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TU-91. 2011 International Economics TU-E 1160 International Economics by Hannele Wallenius 3 INTERNATIONAL TRADE TU-91. 2011 International Economics TU-E 1160 International Economics by Hannele Wallenius 3 INTERNATIONAL TRADE POLICY Aalto University School of Science Department of Industrial Engineering and Management

3. INTERNATIONAL TRADE POLICY n 3. 1 Free Trade Versus Protectionism n 3. 2 3. INTERNATIONAL TRADE POLICY n 3. 1 Free Trade Versus Protectionism n 3. 2 Tariffs and Production Subsidies n 3. 3 Other Commercial Policies International Economics Hannele Wallenius 4 International Trade Policy - 4. 1 Free Trade Versus Protectionism 2

Up to this point, we have explored the benefits of unrestricted international trade BUT Up to this point, we have explored the benefits of unrestricted international trade BUT governments do restrict free international trade in order to protect domestic industries from foreign competition. The restriction of international trade is called protectionism. International Economics Hannele Wallenius 4 International Trade Policy 3

Protectionism is widely viewed as having deepened and prolonged the Great Depression Smoot-Hawley Tariff Protectionism is widely viewed as having deepened and prolonged the Great Depression Smoot-Hawley Tariff Act signed June 1930 raised U. S. tariffs on over 20, 000 imported goods to record levels. Some 60 countries retaliated with their own increased tariffs… Monthly value of imports in 75 countries between 1929 and 1933. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 4

FT. com February 18, 2016 Rising tide of protectionism imperils global trade ‘Worrying’ trend FT. com February 18, 2016 Rising tide of protectionism imperils global trade ‘Worrying’ trend threatens to reverse globalisation, with India, Russia, US the leading culprits A rising tide of protectionism — led by emerging market nations — is undermining global trade and threatening to extend the economic slowdown, data suggest. Governments introduced 539 protectionist measures in the first 10 months of 2015, up from 407 in the same period of 2014 and just 183 in the first 10 months of 2012, according to figures from Global Trade Alert, a think-tank. Although the number of countervailing trade liberalisation measures also rose last year, to 207 as of October 31, the net increase in restrictions was the highest since at least 2009. Instead of tariff increases and quotas, more bailouts and subsidies. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 5

The Case for Free Trade n We have demonstrated how free trade benefits all The Case for Free Trade n We have demonstrated how free trade benefits all trading countries. 1 • The theory of comparative advantage is the case for free trade. • A good/service is not imported unless its net price to the buyer is below that of the domestically produced alternative. 1 An exception: Large countries possess monopoly power in international trade. For them free trade is not Pareto optimal (Brazil in coffee and Japan in automobiles, for instance) International Economics Hannele Wallenius 4 International Trade Policy - 4. 1 Free Trade Versus Protectionism 6

n Later (under Trade Barriers) we will show that: Trade barriers prevent a nation n Later (under Trade Barriers) we will show that: Trade barriers prevent a nation from fully employing the benefits of specialization, push it to adopt relatively inefficient production techniques, and force consumers to pay higher prices for higher prices protected products than they would otherwise pay. International Economics Hannele Wallenius 4 International Trade Policy - 4. 1 Free Trade Versus Protectionism 7

Freer trade cuts the cost of living According to critics of agricultural protectionism, consumers Freer trade cuts the cost of living According to critics of agricultural protectionism, consumers and governments in rich countries have paid $ 350 billion per year supporting agriculture — enough to fly their 41 million dairy cows first class around the world one and a half times. (WTO) International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 8

n Yet for hundreds of years the nations of the world have tried hinder n Yet for hundreds of years the nations of the world have tried hinder the free trade by means of several devices, such as tariffs, quotas, technical or administrative rules and procedures, such as licensing regulations, and exchange control. n Such polices are called commercial policies. n In general, these policies are influenced by political, social, and economic considerations. International Economics Hannele Wallenius 4 International Trade Policy - 4. 1 Free Trade Versus Protectionism 9

The Lure of Protectionism n The argument for so-called The Lure of Protectionism n The argument for so-called "protectionism" (called "fair trade" by some) may at first sound appealing. n Supporters of "protectionist" laws claim that keeping out foreign goods will • save jobs, • give ailing domestic industries a chance to recover and prosper, • and reduce the trade deficits. n Are these claims valid? n Arguments for protection can be either economic or noneconomic. International Economics Hannele Wallenius 4 International Trade Policy - 4. 1 Free Trade Versus Protectionism 10

 The Case for Protection Common Arguments Against Free Trade: 1. Protection saves jobs. The Case for Protection Common Arguments Against Free Trade: 1. Protection saves jobs. 2. Some countries engage in unfair trade practices. 3. Cheap foreign labor makes competition unfair. International Economics Hannele Wallenius 4 International Trade Policy - 4. 1 Free Trade Versus Protectionism 11

4. Protection safeguards national security. 5. Protection discourages dependency. 6. Protection safeguards infant industries. 4. Protection safeguards national security. 5. Protection discourages dependency. 6. Protection safeguards infant industries. 7. Preserving way of life. 8. Simple way to collect money for government. International Economics Hannele Wallenius 4 International Trade Policy - 4. 1 Free Trade Versus Protectionism 12

3 INTERNATIONAL TRADE POLICY n 3. 1 Free Trade Versus Protectionism n 3. 2 3 INTERNATIONAL TRADE POLICY n 3. 1 Free Trade Versus Protectionism n 3. 2 Tariffs and Production Subsidies n 3. 3 Other Commercial Policies International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 13

n World economy gains when countries first begin international trade: Comparative advantage based either n World economy gains when countries first begin international trade: Comparative advantage based either on a relative advantage in technology or on relative factor abundance, or because different countries specialize in producing different brands when economies of scale exist. n . . . But this does not mean that everyone will be better off. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 14

n Let's give two examples of the conflicts to which international trade can lead: n Let's give two examples of the conflicts to which international trade can lead: Consider a) Argentina and Brazil starting to export meat to world market. b) The impact of increased foreign car sales in EU on EU car industry. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 15

n Who gained and who lost? n Should government hear out the producers or n Who gained and who lost? n Should government hear out the producers or consumers pleads? n More generally, how should we decide whether to restrict imports or have free unrestricted trade in all goods? International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 16

Next we will consider different commercial policies n We will show to analyze costs Next we will consider different commercial policies n We will show to analyze costs and benefits of tariffs as well as other types of trade restrictions. n Doing so we will move from positive economics to normative economics. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 17

Most Common Trade Barriers Trade barriers -obstacles to trade- take many forms, three most Most Common Trade Barriers Trade barriers -obstacles to trade- take many forms, three most common ones are: 1. Tariffs: import duty (a tax on imports) Can also be an export duty, but that is less common. February 12, 2016 Russian and Chinese makers of non-stainless steels face European Union tariffs as high as 26. 2 percent after the EU found that imports from the two countries unfairly undercut producers in Europe such as Arcelor. Mittal and Thyssen. Krupp AG. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 18

2. Export and Production Subsidies: n Government payments made to domestic firm to encourage 2. Export and Production Subsidies: n Government payments made to domestic firm to encourage exports or production in general. • Can also act as a barrier to trade. February 8, 2016 The WTO’s decision to end agricultural export subsidies is good news for farmers and consumers In December 2015 at the World Trade Organization’s (WTO) 10 th Ministerial Conference in Nairobi, members finally agreed that export subsidies for agriculture would be abolished. The agreement states that “developed country members shall immediately eliminate their remaining scheduled export subsidy entitlements as of the date of adoption of this decision” and “developing country members shall eliminate their export subsidy entitlements by the end of 2018. ” WTO members also “undertake not to provide export credit, export credit guarantees, or insurance programs” for agricultural products. This is the final step in a long journey to end an absurd and harmful system of economic policymaking. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 19

n Closely related to subsidies is the practice of dumping. • Dumping takes place n Closely related to subsidies is the practice of dumping. • Dumping takes place when a firm or an industry sells products on the world market at price below the cost of production. March 7 th, 2016 Government may extend anti-dumping duty on Chinese Chemical NEW DELHI: Government may re-impose anti-dumping duty of up to USD 144 per ton on import of a chemical from China that is used in several sectors including pottery and ceramics so as to safeguard domestic industry from below cost in-bound shipments. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 20

3. Quotas and Voluntary Export Restraints (VERs): n A limit on the quantity of 3. Quotas and Voluntary Export Restraints (VERs): n A limit on the quantity of imports • Can be mandatory or voluntary, and can be legislated or negotiated with foreign governments Ukrainian exporters unsatisfied with EU trade quotas On Jan. 1, a free trade regime came into effect between Ukraine and the European Union; one month on, there are still rumblings of discontent over conditions. This is because some Ukrainian farmers argue that the quotas were set too low and the duty-free trade volumes have already been exhausted in the first weeks of January. With the free trade agreement fully in force, most tariffs between Ukraine and the EU will be gradually declining over the next 10 years. In the meantime, Ukrainian producers can trade duty-free with the 28 -country bloc only within quotas of 36 commodity groups, most of which are set to increase by 25 -50 percent over the next 5 years. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 21

 Economics of Tariffs n Tariffs are the most common type of trade restriction Economics of Tariffs n Tariffs are the most common type of trade restriction n A tariff requires the importer of a good to pay a specified fraction of the world price to the government n By raising the domestic price of imports, a tariff helps domestic producers but hurts domestic consumers International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 22

The Effect of a Tariff Price Sdom Ddom & Sdom show the domestic demand The Effect of a Tariff Price Sdom Ddom & Sdom show the domestic demand supply for a good. If the world price is Pw, and there is free trade, Pw+ T Pw domestic firms produce Qs, domestic consumption is Qd and the difference is imported. Ddom A tariff can stimulate domestic production and restrict imports: Qd' Qd Quantity Qs Qs ' At a domestic price Pw + T, where T is the size of the tariff, quantity of domestic demand falls to Qd', quantity of domestic supply rises to Qs' and imports fall. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 23

We can summarize the effects of tariffs to n Consumption effect • Domestic consumers We can summarize the effects of tariffs to n Consumption effect • Domestic consumers reduce their consumption. n Production effect • Higher prices make it profitable for domestic producers to increase their output. • Thus the tariff attracts resources into the protected industry from other sectors of the economy. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 24

We can summarize the effects of tariffs continued: n Trade effect • The tariff We can summarize the effects of tariffs continued: n Trade effect • The tariff causes imports to fall. n Revenue effect • After the imposition of the tariff, the government collects a certain amount of money. n Redistribution effect • The tariff redistributes income from consumers to producers. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 25

The Welfare Costs of a Tariff Price The tariff leads both to transfers and The Welfare Costs of a Tariff Price The tariff leads both to transfers and net social losses. Consumer surplus is decreased by the area between Pw+T, Pw and D. S But where does this lost of CS go to? The government raises revenue – i. e. there is a transfer to the government, and there is a transfer in the form of extra profits to producers. Pw+ T Pw D The tariff leads to a social deadweight cost from production Qs Qs ' Qd Quantity inefficiency, given that the good could be imported at Pw. The tariff also leads to a dead-weight loss from consumption inefficiency. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 26

Tariffs continued n The deadweight burden of a tariff suggests that society suffers from Tariffs continued n The deadweight burden of a tariff suggests that society suffers from restricting trade. n This is the case for free trade. n Tariffs have fallen substantially under the GATT (General Agreement on Tariffs and Trade) and WTO (World Trade Organization). International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 27

The case for tariffs – good arguments n When a country's imports form a The case for tariffs – good arguments n When a country's imports form a significant share of the world market for a commodity, a higher level of imports is likely to bid up the world price. Then an imposition of an import tariff could lead to a welfare improvement for the country, relative to free trade. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 28

Optimal Tariff n In this case an economy will gain by imposing a tariff, Optimal Tariff n In this case an economy will gain by imposing a tariff, which will restrict the imports until the benefit of the last import equals its cost to society as a whole. n Effectively this is a transfer from foreign suppliers, who lose out, to the importing country, which gains. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 29

An Example of Optimal Tariff n Let’s assume that country A is an economically An Example of Optimal Tariff n Let’s assume that country A is an economically large country (a large world importer of a product L). n Country B exports product L. n Let’s consider the situation under free trade and after an import tariff is imposed by country A. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 30

PTF is defined by imports = exports Country B has a comparative advantage in PTF is defined by imports = exports Country B has a comparative advantage in production of L. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 31

Free Trade Equilibrium continued n Free trade equilibrium price, PFT, is defined as the Free Trade Equilibrium continued n Free trade equilibrium price, PFT, is defined as the price at which the quantity consumers in A want to import equals the quantity that producers in B want to export. n Next suppose that A imposes a tariff on imports of L which causes imports to fall. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 32

After imposing a tariff country A wants to import only Q 4 – Q After imposing a tariff country A wants to import only Q 4 – Q 3. Tariff revenue e is paid (in effect) by producers in B. And country B is willing to sell that amount at price P’. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 33

n Welfare Cost of a tariff Imposed by a large country in CS in n Welfare Cost of a tariff Imposed by a large country in CS in country A in PS in country A in G revenue Net welfare change Optimal tariff would max $e - $(b + d) International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 34

Optimal tariff - a first-best argument n This policy fulfils the principle of targeting. Optimal tariff - a first-best argument n This policy fulfils the principle of targeting. • Which says that the most efficient way to attain a given objective is to use a policy that influences that activity directly. • Policies that attain the objective, but also influence other activities are second-best, because they distort those other activities. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 35

The case for tariffs – second-best arguments n Way of life • An attempt The case for tariffs – second-best arguments n Way of life • An attempt to preserve ‘traditional’ ways. Ø A production subsidy would be better. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 36

The case for tariffs – second-best arguments continued n Infant industries • An attempt The case for tariffs – second-best arguments continued n Infant industries • An attempt to nurture new activities via learning by doing. Ø A temporary production subsidy probably better. n Revenue • Tariffs raise government revenue. Ø But there are better ways to do that. n Cheap foreign labour • A non-argument – denies benefits of comparative advantage. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 37

Comparison of the Effects of Import Tariffs and Production Subsidies n Domestic production can Comparison of the Effects of Import Tariffs and Production Subsidies n Domestic production can also be increased and imports reduced through the use of a production subsidy. n Actually, temporary production subsidies rather than import tariffs are some times suggested by economists. International Economics Hannele Wallenius WHY? 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 38

Let's compare the effects of these two trade restrictions on the welfare of the Let's compare the effects of these two trade restrictions on the welfare of the society: = dead weight loss (a) Tariff Price Sdom Price (b) Subsidy Sdom+ s Sw + t P’ Sw P Ddom Qs International Economics Hannele Wallenius Sdom Qsd’ Qd Quantity Qs Qsd’ Qd 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas Quantity 39

n Although production subsidies are less inefficient in increasing domestic output, they are relatively n Although production subsidies are less inefficient in increasing domestic output, they are relatively uncommon because they are politically unpopular. • A tariff raises money for the government, but the taxpayers have to provide the funds for the subsidy… n The benefits of a production subsidy in the form of lower consumer prices are frequently not understood by voters who instead object to the resulting expenditure of the public funds. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 40

3 INTERNATIONAL TRADE POLICY n 3. 1 Free Trade Versus Protectionism n 3. 2 3 INTERNATIONAL TRADE POLICY n 3. 1 Free Trade Versus Protectionism n 3. 2 Tariffs and Production Subsidies n 3. 3 Other Commercial Policies International Economics Hannele Wallenius 4 International Trade Policy - 4. 3 Other Commercial Policies 41

Other commercial policies n Although tariff rates have fallen under GATT and WTO, there Other commercial policies n Although tariff rates have fallen under GATT and WTO, there has been an increase of other trade restrictions: • quotas • export subsidies • non-tariff barriers Ø administrative regulations that discriminate against foreign goods. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 42

Quotas n Even though quotas restrict the quantity of imports, this does not mean Quotas n Even though quotas restrict the quantity of imports, this does not mean they have no effect on domestic prices of the restricted goods. n With lower supply the equilibrium price will be higher than under free trade. So quotas affect in a same way as tariffs! International Economics Hannele Wallenius 4 International Trade Policy - 4. 3 Other Commercial Policies 43

Types of Quotas n Embargo—complete ban on import of a certain good. n Tariff Types of Quotas n Embargo—complete ban on import of a certain good. n Tariff Rate Quota (TRQ)—allows a certain quantity of a good into a country at low or zero tariff rate, but applies higher tariff to quantities exceeding the quota. n Voluntary Export Restraint (VER)—an indirect quota resulting from an exporting country “voluntarily” limiting its exports. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 44

Domestic demand supply of good M Areas b and d represent deadweight costs. How Domestic demand supply of good M Areas b and d represent deadweight costs. How about c, who gets these quota rents? Government, domestic producers/importers or foreign producers (VER)? That is, who gets the World price of M licenses! International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 45

Export subsidies Commercial policy to boost exports. Price n Consumption loss Exports P B Export subsidies Commercial policy to boost exports. Price n Consumption loss Exports P B A P’ Production loss G Sw + s E Sw F C Sdom Ddom Qd ’ International Economics Hannele Wallenius Qd Qs Q s’ 4 International Trade Policy - 4. 3 Other Commercial Policies Quantity 46

Export subsidies continued Under free trade, domestic consumption is Qd and production Qs and Export subsidies continued Under free trade, domestic consumption is Qd and production Qs and exports are GE. n With a subsidy on exports alone, domestic producers will restrict supply to the home market to Qd’ so that home consumers pay P’, the same as producers can earn by exporting. Total output is Qs’, and exports AB. Area EFB shows the social cost of producing goods whose marginal cost exceeds the world price for which they are sold. Area CGA shows the social cost of restricting consumption when marginal benefits exceeds the world price of the good. International Economics Hannele Wallenius 4 International Trade Policy - 4. 3 Other Commercial Policies 47

More of Non-Tariff Barriers n delays at border n quality and safety control measures More of Non-Tariff Barriers n delays at border n quality and safety control measures n even standards some times. . . and The European Union and Canada have responded angrily to the 'Buy American' clause in President Obama's $825 bn economic stimulus package. Will 'buying American' cause more harm than good? International Economics Hannele Wallenius They claim it could lead to protectionist trade practices and help spark a new trade war. Philippa Thomas reports from Washington 3 February 2009 4 International Trade Policy - 4. 3 Other Commercial Policies 48

Conclusion Trade protection is usually harmful to the society. Yet governments frequently adopt it Conclusion Trade protection is usually harmful to the society. Yet governments frequently adopt it because it is a politically easy option. International Economics Hannele Wallenius 4 International Trade Policy - 4. 2 Trade Barriers: Tariffs, Subsidies and Quotas 49

End of International Trade Policy Next: 4 ECONOMIC INTEGRATION International Economics Hannele Wallenius 4 End of International Trade Policy Next: 4 ECONOMIC INTEGRATION International Economics Hannele Wallenius 4 International Trade Policy 50