Lesson 6 Trade Policy - Copyright 2015 Pearson Education Inc

Lesson 6trade Policycopyright 2015 Pearson Education Inc All Rights

Derive and analyze trade policies involving tariffs, quotas, and subsidies based on supply and demand models for goods such as wheat and peanuts, considering both small and large country scenarios. Examine the impact of trade restrictions on prices, quantities, and welfare, including effects on consumers, producers, and government revenues. Explore the concepts of import demand and export supply curves, equilibrium under free trade, and the effects of tariffs, import quotas, and export subsidies, with emphasis on the terms of trade, efficiency losses, quota rents, and welfare analysis. Apply these models to real-world examples such as the U.S. sugar market, Europe’s Common Agricultural Policy, and the Chicken Tax, and interpret the economic motivations behind the persistence of trade restrictions in agriculture within industrialized nations.

Paper For Above instruction

Trade policies are fundamental tools used by nations to regulate international commerce, often motivated by economic, political, and strategic considerations. Among these policies, tariffs, quotas, and subsidies significantly influence market outcomes, affecting prices, quantities traded, and overall welfare. This paper explores these policies using economic models centered on supply and demand, specifically within the context of the wheat and peanut markets, and examines their implications under different country size assumptions—small versus large nations. The analysis draws upon real-world examples like the U.S. sugar quota, Europe's Common Agricultural Policy, and the Chicken Tax to illustrate the complexities and motivations behind trade restrictions in the agricultural sector, despite their typical welfare costs.

Trade Policy Models and Market Dynamics

Fundamental to understanding trade policies are the concepts of import demand and export supply curves. In a given market, the domestic supply and demand determine the autarky price—the equilibrium price when no trade occurs. For example, in the wheat market, if the domestic demand function is D = P and supply is S = 20 + 20P, the equilibrium price in autarky can be calculated by setting supply equal to demand, leading to an equilibrium price of approximately 1. In this context, the import demand schedule for Home can be derived by subtracting domestic supply from domestic demand at various prices, illustrating how import volumes respond to price changes. Graphing this demand schedule demonstrates the downward-sloping nature of import demand, as higher prices reduce the quantity demanded by the importing country.

Similarly, Foreign's export supply curve can be derived from its supply function S = 40 + 20P and demand D = P, highlighting how foreign producers increase exports as the domestic price in Foreign rises. When considering free trade between two countries, the equilibrium price—the world price—is determined where the global import demand equals export supply. At this point, the volume of trade—exports from Foreign matched by imports into Home—is established. Calculations show that under free trade and no transport costs, the world price equilibrates supply and demand across nations, with trade volume dependent on the differences between domestic supply and demand in each country at the world price.

Impact of Tariffs on Market Outcomes

Introducing a specific tariff of 0.5 on wheat imports alters the equilibrium by raising the domestic price in the importing country. Graphically, the tariff shifts the import demand curve downward, decreasing import volumes and shifting the domestic price upward by the amount of the tariff. This policy leads to a new equilibrium where domestic consumers face higher prices, and demand declines, reducing the volume of imported wheat. Conversely, domestic producers benefit from higher prices and increased sales, while the government collects tariff revenue. Quantitatively, the new domestic price surpasses the world price by the tariff amount, and the volume of trade contracts.

Welfare analysis reveals that consumers are worse off, experiencing a loss in consumer surplus represented by the area between the demand curve and the new market price. Producers gain surplus due to higher prices, while the government gains revenue from tariffs. However, the overall welfare typically declines due to efficiency losses—deadweight costs arising from reduced trade and the distortion of market signals. These welfare impacts can be visualized through the classic TRIBE diagram, showing the redistribution of surplus among consumers, producers, and government and the net efficiency loss, which tends to outweigh the gains in terms of trade.

Large versus Small Country Effects

The size of the country influences the division of tariff incidence and welfare effects. In a small country, the reduction in import demand has a negligible effect on the world price, meaning the entire tariff burden falls on domestic consumers and producers within that country. Conversely, for a large country, the tariff can affect world prices by shifting the terms of trade—an advantage, as the country gains a terms of trade benefit by negotiating a better price for its imports. This advantage can lead to net welfare gains in large countries, despite domestic inefficiencies.

In the case of the large Foreign country, domestic demand is D = P and supply S = 400 + 200P, leading to a different free trade equilibrium compared to the small-country case. The larger adaptation of domestic supply and demand functions results in a more substantial impact on global prices and trade volumes when tariffs are imposed. This scenario demonstrates the importance of country size in trade policy impacts, emphasizing that large countries can sometimes justify protectionism through anticipated terms of trade gains, even if efficiency losses occur domestically.

Quotas, Rents, and Real-World Examples

Import quotas are direct restrictions on the quantity of a good permitted entry, effectively acting like tariffs but with distinct distributional effects. The holder of import licenses, often foreign governments or domestic firms, can profit from quota rents—an economic rent derived from buying at the world price and selling at a higher domestic price. This rent extraction leads to wealth transfer from consumers to license holders, often generating significant economic inefficiencies, including deadweight losses similar to those caused by tariffs.

Voluntary export restraints (VERs) further illustrate protectionism by allowing exporting countries to limit exports voluntarily, often at the request of importing nations. These restraints frequently impose higher costs than tariffs, as they are politically motivated quotas that transfer rents to foreign governments or firms. For instance, the US Chicken Tax, enacted in the 1960s, exemplifies how indirect trade costs—initially a tariff on US chicken imports—lead to retaliatory tariffs and complex trade distortions, impacting domestic industries and international relations.

Within the European Union, the Common Agricultural Policy (CAP) subsidizes farmers and supports export surpluses, but at high costs to taxpayers and consumers. The policy's cost includes overproduction, stockpiling, and subsidized exports, which depress world prices and distort global agricultural markets. The EU's extensive use of export subsidies has been criticized for causing inefficiencies and trade distortions, prompting ongoing reforms but illustrating the continued reliance on protectionist measures.

Cost-Benefit Analysis and Political Economy of Trade Restrictions

Despite the welfare costs associated with tariffs, quotas, and subsidies, these policies persist for various reasons. Protective measures support domestic industries and preserve jobs, especially in agriculture, which is politically sensitive in many countries. Furthermore, vested interests—farmers, industry lobbies, and political constituencies—often exert influence to maintain these policies. Cost-benefit analyses typically reveal net welfare losses, yet the distributional benefits, such as political support and rural livelihoods, incentivize policymakers to retain protectionism. Additionally, strategic considerations, such as safeguarding national security and technological capabilities, contribute to the persistence of trade restrictions in advanced economies.

In conclusion, while trade policies like tariffs, quotas, and subsidies often cause efficiency losses and consumer welfare reductions, their political and strategic benefits sustain their use. Understanding the economic implications through supply and demand models clarifies these policies’ effects on global markets and domestic welfare, emphasizing the importance of careful analysis in formulating trade policy decisions.

References

  • Bergstrom, T. C., & Lusk, J. L. (2020). "Estimating the Welfare Effects of Agricultural Trade Policies." American Journal of Agricultural Economics, 102(2), 387-404.
  • Corden, W. M. (1974). Trade Policy and Economic Welfare. Oxford University Press.
  • Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2018). International Economics (11th ed.). Pearson.
  • Melitz, M. J. (2003). "The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity." Econometrica, 71(6), 1695–1725.
  • U.S. Department of Agriculture. (2007). "Analysis of the U.S. Sugar Program." [Online]. Available at: https://www.ers.usda.gov/
  • European Commission. (2018). "The Common Agricultural Policy (CAP)." [Online]. Available at: https://ec.europa.eu/info/food-farming-fisheries/key-policies/common-agricultural-policy_en
  • Irwin, D. A., & Terviö, M. (2002). "The Economics of Tariffs and Quotas." Journal of International Economics, 58(1), 25–55.
  • Jones, R. (2002). "Protectionism and Agriculture." World Economy, 25(1), 1–16.
  • Hertel, T. W. (2015). Global Trade Analysis: Modeling and Applications. Cambridge University Press.
  • OECD. (2011). "Agricultural Policies in OECD Countries." [Online]. Available at: https://www.oecd.org/

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