httpmywebliueduuroyeco41 Textbook Section Basic Tariff Analysis of Chapter 9 The Instruments of Trade Policy Recap Tariffs are terrible for a small country We have seen in our analysis of the effects of a tariff in a small country that ID: 636784
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Slide1
Tariffs: Two Countries
Udayan Roy
http://myweb.liu.edu/~uroy/eco41Slide2
Textbook
Section “Basic Tariff Analysis” of Chapter 9 (“The Instruments of Trade Policy”)Slide3
Recap: Tariffs are terrible for a “small” country
We have seen in our analysis of the effects of a tariff in a “small” country that:
Tariffs hurt consumers of imported goods
Tariffs benefit producers of import-competing goods
Tariffs provide revenue for the government
The total costs exceed the total benefits
That is, there are deadweight losses from tariffs
Not only are tariffs worse than free trade, they are worse than a production subsidy that generates the same benefits for producersSlide4
Tariffs: Two-Countries Case
However, …
For
a country that is so large that
events in the country can affect
the worldwide prices of the goods it imports,
the gains from a tariff
may
exceed the losses and the country as a whole
may
benefit from the tariff
.
In a two-country world,
both are
“large”
countries
However, the tariff will harm other countries more than the country that imposes the tariff
may
gain.
So, the world, as a whole, will be harmed by the tariff.
Slide5
Two-country free tradeSlide6
Two-Country Free Trade
There
are two countries:
Home
and
Foreign
Autarky price of wheat is higher in Home
So, under free trade, Home will import wheat from ForeignSlide7
Supply, Demand, and Trade in a Single Industry
(1 of 4)
Recall that, when trade is allowed, Home imports wheat and Foreign exports wheat
The amount that Home wishes to import will decrease as the price of wheat increases (import demand curve)
The amount that Foreign wishes to export will increase as the price of wheat increases (export supply curve)Slide8
Supply, Demand, and Trade in a Single Industry
(2 of 4)
Home’s
import demand
curve (
MD
) is the difference between the quantity that Home consumers demand (
D
) minus the quantity that Home producers supply (
S
), at each price:
MD
=
D
–
S
.Slide9
Figure 9.1
Home’
s
Import Demand Curve
As the price of the good increases, Home consumers demand less, while Home producers supply more, so that the demand for imports declines.Slide10
Supply, Demand, and Trade in a Single Industry
(3 of 4)
Foreign’s
export supply
curve (
XS
)
is the difference between the quantity that Foreign producers
supply (
S
*)
minus the quantity that Foreign consumers
demand (
D
*),
at each
price:
XS
=
S
* – D*.Slide11
Figure 9.2
Foreign’
s
Export Supply Curve
As the price of the good rises, Foreign producers supply more while Foreign consumers demand less, so that the supply available for export rises.Slide12
Supply, Demand, and Trade in a Single Industry
(4 of 4)
In free-trade equilibrium, we must have
import demand = export supply,
home demand − home supply = foreign supply − foreign demand,
home demand + foreign demand = home supply + foreign supply,
world demand = world supply.Slide13
Figure 9.3 World
Free-Trade Equilibrium
The equilibrium world price is where Home import demand (
MD
curve) equals Foreign export supply (
XS
curve).Slide14
Two-Country Trade with a TariffSlide15
Prices after the tariff
Now suppose Home imposes a tariff on the wheat it imports from Foreign
Then,
Price in Home = Price in Foreign + Tariff imposed by Home
For both imported and domestically-produced
wheat,
as long as some
Foreign wheat
continues to be imported into Home even after the tariff
Why?Slide16
Prices after the tariff
Suppose the price of
Foreign-made wheat
in Foreign = 4 per ton
Suppose the
tariff imposed by Home
= 2 per ton
Then the price of
Foreign
-made
wheat in
Home
= 4 + 2 = 6 per ton
Therefore,
Home’s
wheat producers can’t charge more than 6 in HomeBut can they charge less than 6? Can they charge 5.40?No. I have assumed that some Foreign
-made
wheat
continues to be imported into Home
even after the tariff. That would not have happened if Home-made wheat was selling for less than Foreign-made wheat in HomeTherefore, the price of Home-made wheat in Home is also 6
In general, the
Price (of both
Foreign
-made
wheat
and
Home
-made
wheat
)
in Home
= Price in Foreign + Tariff imposed by HomeSlide17
Effects of a Tariff
(1 of 4)
After Home imposes a tariff, in the new equilibrium, we must have:
, and
Home’s import demand must equal
Foreign’s
export supply:
MD
=
XS
.
So, while the free trade outcome is shown by Point 1, the trade-under-tariff outcome is shown by
two
points: Point 2 and Point 3.Slide18
Effects of a Tariff
(1 of 4)
After Home imposes a tariff, in the new equilibrium, we must have:
, and
Home’s import demand must equal
Foreign’s
export supply:
MD
=
XS
.
F
ree trade outcome is shown by Point 1. The price of wheat is
P
W
in both countries, and the amount traded is
Q
W
. That is, Home imports the amount
Q
W
from Foreign, the exporting country.Slide19
Effects of a Tariff
(1 of 4)
After Home imposes a tariff, in the new equilibrium, we must have:
, and
Home’s import demand must equal
Foreign’s
export supply:
MD
=
XS
.
T
he trade-under-tariff outcome is shown by Point 2 and Point 3.
The price of wheat is
P
T
in Home and
P
T
* in Foreign.
Note that
P
T
=
P
T
* + t (tariff).
The amount traded is
Q
T
.Slide20
Effects of a Tariff
(1 of 4)
After Home imposes a tariff, in the new equilibrium, we must have:
, and
Home’s import demand must equal
Foreign’s
export supply:
MD
=
XS
.
Compared to free trade, the tariff
raises
the price in the
importing
country but by
less
than the tariff.
This is because the tariff
reduces
the price in the
exporting
country.
Compared to free trade, the
amount traded
decreases
.Slide21
Effects of a Tariff
(2 of 4)
Because the price in the Home market rises from
P
W
under free trade to
P
T
with the tariff,
Home producers supply more and Home consumers demand less, so
the quantity of imports falls from
Q
W
under free trade to
Q
T
with the tariff.Slide22
Effects of a Tariff
(3 of 4)
Because the price in the Foreign market falls from
P
W
under free trade
to
with the tariff
,
Foreign producers supply less, and Foreign consumers demand more,
so
the quantity of exports falls from
Q
W
to
Q
T
.
Slide23
Effects of a Tariff
(4 of 4)
The quantity of Home imports demanded equals the quantity of Foreign exports supplied when
The increase in the price in Home can be less than the amount of the tariff.
Part of the effect of the tariff causes the Foreign export price to decline.
But this effect is sometimes very small.Slide24
A second expression of the same analysisSlide25
Demand, Before Tariff
Under free trade, the price of wheat in
Home
is the same as in Foreign
Demand is
Demand
B
When the price in
Foreign
(and in
Home)
is 6, the residents of Home buy 10 tons of
wheat
6
10
Demand
B
Quantity
in Home
Price
(in
Foreign
or
Home)Slide26
Effect of Tariff on Importer’s Demand
6
4
10
Demand
B
Demand
A
Quantity
in
Home
Price
in Foreign
1. Before Home imposes a tariff, Home’s demand curve is
Demand
B
. When the price of wheat
in Foreign
is 6, so is the price in Home, and the residents of Home buy 10 tons of wheat
.
2. Then Home imposes a tariff = 2 on
Foreign-made
wheat
3. Now, the
Home residents
will not buy 10 tons unless the price in Foreign is 4.
4. This implies that the new demand in Home
after
the tariff is
Demand
A
.
5. That is, Japan’s demand
corresponding to the price in Foreign
shifts downward by the exact extent of the tariff.
6. Home’s demand
corresponding to the price in Japan
remains
Demand
B
.Slide27
Effect of Tariff on Supply
A similar logic shows that:
Home’s supply (corresponding to the price in
Foreign
)
shifts downward
by the exact extent of the tariff.
Home’s
supply (corresponding to the price in
Home)
remains
Supply
B
.
6
4
10
Supply
B
Supply
A
Quantity
in Home
Price
in
ForeignSlide28
Price in Foreign
,
after
Home’s
tariff
As
Home
’s demand shifts left, so does the World’s demand
As
Home
’s supply shifts right, so does the World’s supply
Therefore, the free trade price of
Foreign’s
exports must fall
Note that
Home
is indeed a “large” country in this exampleHome may potentially benefit, by forcing down the price of its imported goodSlide29
Price
Home
Foreign
World
+
=
Quantity
Recall: The free trade worldwide price is the price at which excess demand in one country is equal to the excess supply in the other country.Slide30
Foreign
Home
Price
Quantity
The price in Foreign
decreases
because of
Home’s
tariff.
1. Home imposes a tariff on its imports.
3. Therefore
Home’s
Demand curve corresponding to the Foreign price (broken line) will be
below
its Demand curve corresponding to the Home price (unbroken line) by the size of the tariff.
4. The same is true for the Supply curve.
The price in
Home
increases
, but by less than the tariff.
2. As a result, the price in Home exceeds the price in Foreign by the size of the tariff.Slide31
Welfare under a tariffSlide32
Figure 9.4 Effects of a Tariff
A tariff
increases
the price in
Home (the importing country) and decreases
the price in
Foreign (the exporting country).Slide33
A
B
C
E
D
F
G
H
I
J
K
L
M
N
O
Free
Trade Price
P
W
Foreign
Home
Price
Quantity
The price in Foreign after
Home
imposes a
tariff
P
T
*
1.
Home
imposes a tariff on its imports.
The price in Home after Home imposes a
tariff
P
T
2. As a result, the price in Home must exceed the price in
Foreign
by the size of the tariff.
Tariff
3. And
Home’s
imports must equal
Foreign’s
exports.Slide34
A
B
C
E
D
F
G
H
I
J
K
L
M
N
O
Foreign
Home
Price
Quantity
The price in Foreign
after
the
tariff
P
T
*
The price in Home
after
the
tariff
P
T
Worldwide free trade
price
P
W
In
Foreign,
consumer surplus
increases
from
A
to
A
B
.
Producer surplus
decreases
from
BC
DE
to
DE
.
In Home, consumer surplus
decreases
from
FG
HIJK
to
FG
.
Producer surplus increases from
LO
to
H
LO
.
And tariff revenue increases from
zero
to
JM
.
Home’s total surplus increases by
M
–
I
–
K
, which could be positive or negative.
Foreign’s
total surplus decreases by
C
.
World’s total surplus increases by
M
–
I
–
K
–
C
, which is negative (because
C
is larger than
M
). In short, even though Home
may
benefit from the tariff it imposes,
Foreign’s
loss will be so large that the World as a whole will definitely be worse off.Slide35
Tariffs: Two Countries Case
Foreign
Home
Before
After
Before
After
Consumer Surplus
A
AB
FGHIJK
FG
Producer Surplus
BCDE
DE
LO
HLO
Tariff Revenue
--
--
--
JM
Total Surplus
AB
C
DE
ABDE
FGH
I
J
K
LO
FGHJLO
M
World’s total surplus increases by
M
–
I
–
K
–
C
, which is negative (because
C
is larger than
M
, and so
M
–
C
< 0).
In short, even though Home
may
benefit from the tariff it imposes,
Foreign’s
loss will be so large that the World as a whole will definitely be worse off.
Home’s total surplus increases by
M
–
I
–
K
, which could be positive or negative.
Foreign’s
total surplus decreases by
C
. Slide36
Gains and Losses from Tariffs: Importing Country
The loss to the country that imposes the tariff
(Home)
include
I
and
K
, which represents the loss of the gains from trade. But,
Home also
gains
M
, which represents the improvement in its terms of trade.
Had Home been a “small” country, it would not have been able to force a reduction in the price of its imported good. Therefore, tariffs would have had only losses and no gains.Slide37
Recap: Effects of Tariff—Small Country
C
G
A
E
D
F
B
Price
of Steel
0
Quantity
of Steel
Domestic
supply
Domestic
demand
Price
with tariff
Tariff
Imports
without tariff
Price
without tariff
World
price
Imports
after tariff
Q
S
Q
S
Q
D
Q
D
Deadweight LossSlide38
Effects of Tariff—Large Country
C
G
A
E
1
D
F
B
Price
of Steel
0
Quantity
of Steel
Domestic
supply
Price
with tariff
Tariff
Imports
without tariff
World price before tariff
Q
S
Q
S
Q
D
Q
D
World price after tariff
Domestic
demand
E
2
A large country can use tariffs to force down the price of its imported good. This leads to additional gain of E
2
. If E
2
exceeds D+F, the country will be better off after imposing the tariff.Slide39
Retaliation
The analysis so far has assumed that one country can impose tariffs on its imports without the other country retaliating with tariffs of its own
If retaliation occurs, even the conditional support for tariffs outlined earlier has no basisSlide40
Textbook
See the “Costs and Benefits of a Tariff” section of Chapter 9 (“The Instruments of Trade Policy”) of
International Economics: Theory and Policy
, 10
th
edition, by Paul Krugman, Maurice Obstfeld, and Marc Melitz.
See especially Figures 9-9 and 9-10.