International Economics I Lecture Note Chapter Three: International Trade Policies

CHAPTER THREE: INTERNATIONAL TRADE POLICY

A policy of no restrictions on the movement of goods between countries is known as the policy of
Free Trade. Restrictions placed with a view to safeguarding home industries constitute the policy of
protection. In the words of Adam Smith, the term 'free trade' has been used to denote "that system of
commercial policy which draws no distinction between domestic and foreign commodities and,
therefore, neither imposes additional burdens on the latter, nor grants any special favors to the
former." Free trade, however, does not require the removal of all duties on commodities. It only
insists that they shall be imposed exclusively for revenue and not at all for protection.

Adam Smith wrote: "If a foreign country can supply us with a commodity cheaper than we ourselves
can produce, better buy it from them with some part of the produce of our own industry, employed in
a way in which we have some advantage." Be continued further: "Whether the advantage which one
country has over another be natural or acquired is in this respect of no consequence. As long as one
country has those advantages and the other wants them, it will always be more advantageous for the
latter rather to buy of the former than to make." The only exception that Adam Smith would make
was industries necessary for defense. These might be protected since defense is more important than
opulence, he said.

The doctrine of free trade is the extension of the doctrine of division of labor to the international
field. In the words of Adam Smith again, "Individuals find it for their interest to employ their
industry in a way in which they have some advantage over their neighbors." In short, the free trade
theory is that such a policy enables every country to devote itself to those forms of production for
which it is best suited on the basis of comparative advantages. Thus this chapter focuses on the
nature and impacts of different trade policies on welfare of a certain nation.

3.1. Arguments for and against Protection

Cases against free trade: protectionism
The term 'protection' is used to denote a policy of encouraging the home industries by the use of
bounties or by the imposition of high customs duties on foreign products. The objective is to build up
great national industries even by sacrificing utilities on the part of existing consumers. The
arguments for protection are stated below.

1. Infant Industry Argument.

This argument was put forward by Friedrich List, J. S. Mill, Alfred Marshal and Souderton.

Compiled by Nega Ejigu, Department of Economics, BDU Page 1

International Economics I Lecture Note Chapter Three: International Trade Policies

Friedrich List: Friedrich List was a German economist, in 1840. In those days, Germany was
making all-out efforts to industrialize its economy. On the other hand, the U.K. had already built by
that time, a sound industrial base. Germany was then facing lot of difficulties in competing with the
established British industry. List had strong view that the development of industries is a pre-requisite
of economic progress. Free trade was good for Britain whose economic position was already well
established. For young emerging German industry, however, protection of a tariff wall was essential.

J. S. Mill: In the words of Mill, “The superiority of one country over another in a branch of
production often arises only from having started it sooner”. There may be no inherent advantage on
one part or disadvantage on the other, but only a present- superiority of acquired skill and exper-
ience. Thus, J. S. Mill, one of the advocates of free trade, accepted only one argument. In Mill’s
words it ran thus: “A productive duty, continued for a reasonable time, might sometimes be the least
inconvenient mode in which a nation can tax itself for the support of such an experiment (introducing
new industries). But it is essential that protection should be confined to cases in which there is good
ground of assurance that the industry which it fosters will after a time be able to dispense with it”.

Alfred Marshall: This prominent English economist, too, conceded the force of the infant industry
argument, although the English economists by and large advocated free trade. However, for
protection to produce social benefits, an infant industry must first grow up. It must eventually be able
to compete at world market prices. Not only has it to grow up, for a protectionist policy to be
profitable, according to Sodersten, it will have to be able to pay back the losses due to protection
during the infant industry period. Only then is there a clear-cut case for infant industry protection.
This argument specially applies to countries that enter the industrial field at a later stage. Such
countries possess potential advantages which may not become effective unless- foreign competition
is excluded for a period of time. Unless an industry in its infancy is protected till it acquires strength
and maturity, it will die in the face of foreign competition.

In general, the infant industry argument rests on the following grounds:

 Every country has its own potentialities for developing some industries in the form of labour
skill, raw materials and entrepreneurial talent. No country is completely devoid of productive
elements which may yet be latent.
 Every nation has the right to develop its potentialities or discover its latent productive
powers. No nation would like its efforts for economic development to be smothered before it
has had a full chance for trial and error.

Compiled by Nega Ejigu, Department of Economics, BDU Page 2

International Economics I Lecture Note Chapter Three: International Trade Policies

 It takes time for the productive elements to be developed. Labour can be trained; raw
materials can be improved; and entrepreneurs can become competent by experience. But they
should have enough time to develop and discover themselves.
 Infant industries cannot be expected to withstand competition from old and well-
entrenched industries. It will be unfair to expose new industries. If infant industries are not
duly protected against competition from strong and well-established' industries, they are
bound to die. This will mean waste of valuable national assets invested in the industry and a
serious setback to entrepreneurial venture in future.

Note that: protection should not be given on a permanent basis. It should be given for a definite
period considered sufficient for the industry to grow. Moreover, it should not be given
indiscriminately to all industries. The industries to be given protection should be selected with proper
care and discrimination so that scarce productive resources of the community are properly allocated.

2. Diversification of Industry Argument

This argument was advanced, among other writers, by Friedrich List in Germany. According to List,
a nation should have a variety of sources of production and employment. Depending on one industry
or on a few industries is dangerous both politically and, economically. Politically it means too much
dependence on foreign trade which may be cut off during a war. Economically, a country depending
on a few industries is exposed to the danger of serious economic dislocation in case some adverse
circumstances affect such an industry. But it must be understood that this argument cuts at the root of
the principle of comparative cost according to which each country must specialize in the production
of certain articles. According to this argument a country must produce even those articles in which it
may not have comparative advantage. In this case it needs protection to continue operating.

3. Employment Argument
It is argued that industrial development through protection increases employment in a country.
Conversely, if protection is not given to old established industries; foreign competition may ruin
them and create unemployment in the country.

4. Conservation of National Resources Argument

Carey and Patten had argued that free trade resulted in the export of agricultural commodities from
America and thus led to the exhaustion of the soil. The argument has some force. If a country exports
its exhaustible materials in a raw-state, it loses manufacturer's profits. It may also be seriously
handicapped when such materials have been altogether exhausted.

Compiled by Nega Ejigu, Department of Economics, BDU Page 3

International Economics I Lecture Note Chapter Three: International Trade Policies

5. Defense Argument
Adam Smith remarked "Defense is better than opulence". It is said that essential to make a country
militarily strong though it may not be economically prosperous. Hitler preached to the German
nation, "Gun! Better than butter." According to this argument a country must actively encourage the
development of those industries which are essential from the point of view of defense, even though it
may result uneconomic distribution of the national resource. The advocates of free trade point out
that this is politics and not economics. On purely economic grounds, they say, free trade is the best.

6. Revenue Argument
Protection is also advocated for revenue purposes. When protective import duties are imposed, they
certainly bring in revenue to the government. But it may be pointed out that there is a certain degree
of incompatibility between the revenue and protection. If full protection is given, the government
will not get any revenue, because full protection will mean that domestic goods have driven foreign
goods altogether. When foreign goods not come in, there will be no revenue from import duty. On
the other hand, if government wants revenue then foreign goods must come in and compete with
domestic goods. Then domestic industries do not get any protection. This incompatibility, however,
arises between maximum protection and maximum revenue. But if the duties are moderate, they will
yield revenue besides affording protection. It is, however, much better to advocate protection for the
sake of protecting industries rather than for raising revenues.
7. Key Industry Argument
If the industrial structure of a country is to be stable and sound, the country must develop 'key' or
basic industries; otherwise foundation of industries will have been laid on sand. The country may not
have any comparative advantage in such industries. But since they are of crucial importance and
have to be developed, protection must be granted to them.

8. Balance of Payments Argument

It may become necessary to check imports by means of tariff in order to rectify adverse balance
payments. The I.M.F. regulations permit member countries to impose temporary restriction trade to
cure a balance of payments deficit. Import restrictions on non -essential imports become necessary in
the interest of accelerated economic growth.

9. Patriotism Argument.
Protection is advocated on patriotic grounds also. It is the duty of every citizen to use home-made
goods as far as possible. We must, therefore, develop our industries, through protection, if necessary,
so that home-made goods in the right quantity and of good quality are made available for use.

Compiled by Nega Ejigu, Department of Economics, BDU Page 4

International Economics I Lecture Note Chapter Three: International Trade Policies

10. Self-sufficiency Argument

Another argument in favor of protection is that we should become self-sufficient and not depend on
other countries for our necessaries. Such dependence proves very dangerous during war when
foreign trade is cut off.

11. Avoid unfair competition

Protection also becomes necessary against unfair competition from abroad arising from dumping,
depreciated exchanges, bounties, etc.

12. For Economic Stability

Protection is also advocated to shut out the baneful influences trade cycles from abroad. It is
expected to make the domestic economy immune from the destabilizing effects of external disturbing
factors. In the Macmillan Committee (1931), the late Lord Keynes put forward the opinion that
protection and not free trade was needed to restore the much-needed economic stability for an
economy which is out of gear.

Arguments against protection

1. Vested interests are created
Once certain industries are given protection, they claim it as a matter of right. It then becomes very
difficult to take away protection. The infants begin kicking if you touch them in any manner. Such
infants refuse to admit that they have grown into adults.

2. Protection produces lethargy

When foreign competition has been removed, it sends the home manufacturers to sleep, as it were.
They do not try to make any improvement, and technical progress comes to a standstill.

3. Protection creates the danger of corruption

The industrialists bribe legislators so that protection is not taken away.

4. Protection creates monopolies

Tariff is said to be the mother of trusts. When foreign competition has been removed, the home
manufacturers are tempted to combine to reap monopoly profits.

5. Consumers and unprotected industries suffer

This is so because imposition of import duties invariably leads to the rising of prices.

Compiled by Nega Ejigu, Department of Economics, BDU Page 5

International Economics I Lecture Note Chapter Three: International Trade Policies

6. The distribution of wealth becomes more unequal

Protection favors the rich capitalists who grow still richer. The gulf between the 'haves' and 'have-
nots' is thus widened still further.

7. Source of conflict
Protection leads to conflict, friction and retaliation in international dealings. It thus breeds the germs
of future wars.

8. Inefficiency in world resource allocation

The most important argument against protection on economic grounds is that it militates against
optimum utilization of resources. It hampers international division of labor so that labor, capital and
other factors of production do not find their most remunerative employment. Their distribution is not
governed by natural economic forces-, but they are artificially forced into certain channels. The
result is that they do not make their maximum possible contribution in the production of commo-
dities. The world output is lower than it could be, so that the standard of living is necessarily
lowered. A natural movement towards world prosperity is hindered.

3.2. Barriers to Trade

The two broader categories of barrier to free trade between countries are natural barriers and man-
made barriers. Natural barriers to trade: arise on account of the cost and the distance involved in
moving goods and services from one country to another. In short, it is the transport cost. Man-made
barriers is further classified into tariff and non-tariff (hidden) barriers.

3.2.1. Tariff and Its Effects

What is tariff? Tariffs are essentially the taxes or duties imposed on the imported or exported
goods. Import duties are more common than export duties so much, so that tariffs are often
identified with import duties. Tariffs are aimed at altering the import prices (or export prices) so as
to regulate the volume of imports (or of exports).
Types of Tariffs
1) Specific tariffs: are tariffs which are assessed on the basis of the physical weight of the
product which is imported or exported. The units are in terms of Birr/Kg, Birr/ tone. They
can be levied on goods like wheat, sugar, coffee, cattle, etc. Specific tariffs cannot be levied
on valuable goods like diamond, modern art paintings, TV etc.

Compiled by Nega Ejigu, Department of Economics, BDU Page 6

International Economics I Lecture Note Chapter Three: International Trade Policies

2) Ad valorem tariffs: are tariffs levied based on the value of the product. It is a percentage
tax. E.g. 10% of the value of diamond, TV etc. Ad valorem tariff is revenue elastic but
specific tariff is not.
3) Compound tariff: combines a specific duty with an ad valorem duty.
4) Discriminatory tariff calls for different rates of duties depending on the country of origin
or destination of the product
5) Non-discriminatory tariffs: uniform tariffs rates imposed on goods and services regardless
of their source of origin or destination. Tariffs are said to be single column when they are
non- discriminatory and double-column when they are discriminatory.
6) Revenue tariffs: these are tariffs that are imposed primarily and produce revenue for the
government
7) Protective tariffs: are tariffs that are imposed primarily to protect the domestic industries
from foreign competitions
8) Retaliatory tariffs: when country A imposes (increases) duties against the products from
country B, it is possible that country B will retaliate and levy duties on goods imported from
country A. Thus, country B’s tariffs are then described as retaliatory tariffs.
9) Countervailing tariffs: Tariffs are said to be countervailing when a country imposes
(increases) import duties with a view to offset export subsiding in the country of origin.

Effects of import tariff on tariff imposing country

Tariff is an important tool of commercial policy. Although it is primarily a protection device yet it
proves to be a double-edged weapon. On the one hand, it limits consumers’ choice by forcing them
to cut consumption of the goods they like and, on the other hand, it shifts the use of resources from
one use to another. The effect of tariffs is to change relative prices of goods, services and factors of
production.

The figure below shows the foreign country’s demand and supply for a given product on the left side
of the graph and to the right is the home (tariff imposing) country’s demand for and supply of same
(homogeneous) product. PH and PF are the pre-trade equilibrium prices in the home and foreign
countries respectively. The price differential (PH-PF) induces trade between the two countries letting
the home country importer and the foreign country an exporter of the product. The free trade price is
therefore Pw at which the home country’s imports are S0D0. Transport costs and tariffs are assumed
to be zero.

Compiled by Nega Ejigu, Department of Economics, BDU Page 7

International Economics I Lecture Note Chapter Three: International Trade Policies

Price

SXH
a

PH b c
Pt
SXF d e f g
Pw h
PF m n p DXH
DXF
0 S0 S1 D1 D0 commodity X
Now let us introduce tariffs. If the rate of import tariff per unit of imported product is equal to the
distance between Pt and Pw, this imposition of tariff by the home country on the imported product
will cause the following effects on the importing country. The welfare effect of tariffs is, perhaps, the
most important effect.

a. Welfare effect of a tariff

 Welfare effect of tariffs on consumers

Before tariffs were imposed (or at the free trade price Pw), the price paid by the consumers per unit of
product was OPw. At this price consumers buy OD0 quantity of the product. At this price the
consumers’ surplus is equal to the sum of the areas a+b+c+d+e+f+g. Imposing a tariff rate of PwPt
per unit of imports will reduce the consumers’ surplus from the free trade level to the sum of the
areas a+b+c. This implies that consumers will loss a welfare level equal to the sum of the areas
d+e+f+g. Thus, tariffs decreases the welfare level of consumers through increased price and
decrease in quantity demand (consumed).

 Welfare effect of tariff on producers

At the free trade price Pw, the level of producers’ surplus that measures of the welfare of domestic
producers is equal to the area h. After tariff, the producers’ surplus increased to the sum of the areas
d+h. The net gain in producers’ surplus equals the area d. This gain in producers’ surplus is part of
the loss in consumers’ surplus. Moreover, the gain in producers’ surplus is due to the protective
(production or import substitution) effect of tariff.

 Welfare effect of tariff on government

Before tariff, there is no revenue to the domestic government collected from import duties. The tariff
rate of PwPt multiplied by the amount of import quantity S1D1 generates tariff revenue of the size of

Compiled by Nega Ejigu, Department of Economics, BDU Page 8

International Economics I Lecture Note Chapter Three: International Trade Policies

the rectangle f to the tariff imposing country’s government. This revenue is also part of the welfare
loss by consumers.

 Overall welfare effect of tariff

This imposition of tariff increases the price of the commodity and thus reduces the consumers’
surplus. In this way, income is transferred from the consumers to producers and the government.
This effect of distribution of income is called the distributive effect. However, all the welfare loss by
consumers is not redistributed to other groups in the society. There is a dead weight loss, also termed
as the cost of tariff. This loss equals the area e+g. It is the net welfare loss to the economy due to
tariff.

b. Price effect

The immediate effect of imposition of tariff is to raise the price of both the imported product and the
domestically produced product (import replacement product) in the home country. The above figure
shows that due to tariff the price of the product increases from Pw to Pt. Thus, the import duty is paid
as well as borne by the importing country exclusively.

c. Consumption effect:

When tariff is imposed, price of the commodity rise and domestic consumption is reduced from 0D0
(free trade consumption) to 0D1 (consumption after tariff) following the law of demand. The
reduction in consumption due to tariff is equal to (D0D1). This is called the consumption effect.

d. Production (Import Substitution), or protective effect:

The domestic production will go up as a result of the tariff. In the figure, the domestic supply curve
SXH is elastic so that when the tariff raises the price from Pw to Pt, the domestic production of the
import replacement goods goes up from 0S0 to 0S1. The amount by which domestic production goes
up as a result of tariff can be described as the extent of import substitution. In the figure, the distance
S0S1 is a measure of this import substitution. Tariff reduces the import competing goods thus
affording protection to the domestic producer. Domestic Production increased as show above as a
result of the imposition of tariff.

e. Balance of trade effect

This effect of tariff is the result of tariffs on the level of imports. At the free trade price Pw, the level
of imports was S0D0. The country was paying a foreign currency equivalent to area of the rectangle

Compiled by Nega Ejigu, Department of Economics, BDU Page 9

International Economics I Lecture Note Chapter Three: International Trade Policies

m+n+p as import payments. But after tariff, the import quantity has been reduced to S1D1 and the
import payment has also been reduced to the area of the rectangle n+f from the free trade import
payment level. Thus, this will lead to improvement in the balance of trade (i.e., either increasing
trade surplus or reducing trade deficits) of the tariff imposing country. Out of the total import cuts
from S0D0 to S1D1, the reduction amounting S0S1 is due to production (import substitution or
protective) effect of tariff and the other D1D0 is due to consumption effect of tariff.

f. The Terms of trade Effect

Tariff reduces the volume of trade and the terms of trade will improve for the country imposing the
tariff.

g. Effect on National Income

If a country is facing unemployment problem, imposition of tariff increase employment and thus
increases income. This happens because with the imposition of tariff, consumers’ demands are
diverted to domestically produced goods. To meet this increased demand for domestic products, new
production units will be set up. As a result, lot of employment will be created and national income
will increase.

Compiled by Nega Ejigu, Department of Economics, BDU Page 10

International Economics I Lecture Note Chapter Three: International Trade Policies

3.2.2. Non-Tariff Barriers and their effects

Non-Tariff Barriers to trade

Non-tariff barriers encompass a variety of measures. Some have insignificant trade consequences;
for example, labeling and packaging requirements can restrict trade, but generally only marginally.
Other non-tariff barriers significantly affect trade patterns; examples include import quotas,
voluntary export restraints, subsidies, and domestic content requirements. These non-tariff barriers
are intended to reduce imports and benefit domestic producers. There are several reasons suggested
for why countries use non-tariff barriers instead of tariff.
 Political reasons: politicians may sometimes be reluctant to levy a tariff because it is an
explicit tax on domestic consumers. Although non-tariff barriers result similar consumers’
welfare loss like tariff, the non-tariff barriers’ effect tends to be more remote and less visible.
Politicians may therefore perceive non-tariff barriers as being more acceptable to the voting
public.
 Certainty of restrictive impact of non- tariff barriers: the restrictive impact of non-tariff
barriers is relatively more certain as a protection instrument than tariff. For example it may be
much easier to show that a quota of 5 million tons restricts food imports to 5 million tons than
to show conclusively that a tariff of Birr 20/ton would result in imports of only 5 million tons
of food imports. Moreover, a rise in an import tariff may encourage the exporting country to
subsidize its exporting companies to make them more price-competitive.
 Non-tariff barriers are not covered by rule of WTO (GATT): many nations have adopted non-
tariff barriers because they are not covered by main body of rules of conduct in international
trade, the General Agreement on Tariffs and Trade (GATT).
Types of non-tariff barriers:
a) Quota: is a direct limitation of the physical quantity of exports and imports permitted in the
country. An import quota, in particular, is a physical restriction on the quantity of goods that
may be imported during a specific time period; the quota generally limits imports to a level
below that which would occur under free-trade conditions. Quota may be unilateral, bilateral or
mixed.
Unilateral quotas: import quotas are generally imposed unilaterally by the home government,
without prior negotiation or consultation with other nations. They are levied and administered
exclusively by the importing nation. Because of their unilateral nature, import quotas may be
resented by other nations and may lead to retaliation quotas. Unilateral quota can be global or
specific:

Compiled by Nega Ejigu, Department of Economics, BDU Page 11

International Economics I Lecture Note Chapter Three: International Trade Policies

Global quota: permits a specified number of goods to be imported each year, but does not specify
where the product is shipped from or who is permitted to import. When the specified amount has
been imported (the quota is filled), additional imports of the product are prevented for the reminder
of the year. In practice, the global quota is difficult to implement. Those who import early in the year
get their goods; those who import late in the year may not. Moreover, goods shipped from distant
locations tend to be discriminated against because of the longer transportation time. For these
reasons, global quotas are relatively uncommon, especially among industrial nations.
Selective (allocated) quota: to avoid the problems of a global quota system, import quotas are
usually allocated to specific countries. For example, Ethiopia might impose a global quota of 10
million tons of canned food per year, of which 3 million must come from the Kenya, 4 million from
Germany, and 3 million from Saudi Arabia. Customs officials in the importing nation monitor the
quantity of a particular good that enters the country from each source. Once the quota for that source
has been filled, no more goods are permitted to be imported.

Bilateral quotas: imply mutual agreement between countries through negations. They do not
provoke retaliation.

Mixing or indirect quotas: in this case the domestic producers are asked to use a fixed proportion of
imported and domestic materials used in producing their products. The quota is not fixed in absolute
forms but in percentage forms.

Tariffs versus quotas

The effect quotas are similar to those of tariffs, but there are also substantive differences between the
two which are worth examining. The following paragraphs explain the similarities between quota
and tariff.
 A tariff of a certain height cuts imports to a certain quantity. It has, therefore a quota
equivalent effect. At the same time a quota would limit imports to a certain quantity and
therefore, raises the import price. A quota has, thus, a tariff equivalent effect.
 Since both quota and tariff raise the import price and reduce the import quantity, they
produce similar effects on the consumption, production, trade balance, TOT, national income
redistribution, factor movements, economic growth and economic welfare.
 Both have the same objectives like protecting domestic industries; expand domestic
employment and correcting balance of payments.
Though quota and tariff may have similar impact, they are not one and the same. They are different
on the basis of the following grounds.

Compiled by Nega Ejigu, Department of Economics, BDU Page 12

International Economics I Lecture Note Chapter Three: International Trade Policies

 Tariffs bring revenue to the government whereas quota does not. Under tariff some of
consumers’ loss goes to government in the form of revenue. But under quota it is ambiguous.
It could go to government if it charges a free for selling import licenses and if not, some of
consumers loss will be distribute to importers and the imports welfare will increase further
more. Tariff revenues can be used for investment on social services, but the quota profits
going to importers may not contribute to net social welfare.
 Distribution of import licenses (associated with quota) may give rise to corruption and
bribery on the part of government. Import tariffs do not create such problems or even if they
do the degree is small.
 Quotas could be more effective than tariffs particularly when the domestic demand and
supply curves for the implored goods are inelastic.

b) Subsidies: by providing domestic firms a cost advantage, a subsidy allows them to market their
products at prices lower than their actual cost or profit considerations warrant. Government
subsidies assume a variety of forms. The overall result is to permit the producer a cost
advantage that would not otherwise exist. Governments sometimes use indirect subsidies to
achieve the same general result. For example, governments may give their exports special
privileges, including tax concessions, insurance arrangements, and loans at below market
interest rates. Governments may also sell surplus materials (such as ships) to domestic exports at
favorable prices. Governments may purchase a firm’s product at a relatively high price and then
dump it in foreign markets at lower price. This has traditionally been the technique used by the
U.S. government in conjunction with its farm-support programs. As with direct cash
disbursements to domestic producers, indirect subsidies are intended to encourage the expansion
of a nation’s exports by permitting them to be sold abroad at lower prices. The net price actually
received by the producer equals the price paid by the purchaser plus the subsidy. The subsidized
producer is thus able to supply a greater quantity at each consumer’s price. For purposes of our
discussion, two types of subsidy can be distinguished;
i) Domestic subsidy: is provided to import-competing producers.
ii) Export subsidy: is provided to exporters.

Effects of Subsidies
1) The Impact of Domestic Subsidy
The figure below illustrates the trade and welfare effects of a subsidy granted to import-competing
producers. Assume that initial domestic supply and demand for the product are depicted by curves
SS0 and DD0 so that the market equilibrium price is P0.

Compiled by Nega Ejigu, Department of Economics, BDU Page 13

International Economics I Lecture Note Chapter Three: International Trade Policies

Assume also that, because the home country is a small buyer of the product, changes in its purchase
do not affect the world price of Pw. Given a free-trade price of Pw, the home country consumes 0Q2
amount of the product; 0Q0 from home production and Q1Q2 from import.

Price

S0 S1
P0
PS A B subsidy
PW SW
Dd
0 Q0 Q1 Q2 Quantity

To partially insulate domestic producers from foreign competition, suppose the home country’s
government grants them a production subsidy of Ps-Pw. The cost advantage made possible by the
subsidy results in a shift in the domestic supply curve from S0 to S1. Domestic production expands
from Q0 to Q1, and imports fall from Q0Q2 to Q1Q2. These changes represent the subsidy’s trade
effect.

The subsidy also affects the national welfare of the home country. According to the figure, the
subsidy permits home country output to rise from 0Q0 to 0Q1. Note that at this output, the net price to
the producers is Ps which is equal to the sum of the price paid by the consumer Pw plus the subsidy
Ps-Pw. To the home government, the total cost of protecting its producers equals the amount of the
subsidy (Ps-Pw) times the amount of output to which it is applied OQ1.

Where does this subsidy revenue go? Part of it is redistributed to the more efficient domestic
producers in the form of producer surplus. This amount is denoted by area A in the figure. There is
also a protective effect, where by more costly domestic output is allowed to be sold in the market as
a result of the subsidy. This is denoted by area B in the figure. To the domestic economy as a whole,
the protective effect represents a deadweight loss of welfare. Attempting to encourage production by
its Import- competing producers, a government might levy tariffs or quotas on imports. But tariffs
and quotas involve larger sacrifices in national welfare than would occur under an equivalent
subsidy. Unlike subsidies, tariffs and quotas distort choices for consumers (resulting in a decrease in
the domestic demand for imports), in addition to permitting less efficient home production to occur.

Compiled by Nega Ejigu, Department of Economics, BDU Page 14

International Economics I Lecture Note Chapter Three: International Trade Policies

The result is the familiar consumption effect of protection, whereby deadweight loss of consumer
surplus is borne by the home nation. This welfare loss is absent in the subsidy case. A subsidy tends
to yield the same result for domestic producers as an equivalent tariff or quota, but at a lower cost in
terms of national welfare. Subsidies are not free goods, however, for they must be financed by
someone. The direct cost of the subsidy is a burden that must be financed out of tax revenues paid by
the public. Moreover, when a subsidy is given to an industry, it is often in return for accepting
government conditions on key matters (such as employee compensation levels).

2) The Impact of Export Subsidy

Besides attempting to protect import- industries, many national governments grant subsidies,
including special tax exemptions and the provision of capital at favored rates, to increase the volume
of exports. By providing a cost advantage to domestic producers, such subsidies are intended to
encourage a nation’s exports by reducing the price paid by foreigners. Foreign consumers are
favored over domestic consumers to the extent that the foreign price of subsidized export is less than
the product’s domestic price.
The grant of an export subsidy yields two direct effects for the home economy: a terms-of-trade
effect and an export revenue effect. Because subsidies tend to reduce the foreign price of home-
nation exports, the home nation’s terms trade worsened. But lower foreign prices generally stimulate
export volume. If the foreign demand for exports is relatively elastic, then a given percentage drop in
foreign price is more than offset by rise in export volume and the home nation’s export revenues
would increase.
The figure below illustrates the case of an export subsidy applied to a commodity in trade between
home country and a foreign country. Under free trade, market equilibrium exists at point E, where
the home country exports 0Qw units of the commodity to the foreign country at a price Pw.
Price

Ps S0 S1
PW E subsidy
P1 F

Dd
0 Qw Q 1 Quantity

Compiled by Nega Ejigu, Department of Economics, BDU Page 15

International Economics I Lecture Note Chapter Three: International Trade Policies

Suppose the exporting country government, to encourage export sales, grants to its exporters a
subsidy of PsP1 per commodity. The home country’s supply curve will shifts from S0 to S1 and
market equilibrium moves to point F. The terms of trade thus turns against exporting country because
its export price falls from Pw to P1 per commodity exported.
Whether the exporter country’s export revenue rises depends on how foreign country buyers respond
to the price decrease. If the percentage increase in the number of the commodity sold to the foreign
country’s buyers more than offsets in the percentage decrease in price, home country’s export
revenue rising from OPwEQ1 to OP1FQ1 units of currency as the result of the decline in the price of
its export good.

Although export subsidies may benefit industries and workers in a subsidized industry by increasing
sales and employment, the benefits may be offset by certain costs that fall on the society as a whole.
Consumers in the exporting nation suffer as the international terms of trade moves against them. This
is because, given a fall in export prices, a greater number of exports must be exchanged for a given
dollar amount in imports. Domestic consumers also find they must pay higher prices than foreigners
for the goods they help subsidize. Furthermore, to the extent that taxes are required to finance the
export subsidy, domestic consumers find themselves poorer.

c) Dumping: Dumping is an international price discrimination which takes place when a producer
sells a commodity abroad at a price lower than that charged in his domestic markeP4. Dumping
is not, therefore, necessarily a synonym of a bargainsale (possibly below cost), as is often
thought, for, on the contrary, it may be a way of maximizing profits. In general three types of
dumping can be distinguished: sporadic, predatory, and persistent.
Sporadic dumping, as the name suggests, occasionally occurs, when a producer, who happens
to have unsold stocks (e.g., because of bad production planning or unforeseen changes in
demand) and wants to get rid of them without spoiling the domestic market, sells them abroad at
reduced prices. This is the type nearest to the concept of a sale below cost.
Predatory dumping takes place when a producer undersells competitors on international
markets in an effort to eliminate them. Of course this producer will also suffer losses but - if he
is successful - can raise the price to the monopoly level, once competitors leave the market. This
type of dumping is, therefore, only temporary.
Persistent dumping is that started off by a producer who enjoys a certain amount of
monopolistic power and exploits the possibility of price discrimination between domestic and
foreign markets in order to maximize profits.

Compiled by Nega Ejigu, Department of Economics, BDU Page 16

International Economics I Lecture Note Chapter Three: International Trade Policies

d) Other Impediments to Free Trade

"Voluntary" Export Restraints. The importing country persuades the exporting country to
"voluntarily" curtail exports to the former. It is, of course, a relative "voluntarity", for it is negotiated
between the importing and the exporting country as an alternative to the imposition, by the former, of
import duties or quotas.
Production Subsidies. If the government subsidizes the domestic production of a commodity, this
subsidy automatically becomes an export subsidy as regards the exported part of the output.
Tied Aid. Developed countries often grant financial assistance to developing countries with the
constraint that the recipient spends the sum received to purchase commodities from the donor. This
causes distortions, which are all the greater when the price (and/or other conditions) in the donor
country is not the cheapest.
Advance-Deposit Requirements. Importers are required to deposit funds (in the central bank, in a
commercial bank, etc.) in an amount proportional to the value of the imported commodities, with no
interest and for a given period of time (usually prior to the receipt of the commodities). Thus
importers are burdened with an additional cost, which depends on the percentage of the value of
imports, on the length of the period and on the rate of interest (which measures a direct cost, if the
importer has to borrow the funds, or an opportunity cost, if he owns them).
Government Procurement. Governments buy a large share of the goods and services currently
produced, and usually prefer to buy domestic rather than equivalent foreign goods of the same price
(in some cases they are allowed by domestic legislation to buy domestic goods even if equivalent
foreign goods have a lower price, not below a certain percentage); besides, governments may have
recourse to a series of techniques aimed at limiting the opportunity for foreign producers to tender
for the supply of goods to the public sector. All this amounts to a discrimination in favour of
domestic producers, which restricts imports.

Formalities of Customs Clearance. These are connected with the imposition of tariffs, such as the
classification and evaluation of the commodities in transit at the customs and other bureaucratic
formalities. A more rigid application of these formalities hinders trade and involves a cost for
importers.

Technical, Safety, Health and Other Regulations. Countries often have different regulations, and
this is in itself an impediment to international trade, for producers have to bear additional costs to
make the commodities conform to the different regulations, according to the country of destination.
Besides, a country may use these regulations to reduce or even stop the imports of certain

Compiled by Nega Ejigu, Department of Economics, BDU Page 17

International Economics I Lecture Note Chapter Three: International Trade Policies

commodities from certain countries, for example, by checking with particular meticulousness and
slowness their conformity to the regulations, or even by issuing regulations which actually prevent
the acceptance of certain foreign commodities.

Border-tax Adjustments. Governments usually levy an "import equalization tax" on imported goods
equal to the indirect tax levied at home on similar goods domestically produced and, vice versa, they
give back to exporters the national indirect tax. This may cause distortions if the import equalization
tax is higher than the national indirect tax (the difference is a covert import duty) or if the sum
returned to exporters is greater than the amount of the national indirect tax (the difference is a covert
export subsidy).

Embargo. The government of a country decrees that certain commodities must not be exported to
certain countries. This is usually done for motives concerning foreign policy, for instance to prevent
(actual or potential) enemy countries from having access to advanced technologies or to put political
pressure on them by economic means.

State Trading. In some countries the government takes all of the country's international trade upon
itself. This is by itself a non-tariff barrier, for the government (directly or indirectly) has a
monopolistic-monopsonistic power as the one and only supplier of domestic goods to foreign
markets and the one and only buyer of foreign goods for the domestic market. If, in addition, the
country has a planned economy, the determination itself of the commodities to be exported and
imported, of the relative amounts, of their prices, etc., is outside the ambit of the pure theory of
international trade dealt with in this book, but falls within the ambit of the theory of planning, which
is outside the scope of the present work.

Compiled by Nega Ejigu, Department of Economics, BDU Page 18