International Trade Policy: Analysis of Tariffs, Unions, and Trade Models

International Trade Policy Analysis

Impact of a 20% Tariff on Personal Computers

Given the following information, we will calculate the cost to consumers, the benefit to producers, the change in government revenue, and the deadweight costs of a proposed 20 percent tariff on personal computers.

Calculations for the 20% PC Tariff

With a 20% tariff, the price of personal computers increases from $2,000 to $2,400 (a $400 increase).

• Cost to Consumers (Loss in Consumer Surplus):
  The total loss in consumer surplus is the area of the trapezoid under the demand curve. This includes the transfer to producers and government, plus the deadweight loss.
  Calculated as: ($2,400 - $2,000) × 140,000 + (($2,400 - $2,000) × (150,000 - 140,000) / 2)
  = $400 × 140,000 + ($400 × 10,000 / 2)
  = $56,000,000 + $2,000,000 = $58,000,000
• Benefit to Producers (Gain in Producer Surplus):
  Producers gain from the higher price and increased domestic production.
  Calculated as: ($2,400 - $2,000) × 100,000 + (($2,400 - $2,000) × (120,000 - 100,000) / 2)
  = $400 × 100,000 + ($400 × 20,000 / 2)
  = $40,000,000 + $4,000,000 = $44,000,000
• Change in Government Revenue (Tariff Revenue):
  Government revenue is generated from the tariff on imported goods.
  Imports after tariff = Domestic Consumption (after tariff) - Domestic Production (after tariff)
  = 140,000 units - 120,000 units = 20,000 units
  Calculated as: Tariff per unit × Quantity Imported
  = $400 × 20,000 = $8,000,000
• Deadweight Costs (Welfare Loss):
  These are the efficiency losses due to the tariff, representing lost gains from trade.
  There are two components:
  
  • Production Deadweight Loss: Due to inefficient domestic production replacing cheaper imports.
    Calculated as: ($2,400 - $2,000) × (120,000 - 100,000) / 2
    = $400 × 20,000 / 2 = $4,000,000
  • Consumption Deadweight Loss: Due to reduced consumption at the higher price.
    Calculated as: ($2,400 - $2,000) × (150,000 - 140,000) / 2
    = $400 × 10,000 / 2 = $2,000,000
  Total Deadweight Costs = $4,000,000 + $2,000,000 = $6,000,000

Welfare Impact of Belgium-Luxembourg Customs Union

Assume that the free trade price of commodity X is €2 in the US, and €3 in Luxembourg. Initially, Belgium applies a 100 percent tariff on all imports. Before the customs union, Belgium produces 60 million units of X and consumes 80 million units. Belgium then forms a customs union with Luxembourg, but maintains the 100 percent tariff with the US. After the formation of the customs union, Belgium produces 50 million units of X, consumes 100 million units of X, and imports 50 million units of X.

Analysis of Welfare Impact

1. Pre-Customs Union Scenario:

• Free Trade Price (US): €2
• Free Trade Price (Luxembourg): €3
• Belgium's Tariff: 100% on all imports
• Price of US goods in Belgium (with tariff): €2 × (1 + 100%) = €4
• At this stage, Belgium's domestic price is effectively €4.
• Domestic Production: 60 million units
• Domestic Consumption: 80 million units
• Imports: 80 million - 60 million = 20 million units (presumably from the US, as it's the cheapest source after tariff).

2. Post-Customs Union Scenario:

• Belgium forms a Customs Union with Luxembourg, eliminating tariffs between them.
• Tariff with US remains 100%.
• Price of US goods in Belgium (with tariff): €4
• Price of Luxembourg goods in Belgium (no tariff): €3
• Belgium will now import from Luxembourg at €3, as it is cheaper than the US price with tariff.
• Domestic Production: 50 million units
• Domestic Consumption: 100 million units
• Imports: 100 million - 50 million = 50 million units (all from Luxembourg).

3. Net Impact on Welfare:

The formation of a customs union can lead to both trade creation and trade diversion.

• Trade Creation Gain:
  This gain arises from shifting from higher-cost domestic production to lower-cost imports (production efficiency) and from increased consumption due to lower prices (consumption efficiency).
  
  • Production Efficiency Gain: (Initial Production - New Production) × (Initial Domestic Price - New Domestic Price) / 2
    = (60 million - 50 million) × (€4 - €3) / 2
    = 10 million × €1 / 2 = €5 million
  • Consumption Efficiency Gain: (New Consumption - Initial Consumption) × (Initial Domestic Price - New Domestic Price) / 2
    = (100 million - 80 million) × (€4 - €3) / 2
    = 20 million × €1 / 2 = €10 million
  Total Trade Creation Gain = €5 million + €10 million = €15 million
• Trade Diversion Loss:
  This loss occurs when imports shift from a more efficient non-member country (US, actual cost €2) to a less efficient member country (Luxembourg, actual cost €3) due to the preferential tariff arrangement.
  Calculated as: (Price from new source - Price from original cheapest source) × Quantity imported from new source
  = (€3 - €2) × 50 million units
  = €1 × 50 million = €50 million

Net Impact on Welfare:
Net Welfare Impact = Trade Creation Gain - Trade Diversion Loss
= €15 million - €50 million = -€35 million

The formation of this customs union results in a net welfare loss for Belgium, primarily due to significant trade diversion.

Economic Benefits of Free Trade Over Autarky

The proposition that free trade is better than no trade (autarky) can be proven by analyzing the changes in consumer and producer surplus when a country opens its economy to international trade.

Let P_A be the autarky price and P_W be the free trade world price. When a country moves from autarky to free trade, assuming P_W is lower than P_A (the country becomes an importer):

• Impact on Consumers: Consumers benefit significantly from free trade. The domestic price falls from P_A to P_W, leading to an increase in domestic consumption. This results in a substantial gain in consumer surplus, represented by the area of the trapezoid below the demand curve and above the new world price.
• Impact on Producers: Domestic producers face increased competition and a lower price (P_W), leading to a decrease in domestic production. This results in a loss in producer surplus, represented by the area of the trapezoid above the supply curve and below the autarky price.
• Net Welfare Gain: While producers lose, the gain to consumers typically outweighs this loss. The net welfare gain from free trade is represented by two triangles:
  • An efficiency gain from increased consumption due to the lower price.
  • An efficiency gain from shifting production from high-cost domestic producers to lower-cost foreign producers.
  These two triangles represent the overall increase in economic efficiency and welfare for the nation. Therefore, free trade leads to a net positive impact on national welfare compared to autarky.

Reasons for Asymmetries in Bilateral Trade Data

Bilateral trade statistics often show discrepancies between what one country reports as exports to another and what the latter reports as imports from the first. Key reasons for these asymmetries include:

• Unallocated Trade: Goods that are shipped to a transit country before reaching their final destination may be recorded differently by the exporting and importing countries.
• Differences in Trade Systems/Reporting: Countries may use different methodologies for recording trade, such as general trade systems (including goods passing through customs) versus special trade systems (only goods entering/leaving for domestic consumption/production).
• Currency Conversion Methods: Variations in exchange rates and the timing of currency conversions can lead to different reported values.
• Time Lags in Reporting: Goods shipped at the end of one reporting period by the exporter might be received and recorded in the next period by the importer.
• Differences in Product Classification: Countries may classify the same goods under different Harmonized System (HS) codes, leading to discrepancies in aggregated trade data.
• Confidentiality Rules: Some countries suppress data for certain products or partners to protect commercial confidentiality, leading to incomplete reporting.
• Smuggling and Illicit Trade: Unrecorded trade activities contribute to discrepancies.

Predicting Bilateral Trade: Models and Key Variables

The most widely used and effective models for predicting bilateral trade flows are Gravity Models.

Gravity Model of Trade

In practice, the statistical equation of a gravity model relates the monetary value of trade between two countries to their respective economic sizes (e.g., GDPs) and to factors that represent trade costs or facilitators between them.

Main Variables Included in Gravity Models:

A number of variables are used to capture trade costs and other influences on trade:

• Bilateral Distance: A proxy for transportation costs and communication barriers; typically has a negative impact on trade.
• Economic Size (GDP/GNP): Larger economies tend to trade more, both as exporters and importers; typically has a positive impact.
• Common Borders: Reduces transportation costs and facilitates trade; typically has a positive impact.
• Common Language: Reduces communication barriers and transaction costs; typically has a positive impact.
• Cultural Factors: Shared cultural heritage, historical ties, or colonial links can foster trade; typically has a positive impact.
• Tariff and Non-Tariff Barriers: Policies like tariffs, quotas, and regulatory differences increase trade costs; typically have a negative impact.
• Membership in Regional Trade Agreements: Reduces trade barriers among members; typically has a positive impact.
• Common Currency: Eliminates exchange rate volatility and conversion costs; typically has a positive impact.