Trade Policy and WTO Accession for Economic Development

Trade Policy and WTO Accession for Economic Development: Application to Russia and the CIS Module 1 Trade Policy Principles by Giorgio Barba Navaretti and Paolo Epifani December 13, 2004

Key questions addressed • What do countries gain by trading with each other instead of opting for self-sufficiency? • What are the main instruments of trade policy? • What are the effects of trade policy on consumers, producers, the government and total welfare? • What are the effects of trade policy in the presence of market imperfections? 2

Structure of the lecture • How to evaluate trade policies • Gains from trade • Instruments of trade policy and their effects: • Price based measures (tariffs, subsidies etc. ) • Non tariff based measures (quotas etc. ) • Trade policy with externalities • Trade policy with imperfect competition 3

How to evaluate trade and trade policy • Individual actors in the country introducing the policy measure: – Consumers: • Changes in prices and varieties of goods consumed ( changes in consumers’ surplus) – Producers: • Changes in prices of goods produced and inputs purchased (changes in producers’ surplus) – Government: • Effects on net revenues • Net effect: • Sum of changes in consumers and producers surplus and in government’s net revenues 4

Gains from trade • Autarchy – Consumers can only buy domestic products – Producers can only sell to domestic consumers ÞDomestic and international prices differ • Free trade • In any product countries can be: – Net importers Þ international price lower than autarky price (p. A>pf) – Net exporters Þ international price higher than autarky price (p. A

Gains from trade • In general: – consumers can buy more and cheaper products and resources like labour and capital are transferred from inefficient to efficient producers • Net importers gain because: – Domestic consumers can buy cheaper products and new varieties – Inefficient domestic producers loose market shares • Net exporters gain because: – Efficient domestic producers sell larger quantities of their products at a higher price – Domestic consumers reduce consumption of expensive 6 products

Figure 1 a – Gains from free imports Welfare under autarky WA = CSA + PSA = a + b'' = a + b. Welfare under free trade WF = a + b + e. Net gain e; Consumers gain b’ and e; producers loose b’ 7

Figure 1 b – Gains from free exports Welfare under autarky WA = CSA + PSA = a’ + a’' + b = a + b. Welfare under free trade WF = a + b + e. Net gain e; Producers gain a’’ and e; producers loose a’’ 8

Instruments of Trade Policy • Price based measures: –Tariffs –Specific: –Ad valorem: –Export subsidies: –Export taxes: p=pf + t p=(1+t)pf px= pf + s px= pf - T • Quantitative restrictions: –Quotas –Voluntary Export Restraints 9

Effects of trade policy in general • Lesson 3. – Import protection as well as export promotion distort production and consumption decisions; therefore, they are generally welfare reducing. – They also have effects on the distribution of income. Even when trade policy reduces national income and causes serious inefficiency in the economic system, it always benefits some firms or individuals at the expense of the rest of society. 10

Effects of a tariff p=pf + t or p=(1+t)pf • Small country: – Raises domestic prices of imported products and domestic substitutes: • Consumers loose (less and more expensive products) • Producers gain (get protection and sell their products at a higher price) • Government gain (tariff revenues) • BUT Net welfare effect NEGATIVE because – Consumers subsidise inefficient producers – Loss of opportunities for beneficial consumption (dead weight loss in consumers’surplus) 11

Effects of a tariff • Large Country: – Effects on consumers, producers same as before – Government revenues increase more than before as they are partly paid for by foreign exporters as world prices decline – Net welfare effects AMBIGUOUS 12

Figure 2 a – Specific import tariff in a small country Change in Net welfare: DWt = DCS + DPS + DTR DWt = - (b + d) < 0 13

Figure 2 b – Specific import tariff in a large country Change in Net welfare: DWt = DCS + DPS + DTR DWt = - (b + d) + e 14

Effects of a subsidy px= pf + s • Small country – Raises the domestic price of the exported goods: • Consumers loose (less and more expensive products) • Producers gain (get a transfer from the government on their exported products and sell their products in the domestic market at a higher price) • Government looses (transfer to producers) • Net welfare effect NEGATIVE because – Government subsidises inefficient producers (dead weight loss in government’s revenues) – Loss of opportunities for beneficial consumption 15

Figure 3 – Export subsidies DWs = - (b + d ) < 0 p D S pf + s pf a b xs c xf d q 16

Effects of an export tax px= pf - T • Equivalent to a negative export subsidy: – Reduces the domestic price of the exported goods: • Consumers gain (more and less expensive products) • Producers loose (transfer to the government on their exported products and sell their products in the domestic market at a lower price) • Government gains (transfer from producers) • Net welfare effect NEGATIVE because – Producers subsidise consumption – Loss of opportunities for efficient production (dead weight lossin producers’ surplus) 17

Figure 4 – Export taxes DWT = - (b + d) p D pf a pf - T S xf b c d x. T q 18

Other effects of a tariff: discouraging exports or, the ‘Lerner Simmetry’ • An import tariff is equivalent to an export tax – Intuition: • An import tariff raises the relative price of import competing products relative to exportable products, even if the absolute price of the latter is unaffected • Scarce resources are diverted from export oriented activities to protected import competing products, where returns are higher • Thus an import tariff has the same negative effects on exports than an export tax 19

Summary effects of price based measures 20

Effects of Import Quotas • Quantitative restriction on imports of a given good • (e. g. Russia cannot import more than x meters of cotton fabric from India per year) • Same effect as tariffs – Raises domestic prices of imported products and domestic substitutes: • Consumers loose (less and more expensive products) • Producers gain (get protection and sell their products at a higher price) – BUT Government may not gain as there is no tariff revenues – Who gets the quota rent? – Net welfare effect NEGATIVE because – Consumers subsidise inefficient producers – Loss of opportunities for beneficial consumption 21

Other Effects of Import Quotas • Why does the GATT prohibits the use of quotas: – Less transparent then tariffs – If markets are imperfectly competitive they give more market power to domestic firms than tariffs – Favour rent seeking behaviour 22

Figure 6 – Import quotas DWt = - (b + d) < 0 Same as tariffs, but who gets c? 23

Externalities • Positive Externalities – Social costs of production are lower than the private costs borne by a firm – Example: learning by doing (costs of production decline with output as workers learn and increase their efficiency) • Increasing output when private costs exceed private returns is inefficient • but these inefficiencies can be offset by learning by doing, which reduces private costs in the longer term 24

Effects of trade policy with externalities • A tariff, by inducing an increase in output to a level where private (marginal) costs exceed the international price (marginal revenues), creates distortions • These distortions can partly be offset by the positive externalities (e. g. learning by doing) stemming from the increase in output – The NET welfare effect is ambiguous 25

Are tariffs justified by externalities? • No – Tariffs are second best instruments, as they correct a market imperfection (learning by doing) by introducing a distortion (increase in domestic price) – Better use first best instruments like production subsidies: they target the market impefection (learning by doing) without creating further distortions (domestic prices do not rise) 26

Figure 7. Tariffs and subsidies with externalities Tariff: DWet = - (b + d) + h Subsidy: DWeps = - b + h p S SS h is the positive externality pf + t pf a b c d h D s=t S 0 S 1 - D 1 D 0 q 27

Trade policy with imperfect competition • When there is imperfect competition (e. g. the domestic producer is a monopolist) – firms have market power (their price is too high and their output too low – trade liberalisation deprives domestic firms (e. g. the domestic monopolist) of their market power as they must face international competition • Domestic prices decline and output increases (pro-competitive effect of trade liberalization) 28

Figure 8 – Monopoly and trade policy 29