ECON7530

Lecture 9
The Instruments of Trade Policy
Nhan Phan
UQ School of Economics
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Last Week – Summary
1. Internal economies of scale imply that more production at the firm
level causes average costs to fall.
2. With monopolistic competition, each firm can set its price due to
product differentiation but must compete with other firms whose
prices are believed to be unaffected by each firm’s actions.
3. Monopolistic competition allows for gains from trade through lower
costs and prices, as well as through wider consumer choice.
4. Monopolistic competition predicts intra-industry trade, and does
not predict changes in income distribution within a country.
Learning Objectives
• Evaluate the costs and benefits of tariffs, their welfare effects, and
winners and losers of tariff policies.
• Discuss what export subsidies and agricultural subsidies are, and
explain how they affect trade in agriculture in the United States and
the European Union.
• Recognize the effect of voluntary export restraints (VERs) on both
importing and exporting countries, and describe how the welfare
effects of these VERs compare with tariff and quota policies.
UQ Extend – Protectionism
Practically all countries large and small impose
some form of trade barrier – of varying strengths –
on their imports from other countries.
Common types of protectionism
1. Tariff
2. Export subsidy
3. Quota
4. Voluntary export restraint
5. Local content requirement
6. Other instruments: export credit subsidies; Source: Cartoon Movement
national procurement; red-tape barriers
UQ Extend – Supply, Demand, and Trade –
Single Industry (Wheat)
∗
• Without trade: 𝑃𝑃𝑊𝑊 > 𝑃𝑃𝑊𝑊 .
•  With trade, wheat will be
shipped from Foreign to Home until
the price difference is eliminated.
• Import demand curve:
𝑀𝑀𝑀𝑀 = 𝐷𝐷 − 𝑆𝑆
• Export supply curve:
𝑋𝑋𝑋𝑋 = 𝑆𝑆 ∗ − 𝐷𝐷 ∗
• In equilibrium:
Import demand = Export Supply
⇔ World demand = World supply
Import Demand Export Supply
Curve (Home) Curve (Foreign)
UQ Extend – Effects of a Tariffs
• Tariff: a tax levied when a good is imported.
• Two types: specific & ad valorem.
• Consider the effect of a specific tariff of 𝑡𝑡.
• A tariff acts like a transportation cost, making sellers unwilling to ship
goods unless the Home price exceeds the Foreign price by the
amount of the tariff:
𝑃𝑃𝑇𝑇 − 𝑡𝑡 = 𝑃𝑃𝑇𝑇∗
• A tariff makes the price rise in the Home market and fall in the
Foreign market.
UQ Extend – Effects of a Tariffs

The price in Foreign falls from 𝑃𝑃𝑊𝑊 to 𝑃𝑃𝑇𝑇∗ : The price in Home rises from 𝑃𝑃𝑊𝑊 to 𝑃𝑃𝑇𝑇 :
 The quantity of exports falls from 𝑄𝑄𝑊𝑊 to 𝑄𝑄𝑇𝑇  The quantity of imports falls from 𝑄𝑄𝑊𝑊 to 𝑄𝑄𝑇𝑇
UQ Extend – Costs and Benefits of Tariffs
• A tariff raises the price of a
good in the importing
country
•  hurts consumers and
benefits producers.
• In addition, the government
gains tariff revenue.
• How to measure these
costs and benefits?
•  Use the concepts of Consumer Surplus Producer Surplus
consumer surplus and
producer surplus.
UQ Extend – The Costs and Benefits of Tariffs
A tariff raises the price in the importing
country from 𝑃𝑃𝑊𝑊 to 𝑃𝑃𝑇𝑇 :
• 𝐂𝐂𝐂𝐂 ↓ : − 𝒂𝒂 + 𝒃𝒃 + 𝒄𝒄 + 𝒅𝒅
• 𝐏𝐏𝐏𝐏 ↑: + 𝒂𝒂
• Government revenue: +(𝒄𝒄 + 𝒆𝒆)
• Change in welfare due to the tariff is
𝒆𝒆 − (𝒃𝒃 + 𝒅𝒅)
• Ambiguous effect for large countries:
• Efficiency loss: Area 𝒃𝒃 + 𝒅𝒅
• Terms of trade gain: Area 𝒆𝒆
• If 𝑒𝑒 > 𝑏𝑏 + 𝑑𝑑, national welfare will increase
under a tariff, at the expense of foreign
countries.
 What about a Small Country?
• The terms of trade does
not change.
• No effect on world price.
• Horizontal import demand
curve: insignificant demand.
• World price remains at 𝑃𝑃𝑊𝑊 .
• Home: 𝑃𝑃𝑇𝑇 = 𝑃𝑃𝑊𝑊 + 𝑡𝑡
• Government revenue
collected at the expense of
consumer surplus loss.
• Overall, only efficiency
loss from tariff.
“We’re Not Gonna Take It!”
• However, foreign
countries can retaliate
with their own tariffs.
• This hurts exporters in
the country that first
adopted the tariff.
• Tariffs can be hard to
remove.
 Case Study: The Trump Trade War
Timeline of average tariffs imposed by
the Trump administration 2018–2019:
• Some tariffs on specific goods (solar
panels, washing machines, steel, and
aluminum) were imposed on a large
set of exporting countries.
• Some tariffs were targeted at specific
countries (mostly China but also the
European Union later on) and covered
many different goods.
• By 2019, over 66% of Chinese exports
to the United States were hit by the
tariffs.
Source: 2019 update of Pablo D. Fajgelbaum, Pinelopi K. Goldberg, Patrick J. Kennedy, and
Amit K. Khandelwal, “The Return to Protectionism,” The Quarterly Journal of Economics 135,
no. 1 (February 1, 2020), pp. 1–55.
Case Study: The Trump Trade War
• How have those tariff increases
affected the prices of goods
consumed in the United States?
• Any terms-of-trade gains were
negligible
• Foreign exporters did not lower their
prices to absorb any of the tariffs.
• Almost the entire brunt of the
tariffs has been borne by U.S.
consumers and firms buying
intermediate goods.
• Substantial annual cost increase of
$300-900 for U.S. households. Source: Kirill Borusyak and Xavier Jaravel, “The Distributional Effects of Trade:
Theory and Evidence from the United States,” SSRN Scholarly Paper, October 6,
2018.
 Case Study: The Trump Trade War
Retaliation by its trading partners:
• China: higher tariffs on par with the
higher tariffs imposed by the
United States.
• Major steel and aluminum
exporters to the U.S. responded
with tariffs on various U.S. imports.
• All those retaliatory tariffs
overwhelmingly targeted
agricultural products.
• The Chinese tariffs covered virtually
all U.S. agricultural exports.
Source: 2019 update of Pablo D. Fajgelbaum, Pinelopi K. Goldberg, Patrick J.
Kennedy, and Amit K. Khandelwal, “The Return to Protectionism,” The Quarterly
Journal of Economics 135, no. 1 (February 1, 2020), pp. 1–55.
Case Study: The Trump Trade War
Fajgelbaum et al. (2019) – per year:
• CS loss 𝑎𝑎 + 𝑏𝑏 + 𝑐𝑐 + 𝑑𝑑 = $114.1b
• PS gain 𝑎𝑎 = $31.8b
• Government revenue 𝑐𝑐 + 𝑒𝑒 = $65.9b
• Potential terms of trade gain was
negligible 𝑒𝑒 ≈ 0 .
Overall efficiency loss 𝑏𝑏 + 𝑑𝑑 = $16.4b
Retaliatory tariff: number of farm
bankruptcies increased by 24% in 2019.
Tariff Engineering – A Case Study
• Is this a light truck, or a passenger car?

Source: Wikimedia Commons

 Tariff Engineering – A Case Study
• “Chicken tax”: U.S.’ 25% tariff on small
commercial van imports from Europe.
• Duty on imported passenger van is 2.5%.
• Ford circumvented the tariff.
• Production in Spain.
• Installs rear windows, rear seats, and seat belts
prior to shipping the vehicles to the U.S. in an
attempt to be classified as passenger vehicles.
• Upon arrival, process reversed before delivery
to dealers. Source: Washington Post | Ford
• Ford has avoided an estimated $250 million
in U.S. tariffs over the years.
Export Subsidy
• Export subsidy: payment to a
firms or individual that ships a
good abroad.
• An export subsidy can also be
specific or ad valorem.
• The domestic price of the good
increases.

Source: CartoonStock
UQ Extend – Export Subsidy
An export subsidy of 𝒔𝒔 raises the price in
the exporting country:
• 𝐂𝐂𝐂𝐂 ↓: − 𝒂𝒂 + 𝒃𝒃
• 𝐏𝐏𝐏𝐏 ↑: + 𝒂𝒂 + 𝒃𝒃 + 𝒄𝒄
• Government revenue falls:
− 𝒃𝒃 + 𝒄𝒄 + 𝒅𝒅 + 𝒆𝒆 + 𝒇𝒇 + 𝒈𝒈
• 𝑃𝑃𝑆𝑆∗ = 𝑃𝑃𝑆𝑆 − 𝑠𝑠  An export subsidy
worsens the terms of trade.
Overall, an export subsidy damages
national welfare.
− 𝒃𝒃 + 𝒅𝒅 + 𝒆𝒆 + 𝒇𝒇 + 𝒈𝒈
• Efficiency loss: 𝒃𝒃 + 𝒅𝒅
• Terms of trade loss: 𝒆𝒆 + 𝒇𝒇 + 𝒈𝒈
Case Study 1
Europe’s Common Agricultural Policy
• The EU buys agricultural products
to support price & subsidises
exports to dispose of excess output.
• Boulanger and Jomini (2010): cost
for European taxpayers is almost
$30 billion more than its benefits in
2007.
• Direct cost in 2013: $65 billion.
• Subsidies to European farmers are
roughly 19% of value of farm
output.
Case Study 2
The Longest Running Trade Dispute
• 2004 – 2021
• “Actionable”:
The WTO allows
countries
impacted by
export subsidies
to impose
countervailing
duties (tariffs)
against the
subsidising
country.

Source: FT | AP
Case Study 2
The Longest Running Trade Dispute
• 2004: the U.S. filed a case with the WTO complaining that Airbus had
received favourable loan agreements for the development of their
new A380 and A350 jumbo jets.
• The EU counterclaimed that Boeing received tax rebates and
favourable contracting terms from the U.S. government.
• The WTO eventually ruled in favour of both cases.
• In 2019, the U.S. imposed tariffs on European wines and specialty
food items.
• The EU retaliated with tariffs on U.S. whiskey, nuts, and tobacco.
• 2021: tariffs suspended after both sides committed to work on
removing unfair subsidies.
UQ Extend – Import Quota
• Import quota: restriction on the quantity of a good that may be
imported.
• This restriction is usually enforced by issuing licenses or quota rights.
• A binding import quota will increase the price of the import
• The quantity demanded will exceed the quantity supplied by Home
producers and from imports.
• When a quota instead of a tariff is used to restrict imports, the
government receives no revenue.
• Quota rents: extra revenue to quota license holders from selling imports at
high prices.
UQ Extend – Case Study: U.S. Sugar
• Imports of sugar into the United States
limited and quota rights passed out to
foreign governments.
• Price of sugar in the United States has
remained well above world prices.
• U.S. consumers are hurt by more than U.S.
producers benefit.
• Foreigners earn quota rents.
• Overall effect on national welfare
negative.
Case Study: U.S. Sugar
• Under NAFTA, Mexico’s sugar exports
were slowly exempted from the quota
restrictions
•  U.S. sugar price premium decreased to its
lowest level in over 25 years.
• 2014: U.S. sugar producers complained,
and the U.S. Commerce Department
sharply reduced Mexican sugar imports.
• U.S. sugar prices have substantially risen
again.
• In 2015, that price was almost double the
world price.
Case Study: Costs of a Quota
For 2014, the sugar quota is
estimated to:
• Cost in total an estimate of $4.4
billion:
• Consumers: 3.5 billion ($11 per
person or $30 for a typical household)
• Producer surplus losses for food
producers (who use refined sugar as
an ingredient): $909 million
• Benefit sugar producers $3.9
billion (mostly to refiners)
Case Study: Costs of a Quota
• If the sugar quota is eliminated:
• +: 17,000–20,000 new jobs in producing
foods containing sugar.
• –: 500–2,000 jobs that might be lost in the
sugar industry.
• Turn the United States from a net importer to
a net exporter of sugar-containing foods.
• However, the sugar producers are better
lobbyists than the sugar-containing food
sector, so this protection has been Source: Wikimedia Commons
extended.
• The collective action problem
UQ Extend – Voluntary Export Restraint
• Voluntary export restraint: works like an import quota, except that
the quota is imposed by the exporting country rather than the
importing country.
• These restraints are usually requested by the importing country.
• Case study: The U.S. asks Japan to limit Japan’s car exports to the U.S.
• The profits or rents from this policy are earned by foreign
governments or foreign producers.
• Foreigners sell a restricted quantity at an increased price.
Case Study – U.S.-Japan Trade
• In 1979, sharp oil price increases caused the U.S. market to shift
abruptly toward smaller cars.
• Japanese producers moved in to fill the increased demand faster than
U.S. auto companies could come out with smaller, more fuel-efficient
models.
• As the Japanese market share soared and U.S. output fell, strong
political forces in the United States demanded protection.
• Rather than act unilaterally and risk creating a trade war, the U.S.
government asked the Japanese government to limit its exports.
 Case Study – U.S.-Japan Trade
• The Japanese, fearing unilateral U.S.
protectionist measures if they did not do so,
agreed to limit their sales.
• The first agreement, in 1981, limited Japanese
exports to the United States to 1.68 million
automobiles.
• A revision raised that total to 1.85 million in 1984.
• In 1985, the agreement was allowed to lapse until
1994.
• The price of Japanese cars in the United
States rose, with the rent captured by
Japanese firms.
• The total costs to the United States are Source: NPR
estimated to have been $3.2 billion in 1984.
Local Content Requirement
• Local content requirement: regulation that requires a specified
fraction of a final good to be produced domestically.
• Also called rules of origin.
• This can either be specified in value terms;
• Or requires some minimum share of the value of a good represent home
value added, or in physical units.
• Provides neither government revenue (as a tariff would) nor quota
rents.
Local Content Requirement
• Domestic producers’ viewpoint: Provides protection in the same way
that an import quota would.
• Buyer of products’ viewpoint (firms using the product as input): no
strict limit on imports, but allows firms to import more if they also
use more home parts.
•  The difference between the prices of home goods and imports is
averaged into the price of the final good and is passed on to
consumers.
Local Content Requirement
Example: Car producer faces a part
cost of $6,000 imported vs
$10,000 produced domestically.
• Suppose 25% local content
requirement.
• Average cost is then $7,000 =
0.75 x $6,000 + 0.25 x $10,000.
• This will be reflected in the new
(higher) price of a car. Source: FT | Bloomberg
Local Content Requirement
• The 2020 USMCA required that any car or truck exported within
North America must have 45% of its content made by workers
earning at least $16 an hour.
• Effectively excludes most of auto parts made in Mexico, where most wages
are below that level.
• Intended to impose additional restrictions on vehicles assembled in Mexico
for sale in the U.S. market.

Source: Adobe Stock

Other Trade Policy Instruments
• Export credit subsidies
• A subsidized loan to exporters
• U.S. Export-Import Bank subsidizes loans to U.S. exporters.
• Government procurement
• Government agencies are obligated to purchase from home suppliers
• Even when they charge higher prices (or have inferior quality) compared to
foreign suppliers.
• Bureaucratic regulations (red tape)
• Safety, health, quality, or customs regulations can act as a form of protection
and trade restriction.
Summary of Trade Policy
Voluntary Export
Policy Tariff Export Subsidy Import Quota
Restraint

Producer surplus Increases Increases Increases Increases

Consumer
Falls Falls Falls Falls
surplus
Falls No change No change
Government
Increases (government (rents to license (rents to
revenue
spending rises) holders) foreigners)
Ambiguous Ambiguous
Overall national
(falls for small Falls (falls for small Falls
welfare
country) country)
Summary of Trade Policy
• For each trade policy, the price of the product rises in the Home
country adopting the policy.
• Home producers supply more and gain.
• Home consumers demand less and lose.
• The world price falls when Home is a “large” country that affects
world prices.
• Tariffs generate government revenue; export subsidies drain it;
import quotas do not affect government revenue.
• All these trade policies create production and consumption
distortions (efficiency loss).