purpose of tariffs
  • provide revenue
  • protect domestic sectors
  • in recent years the use of tariff decreased… use nontariff barriers instead… i.e:
  • import quotas = limitation on the quantity of imports
  • export restraints = limitation on quantity of exports (imposed by exporting country at the importing country’s request)
  • exchange rate is not effected by which ever trade policy the countries use…so quote prices in terms of home currency
  • trade will arise if prices are different in a market in the absence of trade
  • as price of good increases home consumers demand less and home producers supply more demand for import declines
  • as price of good decreases, foreign producers supply more and consumers demand less supply available for export rises
  • world equilibrium = home import demand = foreign export supply
  • in other words… world demand = world supply

Tariff Effects

  • shippers are not willing to move good from foreign to home unless home price exceeds foreign price by at least tariff amount
  • if good = not shipped excess demand at home and excess supply in foreign so home price inc. and foreign will dec. until price differences is tariff amount
  • tariff raise price in home and decreases price in foreign = decline of trade volume

Small Country Tariff

  • tariff imposed cannot lower foreign price of good it imports price of import rises fomr PW to Pw+t and quantity of imports demand falls form D1-S1 to D2-S2
  • so a tariff imposed by a small country will
  • price of imported good = raised by amount of tariff
  • production increases
  • consumption falls
  • as a result → imports fall in the country imposing tariff


Measuring Protection

  • amount of protection = expressed as a percentage of price that would prevail under free trade
  • ad valorem = the percentage itself
  • specific = divide the tariff by the price net of the tariff = ad valorem equivalent
  • problems of trying to calculate rate of production
  • small country assumption is not a good approximation
  • tariff may have different effects on different stages of production of a good

Costs and Benefits of a Trade

  • Tariff raises price of good in importing country and lowers in exporting country
  • In importing country: Consumers loose and producers gain
  • government imposing tariff = gains revenue
  • consumer surplus = difference between price actually pay and price willing to pay (blue triangles)


  • producer surplus = similar to above but on the producer side… producer is willing to sell for a price less than the price he is receiving (sell = 3 and get = 5 so 2 is producer surplus)


  • consumer surplus = a+b+c+d
  • producer surplus is the dots


  • government revenue = c+e
  • Pw to Pt = tariff raises domestic price
  • Pw to Pt* = tariff lowers foreign export price
  • Production increases and consumption decreases
  • Total welfare = Consumer loss – producer gain – government revenue
  • If a country cannot effect world prices (small country) region “e” which represents the terms of trade gain will disappear tariff reduces welfare
  • Thus economy produces at home additional units of the good it could purchase more cheaply abroad
  • Production distortion loss = resulting from fact the tariff leads domestic producers to produce too much if this good
  • Consumer distortion loss = resulting from fact the tariff leads consumers to consume too little if this good
  • Against these two losses, there must be a gain “e” which results form a decline in the foreign export price caused by tariff
  • Cost of tariff exceeds its benefits

Other Instruments of Trade


  • Export subsidies = payment to a firm that ships a good aboard
  • Specific (fixed sum per unit)
  • Ad valorem (proportion of value exported)
  • Will export till domestic price > foreign price
  • Effects are reverse of tariffs
  • Price of exporting country rises
  • Price in importing country falls
  • But price increase is less than the subsidy
  • In exporting country:
  • Consumers = hurt
  • Producers = gain
  • Government losses because it must expend money on subsidy
  • Export subsidy worsens the terms of trade cuz lowers price of export in foreign market
  • Always leads to cost that exceed benefits

Import Quotas Theory

  • Enforced by issuing a license
  • Always raises domestic price of the imported good
  • Immediate result = initial price the demand for the good exceeds domestic supply plus imports… price to be bid up until market clears
  • In the end import quota will raise domestic prices by the same amount as a tariff that limits imports to the same level
  • Quotas = government receives NO revenue
  • The money that was supposed to go to government goes to the holders of the import licenses
  • Quota rents = profits received by the holders of import licenses that arise due to selling the goods for a premium in the domestic market
  • The transfer of rent abroad makes the costs of a quota substantially higher than equivalent tariffs

Voluntary Export Restraints

  • Variant of imports quota = voluntary export restraint (VER) = quota on trade imposed from the exporting country’s side instead of the importer country
  • i.e. auto limitations of exports to USA by Japan
  • VER is always costlier to the importing country than a tariff that limits imports by the same amount
  • Since governments get no money, the VER clearly produces a loss for the importing country

Local Content Requirements

  • Regulation that requires some specified fraction of a final good to be produced domestically
  • Local content requirement does not produce either government revenue or quota rents… instead the diff between the prices of imports and domestic goods gets averaged in the final price and is passed on to consumers

Other Trade Policy Instruments

  • Export credit subsidies
  • National procurement


  • Red tape barriers
  • all 4 policies benefit producers and hurt consumers
  • 2 of the policies hurt the nation as a while tariffs and import quotas are potentially beneficial for only large countries that can drive down world prices
  • in a large country your efficiency loss < trade gain so can be positive welfare but in a small country trade gain = 0 so unambiguous loss

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