Unit 2: The Instruments of Trade Policy Notes

This unit explains how governments interfere with international trade. In theory, free trade allows countries to specialise, reduce costs and improve consumer welfare. In practice, governments often intervene because domestic firms, workers and strategic sectors may suffer when foreign competition becomes too strong or unfair.

Under free trade, buyers and sellers from different countries trade with minimum government interference. Prices are decided by demand and supply. Protectionism is different. It is a government policy used to protect domestic producers against foreign competition by using tariffs, quotas and non-tariff instruments.

Trade policy is shaped by domestic priorities as well as international commitments. When a country enters bilateral, regional or multilateral trade agreements, it accepts obligations that influence what trade restrictions it can or cannot use.

Objectives of Trade Policy

1. Protect Domestic Industries — Industries facing strong or unfair import competition may need protection to survive.
2. Generate Government Revenue — Import duties are a source of revenue, especially in developing economies.
3. Reduce Import Dependence — Trade barriers can reduce excessive dependence on foreign suppliers.
4. Promote Exports — Export incentives help domestic firms compete in international markets.
5. Correct Trade Distortions — If foreign firms dump goods or receive subsidies, the importing country may respond with duties.
6. Protect Health, Safety and Environment — Standards and quality rules prevent entry of unsafe or harmful products.

Tariffs are the most visible trade policy instrument. In this unit, the word tariff mainly refers to import duty because import duties are far more common than export duties.

Specific Tariff

The weakness of a specific tariff is that its protective value falls when import prices rise. If the duty remains fixed but the product price rises, the duty becomes a smaller percentage of the product value.

Ad Valorem Tariff

Ad valorem tariffs preserve the protective value of tariffs because the duty rises with the value of the imported product. However, importers may try to undervalue goods in invoices to reduce the duty burden.

Mixed and Compound Tariffs

Other Important Tariffs

Specific Tariff vs Ad Valorem Tariff

Sometimes foreign firms or foreign governments create distortions in trade. They may sell goods at unfairly low prices or support exporters through subsidies. Importing countries respond through special duties that are triggered when unfair trade practices are identified.

Anti-Dumping Duty

Dumping can be used as a predatory strategy. A foreign exporter may sell at very low prices to destroy domestic competition and later capture the market. Anti-dumping duty is imposed to offset this unfair price advantage.

Countervailing Duty

Countervailing duties restore fair competition. They prevent subsidised foreign goods from entering the domestic market at artificially low prices.

Non-tariff measures have become more important because tariff reduction through WTO negotiations and free trade agreements has reduced the role of traditional tariffs. NTMs are often less visible and more complex than tariffs.

Sanitary and Phytosanitary Measures (SPS)

SPS measures are generally justified on health and safety grounds. But if used excessively, they can become hidden barriers to trade.

Technical Barriers to Trade (TBT)

TBT measures cover both food and non-food products. They include testing, inspection and certification procedures to verify whether products meet required standards.

Import Quotas

Import quotas are usually set below the free trade level of imports. They are enforced through licences. The licence holders earn quota rents because they can buy imports and sell them at higher domestic prices.

Other Non-Technical Measures

Tariff vs Quota

Safeguard Measures

Safeguards are emergency actions. They are not meant to permanently block imports. Their purpose is to give domestic industries time to adjust.

Trade policy is not only about restricting imports. Governments also use export-related measures to increase foreign exchange earnings, support domestic producers and improve global market access.