Trade Policy PDF

Economic Environment Analysis Lecture 4 Last weeks 1. Trade is an important and growing phenomenon. 2. Trade patterns are determined by: 1. Size and Distance (Gravity model). 2. Productivity (Ricardian model). 3. Resource (Heckscher-Ohlin model). 3. There are winners and lo...

Economic Environment Analysis Lecture 4 Last weeks 1. Trade is an important and growing phenomenon. 2. Trade patterns are determined by: 1. Size and Distance (Gravity model). 2. Productivity (Ricardian model). 3. Resource (Heckscher-Ohlin model). 3. There are winners and losers from trade. This week 1. A brief history of world trade system. 2. Trade policy instruments. 3. Free trade: pros and cons. International Trade Policies The issue in a nutshell Negotiated agreements can help avoiding trade wars. A trade war could result if each country has an incentive to adopt protection, regardless of what other countries do. All countries could enact trade restrictions, even if it is in the interest of all countries to have free trade. Countries need an agreement that prevents a trade war or eliminates the protection from one. For example, during trade negotiations, the U.S. agreed to refrain from imposing quotas on Japan in exchange of the removal of Japanese barriers against U.S. exports of agricultural and technology products. The issue in a nutshell Game theory helps understanding the actions of agents based on the constraints they face and their beliefs about others’ actions. Agents have strategic interactions. Nash Equilibrium: Equilibrium when everyone is playing its best responses to the strategies of everyone else. The issue in a nutshell In this example, countries are individually better off with protection (20 >10). But are better off if both agree on free trade (10 > -5). If Japan and the United States can establish a binding agreement to maintain free trade, both can avoid the temptation of protection and both can be made better off. International negotiations International negotiation is when governments agree to engage in mutual tariff reduction. I reduce tariffs on the good I import from you, and you reduce the tariffs on the goods you import from me. Negotiated agreements can help avoiding trade wars: countries imposing tariffs on each other in response to actions they find unfavorable. The U.S. Tariff Rate After rising sharply at the beginning of the 1930s, the average tariff rate of the United States has steadily declined since 1938. Since 1944, much of the reduction in tariffs and other trade restrictions has come about through international negotiations. International negotiations We can date the beginning of the modern internationally coordinated tariff reduction to the 30s. In 1930, the United States passed a remarkably irresponsible tariff law, the Smoot-Hawley Act. Tariff rates rose steeply on more than 20,000 products and U.S. trade fell. Triggered retaliatory responses. Initial attempts to reduce tariff rates were undertaken bilaterally: The United States offered to lower tariffs on some imports if another country would lower its tariffs on some U.S. exports. Bilateral negotiations, however, do not take full advantage of international coordination. Benefits can “spill over” to countries that have not made any concessions. International negotiations Reciprocal Trade Agreement Act in 1934 to counter the large rise in tariffs by bilateral negotiations. Average duty on U.S. imports went from 59% in 1932 to 25% after WW2. In 1947, 23 countries began trade negotiations under the General Agreement on Tariff and Trade (GATT). In 1995, the World Trade Organization (WTO) was established as a formal organization for implementing multilateral trade negotiations (and policing them). The World Trade Organization The World Trade Organization — the WTO — is the international organization whose primary purpose is to open trade for the benefit of all. The WTO currently has 164 members, of which 117 are developing countries. WTO activities are supported by a Secretariat located in Geneva, Switzerland, and has an annual budget of approximately CHF 200 million (~211 million EUR). All major decisions are made by the WTO's member governments: either by ministers (who usually meet at least every two years) or by their ambassadors or delegates (who meet regularly in Geneva). The World Trade Organization WTO negotiations address trade restrictions by: 1. Reducing tariff rates through multilateral negotiations. 2. Binding tariff rates: a tariff is “bound” by having the imposing country agree not to raise it in the future. 3. Eliminating nontariff barriers: quotas and export subsidies are changed to tariffs because the costs of tariff protection are more apparent and easier to negotiate. Subsidies for agricultural exports are an exception. 4. Enforcing the “most favored nation” (MFN) principle: each country in the WTO promises that all countries will pay tariffs no higher than the nation that pays the lowest. An exception is allowed only if the lowest tariff rate is set at zero. The World Trade Organization The World Trade Organization is based on a number of agreements: 1. General Agreement on Tariffs and Trade: covers trade in goods. 2. General Agreement on Tariffs and Services: covers trade in services (e.g., insurance, consulting, legal services, banking). 3. Agreement on Trade-Related Aspects of Intellectual Property: covers international property rights (e.g., patents and copyrights). The World Trade Organization The World Trade Organization is based on a number of agreements: 4. The dispute settlement procedure: a formal procedure where countries in a trade dispute can bring their case to a panel of WTO experts to rule upon. 1. The panel decides whether member counties are breaking their agreements. 2. A country that refuses to adhere to the panel’s decision may be punished by the WTO allowing other countries to impose trade restrictions on its exports. Preferential Trading Agreements Preferential trading agreements are trade agreements between countries in which they lower tariffs for each other but not for the rest of the world. Under the WTO, such discriminatory trade policies are generally not allowed: Each country in the WTO promises that all countries will pay tariffs no higher than the nation that pays the lowest: called the “most favored nation” (MFN) principle. An exception is allowed only if the lowest tariff rate is set at zero. Preferential Trading Agreements There are two types of preferential trading agreements in which tariff rates are set at or near zero: 1. A free trade area: an agreement that allows free trade among members, but each member can have its own trade policy towards non-members. An example is the North America Free Trade Agreement (NAFTA), now the U.S.-Mexico-Canada Agreement (USMCA). 2. A customs union: an agreement that allows free trade among members and requires a common external trade policy towards non-members. An example is the European Union. Preferential Trading Agreements Are preferential trading agreements necessarily good for national welfare? No, it is possible that national welfare decreases under a preferential trading agreement. How? Rather than gaining tariff revenue from inexpensive imports from world markets, a country may import expensive products from member countries but not gain any tariff revenue. Preferential Trading Agreements Preferential trading agreements increase national welfare when new trade is created, but not when existing trade from the outside world is diverted to trade with member countries. Trade creation occurs when high-cost domestic production is replaced by low-cost imports from other members. Trade diversion occurs when low-cost imports from non-members are diverted to high-cost imports from member nations. The Instruments of Trade Policy  The instruments of trade policy A tariff is a tax levied when a good is imported. A specific tariff is levied as a fixed charge for each unit of imported goods. For example, $3 per barrel of oil. An ad valorem tariff is levied as a fraction of the value of imported goods. For example, 25% tariff on the value of imported trucks.  The instruments of trade policy Oldest form of trade policy and large source of income in pre–modern taxation system and in developing countries. Designed to protect specific domestic sectors by raising the prices of foreign goods. e.g. Corn Laws (1773-1815) in the U.K. to protect British agriculture. Protection of infant industries (List, 1841). Tariff analysis Consider how a tariff affects a single market, say agriculture (wheat). Suppose that without trade the price of wheat is higher in Home than in Foreign. With trade, wheat will be shipped from Foreign to Home until prices converge. 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. What happens to prices and quantities in Home? What happens to prices and quantities in Foreign? Let’s define some objects first…  Tariff analysis: preliminaries An import demand curve is the difference between the quantity that Home consumers demand minus the quantity that Home producers supply, at each price. The Home import demand curve MD = D - S As the price of the good increases, Home consumers demand less, while Home producers supply more, so that the demand for imports declines.  Tariff analysis : preliminaries An export supply curve is the difference between the quantity that Foreign producers supply minus the quantity that Foreign consumers demand, at each price. The Foreign export supply curve XS* = S* - D* As the price of the good rises, Foreign producers supply more while Foreign consumers demand less, so that the supply available for export rises.  Tariff analysis : preliminaries In equilibrium: Import demand = export supply, H demand – H supply = F supply – F demand, H demand + F demand = F supply + H supply, World demand = world supply. The equilibrium world price is where Home import demand (MD curve) equals Foreign export supply (XS curve). Tariff analysis Let’s analyze now the effect of a t$ tariff per unit of product. Remember that without trade, the price is higher in Home than in Foreign. 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: PT − t = PT  A tariff makes the price rise in the Home market and fall in the Foreign market.  Tariff analysis: Home The price in Home rises from 𝑃𝑊 under free trade to 𝑃𝑇 with the tariff. Home producers supply more and Home consumers demand less. The quantity of imports falls from 𝑄𝑊 under free trade to 𝑄𝑇 with the tariff. Home is consuming less at a higher price!  Tariff analysis: Foreign The price in Foreign falls from 𝑃𝑊 under free trade to 𝑃𝑇∗ with the tariff. Foreign producers supply less, and Foreign consumers demand more. The quantity of exports falls from 𝑄𝑊 to 𝑄𝑇. Foreign is exporting less at a lower price! Tariff analysis: summary After the introduction of the tariff, the quantity exchanged decreases compared to the free-trade equilibrium. The increase in the price in Home can be less than the amount of the tariff. Part of the effect of the tariff causes the Foreign export price to decline. The price in both countries is between the autarky price and the free- trade price. Price increases in Home and decreases in Foreign. Importantly, note that the tariff is not fully passed-through to consumers: exporters’ bear a part of the tariff by decreasing their price. Tariff analysis : small country For a small country the effect is different. When a country is “small,” it has no effect on the foreign (world) price because its demand is an insignificant part of world demand for the good. Imagine Andorra setting an import tariff on Chinese export. The foreign price does not fall, but remains at 𝑃𝑊. The price in the home market rises by the full amount 𝑃𝑇 = 𝑃𝑊 + 𝑡. Costs and Benefits of Tariffs A tariff raises the price of a good in the importing country, so it hurts consumers and benefits producers there. In addition, the government gains tariff revenue. How to measure these costs and benefits? Use the concepts of consumer surplus and producer surplus. Tariff analysis : preliminaries Consumer surplus measures the amount that consumers gain from purchases by computing the difference in the price actually paid from the maximum price they would be willing to pay for each unit consumed. When price increases, the quantity demanded decreases as well as the consumer surplus. Tariff analysis : preliminaries Producer surplus measures the amount that producers gain from sales by computing the difference in the price received from the minimum price at which they would be willing to sell. When price increases, the quantity supplied increases as well as the producer surplus. Costs and Benefits of Tariffs A tariff raises the price in the importing country: consumer surplus decreases (consumers worse off) producer surplus increases (producers better off). the government collects tariff revenue equal to the tariff rate times the quantity of imports with the tariff. ( ) t QT = PT − PT  ( D2 − S2 ) Total change in welfare:𝑒 − 𝑏 + 𝑑. Costs and Benefits of Tariffs For a “large” country, whose imports and exports affect world prices, the welfare effect of a tariff is ambiguous. The triangles b and d represent the efficiency loss. The tariff distorts production and consumption decisions: producers produce too much and consumers consume too little. The rectangle e represents the terms of trade gain. The tariff lowers the Foreign price, allowing Home to buy its imports cheaper. Costs and Benefits of Tariffs Part of government revenue (e) represents the terms of trade gain, and part (c) represents some of the loss in consumer surplus. The government gains at the expense of consumers and foreigners. If the terms of trade gain exceed the efficiency loss, then national welfare will increase under a tariff, at the expense of foreign countries. However, foreign countries are apt to retaliate. The instruments of trade policy The importance of tariffs declined after WW2. It does not mean that it is the end of trade policy. Non-tariff barriers: import quotas, export subsidy, export restraints, technical barriers, custom delays, etc. Temporary trade barriers: the WTO allows some type of trade barriers: Anti-dumping: a tariff imposes on foreign imports believed to be priced below fair market value. Countervailing duty: tariffs on imported goods to offset export subsidies. Global safeguards: temporarily restrict imports of a product which is causing, or which is threatening to cause, serious injury to the industry. Anti-dumping measures over time Source: Colantone, Ottaviano & Stanig (2022). The backlash of globalization. In Handbook of international economics (Vol. 5, pp. 405-477). Other Instruments of Trade Policy Policy Tariff Export Subsidy Import Quota Voluntary Export Restraint Producer Increases Increases Increases Increases surplus Consumer Falls Falls Falls Falls surplus Government Increases Falls No change No change revenue (government (rents to license (rents to spending rises) holders) foreigners) Overall national Ambiguous Falls Ambiguous Falls welfare (falls for small (falls for small country) country) The Trump Trade War  Winners and Losers of the Trump Trade War Over the 2018–2019 period, the Trump administration drastically increased tariffs targeted both at specific goods as well as specific trading partners. Some tariffs on specific goods were imposed on a large set of exporting countries. Some tariffs were targeted at specific countries (mostly China but also EU) and covered many different goods. By 2019, over 66% of Chinese exports to Source: 2019 update of Pablo D. Fajgelbaum, Pinelopi K. Goldberg, Patrick J. the United States were hit by the tariffs. Kennedy, and Amit K. Khandelwal, “The Return to Protectionism,” The Quarterly Journal of Economics 135, no. 1 (February 1, 2020), p p. 1–55. Winners and Losers of 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 hardly any of the tariffs. Almost the entire brunt of the tariffs has been borne by U.S. consumers and firms buying intermediate goods. The higher import prices due to the tariffs represented a substantial annual cost increase of $300-900 for U.S. households.  Winners and Losers of the Trump Trade War The higher prices for imported goods due to the new tariffs represented a substantial annual cost increase for U.S. households. Source: Kirill Borusyak and Xavier Jaravel, “The Distributional Effects of Trade: Theory and Evidence from the United States,” S SRN Scholarly Paper, October 6, 2018. Winners and Losers of the Trump Trade War The new tariffs imposed by the United States inevitably led to retaliation by its trading partners. Looking at the progression of those retaliatory tariffs (averaged over the set of targeted goods) over time: China responded with higher tariffs on par with the higher tariffs imposed by the United States. Major steel and aluminum exporters to the United States 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.  Winners and Losers of the Trump Trade War All of the United States’ major trading partners responded to the tariffs on their exports with tariffs of their own targeting U.S. 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), p p. 1–55. Free Trade: Good or Bad? The case for free trade First argument is efficiency: free trade allocates resources more efficiently. As we have seen in the cost-benefit analysis of tariffs, tariffs distort the incentives of producers and consumers, affecting welfare. Free trade allows firms or industry to take advantage of economies of scale. Free trade improves competition also avoiding the loss of resources through rent seeking. Spend resources seeking quota rights and the profit that they will earn. Free trade provides opportunities for innovation (dynamic benefits). By providing entrepreneurs with incentives to seek new ways to export or compete with imports, free trade offers more opportunities for innovation. The case for free trade Source: Meyer and Ottaviano (2007) The case against free trade For a “large” country, a tariff lowers the price of imports in world markets and generates a terms of trade gain. Overall, this benefit may exceed the losses caused by distortions in production and consumption. There might exist an optimal import tariff (probably low). Holds only for large economies. Might trigger retaliatory responses. Theory of second-best: domestic market failures may exist that cause free trade to be a suboptimal policy. Our welfare analysis assumes that markets function well. Labor market might be imperfect, leading to unemployment and low wages. Property rights might be not well protected. Environmental costs. The case against free trade Summary International negotiations are a means to avoid trade wars. The WTO and its predecessor have reduced tariffs substantially in the last 50 years, and the WTO has a dispute settlement procedure for trade disputes. The effect of tariffs is twofold with efficiency losses and terms-of-trade gains and Y. It is ambiguous ex ante. The Trump trade war led to a significant welfare loss in the U.S.