CHAPTER THREE

INTERNATIONAL TRADE POLICY

 LEARNING OBJECTIVES
 Upon successful completion of this chapter, you will be
able to:
 Appreciate the debate on whether trade be free or not,
 Identify the major trade policy instruments and their
respective welfare effects on consumers and producers,
 Identify the costs and benefits of a tariff on a small and a
large nation
 Conceptualize the strategies of industrialization adopted
by nations in different times.
 In the previous chapter, we have seen that free trade
maximizes world output and benefits all nations.

 However, practically all nations impose some

restrictions on the free flow of international trade.

 Since these restrictions and regulations deal with the

nation’s trade or commerce, they are generally known
as trade or commercial policies.

 Therefore, in this chapter, we will appreciate the major

trade policy instruments, and the effects of trade policy
intervention on consumers and producers of d/t nations.
3.1. Cases for and Against Free Trade
 A policy of no restrictions on the movement of goods b/n
countries is known as the policy of Free Trade.
 Restrictions placed with a view to safeguarding home industries
constitute the policy of protection.

3.1.1. Cases for Free Trade

 The cases for free trade emphasizes the gains from free trade.
A) Efficiency Argument
 The first case for free trade is the argument that producers and
consumers allocate resources most efficiently when
governments do not distort market prices through trade policy.

National welfare of a small country is highest with free trade.

With restricted trade, consumers pay higher prices and consume
too little while firms produce too much.
 Fig. 3-1: The Efficiency Case for Free Trade
 However, because tariff rates are already low for most
countries, the estimated benefits of moving to free
trade are only a small fraction of national income for
most countries.
2. Economies of Scale
 It is argued that protected markets not only fragment
production internationally, but by reducing competition
and raising profits leads.

 Too many firms to enter the protected industry.

More out but can be achieve at a lower cost
 The scale of production of each firm becomes
inefficient.
3. Dynamic benefits
 Free trade provides competition and opportunities for
innovation.
 By providing entrepreneurs with an incentive to seek
new ways to export or compete with imports, free trade
offers more opportunities for learning and innovation.

4. Protection creates monopolies

 When foreign competition has been removed, the home
manufacturers are tempted to combine to reap
monopoly profits at the expense of consumers.

 Hence, free trade reduces monopoly and thereby

maximizes societal welfare.
5. Political Argument
 Economists often argue that trade policies in practice
are dominated by special-interest politics rather than
consideration of national costs and benefits.

 Better policies are uncertain, hard to identify, depend

on theoretical framework – potentially large margin of
error

Implementation of complex “better policies” can be

challenged by political process.

A simple rule of Free Trade may hence be superior to

any complex strategy.
3.1.2. Cases Against Free Trade:
Protectionism
 The term 'protection' is used to denote a policy of
encouraging the home industries to impose high
customs duties on foreign products.

 The objective is to build up great national

industries even by sacrificing utilities on the part of
existing consumers.

 The arguments for protection are stated below.

 . 
1.Infant Industry Argument

The idea is that when production of a

commodity first begins in a country, the firms
producing it are often small, inexperienced, and
unfamiliar with the technology they are using.

Hence, costs are higher than they will be later

on, and infant firms in the new industry may
need temporary protection from older,
established firms in other countries, until they
become mature, and it able to rival their
competitor.
 Forwarded by Friedrich List, J. S. Mill, & Alfred
Marshal.
 Friedrich List (German economist, in 1840) had
strong view that the development of industries is a
pre-requisite of economic progress.
 He argued that Free trade is good for countries
with well established industries.
 However, for countries with infant and young
industries, protection via high tariff is essential.
 J. S. Mill (a free trade advocate) believes that "The
superiority of one country over another in production often
arises only from having started it sooner.
 In Mill’s words: “A productive duty, continued for a
reasonable time, might sometimes be the least
inconvenient mode in which a nation can tax itself for the
support of introducing new industries.
 he argued that protective tariffs and trade regulation were
sometimes good to support the young industry.
 Alfred Marshall (advocate of free trade) argued that
for protection to produce social benefits, an infant
industry must first grow up.
 It must eventually be able to compete at world
market prices.
 In general, the idea is that if infant industries are not duly protected
against competition from strong and well-established' industries,
they are bound to die.
 Hence, protection is vital.
 However, protection should not be given on a permanent basis.
 It should be given for a definite period considered sufficient for
the industry to grow.
 Moreover, it should not be given unsystematically to all industries.

2. Employment Argument
 It is argued that industrial development through protection
increases employment in a country.

 Conversely, if protection is not given to old established

industries; foreign competition may ruin/ destroy them and
create unemployment in the country.
3. Diversification of Industry Argument
 According to Friedrich List, a nation should have a variety of
sources of production and employment.

 Depending on one industry or on a few industries is dangerous

both politically & economically.

 Politically it means too much dependence on foreign trade which

may be cut off during a war. So it needs diversify industry and
protectionism is essential

 Economically, a country depending on a few industries is exposed

to the danger of serious economic dislocation in case some
adverse circumstances affect such an industry.
4. Defense Argument
 Adam Smith = "Defense is better than wealth". It is
said that protection is vital to make a country
militarily strong however it may not be economically
prosperous.

Hitler preached to the German nation, "Gun! Better

than butter."
According to this argument a country must actively
encourage the development of those industries
which are essential from the point of view of defense.

The advocates of free trade point out that this is

politics and not economics. on purely economic
grounds, they say, free trade is the best.
5. Revenue Argument
Protection is also advocated for revenue purposes.
When protective import duties are imposed, they certainly bring in
revenue to the government.

But it may be pointed out that there is a

certain degree of incompatibility b/n the revenue
and protection.
If full protection is given, the government will not get any
revenue, because full protection will mean that domestic
goods have driven foreign goods altogether.
But if the duties are moderate, they will yield revenue
besides affording protection.
6. Balance of Payments Argument  
 It is necessary to check imports by means of tariff
in order to rectify adverse balance of payments.

 Import restrictions on non-essential imports

become necessary in the interest of accelerated
economic growth via BOP
 E.g cocaine, alchol….
3.2. International Trade Barriers
(Instruments of Trade Policy)
Import tariffs
Export subsidies (export loans, tax
benefits)

Import quotas
Voluntary export restraints (VERs)
self-imposed limit on the quantity of a good that an exporting
country is allowed to export.
It rises CS and lower PS in the export country

Local content requirements (LCRs)

policies imposed by governments that require
firms to use domestically-manufactured
goods
3.2.1. Tariff and Its Effects
 Tariff is the most widely used trade protection policy.
A. What is Tariff?
 A tariff is a tax (duty) levied on a product when it
crosses national boundaries.
– The most widespread tariff is the import tariff- a
tax levied on an imported product.
– A less common tariff is an export tariff- a tax
imposed on an exported product.
• Cocoa exports have been taxed by Ghana, and
oil exports have been taxed by (OPEC) in order
to raise revenue.
Note that: The Ethiopian gov’t (ERCA) collects
customs duty only on imported items.
 There is no export tax: to encourage export.
 A tariff may be imposed for protection or revenue
purposes.
 A protective tariff is designed to insulate import-
competing producers from foreign competition.
 A revenue tariff is imposed for the purpose of generating
tax revenues & may be placed on either exports or
imports.
 Eg: ERCA revenue collection from customs Duty (Million
Birr)
 Types of Tariffs:
 There are may types of tariffs such as:
 Specific tariff
 Ad valorem tariff
 A compound tariff
 Discriminatory tariff
 Non-discriminatory tariffs
 Revenue tariffs
 Protective tariffs
 Retaliatory tariffs
 Countervailing tariffs
 Specific Tariffs are levied as a fixed charge for each unit
of goods imported.

 Eg, an Ethiopian importer of Japan car may be required to

pay a duty to the Ethio-gov’t of 50,000 Br per car, regardless
of the price car’s.
 this tariff can vary according to the type of goods imported. For
example, a country could levy a $15 tariff on each pair of shoes
imported, but levy a $300 tariff on each computer imported and
50,000 Br per car, regardless of the price car’s.

 Ad valorem tariffs are taxes that are levied as a fixed

percentage/fraction of the value of the imported
commodity.

 Eg: Ethiopian importer of a Japan car may be required to pay

an ad valorem duty of 35% to the Ethio-gov’t on imported car.
A compound tariff is a combination of
specific and ad valorem tariffs.

• In either case, the effect of the tariff is to

raise the cost of shipping goods to a
country.

 NB: Currently, the Ethiopian government imposes

only ad valorem tariffs.
 Discriminatory tariff: set different rates of duties
depending on the country of origin or destination of the
product
 Non-discriminatory tariffs: uniform tariffs rates imposed
on goods and services regardless of their source of
origin or destination. Tariffs are said to be single column
when they are non- discriminatory and double-column
when they are discriminatory.
 Revenue tariffs: these are tariffs that are imposed
primarily and produce revenue for the government
 Protective tariffs: are tariffs that are imposed primarily to protect
the domestic industries from foreign competitions
 Retaliatory tariffs: when country A imposes (increases) duties
against the products from country B, it is possible that country B will
retaliate and levy duties on goods imported from country A. Thus,
country B’s tariffs are then described as retaliatory tariffs.

• Example in June 2018, the EU imposed retaliatory

tariffs of 25 percent on U.S. agricultural products,
including whiskies, corn, and processed fruits and
vegetables. At the same time, Turkey imposed tariffs
ranging from 10 to 70 percent on tree nuts, rice, food
preparations, whiskey, and tobacco products.
 Countervailing tariffs: Tariffs are said to be
countervailing when a country imposes (increases)
import duties with a view to offset export subsiding in
the country of origin.

For example, export subsidies given by the Chinese

government will make the Chinese products low priced
in the Indian market. This will be a disadvantage for the
competing Indian products. To overcome this situation,
government of India can impose a countervailing duty
on Chinese imports.
 Tariffs averages 5% or less on industrial products
in developed nations, but are much higher in LDCs.
 See @ Salvatore
The Ethiopian Tariff Structure
 Imports entering Ethiopia are classified as: Imports
subject to tariff (ad Valorem), duty free, & prohibited of
importation.

 In the recent tariff proclamation, 5686 commodities are

included, among w/c 5403 (95% of items) are subject
to tariff.
The remaining 279 (4.85%) & 4 (0.07%) are
exempted & prohibited of importation, respectively.

 In line with this, there are 6 bands of rates: 0%, 5%,

10%, 20%, 30%, & 35%.
 Imports subject to tariff are also classified in to two
categories based on the primary purpose of the imported
item:
 Productive Purpose: such as,
 Import of raw materials, semi finished goods, producers
goods, and items for public use such as minibuses & buses.
 Import of productive goods are largely exempted
although there is up to a 10-20% customs duty rate
applied to some of them.

 Non-Productive: consumer/finished goods imported

for personal use.
 These goods are subject to the highest customs duty rates.
 For Eg, import of automobile is taxed at a 35% customs
duty rate.
3.2.1. Effects of Import Tariffs
Objective:
 To understand the effect of import tariff on
consumers and producers of participating nations.

 Framework:
Partial Equilibrium Analysis (by using DD & SS
curves), &
General Equilibrium Analysis (using PPFs &
indifference curves)
•
•
Figure 3.1: Partial Equilibrium Effects of a Tariff.
 Resulting Effects of Tariff (small country case)

 Consumption effect
 Reduction in domestic consumption
 Production effect
 Expansion of domestic production
 Trade effect
 Decline in imports (decline in the volume of trade)
 Revenue effect
 Raises revenue for the government
 NB:
 The more elastic the demand curve, the greater the
consumption effect.

 The more elastic & flatter the domestic supply curve, the
greater the production effect.

 The more elastic & flatter the DD & domestic SS curves,

the greater the trade effect and the smaller the revenue
effect.
 Effect of a Tariff on Consumer and Producer Surplus

 Consumer surplus is the difference b/n what consumers

would be willing to pay and what they actually pay.

 Imposition of a tariff reduces consumer surplus.

 Producer surplus is the difference b/n what producers

would be willing to receive and what they actually receive.

 Imposition of a tariff increases producer surplus.

 called subsidy effect of tariff.

•

FIG. 3.2: Effect of Tariff on Consumer and Producer

Surplus.
•
•
 Consumption Effect: Consumption distortion loss (area
d)
 Area d represents a loss of welfare that occurs b/c of the increased
price and lower consumption.
 The consumption effect represents a real cost to society, not a
transfer to other sectors of the economy.

Figure: 3.3: Partial Equilibrium Costs and Benefits of a Tariff.

 ii. Partial
Equilibrium Analysis of a Tariffs in a large-country case
Now, assume that Country A is large enough to influence
the world price when it changes the amount of a given
commodity it imports,
In this case the large nation's tariff not only decreases the
quantity demanded and may also reduce the world price of
the good.

Fig. 3.4 shows that the foreign supply curve is no longer

horizontal at the free trade world price,
Pw0. b/c the
large nation must pay higher prices to induce foreigners to
supply more exports of commodity x to the nation.
If a country imposes a specific tariff of T on imports of
oats, the new foreign supply curve shifts up parallel to the
original foreign supply curve by the amount of the tariff.
•
Q1 is domestic quantity supply and Q4 is domestic
quantity demand before tariff (i.e. before tariff
import =Q4 -
Q1)
But after tariff, import =
Q3-Q2, which is
smaller.

Fig.3.4: The effect of a tariff: partial equilibrium, large-country case.

Due to tariff the price of oats rise to p1 from pw0, Area h
is TOT gain
ΔCs= a+b+c+d, Δ ps =a and ΔGR= c+h, the net value or DWL
become= ΔGR- Δcs- Δps= h- (b+d)
Tariff revenue = c+h=p1pw1 * q2q3
c = $7.50 and e = IKMN = ($0.33)(15) = $4.95 are the
nation’s government revenues
c = $7.50 collected from domestic consumers, and IKMN =
e = ($0.33)(15) = $4.95 from foreign exporters
The reason for this is that by increasing PX , the tariff
reduces
consumption and imports of commodity X in the nation, and
since the nation is large, the smaller quantity of exports will
be supplied at a lower price
and it obtain TOT
gain .
With the tariff domestic consumers pay $2.50 higher than
PX = $2.00 in free trade), whereas foreign exporters receive
only PX = $1.67 (instead of $2 under free trade).
Now that the nation is large, the tariff will lower the price of
imports to the nation as a whole (i.e., the nation receives a
TOT benefit from the tariff).
The deadweight loss of a nation from the tariff must now
be balanced against the TOT gain that the nation receives.
Since in this case the TOT benefit to the nation of (e)=$4.95
exceeds the deadweight loss of the tariff, b + d ($3.75) and
the nation receives a net benefit of $1.20 (e − b −d) from the
tariff.
Note that a small nation always incurs a net loss from a
tariff equal to deadweight loss because the small nation
does not affect foreign export or world prices (so that e = 0).
Q. What will happen to domestic and world prices when a
large country imposes an export tariff?

ANS: The world price will increase and the domestic price will decrease.

 the main purpose of an export tariff is raise government

revenue.
•
•
 Why may the demand for imports be less elastic?
 Consumers in Country A may not switch easily to
substitutes when the price of oats rises (I.e., absence of
close substitutes).

Domestic production of oats may be very

unresponsive to the price.
 Thus, consumer have few alternatives other
than buying from the foreign supplier.
Welfare Effect of Tariff
The extent to which the tariff drives up the price faced
in Country A is important in determining who within
Country A benefits and who loses from the tariff and
whether the country as a whole may benefit.
Fig. 3.4 (left panel), the rise in price causes:
Consumers to lose areas a+ b+ c+ d, &
Producers to gain area a.
The tariff revenue gained by the gov’t is no longer just equal to
area c. Rather the tariff revenue collected is c+ h.
Adding these three effects shows that the net
economic efficiency effect on Country A is h– b– d.
Areas b and d still represent deadweight losses from
less efficient production & consumption choices, but
Country A now gains area h at the expense of
producers in the rest of the world.
We can refer to area h as terms of trade gain, b/c Country
A is now able to pay foreigners a lower net-of-tariff price
for the goods that it imports.
For a given import demand elasticity, this terms of
trade gain is likely to be greater the less elastic is
the foreign export supply curve, i.e., the more
dependent foreigners are on sales to country A.
 Whether a country gains from imposing a tariff
depends upon whether its trading partners retaliate
and impose tariffs of their own.
 A trade war that leaves all countries worse off is a
likely outcome.
 Nevertheless, the economic power of individual
countries is not symmetric/ balanced, (some may be
able to gain at the expense of others.
 The world as a whole loses, and that is one of the key
motivations for establishing international rules that
limit the ability of individual countries.
B. General Equilibrium Analysis
Partial equilibrium analysis fails to show other
important effects of tariff.

 For example, when a tariff causes the output of a

particular commodity to rise in Country A, resources
must be drawn into that industry, but we do not
see what happens in other industries from which
those resources must be taken.

 Assuming full employment, output of other

commodities must fall.
 Similarly, when Country A’s imports decline, other
countries will themselves have less money to spend on
imports; therefore Country A’s exports will also fall.
 We can use the PPF & indifference map to
deal with general equilibrium analysis.
We assume that the tariff revenue is redistributed to
consumers,
which means we do not need to introduce a
separate set of preferences for the gov’t.
i. The Small-Country Case
In free trade equilibrium, assuming only two
commodities (food & cloth),
Country A will maximize its welfare by
producing at the point where its domestic ratio
of marginal costs equals the world exchange
ratio, and then by engaging in trade in order to
reach the highest possible indifference curve.
•
 The tariff creates a wedge b/n the domestic and
external price ratios; geometrically, that wedge can be
seen as the angle b/n the two price lines i.e.DD & TT.

 The higher price of food induces firms to expand food

production by a p2 and to reduce cloth production by a p1.

 The production point moves to P2, where the domestic

price line (DD) is tangent to the PPF.
a
 Due to tariff: the nation produce more of
importable commodity, food, however
Less of exportable commodity, cloth
 C2G = Import of this HG goes to
d1 domestic consumers and the
remaining C2H Collected by the
government

G
export

S1

Q1 Q2
•
•
ii. General Equilibrium Analysis: Large Country Case
 When the country imposing a tariff is large enough to
influence the world price of what it buys, we must
consider what effect a tariff will have on the world price
ratio.

 To continue the same example, when Country A impose

a tariff on food, the result may be that the world price of
food falls relative to the price of cloth.

 In that event, for a given ad valorem tariff, the domestic

price of food will not rise as much as before.

 Thus, the shift in production will be somewhat smaller.

 We illustrate this outcome in Figure 3.6,
 where conditions are the same as in the case just
described except that the tariff now causes the
world price ratio to change from the slope of the
line TT to the slope of the line P3C3.

 Production takes place at P3 (NB: the tariff is the

same proportion as before, as measured by the

size of the wedge.)
 International trade now takes place at the world
price ratio (i.e. along the line P3C3).

 A new equilibrium in consumption is reached at

point C3, where the tariff-distorted domestic price
line is tangent to indifference curve, and the world
price line also passes through this point of tangency.

 As drawn in Figure 3.6, Country A reaches a higher

indifference curve as a result of the tariff.
 This result is not inevitable (certain), however.
It depends on the magnitude of the change in
the world exchange ratio.

 Intuitively, one can see that country A benefits

from the tariff when its gain from the improved
TOT outweighs its loss from a less efficient use of
domestic resources.

 How much its TOT will improve depends in turn on

domestic and foreign elasticity of DD & SS.
3.3. The Effective Rate of Protection
So far we have ignored the case in which some of the
inputs are imported.
I.e., we have ignored the large and important trade in
intermediate products.
 For analyzing the protective effect of tariffs, the treatment
of intermediate products makes a great deal of difference.
 When a producer has the option of importing some of the
material inputs required for the production of a given
product, the ad valorem tariff on that product may not
accurately indicate the protection being provided to the
producer.
There exist distinction b/n the nominal tariff rate/ w/
c is ad valorem tariff & the effective rate of
protection (ERP).

The ERP refers to the level of protection

being provided to a particular process of
production by the given nominal tariffs on a
product and on material inputs used in its
production.

We are particularly interested in how a set of tariffs

affects the firm’s value-added or what is available to
cover primary factor costs.
 ERP is defined as the percentage increase in an
industry’s value added per unit of output that results
from a country’s tariff structure.
The standard of comparison is value added under
free trade.

 Suppose the world price of shoes is $20 and that it

takes $12 worth of leather at the free-trade world price
to make a pair of shoes.

 In the manufacture of shoes, then, value added at

world prices is $8.
 Now suppose Country A levies a nominal tariff of 30% on
shoe imports but allows leather to be imported duty free.
 The price of shoes in Country A would rise to $26
=$20+$6 (i.e. the world price plus the tariff), and
consequently the value-added of domestic shoe
producers would become $14= 26-12

 In other words, they could incur factor costs of $14 and

still be competitive with a foreign firm whose factor
costs were $8.

 Thus, the ERP is 75%, while the nominal tariff is only 30%.
Compare a shoe-producing firm in Country A and
its free-trade competitor:

 We expect that high ERP will attract resources into

industries of a country where it has comparative cost
disadvantage.

As a result, the country’s economic efficiency falls.

Note that a tariff on leather would reduce the ERP for shoes.
The reason is: a tariff on leather increases the price of leather in
Country A & raises firms’ costs of production, w/c means value-
added must be smaller for country A firms still to sell shoes at $26.

 20%*8=2.4=14.4 and 26-14.4=11.60

In our example, a 20% nominal tariff on leather would lead to the
following result:
The effective tariff rate on shoes has fallen from 75% to 45% [($11.60 –
$8) /$8 = 45%] as a result of the tariff on leather. Shoe producers in
Country A will tend to favor tariffs on shoes but oppose tariffs on leather.
The tariff structures of many countries show a
systematic pattern in w/c nominal tariff rates
increase as the stage of production advances – that
is, tariff rates are low (or zero) on raw materials,
higher on semi-finished products, and highest on
finished manufactures.

Such a pattern in nominal tariff rates produces an

even greater escalation in effective tariff rates.

Industrial countries have been accused of using

such a tariff structure to preserve their lead in
manufacturing and to keep the LDCs from developing
exports of finished manufactures.
 Although ERPs are higher than nominal rates in the
examples above, they can also be lower and may even be
negative.

 For instance, if the nominal rate on leather were increased

to 60%, then the ERP for shoes would be –15%.

 B/c here, the firms’ value-added margin is less than that

of a free-trade competitor.
3.4. Export Tariffs
 Although governments usually design trade policies to
reduce imports or encourage exports, some countries
have applied tariffs to exports.
 This restriction used to decrease domestic price. and
 LDCs sometimes do so in order to raise revenues.
 Export tariffs may also be used to protect consumers
from increases in world prices of an export commodity.
 For instance, in the 1980s, India used an export tax on tea to
hold down prices to domestic consumers when world tea prices
increased sharply.
 Consumer gain =a +a”
PSL= ABCDE
GR= C and DWL=b+d

a
”

An Export Tax Causes:

The export supply curve to shift upward by the amount of the tax.
Domestic production to decline from Q4 to Q3,
Domestic consumption
to expand from Q1 to Q.
Exports to fall from X to
X as domestic producers
respond to the lower
domestic price P &
foreign purchasers to the higher world price, Pw1.
The Welfare Effect of the Export Tariff
 Consumption increases from Q1 to Q2 and gain area a.

 Domestic production declines from Q4 to Q3 & thus,

Producers lose areas a + b + c + d.

 The government collects tax revenue of c + e.

 Areas b & d are Dead Weight Losses.

o Area e represents terms of trade gain, &

 As demand in the rest of the world becomes less elastic
relative to export supply, this gain will be larger.
•
3.5. Non-Tariff Barriers (NTBs)
 These measures have been on the rise since the 1960s
and have become the most widely discussed topics in
recent international trade negotiations.

NTBs encompass a variety of measures.

Some have negligible trade consequences; for
example, packaging requirements can restrict trade,
but only marginally.

Others significantly affect trade patterns; examples

include import quotas, voluntary export restraints,
subsidies, and domestic content requirements.
 A. Import Quota and Voluntary Export Restraint
(Quantitative restrictions on imports)
Quotas on the quantity of allowable imports have some effects
similar to a tariff.
Agricultural products often are protected by quota, &
Much of world trade in textile products has been governed by quotas.

Voluntary Export Restraint (VER):

is another form of quantitative restrictions
to limit trade.
While the importing country does not restrict the quantity
imported by some regulation, the exporting country agrees to
limit the volume being exported to some agreed upon-level.
The Effect of Import Quota
 Producers gain area a,
 areas a+ b+ c+ d = CS
loss
 Areas b and d are
DWL.

If an import quota of 25 tons is imposed, the domestic price

rises to P as imports fall by 15
tons.
That is, imports are cut back from 40 to 25 and the price
rises from $100 to $150.
Who receives the tariff-equivalent revenue, c?
 Under a quota, the tariff-equivalent revenue, c, goes to
whomever is fortunate to have the right to ship the
product from the exporting to the importing country.

 If quota rights are allocated to importers, they

receive the windfall profit (i.e. sudden profit),

 Suppose oil can be purchased on the world market at $1.50

per barrel and shipped to the East Coast of the US for $0.75
per barrel for a total landed cost of $2.25 at the same time
US quota is being used to protect an internal price of $3.50.
 Those allowed to bring oil into the US receive a gift of $1.25
per barrel b/c they land oil in US at a cost of $2.25, and it is
immediately worth $3.50.

 NB: key assumption of the example above is that US

importers are able to buy foreign goods at a world price
that does not rise as a result of US actions.
 Under such condition, US importers that fulfill the
available quota of goods to be imported: gain area
c.
  If quota rights are allocated to exporters, they receive
the windfall profit.
 For instance, in the case of apparel trade- exporting
nations, such as Hong Kong, established a system of
export quota tickets that had to be acquired for
goods to leave the country.

 These tickets were freely bought and sold among

apparel producers, and their value increased when
the demand for items rose.

 The trade in quota tickets ensured that part of area c

was captured by Hong Kong producers who no longer
would be willing
to sell at the world price PW.
The Effect of voluntary export restraint (VER)
VER: Restriction on exports by exporting country .
 Often at the request of the importing country.

The gov’t of exporting country can allocate the quota

rights & determine who gets the windfall profits.
In this case the bonanza goes to exporting
firms rather than to importers.
 As a result, exporting countries often accept VERs.
VER on Japanese cars that limited sales in
the US to 1.85 million cars per year during the early 1980s had the
effect of raising US car prices by almost $1,000 per car.
 That means an additional profit of about $1.85 billion
per year for the Japanese car companies.
 If the US gov’t had auctioned the quota rights to the
highest bidder, the Treasury would have recaptured the
monopoly rents through the auction revenues.

 The variations discussed above, which determine

whether the importer, the foreign exporter, or the
gov’t gains the tariff-equivalent of the quota, are
important from the perspective of economic efficiency.

 The cost of quantitative restrictions on the

importing country is greater if it loses not only the
DWL, b+ d, but also area c.
Reading!
 The Distinctions b/n Quantitative restrictions Vs
Tariffs

 Irrespective of the efficiency question, however,

there are aspects of quantitative restrictions that
help explain why domestic industries are likely to
prefer them over tariff protection.
 Domestic producers also gain from a quota when
market demand is expanding.

 From Figure 3.6 note the outcome of an outward shift

in the DD curve when the quantity of imports is fixed,
prices rise and the tariff-equivalent effect of the
quantitative restrictions rises.

 A further distinction b/n a tariff and a quota arises if the

domestic industry is not perfectly competitive, and
producers have market power.

Think of the extreme case where demand can be met

by imports or by a domestic monopoly.
 A tariff, unless it is extremely high, provides only limited
protection for the local monopoly b/c the maximum price it
can charge is the world price plus the tariff.

 Any attempt to charge more than that will result in a

flood of imports that will destroy its sales volume.

 A quota, however, offers much more protection for

the monopolist.

 In case of quota, the monopolist, has an incentive to restrict

output to the level at which MC equals MR & still to charge
more than a competitive price.
 Thus, with the same level of imports, a quota will
allow higher prices and monopoly profits than will a
tariff.

 Tariffs are clearly preferable to quotas for

consumers if elements of monopoly exist in the
domestic import competing industry.

 To sum up, under domestic imperfect competition:

For producers quota is preferable to tariff
For consumers tariff is preferable to quota.
B. Export Subsidies
 So far we have seen that gov’t regulations solely to
restrict imports.
 Although that remains a dominant intervention, gov’ts
sometimes encourage exports through subsidies.

 This may occur b/c of a desire to:

Improve a country’s trade account,
Aid a politically powerful industry, or
Help a depressed region in w/c an export industry is
located.
Hard currency

 The subsidy may be a simple cash payment to exporters,

but frequently is more indirect.
R&D grants, favorable financing or tax treatment,
or other benefits.
 However, to simplify the discussion, assume that the
subsidy takes the form of a fixed cash payment for
each unit of a product exported.

 Figure 3.9 illustrates the effects of an export subsidy in

a competitive market, where we allow the country to be
large enough to affect the world price of the good.

 The free-trade world price P0 is given by the

intersection of country A’s export supply curve with the
demand curve for the rest of the world (ROW).

 Exports equal domestic production, Q3 less

consumption, Q2.
The effect of the export subsidy:
Export supply curve shifts downward;
Exporters will accept a lower price in foreign
markets b/c of gov’t subsidy.
Quantity of exports rises as foreign consumers
respond to the drop in price from P0 to Pw1.

 However, domestic market price rises to P1.

The higher price discourages domestic
consumption, and encourages domestic
production.
Figure-3.9: The Effect of an Export Subsidy.
 Export subsidy results in:
Producers expand output from Q3 to Q4 &
Diverting sales from the domestic market to foreign market;
Q2 less Q1.
Foreign buyers benefit from a lower world price, P , W1

But domestic consumers face a higher price, P , as exports rise from

1

X to X .
0 1
Welfare Effects of Export Subsidy
Consumers lose areas a + b,
Domestic producers gain areas a + b + c.
The cost of the subsidy to the gov’t = c + b + d + e +
f (see right panel)

The subsidy drives down the price Country A receives on

foreign markets, and areas e + f represent terms of trade
loss to country A.

Part of the subsidy is a transfer from the gov’t to its

own producers, given by areas c + b + d.

Areas b + d are deadweight losses.

 Area d is a DWL b/c it represents the rising marginal cost of
A’s production, which exceeds what is paid by customers
abroad.
 Area b is a DWL; it represents not only a loss to consumers
and a gain to producers, but also a loss to the gov’t.

 The net effect is that Country A loses e + f + b + d.

The Effect on ROW:
The drop in price internationally provides benefit to
customers abroad,
But producers in the ROW will be worse off.
Worsens the TOT
C. Local Content Requirements
National gov’ts may require firms to use a specific minimum
proportion of inputs of a good to be sourced domestically.

For example, it was a practice in Australia that 85% of component

parts for automobiles must be produced locally.

 With this method, countries may promote local manufactured

products and components.
By limiting foreign competition, the producers of local content
benefits.

Restrictions on imports raise the prices of imported contents.

Higher prices for imported contents raise the cost of the final
products produced locally and in turn raise the prices.

Overall LCR tends to benefit producers but not consumers.

A. Technical, Administrative, and Other Regulations
 These include:
 Safety regulations: for automobiles and
electronics
 Health regulations: for hygienic production and
packaging of imported food products
 Labeling requirements: showing origin and
contents.
E. International Cartels
It is an organization of suppliers of a commodity located in d/
t nations that agrees to restrict output & exports of the
commodity to maximize profits.

Examples:
1.OPEC (1960) (Algeria, Angola, Ecuador, Gabon,
Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar,
Saudi Arabia, UAE, Venezuela): a cartel of major
oil countries which restricts production and exports of oil.
2.International Air Transport Association: a cartel of major airlines that
set international fares & policies.

Cartels are more successful with fewer members producing an

essential commodity with no close substitutes.

 Cartel behaves as a monopolist in maximizing profits.

E.Dumping : is an unfair trade practice by
exporters.
international price discrimination,

Dumping is the sell of a commodity at below cost or at least the sale

of a commodity at a lower price abroad than domestically.

Dumping is classified as:
1.Persistent Dumping (or international
price discrimination): is a continuous
tendency of a domestic monopolist to maximize total profits by
selling the commodity at a higher price in the domestic market
than internationally (where it must meet foreign competition).

2.Sporadic Dumping: is the occasional

sale of a commodity at below cost or at below price abroad than
domestically to unload an unforeseen/ accidental and temporary
surplus of the commodity without reduction of domestic prices.
3. Predatory Dumping:
A temporary sale of a commodity at below cost or at a
lower price abroad to drive foreign producers (domestic
competitors) out of business, after which prices are raised
to take advantage of the newly acquired monopoly power
abroad.

Trade restriction to counter

predatory dumping is justified to
protect domestic industries from unfair competition from
abroad.

These restrictions usually take the form of anti-dumping

duties to offset price differentials.

 
 Domestic producers support protection against any type
of dumping, so they want to discourage imports and
increase their own production and profits.

 Examples:
Japan was accused of dumping steel and TV sets in
the US.
European nations were accused from dumping cars,
steel & agricultural products.

 When dumping is proved, the violating nation or firm

usually chooses to raise prices rather than face dumping
duties.
 3.6. Industrialization Strategies
 After WW-II, LDCs were primarily concerned with
the question of industrialization and rapid
economic growth to lift the mass of their society
from (at least) primary poverty.

 To that end, there were two competing

industrialization strategies (advocated by
economists) and adopted by many developing
countries:
Import Substitution, &
Export Promotion.
1.Import Substitution Strategy (IS)
 In 1950s and 1960s, many LDCs attempted to accelerate
their development by limiting imports of manufactured
goods (to encourage the replacement of imported
manufactures by domestic products) by using trade
restrictions such as tariffs and import quotas, and other
non-tariff barriers.

The strategy of encouraging domestic industry by limiting

imports of manufactured goods is known as the strategy
of import-substituting industrialization.

In particular, import substitution (IS )refers to a deliberate

effort by gov’ts to replace imports by promoting the
emergence and expansion of domestic industries.
 Justifications:
A. The main justification: infant industry argument
 Countries may have a potential comparative advantage
in some industries, but these industries can not initially
compete with well-established industries in other
countries.

 To allow these industries to establish themselves, gov’ts

should temporarily support them until they have grown
strong enough to compete internationally.

 This argument makes sense.

 It is a historical fact that the world's three largest
economies (the US, German & Japan) all began their
industrialization behind heavy trade barriers.
2. Another justification for protection was founded on
the argument that LDCs’ export opportunities are
limited.
 LDCs mainly export primary commodities whereas the
industrial countries export manufactured goods.
 The price and income elasticity of demand for the
primary commodities were lower than those for
manufactures.
 This situation was expected to result in trade deficits and
thereby slower economic growth in LDCs relative to their
developed country counterparts.
 Moreover, Import substitution advocates argued that, in the
long run, this strategy will result in:
 Benefits of greater domestic industrial diversification, and
 Builds ability to export manufactured goods as economies
of scale, and low labor costs cause domestic prices to
become more competitive with world prices.

On the basis of the above justifications, many

developing economies have adopted this strategy.
 For example, in 1950s & 1960s, the larger Latin American and
Asian countries such as Chile, Peru, Argentina, India, Pakistan, &
Philippines were heavily IS oriented.

By the end of the 1960s, some of SSA countries like

Nigeria, Ethiopia, Ghana, & Zambia adopted IS strategies,
and some smaller Latin American and Asian countries also
joined in.
 However, import substitution strategy did not promote
economic development in these countries.

 Because countries adopting these policies grew more

slowly than rich countries and other countries that did
not adopt the strategy.

 IS strategy involved costs and promoted wasteful use

of resources: causing high tariff rates for consumers,
including firms that needed to buy imported inputs for
their products, promoted inefficiently small industries.
2. Export Promotion
 Around the mid-1960s, the strategy of IS was criticized
by an increasing number of economists on the basis of
two separate observations.

1st, it was observed that countries which applied

inward oriented policies were experiencing balance
of payments problems and failing growth rates.
2nd, the success stories of countries which
switched from inward to outward oriented strategy:
 High exports,
 Penetration of industrial countries' markets for
manufactured products, &
 Higher growth rates than under IS strategy.
Thus, from the mid-1960s onwards, export promotion
was advocated as an alternative possible path to
industrialization: via exports of manufactured goods
to advanced nations.

Thus, a number of countries started establishing

incentive schemes to encourage the export sector.
This strategy was known as Export promotion or
Outward-looking strategy.

It refers to governmental efforts to expand the

volume of a country’s exports through increasing
export incentives, decreasing disincentives and other
means to generate more foreign exchange and
improve balance of payments and achieve growth.
Since the mid-1970s, the EP strategy has been increasingly adopted
by a growing number of countries: including
 Countries w/c the WB called “high
performance Asian economies” =South Korea, Taiwan, Singapore,
Hong Kong, Japan, Malaysia, Thailand, Indonesia and China, &
 Others like Brazil, and Chile.

The high performance Asian economies were successful that they

have experienced rapid growth in export sectors and economic
growth.

However, these countries were not free traders b/c they have
pursued IS strategies simultaneously in certain industries, though
they were outward-oriented ( i.e., much more open to trade as
measured by high ratio of exports & imports to GDP).
 It is also unclear if the high volume of exports caused
rapid economic growth or was merely correlated with
rapid economic growth.

 Some economists argue that the cause of rapid

economic growth was high saving and investment rates,
leading to both rapid economic growth & rapid exports
growth.

 In addition, almost all of the high performance Asian

economies have experienced rapid growth in
education--high literacy rates.
 END OF CHAPTER THREE!

NEXT:

CHAPTER FOUR

TRADE & DEVELOPMENT