Tariffs and Export Subsidies:
Simultaneous Shifts in RS and RD
Import tariffs (taxes levied on imports) and export subsidies (payments given to domestic
producers who sell a good abroad) are not usually put in place to affect a country’s terms of
trade. These government interventions in trade usually take place for income distribution,
for the promotion of industries thought to be crucial to the economy, or for balance of
payments. (Note that we will examine these motivations in Chapters 10, 11, and 12.)
Whatever the motive for tariffs and subsidies, however, they do have effects on terms of
trade that can be understood by using the standard trade model.
The distinctive feature of tariffs and export subsidies is that they create a difference
between prices at which goods are traded on the world market and prices at which those
goods can be purchased within a country. The direct effect of a tariff is to make imported
goods more expensive inside a country than they are outside the country. An export subsidy
gives producers an incentive to export. It will therefore be more profitable to sell
CHAPTER 6 The Standard Trade Model 125
abroad than at home unless the price at home is higher, so such a subsidy raises the prices
of exported goods inside a country. Note that this is very different from the effects of a
production subsidy, which also lowers domestic prices for the affected goods (since the
production subsidy does not discriminate based on the sales destination of the goods).
When countries are big exporters or importers of a good (relative to the size of the
world market), the price changes caused by tariffs and subsidies change both relative supply
and relative demand on world markets. The result is a shift in the terms of trade, both
of the country imposing the policy change and of the rest of the world.
Relative Demand and Supply Effects of a Tariff
Tariffs and subsidies drive a wedge between the prices at which goods are traded internationally
(external prices) and the prices at which they are traded within a country
(internal prices). This means that we have to be careful in defining the terms of trade,
which are intended to measure the ratio at which countries exchange goods; for example,
how many units of food can Home import for each unit of cloth that it exports? This means
that the terms of trade correspond to external, rather than internal, prices. When analyzing
the effects of a tariff or export subsidy, therefore, we want to know how that tariff or subsidy
affects relative supply and demand as a function of external prices.
If Home imposes a 20 percent tariff on the value of food imports, for example, the
internal price of food relative to cloth faced by Home producers and consumers will be 20
percent higher than the external relative price of food on the world market. Equivalently,
the internal relative price of cloth on which Home residents base their decisions will be
lower than the relative price on the external market.
At any given world relative price of cloth, then, Home producers will face a lower relative
cloth price and therefore will produce less cloth and more food. At the same time,
Home consumers will shift their consumption toward cloth and away from food. From the
point of view of the world as a whole, the relative supply of cloth will fall (from to
in Figure 6-8) while the relative demand for cloth will rise (from to ).
Clearly, the world relative price of cloth rises from ( to and thus Home’s
terms of trade improve at Foreign’s expense.
(PC/PF)1 (PC/PF)2,
RS2 RD1 RD2
RS1
Relative price
of cloth, PC / PF
(PC /PF)1
(PC /PF)2
2
RD1
1
RD2
RS1
RS2
Relative quantity
of cloth,
QC + QC
QF + QF
*
*
Figure 6-8
Effects of a Food Tariff on the
Terms of Trade
An import tariff on food imposed
by Home both reduces the relative
supply of cloth (from to )
and increases the relative demand
(from to ) for the world as
a whole. As a result, the relative
price of cloth must rise from
(PC/PF)1 to (PC/PF)2.
RD1 RD2
RS1 RS2
126 PART ONE International Trade Theory
The extent of this terms of trade effect depends on how large the country imposing the
tariff is relative to the rest of the world: If the country is only a small part of the world, it
cannot have much effect on world relative supply and demand and therefore cannot have
much effect on relative prices. If the United States, a very large country, were to impose a
20 percent tariff, some estimates suggest that the U.S. terms of trade might rise by 15 percent.
That is, the price of U.S. imports relative to exports might fall by 15 percent on the world
market, while the relative price of imports would rise only 5 percent inside the United States.
On the other hand, if Luxembourg or Paraguay were to impose a 20 percent tariff, the terms
of trade effect would probably be too small to measure.
Effects of an Export Subsidy
Tariffs and export subsidies are often treated as similar policies, since they both seem to
support domestic producers, but they have opposite effects on the terms of trade. Suppose
that Home offers a 20 percent subsidy on the value of any cloth exported. For any given
world prices, this subsidy will raise Home’s internal price of cloth relative to that of food
by 20 percent. The rise in the relative price of cloth will lead Home producers to produce
more cloth and less food, while leading Home consumers to substitute food for cloth. As
illustrated in Figure 6-9, the subsidy will increase the world relative supply of cloth (from
to ) and decrease the world relative demand for cloth (from to ), shifting
equilibrium from point 1 to point 2. A Home export subsidy worsens Home’s terms of
trade and improves Foreign’s.
Implications of Terms of Trade Effects:
Who Gains and Who Loses?
If Home imposes a tariff, it improves its terms of trade at Foreign’s expense. Thus tariffs
hurt the rest of the world. The effect on Home’s welfare is not quite as clear-cut. The terms
of trade improvement benefits Home; however, a tariff also imposes costs by distorting
production and consumption incentives within Home’s economy (see Chapter 9). The
terms of trade gains will outweigh the losses from distortion only as long as the tariff is
RS1 RS2 RD1 RD2
Relative quantity
of cloth,
QC + QC
QF + QF
*
*
Relative price
of cloth, PC /PF
(PC /PF)2
(PC /PF)1
1
RD2
2
RD1
RS2
RS1
Figure 6-9
Effects of a Cloth Subsidy on the
Terms of Trade
An export subsidy on cloth has
the opposite effects on relative
supply and demand than the tariff
on food. Relative supply of cloth
for the world rises, while relative
demand for the world falls.
Home’s terms of trade decline as
the relative price of cloth falls
from (PC/PF)1 to (PC/PF)2.
CHAPTER 6 The Standard Trade Model 127
not too large. We will see later how to define an optimum tariff that maximizes net benefit.
(For small countries that cannot have much impact on their terms of trade, the optimum
tariff is near zero.)
The effects of an export subsidy are quite clear. Foreign’s terms of trade improve at
Home’s expense, leaving it clearly better off. At the same time, Home loses from terms of
trade deterioration and from the distorting effects of its policy.
This analysis seems to show that export subsidies never make sense. In fact, it is difficult
to come up with situations where export subsidies would serve the national interest.
The use of export subsidies as a policy tool usually has more to do with the peculiarities of
trade politics than with economic logic.
Are foreign tariffs always bad for a country and foreign export subsidies always beneficial?
Not necessarily. Our model is of a two-country world, where the other country
exports the good we import and vice versa. In the real, multination world, a foreign government
may subsidize the export of a good that competes with U.S. exports; this foreign
subsidy will obviously hurt the U.S. terms of trade. A good example of this effect is
European subsidies to agricultural exports (see Chapter 9). Alternatively, a country may
impose a tariff on something the United States also imports, lowering its price and benefiting
the United States. We thus need to qualify our conclusions from a two-country
analysis: Subsidies to exports of things the United States imports help us, while tariffs
against U.S. exports hurt us.
The view that subsidized foreign sales to the United States are good for us is not a popular
one. When foreign governments are charged with subsidizing sales in the United States,
the popular and political reaction is that this is unfair competition. Thus when a Commerce
Department study determined that European governments were subsidizing exports of steel
to the United States, our government demanded that they raise their prices. The standard
model tells us that lower steel prices are a good thing for the U.S. economy (which is a net
steel importer). On the other hand, some models based on imperfect competition and
increasing returns to scale in production point to some potential welfare losses from
the European subsidy. Nevertheless, the subsidy’s biggest impact falls on the distribution of
income within the United States. If Europe subsidizes exports of steel to the United States,
most U.S. residents gain from cheaper steel. However, steelworkers, the owners of steel
company stock, and industrial workers in general may not be so lucky.
Simultaneous Shifts in RS and RD
Import tariffs (taxes levied on imports) and export subsidies (payments given to domestic
producers who sell a good abroad) are not usually put in place to affect a country’s terms of
trade. These government interventions in trade usually take place for income distribution,
for the promotion of industries thought to be crucial to the economy, or for balance of
payments. (Note that we will examine these motivations in Chapters 10, 11, and 12.)
Whatever the motive for tariffs and subsidies, however, they do have effects on terms of
trade that can be understood by using the standard trade model.
The distinctive feature of tariffs and export subsidies is that they create a difference
between prices at which goods are traded on the world market and prices at which those
goods can be purchased within a country. The direct effect of a tariff is to make imported
goods more expensive inside a country than they are outside the country. An export subsidy
gives producers an incentive to export. It will therefore be more profitable to sell
CHAPTER 6 The Standard Trade Model 125
abroad than at home unless the price at home is higher, so such a subsidy raises the prices
of exported goods inside a country. Note that this is very different from the effects of a
production subsidy, which also lowers domestic prices for the affected goods (since the
production subsidy does not discriminate based on the sales destination of the goods).
When countries are big exporters or importers of a good (relative to the size of the
world market), the price changes caused by tariffs and subsidies change both relative supply
and relative demand on world markets. The result is a shift in the terms of trade, both
of the country imposing the policy change and of the rest of the world.
Relative Demand and Supply Effects of a Tariff
Tariffs and subsidies drive a wedge between the prices at which goods are traded internationally
(external prices) and the prices at which they are traded within a country
(internal prices). This means that we have to be careful in defining the terms of trade,
which are intended to measure the ratio at which countries exchange goods; for example,
how many units of food can Home import for each unit of cloth that it exports? This means
that the terms of trade correspond to external, rather than internal, prices. When analyzing
the effects of a tariff or export subsidy, therefore, we want to know how that tariff or subsidy
affects relative supply and demand as a function of external prices.
If Home imposes a 20 percent tariff on the value of food imports, for example, the
internal price of food relative to cloth faced by Home producers and consumers will be 20
percent higher than the external relative price of food on the world market. Equivalently,
the internal relative price of cloth on which Home residents base their decisions will be
lower than the relative price on the external market.
At any given world relative price of cloth, then, Home producers will face a lower relative
cloth price and therefore will produce less cloth and more food. At the same time,
Home consumers will shift their consumption toward cloth and away from food. From the
point of view of the world as a whole, the relative supply of cloth will fall (from to
in Figure 6-8) while the relative demand for cloth will rise (from to ).
Clearly, the world relative price of cloth rises from ( to and thus Home’s
terms of trade improve at Foreign’s expense.
(PC/PF)1 (PC/PF)2,
RS2 RD1 RD2
RS1
Relative price
of cloth, PC / PF
(PC /PF)1
(PC /PF)2
2
RD1
1
RD2
RS1
RS2
Relative quantity
of cloth,
QC + QC
QF + QF
*
*
Figure 6-8
Effects of a Food Tariff on the
Terms of Trade
An import tariff on food imposed
by Home both reduces the relative
supply of cloth (from to )
and increases the relative demand
(from to ) for the world as
a whole. As a result, the relative
price of cloth must rise from
(PC/PF)1 to (PC/PF)2.
RD1 RD2
RS1 RS2
126 PART ONE International Trade Theory
The extent of this terms of trade effect depends on how large the country imposing the
tariff is relative to the rest of the world: If the country is only a small part of the world, it
cannot have much effect on world relative supply and demand and therefore cannot have
much effect on relative prices. If the United States, a very large country, were to impose a
20 percent tariff, some estimates suggest that the U.S. terms of trade might rise by 15 percent.
That is, the price of U.S. imports relative to exports might fall by 15 percent on the world
market, while the relative price of imports would rise only 5 percent inside the United States.
On the other hand, if Luxembourg or Paraguay were to impose a 20 percent tariff, the terms
of trade effect would probably be too small to measure.
Effects of an Export Subsidy
Tariffs and export subsidies are often treated as similar policies, since they both seem to
support domestic producers, but they have opposite effects on the terms of trade. Suppose
that Home offers a 20 percent subsidy on the value of any cloth exported. For any given
world prices, this subsidy will raise Home’s internal price of cloth relative to that of food
by 20 percent. The rise in the relative price of cloth will lead Home producers to produce
more cloth and less food, while leading Home consumers to substitute food for cloth. As
illustrated in Figure 6-9, the subsidy will increase the world relative supply of cloth (from
to ) and decrease the world relative demand for cloth (from to ), shifting
equilibrium from point 1 to point 2. A Home export subsidy worsens Home’s terms of
trade and improves Foreign’s.
Implications of Terms of Trade Effects:
Who Gains and Who Loses?
If Home imposes a tariff, it improves its terms of trade at Foreign’s expense. Thus tariffs
hurt the rest of the world. The effect on Home’s welfare is not quite as clear-cut. The terms
of trade improvement benefits Home; however, a tariff also imposes costs by distorting
production and consumption incentives within Home’s economy (see Chapter 9). The
terms of trade gains will outweigh the losses from distortion only as long as the tariff is
RS1 RS2 RD1 RD2
Relative quantity
of cloth,
QC + QC
QF + QF
*
*
Relative price
of cloth, PC /PF
(PC /PF)2
(PC /PF)1
1
RD2
2
RD1
RS2
RS1
Figure 6-9
Effects of a Cloth Subsidy on the
Terms of Trade
An export subsidy on cloth has
the opposite effects on relative
supply and demand than the tariff
on food. Relative supply of cloth
for the world rises, while relative
demand for the world falls.
Home’s terms of trade decline as
the relative price of cloth falls
from (PC/PF)1 to (PC/PF)2.
CHAPTER 6 The Standard Trade Model 127
not too large. We will see later how to define an optimum tariff that maximizes net benefit.
(For small countries that cannot have much impact on their terms of trade, the optimum
tariff is near zero.)
The effects of an export subsidy are quite clear. Foreign’s terms of trade improve at
Home’s expense, leaving it clearly better off. At the same time, Home loses from terms of
trade deterioration and from the distorting effects of its policy.
This analysis seems to show that export subsidies never make sense. In fact, it is difficult
to come up with situations where export subsidies would serve the national interest.
The use of export subsidies as a policy tool usually has more to do with the peculiarities of
trade politics than with economic logic.
Are foreign tariffs always bad for a country and foreign export subsidies always beneficial?
Not necessarily. Our model is of a two-country world, where the other country
exports the good we import and vice versa. In the real, multination world, a foreign government
may subsidize the export of a good that competes with U.S. exports; this foreign
subsidy will obviously hurt the U.S. terms of trade. A good example of this effect is
European subsidies to agricultural exports (see Chapter 9). Alternatively, a country may
impose a tariff on something the United States also imports, lowering its price and benefiting
the United States. We thus need to qualify our conclusions from a two-country
analysis: Subsidies to exports of things the United States imports help us, while tariffs
against U.S. exports hurt us.
The view that subsidized foreign sales to the United States are good for us is not a popular
one. When foreign governments are charged with subsidizing sales in the United States,
the popular and political reaction is that this is unfair competition. Thus when a Commerce
Department study determined that European governments were subsidizing exports of steel
to the United States, our government demanded that they raise their prices. The standard
model tells us that lower steel prices are a good thing for the U.S. economy (which is a net
steel importer). On the other hand, some models based on imperfect competition and
increasing returns to scale in production point to some potential welfare losses from
the European subsidy. Nevertheless, the subsidy’s biggest impact falls on the distribution of
income within the United States. If Europe subsidizes exports of steel to the United States,
most U.S. residents gain from cheaper steel. However, steelworkers, the owners of steel
company stock, and industrial workers in general may not be so lucky.
No comments:
Post a Comment