Quiz 10: The Political Economy of Trade Policy


Free trade means the unrestricted movement of goods and services among countries and has huge advantages for small countries like Philippines. Even though it might prove to hurt the small producers in the domestic market, however, an increased competition, due to the free trade, helps in providing better quality products to the consumers and, gives an incentive to produce high-quality products to the producers. The following are the arguments in favor of free trade: (1)Free trade influences consumers and producers of Philippines decision of choice based on marginal cost-benefit calculations. Their economic decisions are no more dithered by the artificial control by government policies. (2)Free trade will widen the domestic market of Philippines. Consumers of Philippines can avail a wide range of goods and services which was not possible in case of autarky. (3)It offers more opportunities for innovation which might introduce economies of scale in the process of production. (4)Free trade has improved the domestic politics of trade. The domestic trade policy of the country is linked with the politics of globalization. Free trade results in a political cleavage between the supporters of free trade and those opposing open trade.

(A)It is in favor of argument for tariff. United States being a large country has a large share in the world oil market and thus can influence the world oil prices. If the United States imposes tariff on oil, then its domestic price increases which benefit the domestic producers of oil; thereby increasing oil production and exploration which in turn, increases the domestic supply of oil in future. The rationale behind the argument is that tariff restricts the current consumption of oil (the domestic consumers suffer due to higher prices resulting from tariff)and thus the United States can stock their oil inventories which minimizes the future adverse shocks. (b)The argument made is an invalid argument. This is because off- season fruits are non-competing in nature. A sharp fall in its price does not affect the supplies of domestic producers in United States. A sharp fall in prices benefits the domestic consumers. Thus, any trade policy like tariff offsets the benefits of the domestic consumers as tariff increases the domestic price of the fruits. In this case only government will gain as it earns revenue. (c)This is not a valid argument for export subsidy. Any trade policy like export subsidy will increase the incomes of the U.S farmers. It also increases the incomes of those who sell goods and services to the U.S farmers, but at the cost of the welfare of the U.S consumers. It should be recalled that an export subsidy always generates more cost than benefits. If government's goal is to stimulate the demand for the related goods of the farm sector, policies should target that goal only. (d)This is a valid argument. Production semiconductors are of national interest. The domestic production of semiconductors leads to external economies. But, gains to domestic producers come at the expense of higher cost to the consumers who badly need the good. However, a direct subsidy to the domestic chip production would be the best alternative policy. (e)This is not a valid argument. This is because the thousands of timber workers are buyers of the home who are benefitted from the cheap timber. The cheap timber will benefit the home consumers and the users of timber. If the aim of the policy is to reduce the pain of the timber workers, then the better policy is to make direct aid payments to the timber account holder.

It is given that the world price of a good, represented by P w , is 10 per unit. Calculate the equilibrium price for the small country, before the imposition of a tariff, as follows: img img Calculate the equilibrium quantity at the autarky level as follows: img img Therefore, the equilibrium price and quantity are 25.33 and 273.33, respectively. Represent the demand and supply of the good, in absence of a tariff, as follows: img img Now, calculate the amount of the good the country will have to import as follows: img a.With imposition of a tariff of 5 per unit, the domestic price increases from 10 to 15. Now, calculate the new demand and supply as follows: img img img There is an increase in domestic production from 120 to 170, that is, production increases by 50 units. While there is reduction in demand from 350 to 325, that is, demand falls by 25 units. Calculate the welfare effect of the tariff as follows: img img Thus, there is a total welfare benefit of 312.5 units. b.With a production subsidy of 5, the price that the seller receives is 15 per unit instead of 10 per unit. Calculate the new supply as follows: img The production rises to 170, that is, it increases by 50. But demand remains the same at 350. The consumer loss is eliminated as consumers can still consume at a price of 10. Now, Calculate the total effect from subsidy as follows: img Thus, there is a gain in welfare of 375 units. c.The production subsidy produces a greater gain in welfare than the tariff because it only affects the prices in the production side and not the demand side. Consumers stay at the original consumption point and there is no distortion in the quantity demanded. However, the supply increase. This leads to an increase in the overall welfare. On the other hand, tariff affects the prices in both the production and demand side. Therefore, though the supply increases, there is a consequent fall in demand. Thus, the net gain from tariff is less than a targeted policy. d.The optimal production subsidy can be calculated by setting a goal of maximizing change in welfare of a country. Represent change in the welfare of the country as follows: img Here, ? CS is the change in consumer surplus, ? PS is the change in production surplus, ? GVT is the change in government expenditure, and ? SB is the change in social benefit. Represent the new price as follows: img Substitute P New in the supply equation as follows: img Now, calculate the change in producer surplus as follows: img Calculate the change in government expenditure as follows: img Calculate the change in social benefit as follows: img Substitute the value in the equation for maximum change in welfare as follows: img Calculate the derivative for the above equation as follows: img Therefore, img .