Other Instruments of Trade Policy
Tariffs are the simplest trade policies, but in the modern world, most government intervention
in international trade takes other forms, such as export subsidies, import quotas,
voluntary export restraints, and local content requirements. Fortunately, once we have
understood tariffs, it is not too difficult to understand these other trade instruments.
CHAPTER 9 The Instruments of Trade Policy 203
of the original tariffs were dropped, except for the
ones on chickens and light commercial trucks.
Volkswagen stopped producing those vehicles, but
the U.S. “big three” auto and truck producers
were then concerned about competition from
Japanese truck producers and lobbied to keep the
tariff in place.
Japanese producers responded by building those
light trucks in the United States (see Chapter 8).†
As a result, the latest company to be hit by the
consequences of the tariff is Ford, one of those
“big three” U.S. producers! Ford produces a small
commercial van in Europe, the “Transit Connect,”
which is designed (with its smaller capacity and
ability to navigate old, narrow streets) for
European cities. The recent spike in fuel prices
sharply increased demand in some U.S. cities
for this truck. In 2009, Ford started selling these
vehicles in the United States. To get around the
25 percent tariff, Ford installs rear windows, rear
seats, and seat belts prior to shipping the vehicles
to the United States. These vehicles are no longer
classified as commercial trucks but as passenger
vehicles, which are subject to the much lower
2.5 percent tariff. Upon arrival in Baltimore, the
rear seats are promptly removed and the rear windows
replaced with metal panels—before delivery
to the Ford dealers.
*See Matthew Dolan, “To Outfox the Chicken Tax, Ford Strips Its Own Vans,” Wall Street Journal, September 23, 2009.
†Before opening production facilities in the United States, Subaru got around the tariff by bolting two plastic seats to the
open bed of the pickup truck (Subaru BRAT) that the company exported to the United States, thus evading the light
commercial truck classification.
Export Subsidies: Theory
An export subsidy is a payment to a firm or individual that ships a good abroad. Like a
tariff, an export subsidy can be either specific (a fixed sum per unit) or ad valorem (a proportion
of the value exported). When the government offers an export subsidy, shippers
will export the good up to the point at which the domestic price exceeds the foreign price
by the amount of the subsidy.
The effects of an export subsidy on prices are exactly the reverse of those of a tariff
(Figure 9-11). The price in the exporting country rises from to , but because the price
in the importing country falls from to , the price increase is less than the subsidy. PS * PW
PW PS
*
a
Price, P
Quantity, Q
D
S
PW
= consumer loss (a + b)
PS
= producer gain (a + b + c)
d
= cost of government subsidy
(b + c + d + e + f + g)
Exports
e f g
b c
PS
Subsidy
Figure 9-11
Effects of an Export Subsidy
An export subsidy raises prices
in the exporting country while
lowering them in the importing
country.
204 PART TWO International Trade Policy
In the exporting country, consumers are hurt, producers gain, and the government loses
because it must expend money on the subsidy. The consumer loss is the area ; the
producer gain is the area ; the government subsidy (the amount of exports times
the amount of the subsidy) is the area . The net welfare loss is
therefore the sum of the areas . Of these, b and d represent consumption
and production distortion losses of the same kind that a tariff produces. In addition, and
in contrast to a tariff, the export subsidy worsens the terms of trade because it lowers the
price of the export in the foreign market from to . This leads to the additional terms of
trade loss , which is equal to times the quantity exported with the subsidy.
So an export subsidy unambiguously leads to costs that exceed its benefits.
PW - PS * e + f + g
PS * PW
b + d + e + f + g
b + c + d + e + f + g
a + b + c
a + b
Case Study
Europe’s Common Agricultural Policy
In 1957, six Western European nations—Germany, France, Italy, Belgium, the
Netherlands, and Luxembourg—formed the European Economic Community, which
has since grown to include most of Europe. Now called the European Union (EU), its
two biggest effects are on trade policy. First, the members of the European Union have
removed all tariffs with respect to each other, thus creating a customs union (discussed
in the next chapter). Second, the agricultural policy of the European Union has developed
into a massive export subsidy program.
The European Union’s Common Agricultural Policy (CAP) began not as an export subsidy,
but as an effort to guarantee high prices to European farmers by having the European
Union buy agricultural products whenever the prices fell below specified support levels. To
prevent this policy from drawing in large quantities of imports, it was initially backed by
tariffs that offset the difference between European and world agricultural prices.
Since the 1970s, however, the support prices set by the European Union have turned
out to be so high that Europe—which, under free trade, would be an importer of most
agricultural products—was producing more than consumers were willing to buy. As a
result, the European Union found itself obliged to buy and store huge quantities of
food. At the end of 1985, for example, European nations had stored 780,000 tons of
beef, 1.2 million tons of butter, and 12 million tons of wheat. To avoid unlimited
growth in these stockpiles, the European Union turned to a policy of subsidizing
exports to dispose of surplus production.
Figure 9-12 shows how the CAP works. It is, of course, exactly like the export subsidy
shown in Figure 9-11, except that Europe would actually be an importer under free
trade. The support price is set not only above the world price that would prevail in its
absence but also above the price that would equate demand and supply even without
imports. To export the resulting surplus, an export subsidy is paid that offsets the difference
between European and world prices. The subsidized exports themselves tend to
depress the world price, increasing the required subsidy. A recent study estimated that
the welfare cost to European consumers exceeded the benefits to farm producers by
nearly $30 billion (21.5 billion euros) in 2007.2
Despite the considerable net costs of the CAP to European consumers and taxpayers,
the political strength of farmers in the EU has been so strong that the program has
2See Pierre Boulanger and Patrick Jomini, Of the Benefits to the EU of Removing the Common Agricultural
Policy, Sciences Politique Policy Brief, 2010.
CHAPTER 9 The Instruments of Trade Policy 205
been difficult to rein in. One source of pressure has come from
the United States and other food-exporting nations, which complain
that Europe’s export subsidies drive down the price of
their own exports. The budgetary consequences of the CAP
have also posed concerns: In 2009, the CAP cost European taxpayers
$76 billion (55 billion euros)—and that figure doesn’t
include the indirect costs to food consumers. Government subsidies
to European farmers are equal to about 36 percent of the
value of farm output, twice the U.S. figure.
Recent reforms in Europe’s agricultural policy represent an
effort to reduce the distortion of incentives caused by price support
while continuing to provide aid to farmers. If politicians go through with their
plans, farmers will increasingly receive direct payments that aren’t tied to how much
they produce; this should lower agricultural prices and reduce production.
Price, P
Quantity, Q
D
S
= cost of government subsidy
Exports
Support
price
World
price
EU price
without
imports
Figure 9-12
Europe’s Common Agricultural
Policy
Agricultural prices are fixed not
only above world market levels
but also above the price that
would clear the European market.
An export subsidy is used to
dispose of the resulting surplus.
Import Quotas: Theory
An import quota is a direct restriction on the quantity of some good that may be imported.
The restriction is usually enforced by issuing licenses to some group of individuals or
firms. For example, the United States has a quota on imports of foreign cheese. The only
firms allowed to import cheese are certain trading companies, each of which is allocated
the right to import a maximum number of pounds of cheese each year; the size of each
firm’s quota is based on the amount of cheese it imported in the past. In some important
cases, notably sugar and apparel, the right to sell in the United States is given directly to
the governments of exporting countries.
It is important to avoid having the misconception that import quotas somehow limit imports
without raising domestic prices. The truth is that an import quota always raises the
domestic price of the imported good. When imports are limited, the immediate result is
that at the initial price, the demand for the good exceeds domestic supply plus imports.
This causes the price to be bid up until the market clears. In the end, an import quota will
raise domestic prices by the same amount as a tariff that limits imports to the same level
(except in the case of domestic monopoly, in which the quota raises prices more than this;
see the appendix to this chapter).
The difference between a quota and a tariff is that with a quota, the government receives
no revenue. When a quota instead of a tariff is used to restrict imports, the sum of money
that would have appeared with a tariff as government revenue is collected by whoever
receives the import licenses. License holders are thus able to buy imports and resell them at
a higher price in the domestic market. The profits received by the holders of import licenses
are known as quota rents. In assessing the costs and benefits of an import quota, it is crucial
to determine who gets the rents. When the rights to sell in the domestic market are
assigned to governments of exporting countries, as is often the case, the transfer of rents
abroad makes the costs of a quota substantially higher than the equivalent tariff.
206 PART TWO International Trade Policy
Case Study
An Import Quota in Practice: U.S. Sugar
The U.S. sugar problem is similar in its origins to the European agricultural problem:
A domestic price guarantee by the federal government has led to U.S. prices above
world market levels. Unlike the European Union, however, the domestic supply in the
United States does not exceed domestic demand. Thus the United States has been
able to keep domestic prices at the target level with an import quota on sugar.
A special feature of the import quota is that the rights to sell sugar in the United
States are allocated to foreign governments, which then allocate these rights to their
own residents. As a result, rents generated by the sugar quota accrue to foreigners. The
quotas restrict the imports of both raw sugar (almost exclusively, sugar cane) as well as
refined sugar. We now describe the most recent forecast for the effects of the import
restrictions on raw sugar cane (the effects on the sugar refining industry are more complicated,
as raw sugar is a key input of production for that industry).3
Figure 9-13 shows those forecasted effects for 2013. The quota would restrict imports
to approximately 3 million tons; as a result, the price of raw sugar in the United
States would be 35 percent above the price in the outside world. The figure is drawn
with the assumption that the United States is “small” in the world market for raw sugar;
that is, removing the quota would not have a significant effect on the world price.
According to this estimate, free trade would increase sugar imports by 66 percent.
The welfare effects of the import quota are indicated by the areas a, b, c, and d.
Consumers lose the surplus , with a total value of $884 million. Part of
this consumer loss represents a transfer to U.S. sugar producers, who gain the producer
surplus a equal to $272 million. Part of the loss represents the production distortion b
($68 million) and the consumption distortion d ($91 million). The rents to the foreign
governments that receive import rights are summarized by area c, equal to $453 million.
The net loss to the United States is equal to the distortions plus the quota
rents (c), a total of $612 million per year. Notice that much of this net loss comes from
the fact that foreigners get the import rights.
(b + d)
a + b + c + d
3These estimates are based on a report by the U.S. International Trade Commission, The Economic Effects of
Significant U.S. Import Restraints. (Washington, D.C., 2009) cited in Further Readings.
CHAPTER 9 The Instruments of Trade Policy 207
Price, $/ton
= consumer loss (a + b + c + d)
= quota rents (c)
= producer gain (a)
Quantity of sugar,
million tons
Demand
Supply
a c
d
Price in U.S. Market $426
World Price $275
1.8 2.7 5.7 6.9
b
Figure 9-13
Effects of the U.S. Import
Quota on Sugar
The quota limits imports of raw
sugar to 3 million tons. Without
the quota, imports of sugar
would be 66 percent higher, or
5.1 million tons. The result of
the quota is that the price of
sugar is $426 per ton, versus the
$275 price on world markets.
This produces a gain for U.S.
sugar producers, but a much
larger loss for U.S. consumers.
There is no offsetting gain in
revenue because the quota
rents are collected by foreign
governments.
The sugar quota illustrates in an extreme way the tendency of protection to provide
benefits to a small group of producers, each of whom receives a large benefit, at the expense
of a large number of consumers, each of whom bears only a small cost. In this
case, the yearly consumer loss amounts to only about $3 per capita, or a little more than
$11 for a typical family. Not surprisingly, the average American voter is unaware that
the sugar quota exists, and so there is little effective opposition.
From the point of view of the raw sugar producers (farmers and processors), however,
the quota is a life-or-death issue. These producers employ only about 6,500 workers,
so the producer gains from the quota represent an implicit subsidy of about
$42,000 per employee. It should be no surprise that these sugar producers are very
effectively mobilized in defense of their protection.
Opponents of protection often try to frame their criticism not in terms of consumer
and producer surplus but in terms of the cost to consumers of every job “saved” by an
import restriction. Clearly, the loss of the $42,000 subsidy per employee indirectly provided
by the quota would force raw sugar producers to drastically reduce their employment.
Without the quota, it is forecasted that 32 percent of the 6,500 jobs would be lost.
This implies that the cost to the U.S. consumer is equal to $432,000 per job saved.
When one also considers that raw sugar is a key input of refined sugar (which is then
used to produce a vast variety of confectionery consumer goods), the costs escalate
even higher. In Chapter 4 we briefly mentioned these costs, which were roughly double
the ones we have summarized here for raw sugar only. When one further considers that
the high cost of sugar reduces employment in those sugar-using industries, the issue is
no longer that the consumer cost per job saved is astronomically high; rather, it is
plainly that jobs are being lost, not saved, by the sugar quota. The U.S. Department of
Commerce has estimated that, for every farming/processing job saved by high sugar
prices, three jobs are lost in the confectionery manufacturing industries.4
4See U.S Department of Commerce, International Trade Administration, Employment Changes in U.S. Food
Manufacturing: The Impact of Sugar Prices, 2006.
208 PART TWO International Trade Policy
Voluntary Export Restraints
A variant on the import quota is the voluntary export restraint (VER), also known as a
voluntary restraint agreement (VRA). (Welcome to the bureaucratic world of trade policy,
where everything has a three-letter symbol!) A VER is a quota on trade imposed from the
exporting country’s side instead of the importer’s. The most famous example is the limitation
on auto exports to the United States enforced by Japan after 1981.
Voluntary export restraints are generally imposed at the request of the importer and are
agreed to by the exporter to forestall other trade restrictions. As we will see in Chapter 10,
certain political and legal advantages have made VERs preferred instruments of trade policy
in some cases. From an economic point of view, however, a voluntary export restraint
is exactly like an import quota where the licenses are assigned to foreign governments and
is therefore very costly to the importing country.
A VER is always more costly to the importing country than a tariff that limits imports
by the same amount. The difference is that what would have been revenue under a tariff
becomes rents earned by foreigners under the VER, so that the VER clearly produces a
loss for the importing country.
A study of the effects of the three major U.S. voluntary export restraints of the 1980s—
in textiles and apparel, steel, and automobiles—found that about two-thirds of the cost to
consumers of these restraints was accounted for by the rents earned by foreigners.5
In other words, the bulk of the cost represents a transfer of income rather than a loss of
efficiency. This calculation also emphasizes that, from a national point of view, VERs are
much more costly than tariffs. Given this fact, the widespread preference of governments
for VERs over other trade policy measures requires some careful analysis.
Some voluntary export agreements cover more than one country. The most famous multilateral
agreement is the Multi-Fiber Arrangement, which limited textile exports from 22
countries until the beginning of 2005. Such multilateral voluntary restraint agreements are
known by yet another three-letter abbreviation: OMA, for “orderly marketing agreement.”
5See David G. Tarr, A General Equilibrium Analysis of the Welfare and Employment Effects of U.S. Quotas in
Textiles, Autos, and Steel (Washington, D.C.: Federal Trade Commission, 1989).
Case Study
A Voluntary Export Restraint in Practice: Japanese Autos
For much of the 1960s and 1970s, the U.S. auto industry was largely insulated from
import competition by the difference in the kinds of cars bought by U.S. and foreign
consumers. U.S. buyers, living in a large country with low gasoline taxes, preferred
much larger cars than Europeans and Japanese, and, by and large, foreign firms had
chosen not to challenge the United States in the large-car market.
In 1979, however, sharp oil price increases and temporary gasoline shortages
caused the U.S. market to shift abruptly toward smaller cars. Japanese producers,
whose costs had been falling relative to those of their U.S. competitors in any case,
moved in to fill the new demand. As the Japanese market share soared and U.S. output
fell, strong political forces in the United States demanded protection for the U.S. industry.
Rather than act unilaterally and risk creating a trade war, the U.S. government
asked the Japanese government to limit its exports. The Japanese, fearing unilateral
CHAPTER 9 The Instruments of Trade Policy 209
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.
The effects of this voluntary export restraint were complicated by several factors.
First, Japanese and U.S. cars were clearly not perfect substitutes. Second, the Japanese
industry to some extent responded to the quota by upgrading its quality and selling
larger autos with more features. Third, the auto industry is clearly not perfectly competitive.
Nonetheless, the basic results were what the discussion of voluntary export restraints
earlier would have predicted: The price of Japanese cars in the United States
rose, with the rent captured by Japanese firms. The U.S. government estimates the total
costs to the United States to be $3.2 billion in 1984, primarily in transfers to Japan
rather than efficiency losses.
Local Content Requirements
A local content requirement is a regulation that requires some specified fraction of a final
good to be produced domestically. In some cases this fraction is specified in physical
units, like the U.S. oil import quota in the 1960s. In other cases the requirement is stated in
value terms, by requiring that some minimum share of the price of a good represent domestic
value added. Local content laws have been widely used by developing countries
trying to shift their manufacturing base from assembly back into intermediate goods. In
the United States, a local content bill for automobiles was proposed in 1982 but was never
acted on.
From the point of view of the domestic producers of parts, a local content regulation
provides protection in the same way an import quota does. From the point of view of the
firms that must buy locally, however, the effects are somewhat different. Local content
does not place a strict limit on imports. Instead, it allows firms to import more, provided
that they also buy more domestically. This means that the effective price of inputs to the
firm is an average of the price of imported and domestically produced inputs.
Consider, for instance, the earlier automobile example in which the cost of imported
parts is $6,000. Suppose that purchasing the same parts domestically would cost $10,000
but that assembly firms are required to use 50 percent domestic parts. Then they will face
an average cost of parts of , which will be reflected
in the final price of the car.
The important point is that a local content requirement does not produce either government
revenue or quota rents. Instead, the difference between the prices of imports and
domestic goods in effect gets averaged in the final price and is passed on to consumers.
An interesting innovation in local content regulations has been to allow firms to satisfy
their local content requirement by exporting instead of using parts domestically.
This is sometimes important. For example, U.S. auto firms operating in Mexico have
chosen to export some components from Mexico to the United States, even though
those components could be produced in the United States more cheaply, because doing
so allows them to use less Mexican content in producing cars in Mexico for Mexico’s
market.
$8,000 10.5 * $6,000 + 0.5 * $10,0002
210 PART TWO International Trade Policy
Other Trade Policy Instruments
There are many other ways in which governments influence trade. We list some of them
briefly.
1. Export credit subsidies. This is like an export subsidy except that it takes the
form of a subsidized loan to the buyer. The United States, like most other countries,
has a government institution, the Export-Import Bank, that is devoted to providing at
least slightly subsidized loans to aid exports.
2. National procurement. Purchases by the government or strongly regulated firms
can be directed toward domestically produced goods even when these goods are more
expensive than imports. The classic example is the European telecommunications industry.
The nations of the European Union in principle have free trade with each
other. The main purchasers of telecommunications equipment, however, are phone
companies—and in Europe, these companies have until recently all been governmentowned.
These government-owned telephone companies buy from domestic suppliers
even when the suppliers charge higher prices than suppliers in other countries.
The result is that there is very little trade in telecommunications equipment within
Europe.
American Buses, Made in Hungary
In 1995, sleek new buses began rolling onto the
streets of Miami and Baltimore. Probably very few
riders were aware that these buses had been made in
Hungary, of all places.
Why Hungary? Well, before the fall of communism
in Eastern Europe, Hungary had in fact manufactured
buses for export to other Eastern bloc
nations. However, because these buses were poorly
designed and badly made, few people thought the
industry could start exporting to Western countries
any time soon.
What changed the situation was some clever
Hungarian investors’ realization that there is a loophole
in a little-known but important U.S. law, the
Buy American Act, originally passed in 1933. This
law in effect imposes local content requirements on
a significant range of products.
The Buy American Act affects procurement
(purchases by government agencies, including state
and local governments) by requiring that American
firms be given preference in all such purchases.
A bid by a foreign company can be accepted only if
it is a specified percentage below the lowest bid by a
domestic firm. In the case of buses and other transportation
equipment, the foreign bid must be at least
25 percent below the domestic bid, effectively shutting
out foreign producers in most cases. Nor can an
American company simply act as a sales agent for
foreigners: While “American” products can contain
some foreign parts, 51 percent of the materials must
be domestic.
What the Hungarians realized was that they
could set up a production chain that just barely met
this criterion. They set up operations in two locations:
one in Hungary, producing the shells of buses
(the bodies, without anything else), and an assembly
operation in Georgia. American axles and tires were
shipped to Hungary, where they were put onto the
bus shells; these were then shipped back to the
United States, where American-made engines and
transmissions were installed. The whole product
was slightly more than 51 percent American, and
thus these buses were legally “American” buses that
city transit authorities were allowed to buy. The
advantage of the whole scheme was the opportunity
to use inexpensive Hungarian labor: Although
Hungarian workers took about 1,500 hours to assemble
a bus (compared with less than 900 hours in
the United States), their $4 per-hour wage rate made
all the transshipments worthwhile.
CHAPTER 9 The Instruments of Trade Policy 211
3. Red-tape barriers. Sometimes a government wants to restrict imports without
doing so formally. Fortunately or unfortunately, it is easy to twist normal health,
safety, and customs procedures in order to place substantial obstacles in the way of
trade. The classic example is the French decree in 1982 that all Japanese videocassette
recorders had to pass through the tiny customs house at Poitiers—effectively
limiting the actual imports to a handful.
Tariffs are the simplest trade policies, but in the modern world, most government intervention
in international trade takes other forms, such as export subsidies, import quotas,
voluntary export restraints, and local content requirements. Fortunately, once we have
understood tariffs, it is not too difficult to understand these other trade instruments.
CHAPTER 9 The Instruments of Trade Policy 203
of the original tariffs were dropped, except for the
ones on chickens and light commercial trucks.
Volkswagen stopped producing those vehicles, but
the U.S. “big three” auto and truck producers
were then concerned about competition from
Japanese truck producers and lobbied to keep the
tariff in place.
Japanese producers responded by building those
light trucks in the United States (see Chapter 8).†
As a result, the latest company to be hit by the
consequences of the tariff is Ford, one of those
“big three” U.S. producers! Ford produces a small
commercial van in Europe, the “Transit Connect,”
which is designed (with its smaller capacity and
ability to navigate old, narrow streets) for
European cities. The recent spike in fuel prices
sharply increased demand in some U.S. cities
for this truck. In 2009, Ford started selling these
vehicles in the United States. To get around the
25 percent tariff, Ford installs rear windows, rear
seats, and seat belts prior to shipping the vehicles
to the United States. These vehicles are no longer
classified as commercial trucks but as passenger
vehicles, which are subject to the much lower
2.5 percent tariff. Upon arrival in Baltimore, the
rear seats are promptly removed and the rear windows
replaced with metal panels—before delivery
to the Ford dealers.
*See Matthew Dolan, “To Outfox the Chicken Tax, Ford Strips Its Own Vans,” Wall Street Journal, September 23, 2009.
†Before opening production facilities in the United States, Subaru got around the tariff by bolting two plastic seats to the
open bed of the pickup truck (Subaru BRAT) that the company exported to the United States, thus evading the light
commercial truck classification.
Export Subsidies: Theory
An export subsidy is a payment to a firm or individual that ships a good abroad. Like a
tariff, an export subsidy can be either specific (a fixed sum per unit) or ad valorem (a proportion
of the value exported). When the government offers an export subsidy, shippers
will export the good up to the point at which the domestic price exceeds the foreign price
by the amount of the subsidy.
The effects of an export subsidy on prices are exactly the reverse of those of a tariff
(Figure 9-11). The price in the exporting country rises from to , but because the price
in the importing country falls from to , the price increase is less than the subsidy. PS * PW
PW PS
*
a
Price, P
Quantity, Q
D
S
PW
= consumer loss (a + b)
PS
= producer gain (a + b + c)
d
= cost of government subsidy
(b + c + d + e + f + g)
Exports
e f g
b c
PS
Subsidy
Figure 9-11
Effects of an Export Subsidy
An export subsidy raises prices
in the exporting country while
lowering them in the importing
country.
204 PART TWO International Trade Policy
In the exporting country, consumers are hurt, producers gain, and the government loses
because it must expend money on the subsidy. The consumer loss is the area ; the
producer gain is the area ; the government subsidy (the amount of exports times
the amount of the subsidy) is the area . The net welfare loss is
therefore the sum of the areas . Of these, b and d represent consumption
and production distortion losses of the same kind that a tariff produces. In addition, and
in contrast to a tariff, the export subsidy worsens the terms of trade because it lowers the
price of the export in the foreign market from to . This leads to the additional terms of
trade loss , which is equal to times the quantity exported with the subsidy.
So an export subsidy unambiguously leads to costs that exceed its benefits.
PW - PS * e + f + g
PS * PW
b + d + e + f + g
b + c + d + e + f + g
a + b + c
a + b
Case Study
Europe’s Common Agricultural Policy
In 1957, six Western European nations—Germany, France, Italy, Belgium, the
Netherlands, and Luxembourg—formed the European Economic Community, which
has since grown to include most of Europe. Now called the European Union (EU), its
two biggest effects are on trade policy. First, the members of the European Union have
removed all tariffs with respect to each other, thus creating a customs union (discussed
in the next chapter). Second, the agricultural policy of the European Union has developed
into a massive export subsidy program.
The European Union’s Common Agricultural Policy (CAP) began not as an export subsidy,
but as an effort to guarantee high prices to European farmers by having the European
Union buy agricultural products whenever the prices fell below specified support levels. To
prevent this policy from drawing in large quantities of imports, it was initially backed by
tariffs that offset the difference between European and world agricultural prices.
Since the 1970s, however, the support prices set by the European Union have turned
out to be so high that Europe—which, under free trade, would be an importer of most
agricultural products—was producing more than consumers were willing to buy. As a
result, the European Union found itself obliged to buy and store huge quantities of
food. At the end of 1985, for example, European nations had stored 780,000 tons of
beef, 1.2 million tons of butter, and 12 million tons of wheat. To avoid unlimited
growth in these stockpiles, the European Union turned to a policy of subsidizing
exports to dispose of surplus production.
Figure 9-12 shows how the CAP works. It is, of course, exactly like the export subsidy
shown in Figure 9-11, except that Europe would actually be an importer under free
trade. The support price is set not only above the world price that would prevail in its
absence but also above the price that would equate demand and supply even without
imports. To export the resulting surplus, an export subsidy is paid that offsets the difference
between European and world prices. The subsidized exports themselves tend to
depress the world price, increasing the required subsidy. A recent study estimated that
the welfare cost to European consumers exceeded the benefits to farm producers by
nearly $30 billion (21.5 billion euros) in 2007.2
Despite the considerable net costs of the CAP to European consumers and taxpayers,
the political strength of farmers in the EU has been so strong that the program has
2See Pierre Boulanger and Patrick Jomini, Of the Benefits to the EU of Removing the Common Agricultural
Policy, Sciences Politique Policy Brief, 2010.
CHAPTER 9 The Instruments of Trade Policy 205
been difficult to rein in. One source of pressure has come from
the United States and other food-exporting nations, which complain
that Europe’s export subsidies drive down the price of
their own exports. The budgetary consequences of the CAP
have also posed concerns: In 2009, the CAP cost European taxpayers
$76 billion (55 billion euros)—and that figure doesn’t
include the indirect costs to food consumers. Government subsidies
to European farmers are equal to about 36 percent of the
value of farm output, twice the U.S. figure.
Recent reforms in Europe’s agricultural policy represent an
effort to reduce the distortion of incentives caused by price support
while continuing to provide aid to farmers. If politicians go through with their
plans, farmers will increasingly receive direct payments that aren’t tied to how much
they produce; this should lower agricultural prices and reduce production.
Price, P
Quantity, Q
D
S
= cost of government subsidy
Exports
Support
price
World
price
EU price
without
imports
Figure 9-12
Europe’s Common Agricultural
Policy
Agricultural prices are fixed not
only above world market levels
but also above the price that
would clear the European market.
An export subsidy is used to
dispose of the resulting surplus.
Import Quotas: Theory
An import quota is a direct restriction on the quantity of some good that may be imported.
The restriction is usually enforced by issuing licenses to some group of individuals or
firms. For example, the United States has a quota on imports of foreign cheese. The only
firms allowed to import cheese are certain trading companies, each of which is allocated
the right to import a maximum number of pounds of cheese each year; the size of each
firm’s quota is based on the amount of cheese it imported in the past. In some important
cases, notably sugar and apparel, the right to sell in the United States is given directly to
the governments of exporting countries.
It is important to avoid having the misconception that import quotas somehow limit imports
without raising domestic prices. The truth is that an import quota always raises the
domestic price of the imported good. When imports are limited, the immediate result is
that at the initial price, the demand for the good exceeds domestic supply plus imports.
This causes the price to be bid up until the market clears. In the end, an import quota will
raise domestic prices by the same amount as a tariff that limits imports to the same level
(except in the case of domestic monopoly, in which the quota raises prices more than this;
see the appendix to this chapter).
The difference between a quota and a tariff is that with a quota, the government receives
no revenue. When a quota instead of a tariff is used to restrict imports, the sum of money
that would have appeared with a tariff as government revenue is collected by whoever
receives the import licenses. License holders are thus able to buy imports and resell them at
a higher price in the domestic market. The profits received by the holders of import licenses
are known as quota rents. In assessing the costs and benefits of an import quota, it is crucial
to determine who gets the rents. When the rights to sell in the domestic market are
assigned to governments of exporting countries, as is often the case, the transfer of rents
abroad makes the costs of a quota substantially higher than the equivalent tariff.
206 PART TWO International Trade Policy
Case Study
An Import Quota in Practice: U.S. Sugar
The U.S. sugar problem is similar in its origins to the European agricultural problem:
A domestic price guarantee by the federal government has led to U.S. prices above
world market levels. Unlike the European Union, however, the domestic supply in the
United States does not exceed domestic demand. Thus the United States has been
able to keep domestic prices at the target level with an import quota on sugar.
A special feature of the import quota is that the rights to sell sugar in the United
States are allocated to foreign governments, which then allocate these rights to their
own residents. As a result, rents generated by the sugar quota accrue to foreigners. The
quotas restrict the imports of both raw sugar (almost exclusively, sugar cane) as well as
refined sugar. We now describe the most recent forecast for the effects of the import
restrictions on raw sugar cane (the effects on the sugar refining industry are more complicated,
as raw sugar is a key input of production for that industry).3
Figure 9-13 shows those forecasted effects for 2013. The quota would restrict imports
to approximately 3 million tons; as a result, the price of raw sugar in the United
States would be 35 percent above the price in the outside world. The figure is drawn
with the assumption that the United States is “small” in the world market for raw sugar;
that is, removing the quota would not have a significant effect on the world price.
According to this estimate, free trade would increase sugar imports by 66 percent.
The welfare effects of the import quota are indicated by the areas a, b, c, and d.
Consumers lose the surplus , with a total value of $884 million. Part of
this consumer loss represents a transfer to U.S. sugar producers, who gain the producer
surplus a equal to $272 million. Part of the loss represents the production distortion b
($68 million) and the consumption distortion d ($91 million). The rents to the foreign
governments that receive import rights are summarized by area c, equal to $453 million.
The net loss to the United States is equal to the distortions plus the quota
rents (c), a total of $612 million per year. Notice that much of this net loss comes from
the fact that foreigners get the import rights.
(b + d)
a + b + c + d
3These estimates are based on a report by the U.S. International Trade Commission, The Economic Effects of
Significant U.S. Import Restraints. (Washington, D.C., 2009) cited in Further Readings.
CHAPTER 9 The Instruments of Trade Policy 207
Price, $/ton
= consumer loss (a + b + c + d)
= quota rents (c)
= producer gain (a)
Quantity of sugar,
million tons
Demand
Supply
a c
d
Price in U.S. Market $426
World Price $275
1.8 2.7 5.7 6.9
b
Figure 9-13
Effects of the U.S. Import
Quota on Sugar
The quota limits imports of raw
sugar to 3 million tons. Without
the quota, imports of sugar
would be 66 percent higher, or
5.1 million tons. The result of
the quota is that the price of
sugar is $426 per ton, versus the
$275 price on world markets.
This produces a gain for U.S.
sugar producers, but a much
larger loss for U.S. consumers.
There is no offsetting gain in
revenue because the quota
rents are collected by foreign
governments.
The sugar quota illustrates in an extreme way the tendency of protection to provide
benefits to a small group of producers, each of whom receives a large benefit, at the expense
of a large number of consumers, each of whom bears only a small cost. In this
case, the yearly consumer loss amounts to only about $3 per capita, or a little more than
$11 for a typical family. Not surprisingly, the average American voter is unaware that
the sugar quota exists, and so there is little effective opposition.
From the point of view of the raw sugar producers (farmers and processors), however,
the quota is a life-or-death issue. These producers employ only about 6,500 workers,
so the producer gains from the quota represent an implicit subsidy of about
$42,000 per employee. It should be no surprise that these sugar producers are very
effectively mobilized in defense of their protection.
Opponents of protection often try to frame their criticism not in terms of consumer
and producer surplus but in terms of the cost to consumers of every job “saved” by an
import restriction. Clearly, the loss of the $42,000 subsidy per employee indirectly provided
by the quota would force raw sugar producers to drastically reduce their employment.
Without the quota, it is forecasted that 32 percent of the 6,500 jobs would be lost.
This implies that the cost to the U.S. consumer is equal to $432,000 per job saved.
When one also considers that raw sugar is a key input of refined sugar (which is then
used to produce a vast variety of confectionery consumer goods), the costs escalate
even higher. In Chapter 4 we briefly mentioned these costs, which were roughly double
the ones we have summarized here for raw sugar only. When one further considers that
the high cost of sugar reduces employment in those sugar-using industries, the issue is
no longer that the consumer cost per job saved is astronomically high; rather, it is
plainly that jobs are being lost, not saved, by the sugar quota. The U.S. Department of
Commerce has estimated that, for every farming/processing job saved by high sugar
prices, three jobs are lost in the confectionery manufacturing industries.4
4See U.S Department of Commerce, International Trade Administration, Employment Changes in U.S. Food
Manufacturing: The Impact of Sugar Prices, 2006.
208 PART TWO International Trade Policy
Voluntary Export Restraints
A variant on the import quota is the voluntary export restraint (VER), also known as a
voluntary restraint agreement (VRA). (Welcome to the bureaucratic world of trade policy,
where everything has a three-letter symbol!) A VER is a quota on trade imposed from the
exporting country’s side instead of the importer’s. The most famous example is the limitation
on auto exports to the United States enforced by Japan after 1981.
Voluntary export restraints are generally imposed at the request of the importer and are
agreed to by the exporter to forestall other trade restrictions. As we will see in Chapter 10,
certain political and legal advantages have made VERs preferred instruments of trade policy
in some cases. From an economic point of view, however, a voluntary export restraint
is exactly like an import quota where the licenses are assigned to foreign governments and
is therefore very costly to the importing country.
A VER is always more costly to the importing country than a tariff that limits imports
by the same amount. The difference is that what would have been revenue under a tariff
becomes rents earned by foreigners under the VER, so that the VER clearly produces a
loss for the importing country.
A study of the effects of the three major U.S. voluntary export restraints of the 1980s—
in textiles and apparel, steel, and automobiles—found that about two-thirds of the cost to
consumers of these restraints was accounted for by the rents earned by foreigners.5
In other words, the bulk of the cost represents a transfer of income rather than a loss of
efficiency. This calculation also emphasizes that, from a national point of view, VERs are
much more costly than tariffs. Given this fact, the widespread preference of governments
for VERs over other trade policy measures requires some careful analysis.
Some voluntary export agreements cover more than one country. The most famous multilateral
agreement is the Multi-Fiber Arrangement, which limited textile exports from 22
countries until the beginning of 2005. Such multilateral voluntary restraint agreements are
known by yet another three-letter abbreviation: OMA, for “orderly marketing agreement.”
5See David G. Tarr, A General Equilibrium Analysis of the Welfare and Employment Effects of U.S. Quotas in
Textiles, Autos, and Steel (Washington, D.C.: Federal Trade Commission, 1989).
Case Study
A Voluntary Export Restraint in Practice: Japanese Autos
For much of the 1960s and 1970s, the U.S. auto industry was largely insulated from
import competition by the difference in the kinds of cars bought by U.S. and foreign
consumers. U.S. buyers, living in a large country with low gasoline taxes, preferred
much larger cars than Europeans and Japanese, and, by and large, foreign firms had
chosen not to challenge the United States in the large-car market.
In 1979, however, sharp oil price increases and temporary gasoline shortages
caused the U.S. market to shift abruptly toward smaller cars. Japanese producers,
whose costs had been falling relative to those of their U.S. competitors in any case,
moved in to fill the new demand. As the Japanese market share soared and U.S. output
fell, strong political forces in the United States demanded protection for the U.S. industry.
Rather than act unilaterally and risk creating a trade war, the U.S. government
asked the Japanese government to limit its exports. The Japanese, fearing unilateral
CHAPTER 9 The Instruments of Trade Policy 209
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.
The effects of this voluntary export restraint were complicated by several factors.
First, Japanese and U.S. cars were clearly not perfect substitutes. Second, the Japanese
industry to some extent responded to the quota by upgrading its quality and selling
larger autos with more features. Third, the auto industry is clearly not perfectly competitive.
Nonetheless, the basic results were what the discussion of voluntary export restraints
earlier would have predicted: The price of Japanese cars in the United States
rose, with the rent captured by Japanese firms. The U.S. government estimates the total
costs to the United States to be $3.2 billion in 1984, primarily in transfers to Japan
rather than efficiency losses.
Local Content Requirements
A local content requirement is a regulation that requires some specified fraction of a final
good to be produced domestically. In some cases this fraction is specified in physical
units, like the U.S. oil import quota in the 1960s. In other cases the requirement is stated in
value terms, by requiring that some minimum share of the price of a good represent domestic
value added. Local content laws have been widely used by developing countries
trying to shift their manufacturing base from assembly back into intermediate goods. In
the United States, a local content bill for automobiles was proposed in 1982 but was never
acted on.
From the point of view of the domestic producers of parts, a local content regulation
provides protection in the same way an import quota does. From the point of view of the
firms that must buy locally, however, the effects are somewhat different. Local content
does not place a strict limit on imports. Instead, it allows firms to import more, provided
that they also buy more domestically. This means that the effective price of inputs to the
firm is an average of the price of imported and domestically produced inputs.
Consider, for instance, the earlier automobile example in which the cost of imported
parts is $6,000. Suppose that purchasing the same parts domestically would cost $10,000
but that assembly firms are required to use 50 percent domestic parts. Then they will face
an average cost of parts of , which will be reflected
in the final price of the car.
The important point is that a local content requirement does not produce either government
revenue or quota rents. Instead, the difference between the prices of imports and
domestic goods in effect gets averaged in the final price and is passed on to consumers.
An interesting innovation in local content regulations has been to allow firms to satisfy
their local content requirement by exporting instead of using parts domestically.
This is sometimes important. For example, U.S. auto firms operating in Mexico have
chosen to export some components from Mexico to the United States, even though
those components could be produced in the United States more cheaply, because doing
so allows them to use less Mexican content in producing cars in Mexico for Mexico’s
market.
$8,000 10.5 * $6,000 + 0.5 * $10,0002
210 PART TWO International Trade Policy
Other Trade Policy Instruments
There are many other ways in which governments influence trade. We list some of them
briefly.
1. Export credit subsidies. This is like an export subsidy except that it takes the
form of a subsidized loan to the buyer. The United States, like most other countries,
has a government institution, the Export-Import Bank, that is devoted to providing at
least slightly subsidized loans to aid exports.
2. National procurement. Purchases by the government or strongly regulated firms
can be directed toward domestically produced goods even when these goods are more
expensive than imports. The classic example is the European telecommunications industry.
The nations of the European Union in principle have free trade with each
other. The main purchasers of telecommunications equipment, however, are phone
companies—and in Europe, these companies have until recently all been governmentowned.
These government-owned telephone companies buy from domestic suppliers
even when the suppliers charge higher prices than suppliers in other countries.
The result is that there is very little trade in telecommunications equipment within
Europe.
American Buses, Made in Hungary
In 1995, sleek new buses began rolling onto the
streets of Miami and Baltimore. Probably very few
riders were aware that these buses had been made in
Hungary, of all places.
Why Hungary? Well, before the fall of communism
in Eastern Europe, Hungary had in fact manufactured
buses for export to other Eastern bloc
nations. However, because these buses were poorly
designed and badly made, few people thought the
industry could start exporting to Western countries
any time soon.
What changed the situation was some clever
Hungarian investors’ realization that there is a loophole
in a little-known but important U.S. law, the
Buy American Act, originally passed in 1933. This
law in effect imposes local content requirements on
a significant range of products.
The Buy American Act affects procurement
(purchases by government agencies, including state
and local governments) by requiring that American
firms be given preference in all such purchases.
A bid by a foreign company can be accepted only if
it is a specified percentage below the lowest bid by a
domestic firm. In the case of buses and other transportation
equipment, the foreign bid must be at least
25 percent below the domestic bid, effectively shutting
out foreign producers in most cases. Nor can an
American company simply act as a sales agent for
foreigners: While “American” products can contain
some foreign parts, 51 percent of the materials must
be domestic.
What the Hungarians realized was that they
could set up a production chain that just barely met
this criterion. They set up operations in two locations:
one in Hungary, producing the shells of buses
(the bodies, without anything else), and an assembly
operation in Georgia. American axles and tires were
shipped to Hungary, where they were put onto the
bus shells; these were then shipped back to the
United States, where American-made engines and
transmissions were installed. The whole product
was slightly more than 51 percent American, and
thus these buses were legally “American” buses that
city transit authorities were allowed to buy. The
advantage of the whole scheme was the opportunity
to use inexpensive Hungarian labor: Although
Hungarian workers took about 1,500 hours to assemble
a bus (compared with less than 900 hours in
the United States), their $4 per-hour wage rate made
all the transshipments worthwhile.
CHAPTER 9 The Instruments of Trade Policy 211
3. Red-tape barriers. Sometimes a government wants to restrict imports without
doing so formally. Fortunately or unfortunately, it is easy to twist normal health,
safety, and customs procedures in order to place substantial obstacles in the way of
trade. The classic example is the French decree in 1982 that all Japanese videocassette
recorders had to pass through the tiny customs house at Poitiers—effectively
limiting the actual imports to a handful.
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