Wednesday 5 October 2011

Economics note: International trade II: Quota and Tariff

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Graph interpretation: tariff and quota
1)       Effect of free trade
Pw: world price, Df/Sf : demand/supply curve under free trade; bolded line = demand/supply under free trade
Domestic producer: The domestic equilibrium is higher than world price so domestic producer produce until Q1 at price Pw. PS decreases from B+D to D so they lose in the trading.
Domestic consumer: They now buy goods at a lower price Pw < P0 while consumption increased to Q2. CS increased from A to A+B+C. The TSS increase from A+B+D to A+B+C+D, so the net gain is C as they can be consumed at a lower price than the price in which goods are domestically produced. The total expenditure is uncertain, depending on the elasticity.
Exporting producer: Selling at higher price (Pw) and more is produced (Q2). (Q2-Q1) is exported while Q1 is sold domestically. PS increases from D to B+C+D. Total gain increases.
Exporting consumer: They buy at higher price and consume less of it. CS decreases from A+B to A so they lose from the trading. Total expenditure is uncertain depends on elasticity.
2)       Trade barriers: Quota

When a quota is applied, the supply is upward slopping before Q1 (because domestic cost<Pw) and after quota (more of the imported goods are banned). The new equilibrium price is P', amount of domestically produced goods is Q2 while the imported quantity is (Q3-Q2).
Consumer: The CS is A+B, larger than in autarky and smaller than in free trade (A+B+C+D+E+F).The price increased and quantity consumed decreased.
Producer: The PS increase from G to C+G while more is sold in higher price so they gain.
The area E is the gain for importer since they buy goods at Pw and sell at P'. If government has the right of import, then E is the government revenue. D and F is the deadweight loss since people have to buy goods at higher price beyond the quota but originally they can buy it at Pw.
Quota is inefficient due to the existence of deadweight loss.

3)       Trade barriers: tariff

When a tariff is applied, the domestic price rises as much as the tariff. Quantity consumed decrease but quantity produced increase from Q1 to Q2, quantity imported decreases from (Q4-Q1) to (Q3-Q2).
The change of gain for producer and consumer is same as the quota. Area E is the government tax revenue. D and F is the deadweight loss since people can originally buy goods at Pw but now at higher price (Q1~Q2), and they can originally buy goods at (Q3~Q4) in which they gain consumer surplus.
Tariff is also inefficient due to the existence of deadweight loss.
4)       Effectiveness of trade barriers
Quota is ineffective when quota > imported volume under free trade. Tariff is ineffective when amount of tariff > price different in equilibrium price in autarky and world price.
Tariff is less effective when D and S is inelastic since a large change in price cause a small change in quantity. As a result (Q2-Q1) and (Q4-Q3) is small under a large tariff, then it's insignificant to reduce import volume. In this case quota is more certain to reduce the import amount.
5)       Reasons behind trade barriers
Local government protect its local import-competing industries to protect its own economy (e.g when local industries close down, more labour is unemployed) as they don't have absolute/comparative advantages. By imposing trade barriers, price of foreign good rises and local goods are more competitive. This is called protectionism.
Also, trade barriers means that the importing quantity is decreased, that means exporter competes to export their own goods. As a result, the quality of goods is increased.
Other measures include subsidizing the local goods to export, embargo on a certain goods.
However, trade barriers hinder international trade and countries may take revenge by putting more barriers on other goods. As a result, a small economy (e.g. HK) won't impose trade barriers as it's hard for them to build up a autarky economy and they rely on importing necessary goods. World Trade Organization (WTO) is an organization to promote free trade.

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