MODUL V

Current Theory Of International Trade

A. Trade in differentiated goods

A question debated on trade and globalization is why
we trade so much in what appears to be similar goods? The
opponents of globalization often characterized this type of
trade unnecessary. However even if trade takes place in
apparently similar countries, it can have positive effects.

1. The Lancaster Model

The welfare improving effects of trade can be
illustrated by the Lancaster Model in figure 5.1. imagine
that different products can be placed on a preference
circle, where people are situated. Country A produces four
products, a, b, c, and d while country B produces four
products 1, 2, 3 and 4. These products can be soft drinks
such as Coca Cola, Fanta , Pepsi Cola, etc. these products
do not differ in their quality, only in their taste or called
horizontally differentiated. In country A Peter’s
preference is situated closest to product a, which he will
prefer to buy. In country B, Ines’ preferences are closest to
product 4, which she will buy. But not that both Peter and
Ines would ideally prefer to buy products that were
situated exactly at their preference point, illustrated by
the dots on the circles. Hence, the closer they can come to
their true preferences the higher utility do they gain from
buying the products.

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 Figure 5. 1 the Lancaster Model

Source: Bjornskov, C. (2005).

If trade open between two countries, Peter and Ines

will both stop buying a and 4. Instead Peter will buy
product 2, which is produced in country B and is thus an
import. Ines will start buying product d, which is
produced in country A and thus also an imported product.
Both will move closer to their true preferences because the
supply of soft drinks has become more varied. The
Lancaster Model illustrates a strong case for the welfare
improving effects of trade in similar goods between similar
countries.

2. The Dixit-Stiglitz Model

The Dixit-Stiglitz Model a slightly different from
model of trade in similar goods as illustrated in figure 5.2.
imagine that Peter likes beer. Without trade he can buy
four products a, b, c, and d. he obviously will buy product
a but would ideally like to be able to shift between
products situated along the line going from the point a and
downwards to the right. If trade is opened, peter will be
able to buy four new foreign types of beer. Peter will now
be able to shift between buying product beer a, and

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 product beer 2. Therefore he becomes happier because he
will have the choice between a larger variety of beers that
he like. Hence, trade in similar goods between similar
countries is welfare improving.

Figure 5. 2 the Dixit-Stiglitz Model

Source: Bjornskov, C. (2005).

B. Similar Goods with Quality-Difference

Trade in in similar goods need not be of the same
quality. For example, consumers in a number of relatively
poor countries buy cars that very few consumers in rich
countries would prefer or called as vertically differentiated
goods. Firms will only export products that they can also sell
at home. Generally when people get richer they demand for
higher-quality goods. Figure 5.3. illustrates the income in
Denmark is distributed between the point a (the richest) and
b (the poorest). The Portuguese income is distributed
between e and f. hence, the lowest quality that the poorest
Danes will be willing to buy is determined by the point b. The
poorest Portuguese are poorer than the poorest Danes, they
will be willing to buy lower-quality goods at point d. The
quality- difference model complements model relying on
comparative advantages by providing an explanation for why
similar countries sometimes are found to trade much with
each other.

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 Figure 5. 3 Trade with quality differences

Source: Bjornskov, C. (2005).

RANGKUMAN.
Trade that takes place in apparently similar goods
between apparently similar countries, it can have positive
effects. The Lancaster Model explains welfare improving
effects of trade in similar goods or horizontally differentiated
products between similar countries. The Dixit-Stiglitz Model
also explains about trade in similar goods. This model
explains that people become happier, because he will have
the choice between larger varieties of products that he likes.
Although traded goods may appear similar they can be
difference in quality or called as vertically differentiated
products. The implication of trade with quality differences
model is that trade in goods with a quality that can be sold in
both countries. In other words, firms will only export
products that they can also sell at home.

EVALUATION
1. Discuss how the Lancaster Model and Dixit-Stiglitz Model
explain about trade in differentiated goods.
2. Explain about horizontally differentiated products and
vertically differentiated products.
3. Explains how the quality difference model complements
models relying on comparative advantages theory.

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 MODUL VI
Export And Import policy International Trade Policy

A. Trade Policy
Although free trade is beneficial for majority of
countries, however, most countries restrict trade in various
ways. Some instruments for barriers to trade such as tariffs,
import quotas, tariff rate quotas and export subsidies.

B. Tariffs
Tariff protection is the one of the most used way of
barriers to international trade. Tariff is a price any importer
has to pay for his product to enter the country. This raises the
price of his product in the recipient country and therefore
creates a n advantage to domestic producers who do not have
to pay the tariff. Figure 6.1 will illustrate the economics effects
of tariff on demand and supply. Assume that the country is
small such that domestic producers cannot affect the world
market supply, Pw.

Figure 6. 1 The Effects of Tariff

Source: Bjornskov, C. (2005).

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 If the world price is Pw, the horizontal line is world
supply, Sw is flat because domestic are too small to affect the
world price. S is the domestic supply and D is the demand
from domestic consumers. If the country is closed to trade,
the equilibrium price and output would be at the intersection
of D and S. with free trade without tariffs, the domestic
producers have to take the world market price. It means that
equilibrium domestic supply is at qf, domestic demand at df,
and the price equals to the world market price. The import
volume is the difference between demand and supply df - qf.
If the government impose a tariff t on imports,
domestic producers can now take the price Pw + t. Their
supply is expanded to qt and the price domestic consumers
pay is increased to Pt. Imports decrease to dt – qt. this means
that producers gain area A since they now produce more and
receive a higher price. The government gains the area C,
which is the import volume multiplied by the tariff (the
government’s tariff revenue. Consumers pay A+B+C+D, as
they pay higher price and buy less. The total loss is the two
deadweight losses B and D. Hence, tariff induces a loss of
total welfare.

C. Import Quotas
Import quotas used to achieve a maximum level of
imports as imports never exceed the quota. On the other
hand the import volume with tariff protection always
depends on the world market price. The effects of import
quota illustrated in figure 6.2. Q is the import quota imposed
by the government. The limited supply from efficient foreign
competitor result in equilibrium price Pq that higher than the
world market price. C is the quota rent, which the
government can gain as revenue only if it sells the rights to
the quota in an auction, otherwise, the area is effectively
given as a gift to foreign producers. Hence if the government
either does not sell the quota or for some reason sells it to
a low

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 price, the introduction of an import quota results in a larger
welfare loss than a tariff.

Figure 6. 2 The Effects of an import quota

Source: Bjornskov, C. (2005).

D. Tariff Rate Quota

Tariff Rate Quotas (TRQ) are combination of tariffs and
quotas. For example, Botswana pays lower tariffs on beef
exports to the EU than the US, but only up to a limit. For the
first 19,000 tonnes of beef exported to the EU, only the specific
duty is paid, but all exports above that limit have to pay both
the specific and percentage duties. The effecs can be seen in
figure 6.4. Where Spreferential is the supply curve of the
countries that are covered by TRQs. Figure 6.4 illustrates the
case of TRQ.

Figure 6. 3 The Effects of a TRQ

Source: Bjornskov, C. (2005).

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 E. Export Subsidies
Example of export subsidies case such that European
producers might alsi want to export beef to the US. In that
case EU use export subsidy as instrument of trade policy. Or
each tone of chilled beef exported, the producers receives a
large refund, means that European producers can take a
lower price for their goods and still make a profit. As the
subsidy given by the government, consumers eventually have
to bear the cost as their taxes need to be increased to cover
the increased in government expenditure. This effect
illustrated in figure 6.4. Where DM is demand for the
imported good and Sx is the supply of foreign n produce.

Figure 6. 4 The Effects of an Export Subsidy

Source: Bjornskov, C. (2005).

The area def is a deadweight loss that comes about

because the less efficient producers in the exporting
countries take over some of the world’s production of good.
In total, world welfare is lowered and the welfare of the
exporting country even more or so, as it transfers the area
adef to the importing country. This is therefore an example of
what is known as a “beggar-thy-self’ policy.

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SUMMARY
Tariff protection is the one of the most used way of
barriers to international trade. Tariff is a price any importer
has to pay for his product to enter the country. This raises the
price of his product in the recipient country and therefore
creates a n advantage to domestic producers who do not have
to pay the tariff. Import quotas used to achieve a maximum
level of imports as imports never exceed the quota. Tariff
Rate Quotas (TRQ) is combination of tariffs and quotas.
Export subsidy is another example of instrument of trade
policy. As the subsidy given by the government, consumers
eventually have to bear the cost as their taxes need to be
increased to cover the increased in government expenditure
that known as a “beggar-thy-self’ policy. However, there is
always a welfare gain associated with reducing or removing
barriers to trade, including import barriers and export
subsidies.

EVALUATION
1. Identify the benefits of tariff and quota as instruments of
trade policy.
2. Discuss about Tariff Rate Quota.
3. Why Export subsidy also known as a “beggar-thy-self’
policy?

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MODUL VII
Organization And International Trade Policy

A. Non-tariff Barriers to Trade

Countries also use less transparent ways of protecting
their producers against international competition. Requiring
that products to meet certain standards. The standards can be
enforced in two ways, either using product standard or
process standard. In product standards, either the producer,
the exporting country or the importing country validates that
the standard is met. While in process standards, the importing
country requires that products be produced in certain way
such as using a certain technology.

B. Tariff Protection in a Large Country.

Unlike small country, a tariff in a large country can
affect the world market price. Figure 7.1 will illustrate
both the domestic market (the left half) and the market
for import products in this country (the right half). In the
figure can be seen that with small tariffs, the deadweight
loss e can be very small while at large tariffs, it becomes
rather large. While the tariff may lead to increased total
welfare, the rest of the world suffers from the tariff. This
is known as a ‘beggar-thy-neighbor’ policy.

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 Figure 7. 1 The Effects of a tariff in a large country

Source: Bjornskov, C. (2005).

C. infant industry protection

New industries need protection in a period in which
they grow and develop. The industries learn as they grow,
which means that their first years become more efficient. If
exposed to foreign competition, new industries and firms
may never be large enough to be efficient as it is supported
by economies of scale which can sell their product at a lower
price. Figure 7.2. illustrates the infant industry protection
case where the industry supply curve shifts to the right over
time and generates an additional gain H due to increase in
efficiency.

Figure 7. 2 The Effects of a tariff in a large country

Source: Bjornskov, C. (2005).

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 SUMMARY.
In small countries there is always a welfare gain
associated with reducing or removing barriers to trade,
including import barriers and export subsidies. While a tariff
in large country could affect the world market price thus
lowering the global welfare. Although there are proper
arguments for why large countries might gain a welfare
improvement by imposing an import barrier, finally, in the
real world the optimum import tariff might be zero even for
large countries. Finally, protecting an infant industry until it
has become internationally become competitive is good, but
protection in general weakens the incentives to invest in
becoming more competitive.

EVALUATION
1. Discus about Non- tariff barriers to trade
2. Understand the implication of Tariff Protection in a Large
Country
3. Do you agree on the idea of an Infant Industry Protection?