Government Intervention in International Trade Activity 51 by

Government Intervention in International Trade Activity 51 by Advanced Placement Economics Teacher Resource Manual. National Council on Economic Education, New York, N. Y

Objectives n n n Define tariffs, quotas and regulations to limit trade. Describe policies that are intended to protect the domestic economy from the effects of international trade. Explain the effects of tariffs, quotas and subsidies on domestic production and the prices domestic consumers pay.

Government Intervention in International Trade n n The last lesson demonstrated the benefits of trade among nations, showing that total output increased. Nevertheless, most nations attempt to create barriers to trade using tariffs, quotas or regulations. Trade barriers limit the gains from trade and tend to reduce competition and economic efficiency.

Government Intervention in International Trade n Tariff – “a tax levied on imports” (Krugman 450) n n Quotas – “a proportional part or share of a fixed total amount or quantity. ” (“Quota”) n n n Example: The United States imposes a tariff of more than 10% on imports of textiles and shoes. A good example of a quota is the voluntary export restraint (VER) Japan agreed to in the 1980’s limiting the number of cars it exported to the U. S. Import quota – “a legal limit on the quantity of a good that can be imported” (Krugman 452) Example of a regulation to limit trade is the Federal Drug Administration’s test requirements on pharmaceuticals imported into the United States

PRICE Domestic and Foreign Supply Domestic Supply Total Supply with Tariff Total Supply P P 2 P 1 Domestic Demand q q 2 q 1 QUANTITY n For domestic consumers, the price is higher and the quantity available is smaller than under free trade.

n Arguments in support of limitations on trade: n n n n the national defense argument the infant industry argument the “dumping” argument preservation of domestic jobs maintenance of diverse and stable economy prevention of exploitation Most of these arguments do not stand up to scrutiny. Limitations on trade fundamentally allow domestic producers to be inefficient and increase the costs to domestic consumers.

History of Tariffs in U. S. n n n The Smoot-Hawley Act of 1930, tariffs reached a high average rate of 20% Over time, the United States has attempted to reduce tariffs using trade agreements such as the North American Free Trade Agreement (NAFTA) In the Uruguary Round (1986 to 1994) of World Trade Organization negotiations, the U. S. negotiated its lowest rate ever.

Barriers to Trade Activity 51 n n n The free trade movement started about 200 years ago. Previously, it appears that one of the goals of governments was to stifle international trade, presumably for the benefit of their own economies. Over the last 50 years, there have been efforts to reduce trade barriers, with significant success during the 1990 s. Examples of these efforts include the North American Free Trade Agreement (NAFTA), the World Trade Organization (WTO), the European Union (EU) and the Asia-Pacific Economic Cooperation (APEC) forum.

Barriers to Trade Activity 51 n n We want to be able to investigate the economic effects of various barriers to trade that a nation might impose to protect domestic industries. In Fig. 51. 1, the demand curve represents the demand by the domestic economy for a commodity that is produced domestically and also imported. The domestic supply curve indicates what the domestic suppliers are willing and able to produce at alternative prices. If there were no international trade or a complete ban on imports, the equilibrium price would be P, and the equilibrium quantity, Q, would be produced only by domestic firms.

Fig. 51. 1 PRICE Domestic Supply Total Supply P P 1 Domestic Demand q 2 n q q 1 QUANTITY If there is free international trade, the Total Supply curve represents the production by domestic and foreign producers. Domestic consumers would pay p 1 and consumer q 1: n n n They are able to consume more of the commodity at a lower price. Also, at p 1 , domestic firms are producing q and foreign producers are producing (q 1 – q 2). Thus, domestic firms are producing less under free trade than they would if the nation did not import the commodity.

Part A: Quotas Instead of permitting free trade or imposing a complete ban, a nation may decide to set a quota to limit the number of imports. Import quotas are sometimes referred to as voluntary export restraints (VERs) because the two countries have agreed that the exporting nation will not export more than a certain amount.

We can see the effect of an import quota by looking at Fig. 51. 2. Here the domestic price would be ‘p’ and the quantity would be ‘q’ if there were a complete import ban, If there were free trade, the price would be p 1 and the quantity demanded by domestic consumers would be q 1. Notice that under free trade, the entire market is supplied by foreign producers as the market is drawn. This does not have to be the case; it depends on the costs of the domestic industry and the domestic industry’s ability to sell at the lower price. Fig. 51. 2 PRICE Domestic Supply Total Supply P P 1 Domestic Demand q q 1 QUANTITY

n n n Suppose the importing nation imposes a quota, or VER, of X amount; the Total Supply with Quota curve represents the new supply curve. Total Supply with Quota is the domestic supply curve plus X amount at every price level (X = q 2 – q 3 ). The domestic price has risen from p 1 to p 2 and consumers are able to purchase less of the commodity. Equilibrium quantity has decreased from q 1 units to q 2 units. However, domestic producers are now producing q units, and foreign producers are supplying X = q 2 – q 3. PRICE Fig. 51. 2 Domestic Supply Total Supply with Quota Total Supply P P 2 P 1 Domestic Demand q 3 q q 2 q 1 QUANTITY

n Use Fig. 51. 3 to demonstrate what will happen to the domestic price, domestic production and the amount of imports if a quota is removed. The Domestic Supply and Total Supply curves on the graph are without any barriers to trade imposed. Be sure to show on the graph the supply curve with quota. It is not on the graph now. Domestic Supply PRICE Fig. 51. 3 Total Supply P P 1 Domestic Demand q q 1 QUANTITY

PRICE Fig. 51. 3 Domestic Supply Total Supply with Quota Total Supply P P 2 P 1 Domestic Demand q 3 q q 2 q 1 QUANTITY n n n If there were a complete import ban, the equilibrium domestic price would be ‘p’ and the equilibrium quantity would be ‘q’ with the commodity completely produced by the domestic industry. If there were a partial quota, the supply curve labeled Total Supply with Quota would be the relevant curve. The domestic price and quantity would be p 2 and q 2. The amount of the quota would be (q 2 – q 3). Domestic production will be q 3. Removing the quota and moving to the free trade equilibrium, the domestic consumers will pay p 1 and purchase q 1. Removal of a quota has led to a decrease in price and an increase in the quantity consumed. In the case illustrated, there will be zero domestic production under free trade.

2. Write a paragraph summarizing the advantages and disadvantages of a quota to the domestic economy. Be sure to discuss the impact on domestic consumers, domestic producers and foreign producers. The advantage of a quota are that the domestic industry will be able to produce more and receive a higher price for the commodity relative to the free trade equilibrium, and employment in that industry is greater with quota than without a quota. The disadvantage are that consumers pay a higher price and cannot consume as much of the commodity as at the free trade equilibrium. Foreign producers receive a higher price but produce less with a quota than under free trade. 3. If a quota is imposed, explain the methods people would use to circumvent the effects of the quota. An underground market may develop for the commodity. Foreign firms may open factories or assembly plants in the domestic nation and produce the commodity there so that production won’t be subject to the quota.

Part B: Tariffs n A tariff is a tax on an import. The imposition of a tax increases the cost of each unit, which is represented by a decrease in supply. This would result in an increase in equilibrium price and a decrease in equilibrium quantity.

Modify Fig. 51. 4 to show the effect of an import tariff of $7 per unit. Be sure to show on the graph the amount of the tariff. Add one curve to the graph, and label it Total Supply with Tariff. After the imposition of the tariff, label the new equilibrium price ‘p. T’ and the equilibrium quantity ‘q. T’. Domestic Supply Total Supply with Tariff Total Supply Fig. 51. 4 PRICE 4. P PT Tariff = $T P 1 Domestic Demand q 2 q q. T q 1 QUANTITY The imposition of a tariff causes the total supply to decrease because the tariff has caused the price to increase at every level of output. Q 2 is the amount of domestic production after the tariff. The tariff is the vertical distance between the total Supply and the Total Supply with Tariff curves indicated by an arrow on the graph.

PRICE Domestic Supply Total Supply with Tariff Total Supply P PT P 1 Domestic Demand q 2 5. q q. T q 1 QUANTITY What is the effect of the tariff on the equilibrium price and quantity for domestic consumers compared with the free trade levels? The equilibrium quantity decreases to ‘q. T ‘, and the equilibrium price increases to ‘p. T ‘. Note that domestic industry is not producing. How far the curve shifts (how large the tariff is) determines whether domestic firms are producing any output.

6. What are the similarities between the effects of a quota and those of a tariff? Both a quota and a tariff raise the price and limit the quantity to domestic consumers relative to the free trade equilibrium. Foreign firms produce less under either a quota or a tariff.

7. 8. What is the primary difference between the effects of a quota and those of a tariff. With a quota, all of the revenue generated by the price increase goes to the producers. With a tariff, the government receives the tax revenue. Suppose a country can impose either a quota that raises the domestic price to ‘p₂’ as in Fig. 51. 2 or a tariff that raises the domestic price ‘p₂’. Explain whether domestic consumers would prefer a tariff or a quota and why. Domestic consumers would prefer a tariff because the domestic government receives the revenue as opposed to the producers (domestic and foreign. ). Consumers might expect that the overall level of taxes would then decrease. The tariff tax revenue would substitute for other tax revenue.

Part C: Export Subsidies n Nations may choose to assist domestic industries by providing subsidies to an industry. The subsidies would lower the costs and permit the industry to sell at a lower price. This assistance is called an export subsidy because the industry can now compete on the world market and export some of its product to other nations.

9. Modify Fig. 51. 5 to show the effects of an export subsidy on domestic producers. Indicate as ‘p. S ’ and ‘q. S’ the equilibrium price and quantity for domestic consumers after an export subsidy. Add two curves to the graph: a Domestic Supply with Subsidy curve and a total supply with Subsidy curve. Domestic Supply PRICE Fig. 51. 5 Total Supply P P 1 Domestic Demand q q 1 QUANTITY

Domestic Supply without Subsidy Fig. 51. 5 Domestic Supply with Subsidy PRICE P Total Supply without Subsidy Total Supply with Subsidy P 1 PS Domestic Demand q 2 n q 3 q q 1 q. S QUANTITY The equilibrium without subsidy would result in a price of P 1 and a quantity of Q 1 and the domestic economy would be producing Q 2. With the subsidy to the domestic industry, the equilibrium would result in a price of PS and a quantity of QS, and the domestic economy would be producing Q. The quantity supplied by foreign producers is (QS – Q 3).

n (A) (B) (C) According to Fig. 51. 5 with your modifications, what would be the equilibrium price and quantity for a completely closed economy (no imports and no subsidy)? ______ P and Q An open economy (completely free trade with no export subsidy? Q 1 P 1 and _______ An open economy PS anda. Qdomestic with S export subsidy? ______

10. What is the effect of an export subsidy on the equilibrium price and quantity for domestic consumers relative to the free trade equilibrium without a subsidy? The price is lower and the quantity is greater. 11. If an industry receives a subsidy, what will happen at the equilibrium to domestic production and the amount of imports? Fig. 51. 5 – The free trade equilibrium without subsidy would result in a price of P 1 and a quantity of Q 1 and the domestic economy would be producing Q 2. With the subsidy to the domestic industry, the equilibrium would result in a price of PS and a quantity of QS, and the domestic economy would be producing Q 3. With the subsidy, domestic production increases. The exact impact on imports depends on the extent of the subsidy and the demand curve for the commodity.

Part D: Applications 12. n One of the goals of the European Union is the elimination of trade barriers among the member nations. Consumers who buy the commodity will benefit by having lower prices and a greater quantity of the commodity. Domestic producers of imported commodities will lose since the price will decrease as trade barriers are reduced and domestic producers will produce less at the lower price. A second result of the reduced production is that employment in this industry will decrease. However, the economy will be more efficient, and the standard of living will increase.

13. Identify the arguments frequently used to impose some type of trade barrier. Discuss the pros and cons of three arguments. Protection of specific industries from foreign competition: An industry may argue that it cannot compete with foreign producers and that this competition will have an impact on wages and employment. The costs to domestic consumers are the higher prices and restricted quantity. Most governments that favor unrestricted trade will offer short-term protection to allow the industry to adjust. National defense and other noneconomic considerations: Some industries produce defense items and thus should not be driven out of business by foreign competition. This is a noneconomic reason for protecting an industry. The problem with this argument is that the number of industries to which protection is extended may be quite large. The U. S. restricts endangered-species imports for noneconomic reasons. Infant Industry: Start-up industries argue that, to develop, they need protection from foreign competition. Support for this argument is valid only if the expected future benefits exceed the up-front costs of protectionism. Another argument against infant industry protection is that the industry may “never grow up. ” Wage or employment protection: With low prices on imports, domestic workers will lose their jobs and unemployment will rise. The economy as a whole benefits from low prices and increased quantity of goods. The government response could be to retrain the affected workers and to provide adequate monetary and fiscal policies to maintain domestic growth and employment.

Works Cited Krugman, Paul and Robin Wells. “Macroeconomics. ” New York. Worth Publishers. 2006. “Quota. “ Dictionary. com Unabridged (v 1. 1) Based on the Random House Unabridged Dictionary, © Random House, Inc. 2006. http: //dictionary. reference. com/browse /quota