Chapter 3 

Estimating the Impact of Trade Policy Changes on the Price of Imported Products and on Trade in such Products   

One of the most frequently raised questions on policy actions covered by commercial diplomacy is the impact on trade flows. Understanding and communicating the impact of trade policy on trade, and ultimately on revenues, costs, profits, wages and jobs, is the foundation of commercial diplomacy. While economists tend to emphasize the economic efficiency and consumer benefits of trade, the political debate over trade is dominated by arguments over the benefit of increased exports to producers in export industries, and the loss generated by increased imports for producers in import-competing industries. In other words, economists see imports as good, because they allow consumption of goods produced using another country’s resources, and exports as necessary to finance imports, while policymakers often see imports as a threat to domestic producers and interest groups, and exports as a source of new wealth, increased national output, employment, profits, and tax revenues. These policy perceptions are reinforced politically by producers being better organized politically than consumers. Consumer organizations are often co-opted by producer interests. This can result in a mercantilist tilt to trade policy. 

In view of these political realities, proponents of trade liberalization usually focus on new export opportunities created by reducing foreign trade barriers, while opponents of trade liberalization focus on the displacement of domestic production through increased imports.

In this chapter we review the steps necessary to calculate the impact of trade policy on trade flows, and in subsequent chapters we will review the steps necessary to calculate the impact on revenues, costs, profits, wages and jobs. Calculating the impact of a policy measure on trade is generally a two-step process. First, the analyst must calculate the effect of the policy action on the price at which the good or service could be sold in the import market, and second the analyst must calculate the impact of the potential change in price on the quantity consumers wish to purchase. Our starting point is small countries, which can buy as much as they wish at a constant world price
. 
For a large country like the United States, a third step is necessary. The analyst must determine if the change in import demand for a product is sufficient to alter the world price of that product. For economists, the definition of a “large” or “small” country is product specific, and rests on whether a policy change in that producing or consuming country has a noticeable impact on world price. Thus Kuwait, despite its small land area and low population, may be a large country in the oil market, while India may be considered small in many manufactured goods markets like autos and aircraft. In general, the analysis of trade effects is complicated by any departure from the assumption of perfect competition built into most economic models.

  
Calculating the Price Impact of a Policy Action

Tariffs: We start with the case of a small county in a competitive market. We will later discuss some of the complexities introduced by large countries and large firms that can affect world prices. Calculating the impact of the policy action on price is a fairly straightforward calculation in the case of changes to ad valorem tariffs or other fees on imported products in proportion to its price. 

Provided both the importers and domestic retailers are operating under competitive market conditions, we can assume that the increase or reduction of the tariff is passed on to the consumer. Thus a 50% reduction of an 80% duty translates into a 22% percent reduction of the consumer price in the import market. Here is an example: assuming the world price is $1, a 50% cut in the 80% tariff translates into a price reduction of $0.40 from $1.80 to $1.40.[1] Note, however, that a 50% reduction of a 10% duty translates into only a 4 ½ percent cut in the retail price of the import (assuming again that the import price is $1, a 50% cut in the 10% duty translates into a 5 cent cut from $1.10). The general formula for calculating the change in price is the change in the tariff divided by one plus the original tariff rate. The same calculation can be applied to any fee on an imported product in proportion to its price. 

%?Price = (New Tariff – Old Tariff)/ (1+Old Tariff)

Calculating the impact of the change of a tariff or a fee in a noncompetitive market situation, where there is a restraint on competition at either the import or retail stage, is more difficult. In a less than fully competitive market, either the importer or the retailer may pass on only a portion of the reduced fee or tariff, keeping the rest for increased profits. This is called incomplete pass through in the economists’ jargon. The only good way to calculate the extent to which the reduced tariff will reduce prices in the import market is to investigate what happened in previous occasions where the duties were cut, assuming no major change in market structure in the meantime. With a little research you may find studies done by economists, which can give you a rough estimate. Note that studies of exchange rate pass through, a concept we introduce in Chapter 8, are similar but not identical. In other cases, you may have to survey practitioners or examine historical data to develop an estimate.

Quotas: Another common policy action is the reduction or increase of an import quota. Translating a change in the quota to a price change is complicated, but in most cases not necessary for calculating an impact on trade as long as the changed quota continues to restrict trade. In such a case we can assume that trade is increased (reduced) by the full increase (reduction) in the quota. Where the quota that emerges from the change in policy does not bind trade, as happens frequently in the case of textile quotas allocated to highly specific apparel items, you must resort to estimates based on a survey of practitioners or an examination of historical data. 

When a particular regulation overshadows all other import-related regulations, an initial approach to estimating the price effect of removing the regulation is to examine the difference in the price at which the product is sold in the export and import market and to deduct from that price difference all other known costs such as shipping, tariffs, fees, insurance, etc. Since a single regulation seldom is the only cost element that cannot be clearly identified, and differences in retailing costs also play an important role, there is usually a great deal of controversy around such estimates. They nevertheless provide a useful starting point for a more detailed analysis. Additional details and examples of this technique are found later in this chapter.
 

Estimating How a Change in the Price of Imported Products Impacts Trade

Estimating the impact of a change in the price of an imported product on trade in that product involves another two-step process. Economists call the factor used to calculate the direct impact the price elasticity of demand. 

When a percentage reduction in the price leads to a less than proportional increase in quantity demanded, economists say that the demand is inelastic, and when quantity demanded changes more than the change in price, economists say the demand is elastic. Economists estimate a numeric value for this elasticity. A value of 1 means that demand changes in equal proportion to changes in price. Inelastic demand is defined as a value of less than 1, and elastic demand is a value of greater than 1. An elasticity of 0.5 means that quantity demanded changes only half as much proportionally as the price, while an elasticity of 1.5 means that demand changes 50% more proportionally than the price.

The price elasticity of demand for various products can be measured by examining historical data. Economists have studied and published price elasticities for various commodities in different countries. A list of publications summarizing the results of this research is included at the end of this chapter.

Generally, demand for luxury goods and essential food products is relatively price inelastic. People who can afford to pay for luxury goods are not very sensitive to the price when few close substitutes exist (quality gemstones, pleasure craft, etc.) The demand for essential foodstuffs is also usually inelastic since people generally buy them even if the price goes up. In contrast, many consumer goods have a high elasticity, since people can easily find substitutes or do without them.

Consider another intuitive way to think about price elasticities of demand. Suppose you spend 10% of your income on a certain product. If the price of this product falls, you buy more, but do you buy so much more that the fraction of your total income spent on the product increases, or just a little bit more, so that the fraction of income spent on that product falls under 10 percent? In the first case, demand would be elastic, in the second, inelastic. Clearly in the case of food, the “savings” from a fall in the price of food would not be spent only on additional food, with the exception of those consumers well below the poverty line. Lower airfares, however, might cause a business traveler to take the whole family on a future business trip, increasing the fraction of income devoted to airfare. 

For trade policy purposes we want to measure the impact of a change in the price of an imported product on the demand for that product. To be precise, what we need is the import price elasticity of demand. The response of consumers to a change in the price of an imported product is affected by a number of things, including the overall desire of consumers to buy more of a particular type of product when its price falls, the extent to which consumers are willing to substitute imported goods or services for domestically produced substitutes, and the willingness and ability of domestic producers to change their prices. The price elasticity of demand captures consumers’ responsiveness holding all other factors constant, including the response of domestic producers mentioned above, as well as income and the prices of substitutes and complements.

Typical estimates of such import price elasticities are found in the table below, based on a survey by Robert Stern, an international economist, in 1976. These estimates were derived by scouring the published work of economists across a broad range of countries. Industry definitions used for this purpose are from the Standard International Trade Classification system, which is widely used internationally. Stern published values for all the major countries in his book Price Elasticities in International Trade.

Table 3–1  
Typical Import Price Elasticities 

To summarize, the impact of a policy on trade can be measured by estimating first the impact of that measure on the price of the imported product in the import market, then multiplying that percentage change in price by a price elasticity, which measures the consumer response to a change in price. One can estimate the impact of a change in foreign trade barriers on domestic exports in the same way, with the additional step of assuming (unless clearly inappropriate) that the share of the increased imports captured by domestic exporters is the same as their current market share.

The Stern elasticities, however, are for commodity groups so large as to make them of limited use to policymakers. For example, the extreme range for mineral fuels (from 0.01 to 2.78) runs from extremely inelastic to quite elastic. Using the median of 0.96 would be a large mistake either way.

The next section of this chapter provides a more technical treatment of elasticities for those familiar and comfortable with basic economic terminology, followed by case studies and simulations.
  

ELASTICITIES AND THEIR USES IN TRADE POLICY ANALYSIS 

Demand and supply elasticities are important in constructing estimates for the impact of policy changes on output, employment and profits. We cover the three types of demand elasticities first, then the price elasticity of supply.

  
Own Price Elasticity of Demand

This is often called simply the price elasticity of demand, and it refers to how much the quantity demanded adjusts to a change in price. Specifically, it relates the percentage change in the quantity demanded to the percentage change in the price of that good or service. 

In theory, PED can take values between zero and (negative) infinity. A value of 0 means that the quantity demanded is unaffected by changes in price. This unusual situation is called perfectly inelastic demand. An insulin user, for instance, requires a certain dosage per day, and will not change that dosage in response to higher or lower prices. A value near infinity would mean that a one penny cut in price would give you the entire market, while a one penny increase in price would send demand to zero. This equally unusual case is called perfectly elastic demand. Because of differences in tastes among individuals, there are no two goods that are perfect substitutes for everyone, and thus no example of perfectly elastic demand. For instance, we consider four quarters and one dollar bill to be perfect substitutes, yet a service has sprung up in supermarkets in which a five percent fee is charged for turning change into paper money or store credit! However, in practice, the values used in policy analysis range from 0.1 to 10.

Goods and services with price elasticities between zero and one are called inelastic, indicating that a given percent change in price leads to a less than proportional change in demand. Examples of goods with inelastic demand include oil, most types of food, tobacco, alcoholic beverages, and medicines. As a mnemonic device, think of demand that doesn’t stretch or change much in response to price changes.

Goods and services with price elasticities greater than one are called elastic. Like a rubber band, the quantity demanded for these goods changes proportionately more than price, usually due in part to the ready availability of substitutes. Examples of goods that are “price sensitive” or elastic include furniture, autos, and intermediate goods like steel. To summarize and review:

Table 3–2 gives price elasticties for some typical products. Note that long run elasticities are always substantially higher than short run elasticities. In this context, the long run usually means a period greater than three years and the short run usually means a period of less than a year.

The reason long run elasticities are higher is that over time, more adjustments take place. For example, immediately after the oil price shock of 1973 the US trade deficit sharply increased as Americans paid much more for almost the same amount of oil. Over time, consumers chose to purchase more fuel efficient cars and insulated their homes. As more time passed, energy efficient appliances were developed, new homes were built with energy efficiency in mind, and eventually consumers modified their behavior. So, conservation can be part of the answer to price increases and capacity constraints in the long run!

Table 3–2

Estimated Price Elasticities of Demand

Source: R.J. Carbaugh, Contemporary Economics, 2001.  Carbaugh cites 1970 and 1980 journal articles as his sources.  In other words, contemporary sources for elasticities, even for the US , are hard to find. 
  

When you cannot obtain a reliable estimate for the price elasticity of a particular product, you may have to use the range of elasticities calculated for similar products. Issues and problems surrounding the use of elasticities in policy analysis are introduced at the end of this chapter. 
  

Import Price Elasticity

Trade policies impact prices, either directly, when a change in tariff levels raises or lowers the price of imported goods, or indirectly when changes in import quotas increase or decrease the permitted level of imports. Let’s look at two quick examples, using elasticities to calculate the impact of trade policy changes on prices and quantities demanded. Again we are assuming a small country facing a fixed world price, with competitive markets and homogeneous products. Thus pass through is complete.
 
The trade policy action we analyze first is an increase in India’s tariff on milk powder imports from 20 percent to 50 percent.[2] Suppose that there is no quality difference between domestic and foreign milk powder, and there are many foreign suppliers.[3] With a 20 percent tariff, a $10 case of milk powder on the world market would sell for $12 in India.

Therefore in our example Pd (domestic price) = Pw * (1+t) = $10 * 1.2 = $12.

 Domestic producers would match this price, since demand for their milk powder is very elastic; at a price higher than $12 for the domestic product, consumers would buy the import instead.[4]  A 50 percent tariff would increase the domestic price of both the domestic and imported product to $15, an increase of 25%. If the price elasticity of demand for all milk powder is 0.6, then how much will demand decrease as prices rise?  

Since the price elasticity of demand is equal to the percent change in quantity demanded divided by the percent change in price, the percent change in demand is equal to the price elasticity of demand times the percent change in price.

Hence we have –0.6 * 25% = –15%. So if the tariff is raised from 20% to 50%, total demand for and consumption of milk products in India falls by about 15%.

Now suppose instead of the tariff, the Indian government elects to use a quota to limit milk powder imports. If total consumption before the quota is 100 tons, and the new quota limits imports to whatever is required over domestic production to reach a total of 85 tons, a 15% fall in total supply results.[5] Under these simplifying assumptions, we calculate a fall in total demand of 15% and, with the same price elasticity of negative 0.6, we get the same price rise of 25 percent. In other words, a 15-ton reduction in the import quota would have the same effect as an increase in the import duty from 20% to 50%.

For “visual” people, let us view elasticities diagramatically. This will show how the concept of elasticity is fundamentally different from the concept of slope. The following straight-line demand curve has a slope of –1/10 (the quantity demanded increases by 10 for each $1 decrease in price, see Figure 3–1). Yet, as the following diagrams illustrate, the price elasticity of demand changes along the line. Demand is inelastic at low prices and large quantities, where the same change in quantity over a high base is a small percentage change and the same change in price is a larger percentage change. At high prices and small quantities, demand is elastic.

We also see in Figures 3–2 to 3–5 the relationship between elasticity and total revenue. Price increases lead to higher total revenue and higher profits when demand is inelastic (Figures 3–3 and 3–4), while price increases lead to lower total revenue, but not necessarily lower profits, when demand is elastic (Figure 3–5).

DEMAND AND ELASTICITIES:  A VISUAL APPROACH

Footnotes

[1] Prior to the tariff change, domestic consumers paid $1.80 for the imported product, $1 to the foreign producer and $0.80 to the government. The tariff reduction halves the payment to the government to $0.40. In percentage terms, this is can be expressed as about a 22% reduction in price. 
[2] Actually, the tariff increased from 15% to 60% on imports over 10,000 tons. See Financial Times, April 25, 2000.
[3] In reality, the tariff was meant to protect fresh milk producers in India, but considering the case in those terms requires the more sophisticated tools of the appendix to chapter four. 
[4] For a number of commodities, we can assume that the import and the domestic product are perfect substitutes, and thus will sell at the same price. But this is not true for differentiated manufactures goods, where quality variations and branding make prices different. The simple model shown below will not be appropriate in the case of differential products, and a more complex model appropriate for those situations is introduced in Appendix 4-1.
[5] In addition to the assumptions above, we now must assume that the domestic market is competitive, and price rises freely to make demand equal total supply. In the real world, calculating the impact of a quota is much more difficult, hence quotas may be used in part to “disguise” the full impact of protection. 

top