International Trade — Welfare and Political Economy of Tariffs, Import Quotas and Subsidies

International Trade — Splitting the Welfare Effects of Trade Policy by Whose Interest They Serve

Saying that a tariff protects domestic industry is correct but not the end of the analysis. Consumer losses, producer gains, government revenue and deadweight loss have to be separated, and we must check whether the importing country can influence the world price.

1. A small country’s tariff cannot change the world price

If the world price is 10 and the specific tariff is 2, the domestic price rises to 12. The higher price increases domestic production and reduces consumption, so imports fall.

Let demand be $Qd=100-2P$ and supply $Qs=10+P$. Under free trade, consumption is 80, production 20 and imports 60. After the tariff, consumption is 76, production 22 and imports 54.

2. A large country has a terms-of-trade effect, but retaliation must not be left out

A country whose import demand is large enough to affect the world price can use a tariff to push down foreign export prices and gain on its terms of trade. The optimal-tariff argument weighs this gain against the domestic distortion. But it is a one-sided model that leaves out retaliation, supply-chain restructuring and the cost of breaching agreements.

3. The same import limit assigns rents differently under a tariff and a quota

If quota rents are auctioned, the government can recover them; if licences are handed out free, they become objects of favouritism and lobbying. Under a voluntary export restraint, the rents can go to foreign exporters.

4. The effective rate of protection can exceed the nominal tariff

If a finished good is priced at 100 and uses imported intermediates worth 60, domestic value added is 40. With a 20% tariff on the finished good and none on intermediates, value added after protection becomes 60.

5. Arguments for protection must link the cause of a market failure to the instrument

Infant industries, learning externalities, national security and strategic industries are possible arguments. But if the externality lies in domestic production, a production subsidy can be more direct than a tariff that also distorts consumption. We also have to assess whether the government has the information to identify future winners, when support will end, and the risks of lobbying and retaliation.

The next chapter uses unit labour requirements to identify comparative advantage mathematically and calculates the terms of trade and the range of wages.

Check your understanding

With the demand and supply of section 1 and a tariff of 2, find the fall in consumer surplus, the rise in producer surplus and tariff revenue, and check them against the deadweight loss of 6. The fall in consumer surplus is $\frac12(80+76)×2=156$, the rise in producer surplus $\frac12(20+22)×2=42$ and tariff revenue $2×54=108$. $156-42-108=6$ matches the formula. Most of the consumers’ loss is transferred to producers and the government; only 6 disappears.

References

• World Trade Organization, Tariff and trade data
• WTO, World Trade Report
• Paul Krugman, Maurice Obstfeld and Marc Melitz, International Economics