Types of trade barriers

Whilst most economists see a very strong case for free trade between countries, most countries use trade barriers to restrict free trade. The following types of trade barriers are covered in this chapter:

• Tariffs
• Quotas
• Subsidies
• Administrative barriers

Tariffs

Nature of tariffs

Tariffs are taxes put on imported goods as they enter the domestic economy and have to be paid by the individual or organisation importing the good. For example, the European Union charges a 10 per cent tariff on cars. This means a $25,000 Japanese Toyota car would have a $2,500 tariff levied on it, which would be paid by the car dealing business that imported the car. The car dealer will try to pass on some or all the $2,500 tariff to the buyer of the car, but their ability to do this will depend on the price elasticity of demand for the good. Tariffs can be a significant form of government tax revenue and last year $75 billion of tariff revenue was paid on goods entering the US economy.

Graphical analysis of a tariff

Import tariffs can be a percentage ad valorem tax or they can be levied at a specific amount. In this example, we are going to use the US government putting a specific tariff on imported solar panels. The level of tariff the US government has imposed is a $40 per unit tariff on each imported solar panel.

The market for imported goods

In diagram 4.3 the domestic demand and supply for solar panels would give a market price for solar panels of $400. By importing solar panels, consumers can buy them at $250 which is the world price. The world price is determined by the global demand and supply for solar panels. The world supply is shown by WS in diagram 4.3.

At the world price for solar panels quantity demanded for solar panels in the US is 21 million units. US suppliers of solar panels who can sell at the world price of $250 will supply the US domestic market with 8 million units. This means the US economy will import 13 million units of solar panels (21m – 8m = 13m)

Adding the tariff

Adding a $40 tariff per unit to solar panels increases the world supply price and shifts WS up to WS + t to a price of $290. At the higher price of $290 US quantity demanded will fall to 18 million units and the domestic US quantity supplied increases to 10 million units. The increase in price to $290 means more US solar panel suppliers can make a profit and cover their costs.  As US solar panel quantity demanded falls and quantity supplied rises, the quantity imported falls to 8 million units (18m – 10m = 8m).

As well as reducing the quantity of imports, one of the key benefits of tariffs is they raise revenue for the government. This is calculated by multiplying the quantity imported by the value of the tariff. In diagram 4.4 this is shown by the yellow shaded area and is calculated as:

8m x $40 = $320m

The problem with tariffs is they do not necessarily reduce the volume of imports as much as the government would like if the demand and supply for the imported good are price inelastic, although the tariff revenue earned may be significant.

Impact on stakeholders

When a government puts a tariff on a good it impacts domestic consumers, domestic producers and the government. There will also be an impact on foreign producers and overall social welfare. In our US solar panel example, we can examine the impact of the tariff on the different stakeholders by using diagram 4.5.

The impacts on the different stakeholders are:

• There is a fall in the consumer surplus from area ACD before the tariff to area ABE after the tariff is imposed. This means the loss of consumer surplus caused by the increase in the price of the solar panels is area EBCD. Domestic US consumers lose surplus and are worse off because of higher prices.
• Domestic producers gain as their surplus increases from area DGF to area FEH. This gain is shown by the green shaded area in diagram 4.5. Some of this gain will be existing producers earning a great surplus and some will be new producers entering the solar panel market.
• The yellow shaded rectangle will be the gain in US government revenue resulting from the tariff.
• The blue shaded triangle is called a welfare loss. This is the cost of inefficient domestic producers who enter the market for solar panels, but who are only in the market because of the tariff and would not be competitive enough to supply solar panels under normal market conditions.
• The brown shaded triangle is also a welfare loss. This is the loss of consumer surplus from people who no longer buy solar panels. Their loss of surplus is not gained by domestic producers or by the government as tariff revenue.
• Overall, the US economy would suffer a net welfare loss as a result of the tariff.
• The price elasticity of demand and supply of solar panels will determine the size of the changes in consumer and producer surplus, as well as the government tariff revenue and respective welfare losses.
• The advantage of using tariffs is they can reduce imports and also raise government tax revenue.

Quotas

A quota is a method of trade protection where a domestic government sets either a value or a quantity limit on imported goods into the domestic economy.  The benefit of quotas over tariffs is that effective quotas will reduce the value or quantity of imports by a set amount and do not rely on an increase in price decreasing the domestic quantity demanded.

Adding a quota

An example of the use of a quota is tur dal quotas imposed by the Indian government. Tur dal is a lentil used in cooking and is a basic staple food. Diagram 4.6 shows the market for tur dal in India. The world price is $5 per kg which means India’s domestic supply is 20 million kgs and domestic demand is 70 million kgs. This results in 50 million kgs of tur dal being imported into India.

If the Indian government set a quota on tur dal of 30 million kgs to reduce the quantity imported from 50 million kgs to 30 million kgs.  Diagram 4.7 illustrates the impact of the quota on the market for tur dal in India. The 30 million tur dal quota is added to India’s domestic supply to give the domestic market supply for tur dal, S India + q. The market equilibrium for tur dal in India is where D India = S India + q at a price of $7 and a quantity of 60 million kgs. This means that domestic supply from India is 30 million kgs with 30 million kgs imported.

Impact on stakeholders

The imposition of the quota has an impact on domestic consumers, producers and the government. It will also affect foreign producers and overall welfare in society.

Diagram 4.8 examines the impact of the quota on different stakeholders:

• There is a fall in the consumer surplus when the quota is imposed from area ACD to area ABE. This means the loss of consumer surplus caused by the increase in the price of the tar dal is area EBCD. The domestic Indian consumer loses surplus and is worse off because of the increase in the price of tur dal.
• Domestic producers gain as their surplus increases from area DGF to area FEH. This gain is shown by the green shaded area on the diagram. Some of this will be existing producers gaining an increase in surplus and some will be new producers gaining surplus as they enter the tur dal market.
• The blue shaded area is the increase in producer surplus of foreign suppliers of tur dal.
• The red shaded triangle is a welfare loss. This is the cost of inefficient domestic tur dal producers who enter the market and would not be competitive enough under normal market conditions without the quota.
• The yellow shaded triangle is also a welfare loss. This is the loss of the consumer surplus of consumers who no longer buy tur dal. Their loss of surplus is not gained by the domestic or foreign producers and is lost to society.
• Overall, the Indian economy would suffer a net welfare loss as a result of the quota.
• The price elasticity of demand and supply of tur dal will determine the changes in consumer and producer surpluses and respective welfare losses.
• Quotas are more likely to achieve the aim of reducing imports than tariffs because they do not rely on a fall in the quantity demanded by consumers. However, they do not raise revenue and can be subject to corruption because customs officials have to decide which goods can be imported and which cannot.

Subsidies

Nature of trade subsidies

By subsidising domestic producers, governments are giving their producers a cost advantage over foreign producers which acts as a trade barrier.  The advantage of subsidies is they can be used as a ‘hidden’ trade barrier because they do not directly restrict imports and governments can claim they are just supporting a key industry rather than restricting trade. Subsidies on domestic firms can also be used to help domestic exporters by giving them a cost advantage in overseas markets.  The disadvantage of subsidies is they have to be paid for by using government funds.

Graphical analysis of a trade subsidy

Diagram 4.9 shows the domestic market for corn in Argentina. In this example, the world price of corn is $5 per bushel with an Argentinean domestic supply of 8 million bushels and domestic demand of 19 million bushels. This means Argentina imports 11 million bushels of corn. If the Argentinian government pays a subsidy to its corn farmers of $2 per bushel the domestic supply of corn shifts downwards by the amount of the subsidy, and the quantity of corn domestically produced corn increases to 12 million bushels. The quantity of imported corn into Argentina falls to 7 million bushels.

Impact on stakeholders

The payment of a subsidy to domestic producers has an impact on domestic consumers, producers and the government. It will also affect foreign producers and overall welfare in society.

Diagram 4.10 examines the impact of the subsidy on different stakeholders:

• Domestic producers gain from the subsidy as their total revenue increases from $40 million (5m x $8) to $84 million ($7 x 12). This increases their producer surplus by the yellow shaded area in diagram 4.10.
• The government loses because they have to pay the subsidy which is $24 million ($2 x 12m). This will lead to an opportunity cost in terms of other areas of government expenditure or higher taxation.
• The green-shaded triangle is a welfare loss. This is the loss that occurs because of the costs of inefficient domestic corn producers who enter the market and can only maintain their position because of the subsidy they receive from the government.
• Domestic consumers will not be affected by the subsidy because the price of corn in the Argentinian market does not change.
• The price elasticity of supply corn will determine the change in the Argentinian producer surplus, the subsidy the government pays and the size of the welfare loss.

Export subsidies

Nature of export subsidies

Export subsidies are a payment made by the government to producers on each unit they export. The aim of a government using an export subsidy is to encourage domestic producers to increase the amount they export. By boosting exports, the government might try to support a particular industry, improve its balance of trade position and increase the foreign exchange the country earns.

Graphical example of an export subsidy

Diagram 4.10(1) illustrates the market for cheese in Norway with the quantity demanded domestically 13m units and the quantity supplied 24m units which means 11m units if cheese is exported.

Impact on stakeholders

Diagram 4.10(2) illustrates the effect of a $1 export subsidy by the Norwegian government on exported cheese. This shifts the domestic supply curve downwards by $1 per unit from S(Norway) to S(Norway1).

The export subsidy has the following consequences for the different stakeholders:

• Because this is an export subsidy, the $1 subsidy is paid to Norwegian cheese producers to export cheese which means they will receive a price of $5 ($4 world price plus $1 subsidy) for each unit they export. The Norwegian cheese exporters will choose to export their cheese rather than sell it to the domestic market because they receive $5 rather than $4.
• At the world price plus the subsidy the new quantity supplied is 28m units and the new domestic quantity demanded in Norway is 8m units which mean the quantity of Norwegian cheese exported is 20m units.
• The subsidy benefits Norwegian cheese producers who gain producer surplus equal to area ABCD in the diagram. This will also create more employment in the Norwegian cheese market.
• There is a welfare loss because of the costs of inefficient Norwegian cheese drawn into the market. This is shown by the yellow shaded area in the diagram.
• The Norwegian government will have to pay the export subsidy which is the quantity exported multiplied by the subsidy (28m - 8m) x $1 = $20m.
• Norwegian consumers have to pay $5 ($1 more) more for their Cheese because of the export subsidy. This leads to a welfare loss of consumer surplus equal to the green shaded area in the diagram.

Administrative barriers

Administrative trade barriers are where the government imposes excessive rules, regulations and bureaucracy on imported goods. Governments can use administrative barriers to try and reduce imports and protect the country’s domestic producers. Administrative barriers can be used as 'hidden' trade restrictions to protect domestic producers and reduce the threat of other countries retaliating.

Bureaucracy

Governments sometimes put complicated, time-consuming bureaucracy in the way of imports which effectively acts as a trade barrier.  The French government once directed the imports of electronics goods through a single customs post in a small town which greatly increased the processing time for imports and acted as a trade barrier.

Health and safety standards

Governments often impose strict health and safety standards on imported goods which act as trade barriers. The EU has banned the import of hormone-treated beef which acts as a trade barrier to US imported beef, much of which is hormone-treated.

Environmental standards

Governments can restrict the import of products that they claim do not meet set environmental standards.  In the past, the US has restricted imported tuna from Mexico because they claimed the Mexican fishing boats used fishing nets that killed Dolphins.

Government contracts

Governments can restrict imports by only awarding government contracts to domestic firms.  The US recently awarded the contract for the manufacture of all its military uniforms to US producers.

Patriotic or nationalistic campaigns

Governments can put pressure on their citizens to purchase domestically produced goods by making the purchase of imports seem unpatriotic. Japan is often seen as a country where their cultural pressure to buy domestically produced goods.

Reasons why governments restrict free trade

All governments around the world are involved in some form of protectionism. The extent of protectionism depends on the nature of the government and the political situation. For example, US trade policy over the last four years has been much more protectionist. The reasons why governments use protectionism are analysed below.

To protect new industries (infant/sunrise industry argument)

When a country is trying to develop an industrial base, governments put trade barriers in place to protect a new industry against foreign competition.  This allows the domestic firm time to build the economies of scale needed to compete and become established in international markets.  The electric vehicle battery industry in South Korea has been heavily subsidised in recent years to allow the market to become established.

Economically least developed country (ELDC) diversification

The use of trade barriers by economically less developed countries is seen as a development strategy similar to the infant industry argument. By using tariffs, quotas and subsidies ELDCs can diversify away from primary commodity production to growing markets in manufactured goods. For example, many African countries have used trade barriers to develop their renewable energy sectors such as manufacturing solar panels.

Declining industry (sunset industry argument)

Industries are often in decline because they cannot compete with overseas producers.  This has been the case with US steel producers who called for tariffs because of low-priced competition from Asia and Eastern Europe. 

This type of approach is normally used because of the unemployment a decline in a major industry causes, along with regional deprivation where communities are adversely affected when an industry collapses. This has been the case in the ‘Rust Belt’ steel towns of the Midwest in the United States.

Unemployment

This can be linked to the previous point of protecting declining industries.  Historically governments have often responded to a recession and rising unemployment by applying trade barriers. This was the case in the 1930s when the Great Depression led to increased protectionism amongst trading nations. The Smoot-Hawley Tariff Act of 1930 in the US raised tariffs on 20,000 imported products in an attempt to deal with the Great Depression. 

To raise revenue

Tariffs can be a source of government finance, particularly for developing countries that find it difficult to raise revenue through direct and indirect taxation.  The revenue raised depends on the price elasticity of demand for the imported product.  If the product is price inelastic then the revenue raised will be significant, but this may well mean a tariff on a necessity product like imported food has a negative effect on poorer consumers in the developing country.

To deal with a balance of payments current account deficit

A government may respond to a deficit in its current account by putting trade barriers on imported goods and reducing import expenditure. Because of possible retaliation by other countries this approach may yield short-term improvements but may lead to a fall in export revenue in the long term.

Anti-dumping

Dumping occurs when producers export products to another country and sell them at a very low price (sometimes below unit cost). Dumping is also evident when a country’s producers set a price below the level charged in their own domestic economy. The Chinese solar panel industry has been accused of dumping its products in the European Union.

Unfair competition

Many countries use trade barriers to protect their domestic markets from what they see as unfair competition. For example, the EU argues that its trade barriers on textiles are in place because the competition in manufactured clothing from low-cost producers in Asia is unfair. Low wages and poor working conditions of ‘sweatshops’ in some exporting countries are seen as an unfair advantage.

Health and safety standards

Governments sometimes impose trade barriers on products that do not meet domestic standards such as EU restrictions on chlorine-washed chicken from the United States. The EU believes that poultry farming standards in the US do not meet the necessary animal welfare level so will not allow the import of chlorine-washed chicken.   

Environmental standards

Countries sometimes choose to put trade barriers on goods because of environmental concerns. For example, the EU threatened wide-ranging trade barriers against Brazil two years ago because of the burning of areas of the Amazon rainforest.

Strategic reasons

Governments sometimes protect an industry because it has strategic importance.  If, for example, a country was involved in a political conflict it might want to be able to rely on its own food, energy and steel industries. A country like Israel, for example, is constantly under threat from surrounding countries and believes in the importance of maintaining food security by protecting its agricultural industry.

Retaliation

An important consequence of a country imposing trade barriers on another country’s industry is retaliation by the country affected by the trade barriers. In extreme cases, this can lead to a trade war where each country in a trade dispute puts increasing trade barriers on each other's goods. The trade dispute between America and China over the last 3 years has seen trade barriers and retaliation by both countries. Retaliation means an industry unrelated to a trade barrier being imposed can be affected. For example, when the US put trade barriers on EU steel the EU responded by putting a tariff on Harley Davison motorcycles.  

Evaluation of protectionism

The overall belief of economists is that countries benefit from free trade and these arguments are set out in chapter 4.1. The benefit of free trade means that trade barriers are a cost to society. These costs have been identified in the different trade barriers covered in this chapter.

Costs of protectionism:

• Higher import prices for consumers and reduced consumer surplus
• Welfare loss of consumers who no longer buy an imported good
• Increased import costs for businesses
• Welfare loss of inefficient production
• Reduced consumer choice
• Costs to the government of managing quotas and other trade barriers
• Retaliation against export industries.

There are, however, some situations where trade barriers can be a benefit to a country although retaliation will weaken these benefits.

Benefits of protectionism:

• Can improve protect environmental and health and safety standards
• Allows a country to develop an industrial base
• Can be used to raise tariff revenue
• Reduces unfair competition and dumping
• Reduces the speed of industrial decline
• Protects employment.

Politics and protectionism

Because governments impose trade barriers there is a huge amount of politics involved in decisions to apply trade barriers.  Trade restrictions are often put in place in response to political lobbying by powerful interest groups who put pressure on politicians who, in their desire to get re-elected, push for trade restrictions.  President Trump has used US tariffs on imported manufactured goods as part of a political strategy as well as an economic one. For example, many of the ‘Rust Belt’ steel towns that have benefited from trade barriers on steel are so-called ‘swing states’, which are very important for winning the US presidential election.