Trade Policy

  1. General Equilibrium Effects of a Tariff

Despite the convincing arguments for free trade, few countries practice it in the real world. Some countries form a free trade area such as NAFTA or European Union, but they also limit imports from other countries that are not members of free trade area or a common market.

          In this section, we consider various instruments to restrict international trade and examine their efficiency and welfare implications.


A tariff is imposed on imports

 p1 = p*1, p2 = p*2(1 + t2).

 Large country When the Home country is large, an increase in tariff increases domestic price p2, while it lowers the foreign price p*2. [For example, an increase in oil production in the US depresses the world price of petroleum.]
Small country A small country cannot affect world prices.

A tariff raises the domestic relative price (p1/p2) of the importable above the fixed world price (p1*/p2*). As a result, the trade triangle shrinks.

General equilibrium effects of a tariff

A tariff on a product not only affects its imports but also consumption and production of other related goods.

Secondary effects: Other markets are also affected.


A general equilibrium analysis is important in that it views the impact of a price change on the whole economy. In general, a change in the price of one good affects not only that market but also other related markets. For instance, an increase in the price of oil not only reduces oil consumption but also has a significant impact on the automobile market and the petrochemical industry. Also, a significant increase in oil price encourages firms to look for alternative energy sources such as ethanol.


A tariff shrinks the trade triangle. The line BF shows the magnitude of imports and exports under free trade. The line B'F' shows the magnitudes of trade when a tariff is imposed. These two lines generate two trade triangles as shown in the next figure.


Remark: The main drawback of the general equilibrium analysis is that the utility function is not observable, and hence welfare losses cannot be quantified.

In contrast, a partial equilibrium analysis makes it possible to estimate benefits and losses, focusing only on the market whose price is affected by tariffs or quotas.


  2. Partial Equilibrium Effects of a Tariff
 What it does Ignore other markets
 Advantage benefits and costs are observable. 
 small country case  
 A Numerical Example  
Autarky case

What is the price level in autarky?

26 - x = 2 + x. 24 = 2x, x = 12.

p = 26 - 12 = 14.

Consumer surplus = area below the demand curve and above the market price

(26 - 14) × 12/2 = 72.

Producer surplus = area above the supply curve and below the market price

(14 - 2) × 12/2 = 72.

 Free trade case Demand: p = 26 - x

Supply: p = 2 + y

Free Trade

t = 0, p* = 5

Domestic Production. 5 = 2 + y, y = 3

Domestic Consumption 5 = 26 - x, x = 21

Import = 21 - 3 = 18.

CS = (26 - 5)× 21/2 = 441/2

PS = 3 × 3/2 = 9/2.

TS = 225.

 Tariff is imposed

Restricted Trade

Tariff: t = 5

Domestic price p = p* + t = 10.

Domestic Production: 10 = 2 + y. y = 8.

Consumption: 10 = 26 - x, x = 16

Imports: Q = x - y = 16 - 8 = 8.

Consumer Surplus = (26-10)× 16/2 = 128

Producer Surplus = (10 - 2) × 8/2 = 32

Tariff Revenue = 5 × 8 = 40

Total Surplus = 128 + 32 + 40 = 200.

Deadweight Loss = (18 - 8)× 5/2 = 25. or 225 - 200 = 25.

(The sum of the two red triangles)

  3. Export Tax (Tariff)
Sometimes a tariff is imposed on exports

An export tax is a negative export subsidy. Used by infant governments that have difficulty raising revenue.

In the absence of an export tax, the world price is p*. At this price, the social surplus is the sum of consumer surplus and producer surplus.

When a small country imposes an export tax, it does not affect the world price p*. It only depresses the domestic price to p by the amount of the export tax,

p1(1 + t1) = p*1, p2 = p*2.

Of course, consumer surplus increases, but producer surplus shrinks even further. The government also collects the tax, equal to the rectangular area, from the exporters. Accordingly, the two red triangles represent the welfare loss from an export tax.



  4. Export Subsidy

Most countries are reluctant to tax exports.

Instead, they often subsidize exports. Export subsidies are given to farmers in EU and US during the Reagan era. This is the main complaint of developing countries.

  Export subsidies were reduced after the Uruguay Round 
An export subsidy is the opposite of a tax

Again, we are dealing with an export subsidy for a small country. An export subsidy does not affect the world price p*. However, domestic price rises above the world price by the amount of export subsidy. This time, consumer surplus shrinks, but producer surplus increases much more.

Also, the government must bear the cost of subsidy (instead of earning tax revenue). Accordingly, the two red triangles represent the deadweight welfare loss.


  5. (Theoretical) Equivalence of Tariffs and Quotas
 Equivalence Tariffs and quotas are equivalent in the sense that the resulting prices, consumption and production are identical.


For any import quota, there is an equivalent tariff. Conversely, for any tariff, there is an equivalent quota.

The only difference is that tariff revenue turns into quota revenue, which the government could collect from importers.

 In practice Tariffs and quotas are not equivalent. 
Advantages of Quota

(i) Useful in countering short run disturbances.

In contrast, tariff is a permanent measure.

(ii) more certain than tariff to restrict import .

Disadvantages of Quota

(i) Cumbersome (high administrative costs).

(ii) Difficult to implement when a product consists of several parts from different countries.

Need to specify the quantity for each good imported. Excessive paper work.

(iii) Difficult to know how severe an import quota is.

 Main advantage of tariffs Transparency, which facilitates trade negotiations.

Quotas are more difficult to compare

(1 million tons vs 10,000 cars)

Tariffs are easily compared (50% vs 10%).


Applied Tariff Rates (source: World Bank): These differ from tariff rates on dutiable imports. Bound tariff (= maximum tariff) rates differ across products and across countries. Applied Tariff Rates are the actual tariff rates.

  1996 2012
 US 4.1% 2.8%
 Japan 4.5% 2.4%
 France (EU) 4% 1.5%
 China 19.8% 7.5%
 South Korea 9.8% 5.2%
 Mexico 14.5% 12.5%
 World 34% 2.9%

  6. Tariffication
 "tariffy" convert non-tariff barriers into (equivalent) tariffs.  
  Transparency was emphasized during the Uruguay Round. Accordingly, the tariffication proposal by the US was adopted in the Uruguay Round. Mostly applied to agricultural restrictions. 

Two stage process

(i) Convert NTBs into an "equivalent tariff" or tariff-rate Quotas

(ii) Reduce the converted tariff over the years

 LDCs were given more time to reduce these converted tariffs.

 Tariff-Rate Quota

(i) Zero or low tariff up to a limit, and

(ii) then a higher tariff rate beyond the limit.

For instance, under NAFTA, agricultural imports from Mexico and Canada are under tariff-rate quotas. Zero tariff up to a limit, but a high tariff thereafter.


  7. Production Subsidy

It distorts only production.

Production subsidies do not distort consumption decisions.

Ethanol plant, Ida Grove, Iowa

Production subsidy increases domestic production'

(because p* intersects with S' = S + subsidy.

Production subsidy = rectangle= brown parallelogram.

Welfare loss = triangle.


  8. Voluntary Export Restraint

The exporting country "voluntarily reduces exports below a limit."

VERs are implemented on a bilateral basis (e.g., between the US and Japan). During the Uruguay Round, existing VERs were phased out.


No government revenue is generated.

The foreign exporters raise price.

"Tariff revenue" or "quota revenue" that the government or domestic importers would have collected disappears. 

Quota revenue under a Quota

Export price under a VER

VER is the worst instrument

This figure depicts the supply curve under a voluntary export restraint.

The welfare loss is higher by the area of a parallelogram, equal to the tariff revenue which would have been recovered by the government if a tariff or a quota were imposed.

 VER on Japanese cars

Nevertheless, VERs were popular during the 1980s. Lasted more than 10 years.

VER saved American jobs, but American consumers paid about $160,000 for each job saved.


9. Lerner Symmetry Theorem