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Topics

• Introduction
• Benefits and Costs of Trade
  • Benefits and Costs of International Trade
• Trade Restrictions and Agreements—Tariffs, Quotas, and Export Subsidies
  • Tariffs
  • Quotas
  • Export Subsidies
• Trading Blocs and Regional Integration
  • Types Of Trading Blocs
  • Regional Integration

Table of Contents

Introduction

• Benefits and costs of international trade
• Types of trade restrictions and their economic implications
• Trading blocs and regional integration

Benefits and Costs of Trade

Benefits of International Trade

• Countries gain from the exchange and specialization. A country benefits from exchange trade if either of the following two conditions occur in an exchange, (as there is efficient allocation of resources):
  • Higher price for exports relative to selling internally.
  • Lower price for imports relative to producing internally.
• Households and firms have greater product variety.

• Competition increases and resources are allocated more efficiently.
  • In an open economy, increased competition from foreign forms reduces the monopoly power of domestic firms and forces them to be efficient.
  • By increasing production of the exported good and reducing production of the imported good, a country achieves a more efficient allocation of resources. This efficiency enables the consumption of a larger basket of goods, increasing overall welfare.
• Industries experience greater economies of scale.
  • In an open economy, companies are forced to compete with global players and that forces them to become more efficient or go out of business.
• Greater employment in exporting countries.

Note: The term “gains from trade” implies that the overall benefits of trade outweigh the losses from trade. It does not mean that all stakeholders (producers, consumers, government) benefit (or benefit equally) from trade.

Costs of International Trade

• Potential income inequality.
  • It depends on whether the industry is expanding or contracting.

• Loss of jobs because less inefficient firms will be forced to exit.

Trade Restrictions and Agreements—Tariffs, Quotas, and Export Subsidies

Trade restrictions are government policies that limit the ability of domestic households and firms to freely trade with other countries.

Tariffs

Tariffs are taxes imposed by a government on imported goods. Tariffs are common in countries where the government finds it difficult to collect taxes from its citizens.

Why governments levy tariffs:

• To protect domestic industries.
• To reduce trade deficit. Tariffs reduce the demand for imports by increasing their price above the free trade price.

“Small” country: A country is a price taker in the world market for a product, and is too small to affect the world market price. For example, India is a price taker for luxury bikes like Ducati, Harley Davidson, and Triumph.

“Large” country: A country is a large importer of the product and can influence the world market price. For example, the United States is a large country for the automobile market. If it were to impose tariffs on imported cars, then exporters would reduce the price of the cars to retain market share.

Generally, tariffs result in loss in global welfare.

Welfare effects of Tariff and Import Quota

• Under free trade:
  • $Q^1$ is domestic supply and $Q^4$ is domestic consumption.
  • Import demand = Demand – Supply = Distance b/w $Q^4$ and $Q^1$
  • Assume the country is Portugal, and it imports cars. It is a price taker and the price per car (P*) is 100.
• After tariff is imposed:
  • $Q^2$ is domestic supply and $Q^3$ is domestic consumption.
  • Import demand = Distance b/w $Q^3$ and $Q^2$
  • Domestic producers supply more and consumers demand less. The price is represented by $P_t$.
  • Assume Portugal imposes a 50% tariff, so the price of the car is now 150.

Interpretation of what happens after the tariff:

• Tariff results in a deadweight loss, known as welfare loss here, denoted by B + D.
• Producer surplus increases to A because of a higher price for their output.
• Government revenue increases because of the tariff collected, as denoted by C.
• Consumer surplus decreases because of the increase in price.

If the U.S. imposes a tariff, then Japan will reduce the price of cars. Terms of trade for the U.S. will improve as the price of imports has gone down.

The outcome is:

• For the importing country (US): producers gain, but consumers lose. Creates tariff revenue for the government.
• For the exporting country (Japan): producers lose but consumers gain.

Quotas

Quota is a restriction on the absolute amount (quantity) of imports allowed over some period, typically a year. An import license specifies the maximum quantity that can be imported during a given period; it is used to implement a quota.

Quota rents: The extra profit earned by foreign producers. Exporters earn greater profits with quotas because they often raise the price of their goods.

Welfare effects of Tariff and Import Quota

Interpretation:

• With tariffs, it was clear that region C was the revenue earned by the government. But, in the case of quota, these are profits earned by the exporters as they raise the prices of their goods. If there was no quota, the prices of these goods would not have increased.
• With tariffs, the loss in welfare was equal to the deadweight loss of B+D. But, with quotas, it is equal to B+C+D. The amount lost in C can be eliminated if the government sells the import licenses to the exporters for a fee, and this amount must be equal to C.

Voluntary export restraint: Export quota administered by the exporting country; exporting country agrees to limit exports of a particular good usually at the request of the importing country to avoid tariffs or quotas. A VER allows importing countries to protect domestic industries from a surge of imports.

The difference between an import quota and a VER is that the former is imposed by the importing country, while the latter is imposed by the exporter.

Export Subsidies

Export subsidies are payments by the government to a firm for each unit exported:

• The objective is to stimulate exports, increase production in certain industries, and create domestic employment.
• The exporter has an incentive to focus on the export market because the firm receives the international price plus the per-unit subsidy for each unit of the good exported.
• The most export-subsidized industry in the world is agriculture.
• Countervailing duties are duties levied by the importing country against subsidized exports entering the country. This tariff is imposed to offset the effect of subsidy.
• If a small country imposes export subsidies, domestic price rises.
• If a large country imposes export subsidies, world prices decline as quantity increases.
• For example, the European Union subsidizes sugar and is the second largest exporter in the world.
• Net welfare is down in the large and small country.

Effects of Alternative Trade Policies on Price, Production, Consumption, and Trade

• Domestic consumption, consumer surplus decreases.
• Domestic production, producer surplus and price increases.

Trading Blocs and Regional Integration

A regional trading bloc, is an agreement between a group of countries, that are geographically close to each other, to reduce and eliminate barriers to trade and movement of factors of production among the members of the bloc. They have zero or very low tariffs on imports from members.

Types Of Trading Blocs

The diagram below shows the various types of regional trading blocs in an increasing order of integration.

Regional Integration

Regional integration is popular because removing trade and investment barriers among a small group of countries is easier, politically less contentious, and faster than multilateral trade negotiations under the World Trade Organization. (WTO).

Regional integration results in preferential treatment for members over non-members and can cause changes in trade patterns.

• Trade creation occurs when regional integration results in the replacement of higher-cost domestic production by lower-cost imports from other members.
• Trade diversion occurs when lower-cost imports from non-member countries are replaced with higher-cost imports from members.

Challenges to Deeper Integration:
There are at least two challenges to moving from an FTA to deeper levels of integration.

• Cultural and historical considerations, such as wars and conflicts, may complicate the integration process.
• A high level of economic integration limits member countries’ ability to pursue independent economic and social policies