Government Intervention in Government Intervention in International TradeInternational Trade

Activity 51Activity 51

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Advanced Placement Economics Teacher Resource Advanced Placement Economics Teacher Resource ManualManual. National Council on Economic Education, . National Council on Economic Education,

New York, N.YNew York, N.Y

ObjectivesObjectives

Define Define tariffs, quotas tariffs, quotas andand regulations to limit trade.regulations to limit trade.

Describe policies that are intended to Describe policies that are intended to protect the domestic economy from protect the domestic economy from the effects of international trade.the effects of international trade.

Explain the effects of tariffs, quotas Explain the effects of tariffs, quotas and subsidies on domestic and subsidies on domestic production and the prices domestic production and the prices domestic consumers pay.consumers pay.

Government Intervention in Government Intervention in International TradeInternational Trade

The last lesson demonstrated the The last lesson demonstrated the benefits of trade among nations, benefits of trade among nations, showing that total output increased. showing that total output increased. Nevertheless, most nations attempt to Nevertheless, most nations attempt to create barriers to trade using tariffs, create barriers to trade using tariffs, quotas or regulations. quotas or regulations.

Trade barriers limit the gains from trade Trade barriers limit the gains from trade and tend to reduce competition and and tend to reduce competition and economic efficiency.economic efficiency.

Government Intervention in Government Intervention in International TradeInternational Trade

Tariff – “a tax levied on imports” Tariff – “a tax levied on imports” (Krugman 450)(Krugman 450) Example: The United States imposes a tariff of more than 10% Example: The United States imposes a tariff of more than 10%

on imports of textiles and shoes.on imports of textiles and shoes. Quotas – “a proportional part or share of a fixed Quotas – “a proportional part or share of a fixed

total amount or quantity.” total amount or quantity.” ((“Quota”)“Quota”) A good example of a quota is the voluntary export restraint A good example of a quota is the voluntary export restraint

(VER) Japan agreed to in the 1980’s limiting the number of cars (VER) Japan agreed to in the 1980’s limiting the number of cars it exported to the U.S. it exported to the U.S.

Import quota – “a legal limit on the quantity of a Import quota – “a legal limit on the quantity of a good that can be imported” good that can be imported” (Krugman 452)(Krugman 452)

Example of a Example of a regulation to limit traderegulation to limit trade is the is the Federal Drug Administration’s test requirements Federal Drug Administration’s test requirements on pharmaceuticals imported into the United on pharmaceuticals imported into the United StatesStates

Domestic and Foreign SupplyDomestic and Foreign Supply

For domestic consumers, the price is For domestic consumers, the price is higher and the quantity available is higher and the quantity available is smaller than under free trade.smaller than under free trade.

PR

ICE

QUANTITY

Domestic Supply

Total Supply

Domestic Demand

Total Supply with Tariff

P

P1

P2

q q1q2

Arguments in support of limitations on Arguments in support of limitations on trade:trade: the national defense argumentthe national defense argument the infant industry argumentthe infant industry argument the “dumping” argumentthe “dumping” argument preservation of domestic jobspreservation of domestic jobs maintenance of diverse and stable economy maintenance of diverse and stable economy prevention of exploitationprevention of exploitation

Most of these arguments do not stand up Most of these arguments do not stand up to scrutiny.to scrutiny.

Limitations on trade fundamentally allow Limitations on trade fundamentally allow domestic producers to be inefficient and domestic producers to be inefficient and increase the costs to domestic consumers.increase the costs to domestic consumers.

History of Tariffs in U.S.History of Tariffs in U.S.

The Smoot-Hawley Act of 1930, tariffs The Smoot-Hawley Act of 1930, tariffs reached a high average rate of 20%reached a high average rate of 20%

Over time, the United States has Over time, the United States has attempted to reduce tariffs using trade attempted to reduce tariffs using trade agreements such as the North American agreements such as the North American Free Trade Agreement (NAFTA)Free Trade Agreement (NAFTA)

In the Uruguary Round (1986 to 1994) of In the Uruguary Round (1986 to 1994) of World Trade Organization negotiations, the World Trade Organization negotiations, the U.S. negotiated its lowest rate ever.U.S. negotiated its lowest rate ever.

Barriers to TradeBarriers to TradeActivity 51Activity 51

The free trade movement started about The free trade movement started about 200 years ago. Previously, it appears that 200 years ago. Previously, it appears that one of the goals of governments was to one of the goals of governments was to stifle international trade, presumably for stifle international trade, presumably for the benefit of their own economies. the benefit of their own economies.

Over the last 50 years, there have been Over the last 50 years, there have been efforts to reduce trade barriers, with efforts to reduce trade barriers, with significant success during the 1990s. significant success during the 1990s.

Examples of these efforts include the North Examples of these efforts include the North American Free Trade Agreement (NAFTA), American Free Trade Agreement (NAFTA), the World Trade Organization (WTO), the the World Trade Organization (WTO), the European Union (EU) and the Asia-Pacific European Union (EU) and the Asia-Pacific Economic Cooperation (APEC) forum.Economic Cooperation (APEC) forum.

Barriers to TradeBarriers to TradeActivity 51Activity 51

We want to be able to investigate the economic We want to be able to investigate the economic effects of various barriers to trade that a nation effects of various barriers to trade that a nation might impose to protect domestic industries. might impose to protect domestic industries.

In Fig. 51.1, the demand curve represents the In Fig. 51.1, the demand curve represents the demand by the domestic economy for a demand by the domestic economy for a commodity that is produced domestically and also commodity that is produced domestically and also imported. imported.

The domestic supply curve indicates what the The domestic supply curve indicates what the domestic suppliers are willing and able to produce domestic suppliers are willing and able to produce at alternative prices. at alternative prices.

If there were no international trade or a complete If there were no international trade or a complete ban on imports, the equilibrium price would be P, ban on imports, the equilibrium price would be P, and the equilibrium quantity, Q, would be and the equilibrium quantity, Q, would be produced only by domestic firms.produced only by domestic firms.

If there is free international trade, the Total Supply If there is free international trade, the Total Supply curve represents the production by domestic and curve represents the production by domestic and foreign producers. Domestic consumers would pay pforeign producers. Domestic consumers would pay p11 and consumer qand consumer q11: : They are able to consume more of the commodity at a lower They are able to consume more of the commodity at a lower

price. price. Also, at p1 , domestic firms are producing q and foreign Also, at p1 , domestic firms are producing q and foreign

producers are producing (qproducers are producing (q1 – q – q2).). Thus, domestic firms are producing less under free trade than Thus, domestic firms are producing less under free trade than

they would if the nation did not import the commodity.they would if the nation did not import the commodity.

Fig. 51.1

PR

ICE

QUANTITY

Domestic Supply

Total Supply

Domestic Demand

q q1q2

PP1

Part A: QuotasPart A: Quotas

Instead of permitting free trade or Instead of permitting free trade or imposing a complete ban, a nation may imposing a complete ban, a nation may decide to set a quota to limit the decide to set a quota to limit the number of imports. Import quotas are number of imports. Import quotas are sometimes referred to as sometimes referred to as voluntary voluntary export restraintsexport restraints (VERs) because the (VERs) because the two countries have agreed that the two countries have agreed that the exporting nation will not export more exporting nation will not export more than a certain amount.than a certain amount.

We can see the effect of an import quota by looking at Fig. 51.2. We can see the effect of an import quota by looking at Fig. 51.2. Here the domestic price would be ‘p’ and the quantity would be Here the domestic price would be ‘p’ and the quantity would be ‘q’ if there were a complete import ban, If there were free ‘q’ if there were a complete import ban, If there were free trade, the price would be ptrade, the price would be p11 and the quantity demanded by and the quantity demanded by domestic consumers would be qdomestic consumers would be q11..

Notice that under free trade, the entire market is supplied by Notice that under free trade, the entire market is supplied by foreign producers as the market is drawn. This does not have foreign producers as the market is drawn. This does not have to be the case; it depends on the costs of the domestic industry to be the case; it depends on the costs of the domestic industry and the domestic industry’s ability to sell at the lower price.and the domestic industry’s ability to sell at the lower price.

PR

ICE

QUANTITY

Domestic Supply

Total Supply

Domestic Demand

P

P1

q q1

Fig. 51.2

Suppose the importing nation imposes a quota, or VER, of X Suppose the importing nation imposes a quota, or VER, of X amount; the Total Supply with Quota curve represents the new amount; the Total Supply with Quota curve represents the new supply curve. Total Supply with Quota is the domestic supply supply curve. Total Supply with Quota is the domestic supply curve plus X amount at every price level (X = qcurve plus X amount at every price level (X = q22 – q – q33 ). ).

The domestic price has risen from pThe domestic price has risen from p11 to p to p22 and consumers are and consumers are able to purchase less of the commodity.able to purchase less of the commodity.

Equilibrium quantity has decreased from qEquilibrium quantity has decreased from q11 units to q units to q22 units. units. However, domestic producers are now producing q units, and However, domestic producers are now producing q units, and foreign producers are supplying X = qforeign producers are supplying X = q22 – q– q33..

PR

ICE

QUANTITY

Domestic Supply

Total Supply

Domestic Demand

P

P1

P2

q q1q2

Total Supply with Quota

q3

Fig. 51.2

Use Fig. 51.3 to demonstrate what will happen to Use Fig. 51.3 to demonstrate what will happen to the domestic price, domestic production and the the domestic price, domestic production and the amount of imports if a quota is removed. The amount of imports if a quota is removed. The Domestic Supply and Total Supply curves on the Domestic Supply and Total Supply curves on the graph are without any barriers to trade imposed. graph are without any barriers to trade imposed. Be sure to show on the graph the supply curve Be sure to show on the graph the supply curve with quota. It is not on the graph now.with quota. It is not on the graph now.

PR

ICE

QUANTITY

Domestic Supply

Total Supply

Domestic Demand

P

P1

q q1

Fig. 51.3

If there were a complete import ban, the equilibrium domestic If there were a complete import ban, the equilibrium domestic price would be ‘p’ and the equilibrium quantity would be ‘q’ price would be ‘p’ and the equilibrium quantity would be ‘q’ with the commodity completely produced by the domestic with the commodity completely produced by the domestic industry. industry.

If there were a partial quota, the supply curve labeled Total If there were a partial quota, the supply curve labeled Total Supply with Quota would be the relevant curve. The domestic Supply with Quota would be the relevant curve. The domestic price and quantity would be pprice and quantity would be p22 and q and q22. The amount of the . The amount of the quota would be (qquota would be (q22 – q – q33). Domestic production will be q). Domestic production will be q33. . Removing the quota and moving to the free trade equilibrium, Removing the quota and moving to the free trade equilibrium, the domestic consumers will pay pthe domestic consumers will pay p11 and purchase q and purchase q11. .

Removal of a quota has led to a decrease in price and an Removal of a quota has led to a decrease in price and an increase in the quantity consumed. In the case illustrated, increase in the quantity consumed. In the case illustrated, there will be zero domestic production under free trade.there will be zero domestic production under free trade.

PR

ICE

Domestic Supply

Total Supply

Domestic Demand

P

P1

P2

q q1q2

Total Supply with Quota

q3

QUANTITY

Fig. 51.3

2.2. Write a paragraph summarizing the advantages Write a paragraph summarizing the advantages and disadvantages of a quota to the domestic and disadvantages of a quota to the domestic economy. Be sure to discuss the impact on economy. Be sure to discuss the impact on domestic consumers, domestic producers and domestic consumers, domestic producers and foreign producers.foreign producers.

3.3. If a quota is imposed, explain the methods If a quota is imposed, explain the methods people would use to circumvent the effects of people would use to circumvent the effects of the quota.the quota.

The advantage of a quota are that the domestic industry will be able to produce more and receive a higher price for the commodity relative to the free trade equilibrium, and employment in that industry is greater with quota than without a quota. The disadvantage are that consumers pay a higher price and cannot consume as much of the commodity as at the free trade equilibrium. Foreign producers receive a higher price but produce less with a quota than under free trade.

An underground market may develop for the commodity. Foreign firms may open factories or assembly plants in the domestic nation and produce the commodity there so that production won’t be subject to the quota.

Part B: TariffsPart B: Tariffs

A tariff is a tax on an import. The A tariff is a tax on an import. The imposition of a tax increases the cost imposition of a tax increases the cost of each unit, which is represented by of each unit, which is represented by a decrease in supply. This would a decrease in supply. This would result in an increase in equilibrium result in an increase in equilibrium price and a decrease in equilibrium price and a decrease in equilibrium quantity.quantity.

4.4. Modify Fig. 51.4 to show the effect of an import Modify Fig. 51.4 to show the effect of an import tariff of $7 per unit. Be sure to show on the graph tariff of $7 per unit. Be sure to show on the graph the amount of the tariff. Add one curve to the the amount of the tariff. Add one curve to the graph, and label it Total Supply with Tariff. After graph, and label it Total Supply with Tariff. After the imposition of the tariff, label the new the imposition of the tariff, label the new equilibrium price ‘pequilibrium price ‘pTT’ and the equilibrium quantity ’ and the equilibrium quantity ‘q‘qTT’.’.

PR

ICE

Domestic Supply

Total Supply

Domestic Demand

P

P1

PT

q q1qT

Total Supply with Tariff

q2

Fig. 51.4

Tariff = $T

QUANTITY

The imposition of a tariff causes the total supply to decrease because the tariff has caused the price to increase at every level of output. Q2 is the amount of domestic production after the tariff. The tariff is the vertical distance between the total Supply and the Total Supply with Tariff curves indicated by an arrow on the graph.

5.5. What is the effect of the tariff on the What is the effect of the tariff on the equilibrium price and quantity for equilibrium price and quantity for domestic consumers compared with the domestic consumers compared with the free trade levels?free trade levels?

PR

ICE

Domestic Supply

Total Supply

Domestic Demand

P

P1

PT

q q1qT

Total Supply with Tariff

q2 QUANTITY

The equilibrium quantity decreases to ‘qT ‘, and the equilibrium price increases to ‘pT ‘. Note that domestic industry is not producing. How far the curve shifts (how large the tariff is) determines whether domestic firms are producing any output.

6.6. What are the similarities between the What are the similarities between the effects of a quota and those of a tariff?effects of a quota and those of a tariff?

Both a quota and a tariff raise the price and limit the quantity to domestic consumers relative to the free trade equilibrium. Foreign firms produce less under either a quota or a tariff.

7.7. What is the primary difference between the What is the primary difference between the effects of a quota and those of a tariff.effects of a quota and those of a tariff.

8.8. Suppose a country can impose either a Suppose a country can impose either a quota that raises the domestic price to ‘pquota that raises the domestic price to ‘p₂’₂’ as in Fig. 51.2 or a tariff that raises the as in Fig. 51.2 or a tariff that raises the domestic price ‘pdomestic price ‘p₂’₂’. Explain whether . Explain whether domestic consumers would prefer a tariff or domestic consumers would prefer a tariff or a quota and why.a quota and why.

With a quota, all of the revenue generated by the price increase goes to the producers. With a tariff, the government receives the tax revenue.

Domestic consumers would prefer a tariff because the domestic government receives the revenue as opposed to the producers (domestic and foreign.). Consumers might expect that the overall level of taxes would then decrease. The tariff tax revenue would substitute for other tax revenue.

Part C: Export SubsidiesPart C: Export Subsidies

Nations may choose to assist Nations may choose to assist domestic industries by providing domestic industries by providing subsidies to an industry. The subsidies to an industry. The subsidies would lower the costs and subsidies would lower the costs and permit the industry to sell at a lower permit the industry to sell at a lower price. This assistance is called an price. This assistance is called an export subsidyexport subsidy because the industry because the industry can now compete on the world can now compete on the world market and export some of its market and export some of its product to other nations.product to other nations.

9.9. Modify Fig. 51.5 to show the effects of an export Modify Fig. 51.5 to show the effects of an export subsidy on domestic producers. Indicate as ‘psubsidy on domestic producers. Indicate as ‘pSS ’ ’ and ‘qand ‘qSS’ the equilibrium price and quantity for ’ the equilibrium price and quantity for domestic consumers after an export subsidy. domestic consumers after an export subsidy. Add two curves to the graph: a Domestic Supply Add two curves to the graph: a Domestic Supply with Subsidy curve and a total supply with with Subsidy curve and a total supply with Subsidy curve.Subsidy curve.

PR

ICE

QUANTITY

Domestic Supply

Total Supply

Domestic Demand

P

P1

q q1

Fig. 51.5

The equilibrium without subsidy would result in a The equilibrium without subsidy would result in a price of Pprice of P11 and a quantity of Q and a quantity of Q11 and the domestic and the domestic economy would be producing Qeconomy would be producing Q22. With the subsidy . With the subsidy to the domestic industry, the equilibrium would to the domestic industry, the equilibrium would result in a price of Presult in a price of PSS and a quantity of Q and a quantity of QSS, and the , and the domestic economy would be producing Q. The domestic economy would be producing Q. The quantity supplied by foreign producers is (Qquantity supplied by foreign producers is (QSS – Q – Q33).).

PR

ICE

QUANTITY

Domestic Supply without Subsidy

Total Supply without Subsidy

Domestic Demand

P

P1

q q1

Fig. 51.5

PS

q2 qSq3

Domestic Supply with Subsidy

Total Supply with Subsidy

According to Fig. 51.5 with your According to Fig. 51.5 with your modifications, what would be the modifications, what would be the equilibrium price and quantity forequilibrium price and quantity for

(A)(A) a completely closed economy (no a completely closed economy (no imports and no subsidy)? imports and no subsidy)? ________________________

(B)(B) An open economy (completely free An open economy (completely free trade with no export subsidy? trade with no export subsidy? __________________________

(C)(C) An open economy with a domestic An open economy with a domestic export subsidy? ____________export subsidy? ____________

P and Q

P1 and Q1

PS and QS

10.10. What is the effect of an export subsidy What is the effect of an export subsidy on the equilibrium price and quantity for on the equilibrium price and quantity for domestic consumers relative to the free domestic consumers relative to the free trade equilibrium without a subsidy?trade equilibrium without a subsidy?

11.11. If an industry receives a subsidy, what If an industry receives a subsidy, what will happen at the equilibrium to will happen at the equilibrium to domestic production and the amount of domestic production and the amount of imports?imports?

The price is lower and the quantity is greater.The price is lower and the quantity is greater.

Fig. 51.5 – The free trade equilibrium without subsidy would result in a Fig. 51.5 – The free trade equilibrium without subsidy would result in a price of Pprice of P11 and a quantity of Q and a quantity of Q11 and the domestic economy would be and the domestic economy would be producing Qproducing Q22. With the subsidy to the domestic industry, the . With the subsidy to the domestic industry, the equilibrium would result in a price of Pequilibrium would result in a price of PSS and a quantity of Q and a quantity of QSS, and the , and the domestic economy would be producing Qdomestic economy would be producing Q33. With the subsidy, . With the subsidy, domestic production increases. The exact impact on imports depends domestic production increases. The exact impact on imports depends on the extent of the subsidy and the demand curve for the on the extent of the subsidy and the demand curve for the commodity.commodity.

Part D: Part D: ApplicationsApplications

12.12. One of the goals of the European One of the goals of the European Union is the elimination of trade Union is the elimination of trade barriers among the member nations.barriers among the member nations.

Consumers who buy the commodity will benefit by Consumers who buy the commodity will benefit by having lower prices and a greater quantity of the having lower prices and a greater quantity of the commodity. Domestic producers of imported commodity. Domestic producers of imported commodities will lose since the price will decrease as commodities will lose since the price will decrease as trade barriers are reduced and domestic producers trade barriers are reduced and domestic producers will produce less at the lower price. A second result will produce less at the lower price. A second result of the reduced production is that employment in this of the reduced production is that employment in this industry will decrease. However, the economy will be industry will decrease. However, the economy will be more efficient, and the standard of living will more efficient, and the standard of living will increase.increase.

13.13. Identify the arguments frequently used to Identify the arguments frequently used to impose some type of trade barrier. Discuss the impose some type of trade barrier. Discuss the pros and cons of three arguments.pros and cons of three arguments.

Protection of specific industries from foreign competition:Protection of specific industries from foreign competition: An industry may argue An industry may argue that it cannot compete with foreign producers and that this competition will have that it cannot compete with foreign producers and that this competition will have an impact on wages and employment. The costs to domestic consumers are the an impact on wages and employment. The costs to domestic consumers are the higher prices and restricted quantity. Most governments that favor unrestricted higher prices and restricted quantity. Most governments that favor unrestricted trade will offer short-term protection to allow the industry to adjust.trade will offer short-term protection to allow the industry to adjust.

National defense and other noneconomic considerations:National defense and other noneconomic considerations: Some industries produce Some industries produce defense items and thus should not be driven out of business by foreign competition. defense items and thus should not be driven out of business by foreign competition. This is a noneconomic reason for protecting an industry. The problem with this This is a noneconomic reason for protecting an industry. The problem with this argument is that the number of industries to which protection is extended may be argument is that the number of industries to which protection is extended may be quite large. The U. S. restricts endangered-species imports for noneconomic quite large. The U. S. restricts endangered-species imports for noneconomic reasons.reasons.

Infant Industry:Infant Industry: Start-up industries argue that, to develop, they need protection from Start-up industries argue that, to develop, they need protection from foreign competition. Support for this argument is valid only if the expected future foreign competition. Support for this argument is valid only if the expected future benefits exceed the up-front costs of protectionism. Another argument against benefits exceed the up-front costs of protectionism. Another argument against infant industry protection is that the industry may “never grow up.”infant industry protection is that the industry may “never grow up.”

Wage or employment protection:Wage or employment protection: With low prices on imports, domestic workers will With low prices on imports, domestic workers will lose their jobs and unemployment will rise. The economy as a whole benefits from lose their jobs and unemployment will rise. The economy as a whole benefits from low prices and increased quantity of goods. The government response could be to low prices and increased quantity of goods. The government response could be to retrain the affected workers and to provide adequate monetary and fiscal policies retrain the affected workers and to provide adequate monetary and fiscal policies to maintain domestic growth and employment.to maintain domestic growth and employment.

Works CitedWorks Cited

Krugman, Paul and Robin Wells. Krugman, Paul and Robin Wells. “Macroeconomics.”“Macroeconomics.” New York. Worth New York. Worth Publishers. 2006.Publishers. 2006.

““Quota.“ Quota.“ Dictionary.com Unabridged (v 1.1)Dictionary.com Unabridged (v 1.1)Based on the Random House Based on the Random House

Unabridged Dictionary, © Random Unabridged Dictionary, © Random House, House, Inc. 2006. Inc. 2006. http://dictionary.reference.com/browsehttp://dictionary.reference.com/browse/quota/quota