Chapter 9
The Instruments of Trade Policy
■ Chapter 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.
Local Content Requirements.
Box: Bridging the Gap.
Other Trade Policy Instruments.
52 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
The Effects of Trade Policy: A Summary.
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.
54 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
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 that 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 is 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 on to foreign exporters).
Because 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. For example, Europe’s common agricultural policy has raised the
price European farmers receive so much that Europe ends up exporting agricultural goods despite very
high labor and land costs. The net cost of this shift to consumers is about $30 billion a year.
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. For example, a quota
on sugar imported into the United States has greatly increased the fortunes of foreign sugar producers
(many of which are owned by American sugar refiners), at a significant cost to American consumers.
Estimates place the cost of each job in the American sugar industry “saved” by protection at $1.75 million,
and this number does not include the job losses in the food industry created by higher sugar prices.
Voluntary export restraints are a form of quotas in which import licenses are held by foreign governments.
For example, Japan voluntarily limited exports of cars to the United States to forestall any import tariffs on
cars from Japan in the wake of the oil price spike of 1979. The net result of these VER’s was to raise the
price of Japanese cars, with the gains accruing directly to Japanese manufacturers. A similar story is
happening now with voluntary export restraints on solar panels exported from China to the European
Union.
Another trade instrument is to mandate local content requirements. These raise the price of imports as well
as domestic goods competing with imports but do not yield either tariff revenue or quota rents. The recent
construction of the new Bay Bridge linking San Francisco and Oakland is used as a case study. Federal
funding was available for this project but would have required the state of California to use a much more
Chapter 9 The Instruments of Trade Policy 55
costly American contractor as opposed to the significantly cheaper Chinese bid. In the end, the bridge was
built through local bonds rather than federal funding because of the local content requirement of federal
funding.
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.
■ Answers to Textbook Problems
1. The import demand equation, MD, is found by subtracting the Home supply equation from the Home
2. a. Foreign’s export supply curve, XS, is XS = −40 + 40 × P. In the absence of trade, the price is 1.
3. a. The new MD curve is 80 − 40 × (P + t) where t is the specific tariff rate, equal to 0.5. (Note: In
56 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
is imposed. With an ad valorem tariff, the MD equation would be expressed as MD = 80
−40 × (1 + t)P. The equation for the export supply curve by the foreign country is unchanged.
MD = XS
80 − 40 × (P + 0.5) = 40P − 40
b. and c. The welfare of the Home country is best studied using the combined numerical and
graphical solutions presented below in Figure 9-1.
Figure 9-1.
where the areas in the figure are:
a. 55(1.75 − 1.50) − 0.5(55 − 50)(1.75 − 1.50) = 13.125
Chapter 9 The Instruments of Trade Policy 57
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Consumer surplus change: –(a + b + c + d) = −16.875. Producer surplus change: a = 13.125.
Government revenue change: c + e = 5. Efficiency losses b + d are exceeded by terms of trade
gain e. (Note: In the calculations for the a, b, and d areas, a figure of 0.5 shows up. This is
because we are measuring the area of a triangle, which is one-half of the area of the rectangle
defined by the product of the horizontal and vertical sides.)
4. Using the same solution methodology as in Problem 3, when the Home country is very small relative
to the Foreign country, its effects on the terms of trade are expected to be much smaller. The small
country is much more likely to be hurt by its imposition of a tariff. Indeed, this intuition is shown in
this problem. The free trade equilibrium is now at the price $1.09 and the trade volume is now 36.40.
5. The effective rate of protection (ERP) is defined as (Vt − Vw)/Vw, where Vt is the value added under
6. The effective rate of protection takes into consideration the costs of imported intermediate goods.
Here, 55% of the cost can be imported, suggesting with no distortion, Home value added would be
58 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
7. We first use Foreign’s export supply and Home’s import demand curves to determine the new world
price. The Foreign supply of exports curve, with a Foreign subsidy of 0.5 per unit, becomes
XS = −40 + 40(1 + 0.5) × P. The equilibrium world price is 1.2, and the internal Foreign price is 1.8.
8. a. False, unemployment has more to do with labor market issues and the business cycle than with
tariff policy. Empirical estimates suggest that the cost to society of jobs saved through tariffs is
9. At a price of $10 per bag of peanuts, Acirema imports 200 bags of peanuts. A quota limiting the
import of peanuts to 50 bags has the following effects:
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10. The reason is largely that the benefits of these policies accrue to a small group of people and the costs are spread out
over many people. Thus, those who benefit care far more deeply about these policies. These typical political
11. It would improve the income distribution within the economy because wages in manufacturing would increase, and