Chapter 8 Domestic Policies and International Trade

8.1 Chapter Overview

Policy analysis in international trade theory generally emphasizes the analysis of trade policies specifically. Trade policyAny policy that directly affects the flow of goods and services between countries, such as import tariffs, import quotas, voluntary export restraints, export taxes, and export subsidies. includes any policy that directly affects the flow of goods and services between countries, including import tariffs, import quotas, voluntary export restraints, export taxes, export subsidies, and so on. During the 1980s and 1990s, as trade barriers came down, especially between developed countries, more and more attention was brought to the effects of certain domestic policyAny type of tax or subsidy policy or any type of government regulation that targets the domestic behavior of firms or consumers. types, including their international effects.

For example, there is increasing concern in the United States about the environmental and labor policies of many U.S. trade partners. With regard to environmental policies, some have argued that more lenient environmental regulations in many less-developed countries give firms in those countries a competitive edge relative to firms operating in the United States. The same argument is used in regard to labor practices. Many U.S. industry representatives argue that low foreign wages, lenient occupational safety regulations, and in some cases the use of child labor or prison labor give some countries a competitive edge in international markets.

In general, for small countries, domestic policies will affect domestic prices, production levels, trade flows, and welfare but will not affect foreign prices, production levels, and welfare. This means that countries like the United States may not need to worry much about domestic practices in very small countries. However, when a country is large in international markets, domestic policies will affect prices, production levels, profits, and welfare, both domestically and internationally.

8.2 Domestic Production Subsidies

A domestic production subsidyA payment made by a government to firms in a particular industry based on output or production levels. is a payment made by a government to firms in a particular industry based on the level of output or production. The subsidy can be specified either as an ad valorem subsidy (a percentage of the value of production) or as a specific subsidy (a dollar payment per unit of output). A domestic production subsidy is different from an export subsidy. A production subsidy provides a payment based on all production regardless of where it is sold. An export subsidy, on the other hand, only offers a payment to the quantity or value that is actually exported. An export subsidy is classified as a trade policy, whereas a production subsidy is a domestic policy.

Domestic production subsidies are generally used for two main reasons. First, subsidies provide a way of raising the incomes of producers in a particular industry. This is in part why many countries apply production subsidies on agricultural commodities: it raises the incomes of farmers. The second reason to use production subsidies is to stimulate output of a particular good. This might be done because the product is assumed to be critical for national security. This argument is sometimes used to justify subsidies to agricultural goods, as well as steel, motor vehicles, the aerospace industry, and many other products. Countries might also wish to subsidize certain industries if it is believed that the industries are important in stimulating growth of the economy. This is the reason many companies receive research and development (R&D) subsidies. Although R&D subsidies are not strictly production subsidies, they can have similar effects.

We will analyze the international trade effects of a domestic production subsidy using a partial equilibrium analysis. We will assume that the market in question is perfectly competitive and that the country is “small.” We will also ignore any benefits the policy may generate, such as creating a more pleasing distribution of income or generating valuable external effects. Instead, we will focus entirely on the producer, consumer, and government revenue effects of each policy.

Next, we consider the effects of a production subsidy under two separate scenarios. In the first case, the subsidy is implemented in a country that is not trading with the rest of the world. This case is used to show how a domestic policy can cause international trade. The second case considers the price and welfare effects of a production subsidy implemented by a country that is initially importing the good from the rest of the world.

8.3 Production Subsidies as a Reason for Trade

This section will show how a production subsidy can cause trade for a small, perfectly competitive, open economy. The analysis indicates that domestic policies can be a cause of trade even in the absence of other reasons for trade. In other words, even if countries were identical with respect to their resource endowments, their technology, and their preferences and even if there were no economies of scale or imperfectly competitive markets, domestic policies could induce trade between countries.

Consider a small open economy with a perfectly competitive industry. Let the domestic market be represented by the supply and demand curves in Figure 8.1 "Inducing Exports with a Domestic Production Subsidy". Suppose initially that free trade is allowed with the rest of the world, but by coincidence (actually by assumption), let the free trade price be exactly equal to the autarky price for the good. This is shown as the price, P_FT. This implies that no imports or exports occur, even though there is free trade.

Figure 8.1 Inducing Exports with a Domestic Production Subsidy

Next, suppose that the government of this country offers a specific (per unit) production subsidy to the domestic firms. Let the subsidy rate be set at “s.” This means the government will pay “s” dollars for every unit the domestic firm produces, regardless of where the product is sold.

The subsidy effectively raises the price that the producer receives for each unit of the good produced and sold. At the same time, the subsidy will not affect the domestic price that consumers pay. In other words, the subsidy will cause the price received by producers (the producer price) to rise above the price paid by consumers (the consumer price). The new producer price is labeled P_P in Figure 8.1 "Inducing Exports with a Domestic Production Subsidy", while the consumer price, P_C, remains equal to the free trade price. Thus P_P = P_FT + s and P_C = P_FT. These price changes occur because these prices will allow domestic firms in the small country to maximize their profits in the face of free competition with firms in the rest of the world.

The subsidy will increase domestic production. At the market price P_FT, domestic firms were willing to supply to Q₁. Once the producer price rises to P_P, domestic supply will rise to Q₂. Demand would remain the same, however, since the consumer price remains fixed. The difference between domestic supply and demand, Q₂ − Q₁, represents the level of exports to the rest of the world. Since exports did not exist prior to the subsidy, this is an example in which a domestic policy (a production subsidy) can cause trade (i.e., exports) to occur.

8.4 Production Subsidy Effects in a Small Importing Country

Domestic policies can affect trade in an industry for a country that is either an exporter or an import-competitor initially. In this example, we consider the price, production, and welfare effects of a production subsidy when the subsidized product is initially imported into the country.

We depict this equilibrium in Figure 8.2 "A Domestic Production Subsidy in a Small Importing Country". The free trade price is given by P_FT. The domestic supply is S₁, and domestic demand is D₁, which determines imports in free trade as D₁ − S₁ (the length of the red line).

Figure 8.2 A Domestic Production Subsidy in a Small Importing Country

When a production subsidy “s” is imposed, the domestic producer price rises by the subsidy value to P_P. Because free trade is maintained and the importing country is small, the domestic consumer price remains at P_FT. Thus the effect of the subsidy in this case is to raise domestic supply from S₁ to S₂ while domestic demand remains at D₁. As a result, imports fall from (D₁ − S₁) to (D₁ − S₂).

The welfare effects of the production subsidy are shown in Table 8.1 "Static Welfare Effects of a Production Subsidy". The letters in Table 8.1 "Static Welfare Effects of a Production Subsidy" refer to the areas labeled in Figure 8.2 "A Domestic Production Subsidy in a Small Importing Country".

Consumers are left unaffected by the subsidy since the domestic consumer price remains the same. Producers gain in terms of producer surplus. The subsidy causes the price producers receive to rise to P_P, which in turn stimulates an increase in output from S₁ to S₂. The government, however, must pay the subsidy, and that means someone must pay higher taxes to fund it. The total amount of the subsidy payments is given by the product of (P_P − P_FT) in Figure 8.2 "A Domestic Production Subsidy in a Small Importing Country" (which corresponds to the subsidy rate) and the quantity produced, S₂. Since the cost of the subsidy exceeds the benefits to producers, the net national welfare effect of the production subsidy is negative. Although one segment of the population benefits—namely, those connected with the import-competing industry—there remains a production efficiency loss, given by area b.

In the rest of the world, the small country assumption implies that this domestic policy (the production subsidy) would have no noticeable effects. Foreign prices would remain unchanged, and although their exports to this country would fall, these changes in trade volumes are too small to be noticed in the rest of the world. Thus the welfare effects on the rest of the world are said to be nonexistent, or zero.

8.5 Domestic Consumption Taxes

A domestic consumption taxA tax collected by a government on sales of a particular product. is a tax collected by a government on sales of a particular product. The tax can be levied either as an ad valorem tax (a percentage of the value of the good) or as a specific tax (a charge per unit of the good sold). The domestic consumption tax is different from an import tariff or an export tax. The consumption tax is levied on all the goods sold in the domestic market regardless of where the goods are produced. An import tariff or export tax, on the other hand, is levied only on units of the goods actually imported or exported. An import tariff and an export tax are classified as trade policies, whereas the consumption tax is a domestic policy.

Domestic consumption taxes are often used as a source of government revenue. In the United States, the most common type of ad valorem consumption tax is the sales tax levied by state governments. The most common specific consumption taxes include gasoline, alcohol, and cigarette taxes. The latter two are sometimes referred to as “sin” taxes, since they are also designed to reduce consumption of potentially harmful substances. Thus sometimes consumption taxes are used to discourage certain types of consumption.

We will analyze the international trade effects of a domestic consumption tax using a partial equilibrium analysis. We will assume that the market in question is perfectly competitive and that the country is “small.” We will also ignore any benefits the policy may generate, such as creating a more pleasing distribution of income or generating valuable external effects. Instead, we will focus entirely on the producer, consumer, and government revenue effects of each policy.

Next, we consider the effects of a consumption tax under two separate scenarios. In the first case, the tax is implemented in a country that is not trading with the rest of the world. This case is used to show how a domestic policy can cause international trade. The second case considers the price and welfare effects of a consumption tax implemented by a country that is initially importing the good from the rest of the world.

8.6 Consumption Taxes as a Reason for Trade

This section will show how a consumption tax can cause trade for a small, perfectly competitive, open economy. In other words, even if countries were identical with respect to their resource endowments, their technology, and their preferences and even if there were no economies of scale or imperfectly competitive markets, a purely domestic policy, such as a consumption tax, can induce trade between countries.

Consider a small open economy with a perfectly competitive industry. Let the domestic market be represented by the supply and demand curves in Figure 8.3 "Inducing Exports with a Domestic Consumption Subsidy". Suppose initially that free trade is allowed with the rest of the world, but by coincidence (actually by assumption), let the free trade price be exactly equal to the autarky price for the good. This is shown as the price, P_FT. At that price, both supply and demand equal Q₁, and thus no imports or exports occur, even though there is free trade.

Figure 8.3 Inducing Exports with a Domestic Consumption Subsidy

Next, suppose that the government of this country imposes a specific (per unit) consumption tax on this product. Let the tax rate be set at “t.” This means the government will collect “t” dollars for every unit of the good sold in the domestic market, regardless of whether the product is produced domestically or imported.

The tax will raise the domestic consumer price of the good by the full amount of the tax to P_C and reduce domestic demand to Q₂. Domestic producers will not be affected by the consumption tax since continued competition in free trade with firms in the rest of the world will allow them to continue to charge the world price of P_FT. Note that in a closed economy, the producers would absorb some of the tax burden by lowering their price so as to maintain the profit maximum. However, being open to trade implies that the country can purchase as much as it likes at the world price. This means that the producer price P_P will remain equal to the free trade price P_FT, and the full burden of the tax falls on consumers. Thus P_C = P_FT + t and P_P = P_FT.

Since the tax has no effect on the producer price but raises the consumer price, domestic demand falls to Q₂ while domestic supply remains at Q₁. The difference, Q₁ − Q₂ (the length of the red line), represents the amount exported to the rest of the world. This implies that the consumption tax will induce exports of the good. Thus this is an example in which a domestic policy (a consumption tax) can cause trade (i.e., exports) to occur.

8.7 Consumption Tax Effects in a Small Importing Country

Domestic policies can affect trade in an industry for a country that is either an exporter or an import-competitor initially. In this example, we consider the price, production, and welfare effects of a consumption tax when the taxed commodity is initially imported in the country.

We depict the initial equilibrium in Figure 8.4 "A Domestic Consumption Tax in a Small Importing Country". The free trade price is given by P_FT. The domestic supply is S₁, and domestic demand is D₁, which determines imports in free trade as D₁ − S₁ (the length of the red line).

Figure 8.4 A Domestic Consumption Tax in a Small Importing Country

When a specific consumption tax “t” is imposed, the consumer price will rise by the amount of the tax to P_C. The higher price paid by consumers will reduce their demand to D₂. The producer price will remain at the free trade price indicated at P_P = P_FT, and hence domestic supply will remain at S₁. The tax will reduce imports from (D₁ − S₁) to (D₂ − S₁).

The welfare effects of the consumption tax are shown in Table 8.3 "Static Welfare Effects of a Consumption Tax".

Consumers suffer a loss in surplus because the price they pay rises by the amount of the consumption tax. Producers experience no change in surplus since the producer price (i.e., the price received by producers) remains at the free trade level. Note that even though imports fall, this decrease has no positive effect on producers in this situation. Finally, the government receives tax revenue from the consumption tax. The revenue is calculated as the tax, t (given by P_C − P_P), multiplied by the quantity consumed, D₂.

Since the cost to consumers exceeds the benefits accruing to the government, the net national welfare effect of the consumption tax is negative. Although some segments of the population benefit, there remains a consumption efficiency loss, given by area c.

In the rest of the world, the small country assumption implies that this domestic policy (the consumption tax) would have no noticeable effects. Foreign prices would remain unchanged, and although their exports to this country would fall, these changes in trade volumes are too small to be noticed in the rest of the world. Thus the welfare effects on the rest of the world are said to be nonexistent, or zero.

8.8 Equivalence of an Import Tariff with a Domestic (Consumption Tax plus Production Subsidy)

We begin by demonstrating the effects of a consumption tax and a production subsidy applied simultaneously by a small importing country. Then we will show why the net effects are identical to an import tariff applied in the same setting and at the same rate.

In Figure 8.5 "A Domestic Production Subsidy and Consumption Tax in a Small Importing Country", the free trade price is given by P_FT. The domestic supply is S₁, and domestic demand is D₁, which determines imports in free trade as D₁ − S₁ (the red line).

Figure 8.5 A Domestic Production Subsidy and Consumption Tax in a Small Importing Country

When a specific consumption tax “t” is implemented, the consumer price increases by the amount of the tax to P_C. Because free trade is maintained, the producer’s price would remain at P_FT. The increase in the consumer price reduces domestic demand to D₂.

When a specific production subsidy “s” is implemented, the producer price will rise by the amount of the tax to P_P, but it will not affect the consumer price. As long as the production subsidy and the consumption tax are set at the same value (i.e., t = s), which we will assume, the new producer price will equal the new consumer price (i.e., P_C = P_P).

The effect of the production subsidy and the consumption tax together is to lower imports from D₁ − S₁ to D₂ − S₂.

The combined welfare effects of the production subsidy and consumption tax are shown in Table 8.5 "Static Welfare Effects of a Production Subsidy plus Consumption Tax".

Consumers suffer a loss in surplus because the price they pay rises by the amount of the consumption tax.

Producers gain in terms of producer surplus. The production subsidy raises the price producers receive by the amount of the subsidy, which in turn stimulates an increase in output.

The government receives tax revenue from the consumption tax but must pay for the production subsidy. However, since the subsidy and tax rates are assumed to be identical and since consumption exceeds production (because the country is an importer of the product), the revenue inflow exceeds the outflow. Thus the net effect is a gain in revenue for the government.

In the end, the cost to consumers exceeds the sum of the benefits accruing to producers and the government; thus the net national welfare effect of the two policies is negative.

Notice that these effects are identical to the effects of a tariff applied by a small importing country if the tariff is set at the same rate as the production subsidy and the consumption tax. If a specific tariff, “t,” of the same size as the subsidy and tax were applied, the domestic price would rise to P_T = P_FT + t. Domestic producers, who are not charged the tariff, would experience an increase in their price to P_T. The consumer price would also rise to P_T. This means that the producer and consumer welfare effects would be identical to the case of a production subsidy and a consumption tax. The government would only collect a tax on the imported commodities, which implies tariff revenue given by (c). This is exactly equal to the net revenue collected by the government from the production subsidy and consumption tax combined. The net national welfare losses to the economy in both cases are represented by the sum of the production efficiency loss (b) and the consumption efficiency loss (d).