CH 34

Chapter 34
Trade Policy
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

In this chapter you will learn to
1. Describe the various situations in which a country may

rationally choose to protect some industries.
2. Describe the most common fallacious arguments in favor of
protection.
3. Describe the effects of a tariff or quota on imported goods.
4. Explain why trade-remedy laws are sometimes just thinly
disguised protection.
5. Explain the distinction between trade creation and trade
diversion.
6. Describe the main features of the North American Free
Trade Agreement.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-2
Free Trade or Protection?
Protectionism:
- any policies designed to protect domestic industries
from foreign competition
Important examples:
- tariffs
- nontariff barriers
- import quotas and VERs
- cumbersome customs regulations

The Case for Free Trade
Free trade encourages countries to specialize along the lines

of comparative advantage:
 allows an increase in average material living
standards
The gains from specialization and trade make the country as

a whole better off.
But free trade does not necessarily make every individual

better off.

The Case for Protection
Two important valid arguments for protection:

1. Objectives other than maximizing national income
a) Diversification
- advantages from a diversified pattern of production
b) Social
- the protection of specific groups
In both cases, the cost is reduced average income.

The Case for Protection
2. Maximize national income, possibly at the expense of

other countries’ incomes:
a) Improve the terms of trade
- only possible for large countries
b) Protect “infant” industries
- do scale economies exist?
- must make sure they eventually “grow up”
c) Earn pure profits in foreign markets
- “strategic” trade policy
Fallacious Arguments for Protection
Many arguments against free trade are based on popular

misconceptions about markets and economies:
a) Protectionist policies help “keep the money at home”

b) Protection from low-wage foreign labor
c) Exports are “good” whereas imports are “bad”
d) Protectionist policies create more domestic jobs

Methods of Protection
Tariffs
Consider the market
for some imported
Price
D S
good with a world
price of pw .
world
• price
Under free trade,
domestic production
pw • • is Q1 whereas
Imports domestic
consumption is Q2.
Q1 Q2
Quantity
Figure 34.1 The Deadweight
Loss of a Tariff
Domestic producer
surplus rises by area 1.
Domestic consumer
surplus falls by areas
1 + 2 + 3 + 4.
Imports fall, but the

government receives
tariff revenue equal to
area 3.
The overall loss to the

domestic economy
=2+4
Quotas and Voluntary Export
Restraints (VERs)
The same result can be accomplished by a quantity
restriction:
- import quota
- voluntary export restriction (VER)
Same effect on the domestic consumers and producers:

- but foreign producers now receive higher price
- area 3 is extra revenues for foreign producers
rather than tariff revenues for government

Figure 34.2 The Deadweight
Loss of an Import Quota
Deadweight loss = Areas 2 + 3 + 4

Tariffs versus Quotas?
In general, a quota and a volume-equivalent tariff have

different welfare implications for the two countries.
- exporting country prefers a quota
- importing country prefers a tariff
The recently resolved Canada-U.S. trade dispute over

softwood lumber is a good example of the use of both tariffs
and import quotas.

Trade-Remedy Laws and Nontariff
Barriers
Some nontariff barriers were originally created to remedy

problems that arise from international trade.
Dumping:
- when a product is sold in export markets for a
lower price than in the domestic market for reasons
unrelated to costs
Countervailing duties:
- a tariff used to offset the effects of subsidies paid by
foreign governments
Current Trade Policy
The GATT and the WTO

Under the GATT, countries agreed to reduce trade barriers
through multilateral negotiations and not to raise them
unilaterally.
With the end of the Uruguay Round in 1994, the GATT was
succeeded by WTO.
The current round is the Doha Round (2000)

- the very contentious issue is agriculture
Current Trade Policy
In recent years, there has been an emerging debate about

the WTO:
- should environmental and labor issues be

included within the agreements?
- are the negotiations undemocratic?
- the Doha Round includes very little on environmental

issues and labor standards

Regional Trade Agreements
Attempts to liberalize trade over a much smaller group of

countries include:
• free-trade agreements (e.g., NAFTA)
• customs unions (e.g., Mercosur)
• common markets (e.g., EU)

Trade agreements usually reallocate resources through two

effects:
1. Trade creation
When producers in one member country find that they

can export to another member country as a result of the
elimination of the tariffs.
For example:
Under NAFTA, some U.S. firms find that they could
undersell their Mexican competitors in some product
lines, and some Mexican firms find that they could
undersell their U.S. competitors in other product lines.
2. Trade diversion
When exporters in one member country replace foreign

exporters as suppliers to another member country.
For example:
Under NAFTA, U.S. firms find that they can undersell
competitors from the rest of the world in the Mexican
market, not because they are the cheapest source of
supply, but because their tariff-free prices under NAFTA.

Trade Creation versus Trade
Diversion
Trade creation represents efficient specialization according to

comparative advantage.
From the global perspective, trade diversion represents an

inefficient reallocation of resources.

Trade Creation versus Trade
Diversion
APPLYING ECONOMIC CONCEPTS 34.1

Should the WTO Be Abolished?

The North American Free Trade
Agreement
NAFTA is guided by the fundamental principle of national

treatment.
Other provisions include:

• the elimination of tariffs by 2010
• national treatment to foreign investment
• existing trade restrictions are “grandfathered” or have
“sunset” clauses
• some goods remain subject to non-tariff trade restrictions
(such as Canadian cultural industries)
Dispute Settlement Mechanism for
NAFTA
There is also an important dispute settlement mechanism:

- a review panel has the power to suspend any
antidumping or countervailing duties
The results of NAFTA:

- Industry has restructured in the direction of greater
export orientation in all three countries, and trade creation has
occurred.

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Chapter 34

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

1. Describe the various situations in which a country may

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-3

Free trade encourages countries to specialize along the lines

The gains from specialization and trade make the country as

But free trade does not necessarily make every individual

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-4

Two important valid arguments for protection:

In both cases, the cost is reduced average income.

2. Maximize national income, possibly at the expense of

Many arguments against free trade are based on popular

a) Protectionist policies help “keep the money at home”

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-7

Imports fall, but the

The overall loss to the

Same effect on the domestic consumers and producers:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-10

Deadweight loss = Areas 2 + 3 + 4

In general, a quota and a volume-equivalent tariff have

The recently resolved Canada-U.S. trade dispute over

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-12

Some nontariff barriers were originally created to remedy

The GATT and the WTO

The current round is the Doha Round (2000)

In recent years, there has been an emerging debate about

- should environmental and labor issues be

- are the negotiations undemocratic?

- the Doha Round includes very little on environmental

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-15

Attempts to liberalize trade over a much smaller group of

• customs unions (e.g., Mercosur)

• common markets (e.g., EU)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-16

Trade agreements usually reallocate resources through two

When producers in one member country find that they

When exporters in one member country replace foreign

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-18

Trade creation represents efficient specialization according to

From the global perspective, trade diversion represents an

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-19

APPLYING ECONOMIC CONCEPTS 34.1

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-20

NAFTA is guided by the fundamental principle of national

Other provisions include:

There is also an important dispute settlement mechanism:

The results of NAFTA:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 34-22

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