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P2
P1
Surplus for
consumer D
purchasing quantity
D2 D2 D1 Quantity
The Gains from Trade
• Part (b) of figure 8.1 illustrates producer surplus.
• Remember that the supply curve represents a
firm’s marginal cost of production.
• PS is the difference between MC and price.
• Producer surplus is the area above the supply
curve to the price received, up to the quantity
sold.
• We can also refer to PS as the return to fixed
factors of production in the industry, and can
loosely refer to it as “profit.”
The Gains from Trade
P1
P0
Surplus for firm producing
quantity S0
S0 S1 Quantity
The Gains from Trade
• Home Welfare
Again we consider the world of two countries, Home
and Foreign, with producers and consumers.
Total Home welfare can be measured by adding up
consumer and producer surplus.
We will compare the welfare in Home in no-trade and
free-trade situations.
• No-Trade
Figure 8.2 (a) shows the no-trade equilibrium
Consumer and producer surplus are shown as the
areas defined before. Adding these gives total surplus
for Home before trade.
The Gains from Trade
Figure 8.2
(a) No-Trade
Price
No-trade equilibrium
CS
PA A
PS
Q0 Quantity
The Gains from Trade
PA
S1 D1 Quantity
Imports
The Gains from Trade
S1 D1 Quantity
Imports, M1
The Gains from Trade
B
PW
Import demand
D curve, M
S1 Q0 D1 Quantity M1 Imports
Imports, M1
Import Tariffs for a Small Country
C
PW+t X*+t
B Foreign export
PW supply, X*
D M
S1 S2 D1 Quantity M2 M1 Imports
D2
M2
Import Tariffs for a Small Country
b d
PW+t
a c
PW
S1 S2 D2 D1 Quantity
M2
Import Tariffs for a Small Country
b d
PW+t
a c
PW
S1 S2 D2 D1 Quantity
M2
Import Tariffs for a Small Country
S1 S2 D2 D1 Quantity
M2
Import Tariffs for a Small Country
• Overall Effect of the Tariff on Welfare
• Note, we do not care whether the consumers facing higher
prices are rich or poor, and do not care whether the
specific factors in the industry earn a lot or a little.
• The overall impact of the tariff in the small country can be
summarized as follows:
Fall in consumer surplus -(a+b+c+d)
Rise in producer surplus +a
Rise in government revenue +c
Net effect on Home welfare -(b+d)
b d c is a transfer from
PW+t consumers to government
a c (b+d) is deadweight loss—
PW losses not offset by other
gains
S1 S2 D2 D1 Quantity
M2
Import Tariffs for a Small Country
Figure 8.5 (b)
Price
X*+ t
C
X*
M
M2 M1 Imports
Import Tariffs for a Small Country
APPLICATION
• We will estimate the deadweight loss due to the
U.S. steel tariff in place from March 2002 to
December 2003.
• President Bush requested that the U.S.
International Trade Commission (ITC) initiate a
Section 201 investigation into the steel industry.
• The tariffs varied across products, ranging from
10 to 20%—shown in Table 8.1—then falling over
time to be eliminated after 3 years.
U.S. Tariffs on Steel
APPLICATION
• President Bush took the recommendation of the
ITC but applied even higher tariffs, ranging from
8% to 30%.
• Knowing the U.S. trading partners would be upset
by this, President Bush exempted some countries
from the tariffs.
These included Canada, Mexico, Jordan, and Israel,
which all have free trade agreements with the U.S., and
100 small developing countries that were exporting only
a very small amount of steel to the U.S.
U.S. Tariffs on Steel
APPLICATION
Table 8.1
U.S. Tariffs on Steel
APPLICATION
• Deadweight Loss due to the Steel Tariff
We need to estimate the areas of triangle b+d we found in figure
8.5(b).
The base is the change in imports, ΔM, and the height is the
increase in domestic price, ΔP = t.
We will also use the percentage tariff, t/PW, and the percentage
change in the quantity of imports, % ΔM = ΔM/M.
U.S. Tariffs on Steel
APPLICATION
PW+t
t c
PW
M2 M1 Imports
ΔM
U.S. Tariffs on Steel
APPLICATION
• Using these definitions, the deadweight loss
relative to the value of imports can be rewritten
as:
DWL 1 tM 1 t
W W %M
P M 2 P M 2 P
W
APPLICATION
B*
PW
Home import
PA* demand, M
A*'
A*
S X*+t
A
t X*
C
P*+t
t PW
t
B*
P*
D C*
S1 S2 D2 D1 Quantity M2 M1 Imports
M2
M1
Import Tariffs for a Large Country
• Home Welfare
The higher Home price makes consumers worse off,
lowering consumer surplus (shown by (a+b+c+d) in
figure 8.7).
Since P* is lower than PW Home firms are better off with
the higher price and increased surplus, a.
Revenue collected from the tariff equals the amount of
the tariff, t, times the new amount of imports, M2, giving
total revenue of (c+e).
Summing all the gains and losses, we obtain the overall
impact of the tariff in the large country.
Import Tariffs for a Large Country
• Home Welfare
Fall in consumer surplus -(a+b+c+d)
Rise in producer surplus +a
Rise in government revenue +(c + e)
Net effect on Home welfaree – (b+d) + (e)
X*+t
S
b+d t X*
A
C
P*+t
a b c d
PW B*
P*
e e C*
D
M
S1 S2 D2 D1 Quantity M2 M1 Imports
Import Tariffs for a Large Country
• Home welfare may improve, but it comes at the expense of
foreign exporters.
X*+t
S
b+d t X*
A
C
P*+t
a b c d
PW B*
P*
e e f
D C*
M
S1 S2 D2 D1 Quantity M2 M1 Imports
U.S. Tariffs on Steel Once Again
APPLICATION
• Returning to the U.S. tariff on steel, we can
reevaluate the effect on U.S. welfare in the large-
country case.
• If the U.S. is a large enough importer of steel,
then the foreign export price will fall and the U.S.
import price will rise by less than the tariff.
It is possible that the U.S. gained from the tariff.
U.S. Tariffs on Steel Once Again
APPLICATION
• Optimal Tariff
Compute the deadweight loss (area b+d) and the terms-of-
trade gain (area e) for each imported steel product.
Figure 8.8 graphs Home welfare against the level of the tariff.
U.S. Tariffs on Steel Once Again
A
No Trade
APPLICATION
APPLICATION
• Optimal Tariffs for Steel
If we apply this formula to the U.S. steel tariffs, we can
see how the tariffs applied compare to the theoretical
optimal tariff.
Table 8.2 shows various steel products along with their
respective elasticities of export supply to the U.S.
We can compare the actual tariff to the optimal tariff to
see where there were gains and where there were
losses from the tariffs.
But what about retaliation?...
U.S. Tariffs on Steel Once Again
APPLICATION
Table 8.2
Import Quotas
HEADLINES
• The current U.S. sugar program guarantees that
American sugar producers receive a set price for
their product.
• If they are not able to sell all their sugar at the
“break-even” price after accounting for their loans,
they can sell the excess to the U.S. Department of
Agriculture.
• To keep from storing a large stock of sugar, the
U.S. regulates supply by imposing import quotas
on sugar.
Sweet Opportunity
HEADLINES
• But, the U.S. price of sugar has been two to three
times higher than the world price of sugar for
about 25 years.
• The longer the protection holds, the more
inefficient the U.S. producers become, and the
more powerful they become as a special interest
group.
• Given that the current world price of sugar has
increased and put foreign producers on par with
the U.S., there is an opportunity to do away with
the sugar program.
Import Quotas
Foreign export
B supply, X*
PW
Home import
D demand, M
S1 D1 Quantity M1 Imports
M1
(a) Home market (b) Import market
Import Quotas
S
Price Price
X
F
o
A r
b d e
i C b+d
P2 g
a c c n Foreign export
e B supply, X*
PW
x
p
Home import
o
D demand, M
r
Quantity t
S1 S2 D2 D1 M M1 Imports
s 2
u
(a) Home market p Import market
(b)
p
l
Import Quotas
• There are four possible ways these rents can be
allocated.
1. Giving the Quota to Home Firms:
Quota licenses can be given to Home firms
Permits to import the quantity allowed under the quota system.
The net effects on Home welfare due to the quota are then as
follows:
Fall in consumer surplus -(a+b+c+d)
Rise in producer surplus +a
Quota rents earned at Home +c
Net effect on Home welfare: -(b+d)
This is the same loss we saw with a tariff.
(b+d) is still a deadweight loss associated with the quota.
Import Quotas
2. Rent Seeking
Because of the gains associated with owning a quota
license, firms have an incentive to engage in
inefficient activities in order to obtain them.
Table 8.3
Auctioning Import Quotas in
Australia and New Zealand
APPLICATION
Table 8.4
China and the Multifibre Arrangement
APPLICATION
• One of the principles of GATT was that countries should
not use quotas to restrict imports.
• The MFA was a major exception to that which allowed the
industrialized countries to restrict imports of textile and
apparel products from the developing countries.
• Organized under GATT, importing countries could join the
MFA and arrange quotas bilaterally or unilaterally.
• Under the Uruguay round of WTO, developing countries
were able to negotiate an end to this system of import
quotas.
• Some developing countries and large producers in
importing countries were concerned with the potential of
Chinese exports on their economies.
China and the Multifibre Arrangement
APPLICATION
• Growth in Exports from China
Immediately after January 1, 2005, exports of textiles
and apparel from China grew rapidly.
In 2005, China’s textile and apparel imports to the U.S.
rose by more than 40% compared to 2004.
Figure 8.10 (a) shows the change in the value of
exports of textiles and apparel from different countries.
Note China.
The increases from China came at the expense of
some higher-cost exporters, some of whose exports to
the U.S. declined by 10 to 20%.
China and the Multifibre Arrangement
APPLICATION
Figure 8.10
China and the Multifibre Arrangement
APPLICATION
• Panel (b) of figure 8.10 shows the percentage
change in the prices of textiles and apparel
products from each country, depending on
whether the products were subject to the MFA
quota before January 1, 2005, or not.
• China had the largest drop in the prices from 2004
to 2005.
• Many other countries had a substantial fall in their
prices due to the end of the MFA quota.
China and the Multifibre Arrangement
APPLICATION
Figure 8.10
China and the Multifibre Arrangement
APPLICATION
• Welfare Cost of the MFA
Given the drop in prices in 2005, it is possible to
estimate the welfare loss due to the MFA.
Using the price drops from figure 8.10, the welfare loss
for the U.S. (b+c+d), is estimated at $6.5 to $16.2
billion in 2005 from the MFA.
APPLICATION
• Import Quality
Quotas are set on the quantity, not the quality of items imported.
Selling a higher value good for the same quantity will still meet the
quota limit but will bring more money back home.
Incentive to export higher quality products.