Book Title
International Economics: Theory and Policy 9th Edition

978-0132146654 Chapter 9 Lecture Notes

December 18, 2019
42  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
Overview of Section II:
International Trade Policy
Section II of the text consists of four chapters:
Chapter 9 The Instruments of Trade Policy  
Chapter 10 The Political Economy of Trade Policy  
Chapter 11 Trade Policy in Developing Countries  
Chapter 12 Controversies in Trade Policy  
.1 nSection II Overview
Trade policy issues figure prominently in current political debates and public policy discussions. The first
two chapters of this section of the text are concerned with the instruments of trade policy and the arguments
for free trade and managed trade. The second two chapters consider these concepts in the context of specific
sets of countries that face common problems. Throughout, the use of case studies provides the student with
real-world examples that clearly illustrate the theoretical arguments.
Chapter 9 discusses various instruments of trade policy including tariffs, quotas, voluntary export restraints,
and local content requirements. The effects of these policies on prices and trade volumes are determined in
the context of a partial equilibrium framework. The chapter reviews the analytical tools of consumer and
producer surplus, and uses these tools to consider the welfare effects of various protectionist measures.
The specific incidents of trade restrictions presented as case studies include import quotas on sugar entering
U.S. markets, voluntary export restraints on Japanese autos, and oil import quotas.
Chapter 10 presents the set of ideas known as the political economy of trade theory. These ideas enable
you to understand why certain trade restrictions exist, despite the force of general economic arguments,
which suggest that they reduce aggregate welfare. Possible motivations for trade restrictions are identified
as those which increase national welfare, such as the optimum tariff, and those which foster either income
redistribution or the preservation of status quo. While sometimes politically popular, these motivations
for trade restrictions ignore the possibility of retaliation and usually fail tests based upon basic welfare
analysis. Trade agreements of the 1990s are discussed, including the Uruguay Round, and distinctions
are made between Free Trade Areas and Customs Unions as well as between trade creation and trade
Chapter 11 considers the possible uses of trade policies to promote the growth of developing economies.
The chapter reviews the relative successes of different development strategies. It examines arguments for
and the results of import-substituting industrialization. It also discusses the decline of import-substituting
industrialization and the increase in trade liberalization in developing countries since the mid-1980s. The
chapter concludes with a discussion of export-led growth and the experience of the high-performing Asian
Chapter 12 considers recent controversies in trade policy. The first part of the chapter considers the notion
43  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
of strategic trade policy, which first arose in the 1990s. Strategic trade policy refers to the use of trade (and
other) tools for channeling resources to sectors targeted for growth by industrial country governments. The
chapter presents some commonly voiced arguments for intervention in particular sectors of the economy,
and then shows how these arguments are critically flawed. The second part of the chapter introduces more
sophisticated arguments for strategic trade policy. The most persuasive of these is the existence of some
form of market failure. The third part of the chapter considers the impact of rising trade on workers in
developing countries, and more broadly, the debate over globalization. This debate has been argued in
academia and policy circles, but also on the streets of Seattle, Genoa, and other cities hosting global
economic summits. Finally, the chapter considers links between trade and the environment.
Chapter 9 The Instruments of Trade Policy    44
Chapter 9
The Instruments of Trade Policy
.2 nChapter Organization
Basic Tariff Analysis
  Supply, Demand, and Trade in a Single Industry
  Effects of a Tariff
  Measuring the Amount of Protection
Costs and Benefits of a Tariff
  Consumer and Producer Surplus
  Measuring the Costs and Benefits
  Box: Tariffs for the Long Haul
Other Instruments of Trade Policy
  Export Subsidies: Theory
  Case Study: Europe’s Common Agricultural Policy
  Import Quotas: Theory
  Case Study: An Import Quota in Practice: U.S. Sugar
  Voluntary Export Restraints
  Case Study: A Voluntary Export Restraint in Practice: Japanese Autos
  Local Content Requirements
  Box: American Buses, Made in Hungary
  Other Trade Policy Instruments
The Effects of Trade Policy: A Summary
APPENDIX TO CHAPTER 9: Tariffs and Import Quotas in the Presence of Monopoly
  The Model with Free Trade
  The Model with a Tariff
  The Model with an Import Quota
  Comparing a Tariff and a Quota
nChapter Overview
This chapter and the next three focus on international trade policy. Students will have heard various
arguments for and against restrictive trade practices in the media. Some of these arguments are sound
and some are clearly not grounded in fact. This chapter provides a framework for analyzing the economic
effects of trade policies by describing the tools of trade policy and analyzing their effects on consumers
and producers in domestic and foreign countries. Case studies discuss actual episodes of restrictive trade
practices. An instructor might try to underscore the relevance of these issues by having students scan
newspapers and magazines for other timely examples of protectionism at work.
45  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
The analysis presented here takes a partial equilibrium view, focusing on demand and supply in one market,
rather than the general equilibrium approach followed in previous chapters. Import demand and export
supply curves are derived from domestic and foreign demand and supply curves. There are a number of
trade policy instruments analyzed in this chapter using these tools. Some of the important instruments
of trade policy include specific tariffs, defined as taxes levied as a fixed charge for each unit of a good
imported; ad valorem tariffs, levied as a fraction of the value of the imported good; export subsidies, which
are payments given to a firm or industry that ships a good abroad; import quotas, which are direct restrictions
on the quantity of some good that may be imported; voluntary export restraints, which are quotas on trading
that are imposed by the exporting country instead of the importing country; and local content requirements,
which are regulations that require that some specified fraction of a good is produced domestically.
The import supply and export demand analysis demonstrates that the imposition of a tariff drives a wedge
between prices in domestic and foreign markets, and increases prices in the country imposing the tariff and
lowers the price in the other country by less than the amount of the tariff. This contrasts with most textbook
presentations which make the small country assumption that the domestic internal price equals the world
price times one plus the tariff rate. The actual protection provided by a tariff will not equal the tariff rate if
imported intermediate goods are used in the production of the protected good. The proper measurement,
the effective rate of protection, is described in the text and calculated for a sample problem.
The analysis of the costs and benefits of trade restrictions require tools of welfare analysis. The text explains
the essential tools of consumer and producer surplus. Consumer surplus on each unit sold is defined as the
difference between the actual price and the amount that consumers would have been willing to pay for
the product. Geometrically, consumer surplus is equal to the area under the demand curve and above the
price of the good. Producer surplus is the difference between the minimum amount for which a producer
is willing to sell his product and the price which he actually receives. Geometrically, producer surplus is
equal to the area above the supply curve and below the price line. These tools are fundamental to the
student’s understanding of the implications of trade policies and should be developed carefully.
The costs of a tariff include distortionary efficiency losses in both consumption and production. A tariff
provides gains from terms of trade improvement when and if it lowers the foreign export price. Summing
the areas in a diagram of internal demand and supply provides a method for analyzing the net loss or gain
from a tariff. The gain from a tariff is larger the greater the decrease in foreign export price from the tariff
(as the tariff-imposing country is able to pass some of the costs of the tariff onto foreign exporters). Since
large countries will have a larger influence on export prices than small countries, a large country is more
likely to gain, and therefore impose an import tariff.
Other instruments of trade policy can be analyzed with this method. An export subsidy operates in
exactly the reverse fashion of an import tariff. An import quota has similar effects as an import tariff
upon prices and quantities, but revenues, in the form of quota rents, accrue to the quota license holders,
who are often foreign producers. Voluntary export restraints are a form of quotas in which import licenses
are held by foreign governments. Local content requirements raise the price of imports and domestic goods
and do not result in either government revenue or quota rents.
Throughout the chapter the analysis of different trade restrictions are illustrated by drawing upon specific
episodes. Europe’s common agricultural policy provides and example of export subsidies in action. The
case study corresponding to quotas describes trade restrictions on U.S. sugar imports. Voluntary export
restraints are discussed in the context of Japanese auto sales to the United States. The oil import quota in
the United States in the 1960s provides an example of a local content scheme.
The Appendix discusses tariffs and import quotas in the presence of a domestic monopoly. Free trade
eliminates the monopoly power of a domestic producer and the monopolist mimics the actions of a firm
in a perfectly competitive market, setting output such that marginal cost equals world price. A tariff raises
domestic price. The monopolist, still facing a perfectly elastic demand curve, sets output such that marginal
cost equals internal price. A monopolist faces a downward sloping demand curve under a quota. A quota
is not equivalent to a tariff in this case. Domestic production is lower and internal price higher when a
particular level of imports is obtained through the imposition of a quota rather than a tariff.