The Large-Country Case

When the country imposing a tariff is large enough to influence the world price of what it buys, we must consider what effect a tariff will have on the world price ratio. To continue the same example, when Country A levies a tariff on food, the result may be that the world price of food falls relative to the price of cloth.

In that event, for a given ad valorem tariff, the domestic price of food will not rise as much as before. Thus the shift in production will be somewhat smaller. We illustrate this outcome in Figure 7, where conditions arc the same as in the case just described except that the tariff now causes the world price ratio to change from the slope of the line TT to the slope of the line P₃C₃. Production takes place at P₃. (Note that the tariff is the same proportion as before, as measured by the size of the wedge.)

International trade now takes place at the world price ratio (i.e., along the line P₃C₃). A new equilibrium in consumption is reached at point С₃, where the tariff-distorted domestic price line is tangent to a community indifference curve, and the world price line also passes through this point of tangency. As drawn in Figure 7, Country A reaches a higher indifference curve as a result of the tariff. This result is not inevitable, however. It depends on the magnitude of the change in the world terms of trade. Intuitively, one can see that Country A benefits from the tariff when its gain from the improved terms of trade outweighs its loss from a less efficient use of domestic resources. How much its terms of trade will improve depends in turn on domestic and foreign elasticities of demand and supply.

The terms-of-trade effect of a tariff can also be seen with the aid of offer curves, although the welfare effect cannot be shown without further complicating the diagram. Suppose we have offer curves OA for Country A and OB for Country B, as portrayed in Figure 6-9. With free trade, equilibrium is at point E; the terms of trade are given by the vector OE; Country A exports OC of cloth and imports OF of food. If Country A imposes an ad valorem tariff on its food imports, its offer curve shifts from OA to OA’. The terms of trade turn in favor of Country A, from Of to OE'.

The less elastic Country B's offer curve, the more the terms of trade will shift in favor of Country A. If Country B's offer curve is perfectly elastic, the terms of trade will not change at all. For example, in Figure 8, if the vector OE represented Country B's offer curve, the tariff imposed by Country A would reduce its exports and imports, but would leave the terms of trade unchanged. The new equilibrium would be at E". (This is the small-country case again.)

Thus we conclude that if a country faces an offer curve in the rest of the world that is less than perfectly elastic, it can improve its terms of trade by imposing a tariff on imports. The benefit from the improved terms of trade may be large enough to exceed the loss from less efficient resource use, leaving the country with a net gain in economic welfare. We should note, however, that this gain is at the expense of the rest of the world. If other countries act in concert, they can retaliate by imposing tariffs of their own, thus causing the terms of trade to shift back the other way.

Cloth

FIGURE 7The effects of a tariff general equilibrium, large-country case

0 C

Cloth (A's export)

FIGURE 8 The effect of a tariff on the terms of trade.

Cloth

FIGURE 9 Tariff retaliation: reduction in the volume of trade. '

For example, suppose that Country A levies a tariff and succeeds in shifting the terms of trade from OE to OE’ as in Figure 9 (the same situation presented in Figure 8). Country B may resent this action and respond by imposing tariffs of its own, say, by shifting its offer curve to OB'. Now the equilibrium is at the intersection of the two tariff-distorted offer curves, that is, at point E". In this case, the terms of trade arc back to the free-trade ratio (not a necessary result), but world trade is greatly reduced and so is world welfare. A trade agreement for the mutual, reciprocal reduction of tariffs would be beneficial to both countries.

Export barriers

Nations can restrict their foreign trade by erecting barrier to exports as well as imports. Export quotas are rarer, but tend to be more severe than import quotas. The usual export quota is zero.

More common is export tax, which has effects that symmetrical to those of import tax.

If the exporting nation possesses some monopoly power in the world market, it could use the export duty to exploit this power to national advantage.

A different kind of export monopoly is the state export monopoly, in which the government gives itself the sole national right to export a good, whether or not it has any monopoly power in world markets.

Example:

“Marketing boards” for such export crops as cocoa and coffee, and the state monopoly on foreign trade in socialist countries up to 1989.

2.4. Export subsidies

Exports are actually subsidized more often than are taxed. This is curious and potentially controversial. It is curios because the same countries restrict imports without noting that subsidizing exports implicitly subsidizes imports by raising the country’s exchange rate slightly, making it easier for others in the same country to buy foreign goods. It is potentially controversial because subsidizing exports violates international agreements.

GATT-proscribes exports subsidies as “unfair competition” and allows importing countries to relate with protectionist “countervailing duties”. Governments subsidize exports in many ways, even though they do so quaintly to escape indictment under the GATT. They use taxpayers’ money to give low-interest loans to either exporters or their foreign customers.

Example:
The U.S. Export-Import Bank founded in the 1930s, which has compromised its name by giving easy credit to U.S. exporters and their customers but not to U.S. importers or their foreign suppliers.

Government also engage in direct proportional expenditures on behalf of exporters, advertising their products abroad and supplying cheap information on export market possibilities. Income tax rules are twisted so as to give tax relief based on the value of goods or services each firm exports.

Export subsidies are very small on the average but loom large in certain products and for certain companies. For manufactured goods as a whole, they probably do not reach 1 percent of the value of exports for any major country even with a generous definition of what constitutes a subsidizing policy.

On the other hand, export subsidies are large in certain cases. The biggest percentage export subsidies apply to agricultural products. All major countries have committed themselves to government programs that raise farmers’ incomes by artificially using tax money to buy up (and to pay farmers not to plant) “surplus” farm products.

Thus far it has been assumed that government regulation of international trade is intended solely to restrict imports. Although that remains the dominant form of intervention, governments sometimes attempt to encourage exports through subsidies. This may occur because of a desire to improve a country's trade account, aid a politically powerful industry, or help a depressed region in which an export industry is located. The subsidy may be a simple cash payment to exporters, but frequently is more indirect or subtle. Research and development grants, favorable tax treatment, or a variety of other government benefits may be provided to encourage exports. In order to simplify this discussion, however, it will be assumed that the subsidy takes the form of a fixed cash payment for each unit of a product which is exported. It can therefore be viewed as a negative export tariff.

Figure 10 illustrates the effects of an export subsidy under the assumption that the exporting country is small and that it therefore faces an infinitely elastic demand in the rest of the world.

The subsidy has the effect of allowing exporting firms to receive revenues per unit of P’_d which equals the world price plus the subsidy. The subsidy is available on domestic sales in the exporting company, so these firms are willing to sell to local customers only at a higher price (P^) than prevailed earlier. E-, volumes rise from X to X\ both because local consumers buy less and becausethedomestic industry produces more at the higher price. The cost to taxpayers in the subsidizing country is area b+c+d. In addition, domestic residents lose consumer surplus of area a + b. The local industry, however, receives benefits in the form of an increase in producer surplus of area a + b + c.

The dead weight losses arc triangles b+d, the first of which is part of the loss of consumer surplus and the latter being a loss of productive efficiency which re from producing goods at a cost (the area under the supply curve) which is higher than the revenues which arc received from foreign customers (the area under D_row). The interpretation of the dead weight loss triangle b deserves more explanation. It is an area that represents a loss by two parties and a gain for one party. It is partof the lost consumer surplus for domestic residents and part of the cost to taxpayers but it is also part of the increased producer surplus benefits to the domestic industry. It is a dead weight loss because these units were previously being consumed

D_x = domestic demand in the exporting country

S_x = supply in the exporting country

D_ROW = demand in the rest of the world

FIGURE 10 The effects of an export subsidy provided by a small country.

local residents who valued them at the area under their demand curve (D_x), which includes triangle b, but these units arc now consumed by foreign consumers who value them only at the area under their demand curve (Drow), which excludes this triangle. Benefits to foreign customers from the consumption of these goods arc less than the lost benefits to local consumers by the amount of triangle b.

In Figure 10 it was assumed that the subsidizing country was small relative to its export market, and therefore that the world price was not affected by the subsidy, which was why the local price rose by the full amount of the subsidy. In the real world, exporting countries may not be small, and the world price may be driven down by the subsidy. Such price declines would provide obvious benefits to consumers in importing countries, but create understandable unhappiness among import competing firms. They face lower prices for their products, reduced profits, and the need to contract their operations. Export subsidies arc widely viewed as an unfair competitive tool, and countervailing duties can be imposed on imports that can be proven to have been subsidized.

A major problem exists, however, in defining precisely what is a subsidy that allows a countervailing duty in response. Such a subsidy would obviously exist if a government made direct cash payments to firms in proportion to their export sales, but governments are seldom so obvious. A payment or benefit may exist which appears to be available to firms in an industry without regard to whether sales arc domestic or foreign. If the vast majority of subsidized sales are in the export market, however, importing countries are likely to view the payment as an export subsidy and attempt to impose a countervailing duty.

The recent conflict between Canada and the United States with regard to softwood lumber illustrates this problem. British Columbia allows local firms to harvest lumber on provincially owned land in exchange for stumpage fees which are con­siderably lower than those prevailing in the United States. These cost savings are available on all lumber cut on this land, including that which is sold to Canadian buyers. The U.S. lumber industry, however, views the lower Canadian stumpage fees as an unfair cost advantage for British Columbia, and argues that a subsidy existed which called for a countervailing duty. The International Trade Administration of the U.S. Department of Commerce has supported the position of the U.S. industry, and a 6.4 percent countervailing duty has been proposed. The Canadian government and lumber producers in British Columbia feel that the U.S. decision is unfair, and an appeals process is being pursued.

If any government policy which benefits an exporting industry can be viewed as an export subsidy which allows a countervailing duty, conflicts such as the U.S.-Canada lumber case will be never-ending. This problem can be solved only if an export subsidy can be defined more precisely and if all of the major trading countries abide by that definition. This is an obvious topic for trade negotiations and export subsidies are one of the subjects of the current GATT round.

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