Chapter 58: Trade Policy, Integration, Tariffs, and Welfare. The Encyclopedia of Economic Principals, interactive companion

Demonstration 1 of 4

A tariff that pays the large buyer

When can a large importer gain from a tariff at its suppliers' expense?

A large buyer that cuts its purchases pushes down the price foreign suppliers accept. That price concession on the units still bought is the gain; the units no longer traded are the loss.

$Equation, written in LaTeX: t^*=\frac{1}{8}=0.125,$

Equation, written in LaTeX: p=1.125(19.75)=22.21875.

Equation, written in LaTeX: 0.25(108)=27.

$Equation, written in LaTeX: \frac{1}{2}(12)(2.46875)=14.8125.$

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The country imports 120 units at foreign price 20 and sets a 12.5 percent tariff. eps is the elasticity of foreign export supply; the import contraction is an assumed response, and the foreign price falls by the contraction divided by eps.

Predict first. If foreign supply is very elastic (eps = 16) and imports fall 10 percent, does the 12.5 percent tariff still pay?

Your prediction Yes, the national gain stays positive No, the national gain turns negative

Foreign supply elasticity

Import contraction

Figure: A tariff that pays the large buyer. Import market with the foreign supply curve. A 12.5 percent tariff cuts imports to 108 and the foreign price to 19.7500; the gain rectangle is 27.0000 and the distortion triangle 14.8125. — Foreign supply elasticity: 8, Import contraction: 10%
Constructed example: the chapter's hypothetical large buyer (120 units at 20, eps 8, 10 percent contraction); elasticities of 4 and 16 and contractions of 5 and 20 percent are added for comparison.

Foreign price p*: 19.7500
Home price: 22.21875
Terms-of-trade gain: 27.0000
Distortion: 14.8125
National gain: 12.1875
Benchmark t* = 1/eps: 0.1250

Imports fall 10 percent to 108 and the foreign price falls 10 / 8 = 1.2500 percent to 19.7500. The home price is 1.125 x 19.7500 = 22.21875. Gain = 0.2500 x 108 = 27.0000; distortion = 0.5 x 12 x 2.46875 = 14.8125; national gain = 27.0000 - 14.8125 = 12.1875, so the tariff pays the importing country.

Worked steps

p* = 20 x (1 - 1.2500%) = 19.7500
Home price = 1.125 x 19.7500 = 22.21875
Gain = 0.2500 x 108 = 27.0000
Distortion = 0.5 x 12 x 2.46875 = 14.8125
Net = 27.0000 - 14.8125 = 12.1875

Use the idea

Before arguing for a terms-of-trade tariff, estimate how much the foreign price really responds and set it against the lost trade.

Where the conclusion applies

Linear approximation, an assumed import response, no administration cost and no retaliation. Global welfare falls by the distortion even when the country gains.

Check your understanding: With eps = 16 and a 10 percent contraction, what is the national gain at t = 12.5 percent?

p* = 19.875; gain 0.125 x 108 = 13.5; wedge 0.125 x 19.875 = 2.484375; triangle 0.5 x 12 x 2.484375 = 14.906; net 13.5 - 14.906 = -1.41.

Chapter 58 source: section "Optimal-tariff argument".

Demonstration 2 of 4

When depreciation improves the trade balance

Does a 20 percent depreciation turn the trade balance positive?

Depreciation raises the domestic cost of each import. The balance improves only if volumes respond enough: roughly when the export and import elasticities sum to more than one.

$Equation, written in LaTeX: P_XX=5(224)=1{,}120$

$Equation, written in LaTeX: eP_M^*M=6(176)=1{,}056.$

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Exporters sell X units at P_X = 5 domestic units; residents import M units at P_M* = 5 foreign units. The exchange rate e rises from 1 to 1.20 with full pass-through. TB = P_X X - e P_M* M.

Predict first. Does a 20 percent depreciation always improve the trade balance?

Your prediction Yes, always No, it depends on the volume responses

Export volume after

Import volume after

Figure: When depreciation improves the trade balance. Bars of export receipts and import spending: 1,000 each before; 1,120 and 1,056 after the depreciation, a trade balance of 64. — Export volume after: 224, Import volume after: 176
Constructed example: the chapter's hypothetical flows (200 each at 5; after depreciation 224 and 176, or 206 and 194); volumes of 215 exports and 185 imports are added for comparison.

Export receipts: 1,120
Import spending: 1,056
Trade balance: 64
eps_X: 0.62
eps_M: 0.70
eps_X + eps_M: 1.32

Exports earn 5 x 224 = 1,120; imports cost 1.20 x 5 x 176 = 6 x 176 = 1,056, so TB = 1,120 - 1,056 = 64, a surplus. Midpoint elasticities are 0.62 and 0.70, summing to 1.32.

Worked steps

P_X X = 5 x 224 = 1,120
e P_M* M = 6 x 176 = 1,056
TB = 1,120 - 1,056 = 64
eps_X = (24 / 212) / (0.8333 / 4.5833) = 0.62
eps_M = (24 / 188) / (1 / 5.5) = 0.70

Use the idea

Judge a depreciation by estimated volume responses, not by the price change alone.

Where the conclusion applies

Full pass-through to import prices, export prices fixed in domestic currency and a starting balance of zero. Volumes are assumed outcomes.

Check your understanding: With 206 exports and 194 imports, what is the trade balance?

5 x 206 - 6 x 194 = 1,030 - 1,164 = -134.

Chapter 58 source: section "Marshall-Lerner condition".

Demonstration 3 of 4

Creation versus diversion

Does a free trade agreement raise welfare just because partner trade grows?

Switching from costly home output to a cheaper partner saves resources (creation). Switching from the cheapest outsider to a dearer partner only because its tariff vanished wastes resources and tariff revenue (diversion).

Equation, written in LaTeX: 12(80)=960.

Equation, written in LaTeX: (13-11.50)(120)=180,

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Product C: home cost 16, partner 12, outsider 11, tariff 6, 80 units. Product D: no home output, outsider 9, partner cost and tariff set below, 120 units. The agreement removes the tariff on the partner only; quantities are fixed.

Predict first. Does more partner trade guarantee a welfare gain?

Your prediction Yes No

Partner cost for product D

Tariff on product D

Figure: Creation versus diversion. Bars: creation in C 320, D buyer saving 180, D lost revenue -480, D net -300, total 20. — Partner cost for product D: 11.50, Tariff on product D: 4
Constructed example: the chapter's hypothetical products C and D (partner 11.50, tariff 4 in D); partner costs of 9.5 and 12.5 and tariffs of 2 and 6 in D are added for comparison.

Creation (C): 320
D buyers switch: yes
D welfare change: -300
Net welfare: 20

In C buyers move from home output at 16 to the partner at 12: (16 - 12) x 80 = 320. In D the partner's 11.50 beats the outsider's delivered 9 + 4 = 13.00, so buyers switch: saving (13.00 - 11.50) x 120 = 180, lost revenue 4 x 120 = 480, net -300. Net: 320 + (-300) = 20.

Worked steps

C: 16 x 80 - 12 x 80 = 1,280 - 960 = 320
D: outsider delivered 9 + 4 = 13.00; partner 11.50
D: 180 - 480 = -300
Net = 320 + (-300) = 20

Use the idea

Evaluate a trade agreement product by product: ask whether the new source is cheaper in resource cost, not just in delivered price.

Where the conclusion applies

Fixed quantities, constant costs and tariff revenue valued one for one. With demand responses, extra consumption gains would be added.

Check your understanding: If the partner's cost for D were 12.5 with tariff 4, do buyers switch, and what is D's welfare change?

Delivered outsider 13 is above 12.5, so they switch: (13 - 12.5) x 120 - 480 = 60 - 480 = -420.

Chapter 58 source: section "Trade creation and trade diversion".

Demonstration 4 of 4

Prices apart by the cost of moving goods

How far apart can two connected markets' prices stay?

Traders buy where goods are cheap and sell where they are dear until the price gap just covers the cost of moving goods. Cheaper transport narrows that equilibrium gap.

$Equation, written in LaTeX: c_{AB}=21+8+5+4+3=41.$

$Equation, written in LaTeX: \pi_{AB}=201-150-41=10.$

Equation, written in LaTeX: 15+8+5+4+3=35.

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P_A and P_B are prices in Harbor A and City B. c_AB adds freight, customs 8, spoilage 5, insurance 4 and finance 3 per unit. The margin is P_B - P_A - c_AB.

Predict first. After arbitrage, do the two prices become equal?

Your prediction Yes No, they stay apart by the transfer cost

Freight per unit

Market state

Figure: Prices apart by the cost of moving goods. Price in A 150 and in B 201, with a transfer cost band of 41; the margin is 10. — Freight per unit: 21, Market state: Before trader entry
Constructed example: the chapter's hypothetical route (150 and 201, costs 21 + 8 + 5 + 4 + 3, adjusted prices 154 and 195, and 156 and 191 with freight 15); freight of 27 with adjusted prices 152 and 199, and the starting prices 150 and 201 paired with freight 15 and 27, are added.

Transfer cost: 41
Price spread: 51
Margin: 10

c = 21 + 8 + 5 + 4 + 3 = 41. Margin = 201 - 150 - 41 = 10. Traders keep shipping until the margin closes.

Worked steps

c = 21 + 8 + 5 + 4 + 3 = 41
Spread = 201 - 150 = 51
Margin = 51 - 41 = 10

Use the idea

Read a persistent price gap between two places as a measure of transfer costs before calling it inefficiency.

Where the conclusion applies

Constant per-unit costs, competitive traders and adjusted prices that are assumed outcomes.

Check your understanding: With freight 15, what is the margin at the old prices 154 and 195?

195 - 154 - 35 = 6.

Chapter 58 source: section "Commodity Arbitrage and Spatial Price Differentials".

A tariff that pays the large buyer

Choose an example

Calculated values

Worked steps

Use the idea

Where the conclusion applies

When depreciation improves the trade balance

Choose an example

Calculated values

Worked steps

Use the idea

Where the conclusion applies

Creation versus diversion

Choose an example

Calculated values

Worked steps

Use the idea

Where the conclusion applies

Prices apart by the cost of moving goods

Choose an example

Calculated values

Worked steps

Use the idea

Where the conclusion applies