Costs and benefits of tariffs

Preview Types of tariffs Effects of tariffs when domestic consumers fully pay Effects of tariffs when foreign producers partially pay Optimal tariff Effective rate of protection

Types of tariffs A tariff is a tax on goods and services produced abroad and sold domestically. It is also sometimes called a duty. Products that do not have tariffs/taxes are called duty free. Tariffs or duties are usually collected by customs officials at the port of entry. See http://www.customs.go.kr/

Types of tariffs A specific tariff is an amount of money per unit of the imported product. for example, 3,000원 per kg of rice An ad valorem tariff is a percentage of the estimated value of the imported product. for example, 5% of the value of rice Tariffs generally raise the domestic price of imported products above the price in international markets, and generally domestic consumers pay all or part of the tariff.

Types of tariffs Most favored nation (MFN) tariffs are tariffs that each member of the World Trade Organization (WTO) promises to apply to all other members, as it applies to the country to which it gives its lowest or most favorable rate. But exceptions include tariff rates used in a preferential trade agreement and for very poor countries. Some countries impose higher tariffs on products from countries that are not part of the WTO.

Types of tariffs Preferential tariffs are exceptions to the MFN tariffs and are lower than MFN tariffs. They allowed by the WTO for members of a preferential trading agreement: customs union (with a common external tariff policy) or a free trade area (with no common external tariff policy). very poor countries. The largest of set of unilateral preferential tariffs for poor countries is the Generalized System of Preferences (GSP), which lists the countries and the types of goods on which preferential tariffs may be applied.

Types of tariffs A bound tariff is the maximum (potential) tariff that a country promises to charge WTO members now or in the future. WTO members are allowed to raise or to lower their tariff rates over time, but they promise to raise them only up to the bound tariff rate. Bound tariffs are not necessarily actual tariffs; they are the maximum potential tariffs for WTO members. In other words, the actual tariff rate is less than or equal to the bound tariff rate for WTO members.

Types of tariffs percent bound tariff rate Tariff rate for non-WTO members bound tariff rate Most favored nation tariff rate Preferential tariff rate

Types of tariffs If the domestic government imposes or raises a tariff, in response foreign governments might not impose their own tariffs, or they might impose them as “retaliation”. foreign producers might keep the price of their product the same, or not, if they want to accommodate domestic consumers in order to maintain their shares in the domestic market.

Tariffs when domestic consumers fully pay First, let’s assume that foreign producers do not change the price of their product, so that domestic consumers must pay all of the tariff. Foreign suppliers might not change the price of their product because events in the domestic market (like the imposition of a tariff) have no significant influence on the price that foreign suppliers want to charge.

Tariffs when domestic consumers fully pay Because tariffs generally raise the domestic price of imported products, the quantity of imported products should fall, and domestic consumers will be worse off because some can no longer afford to buy imported or domestic products. those who continue to buy imported products need to pay more. some will switch to less desirable and more expensive substitutes that were produced domestically. some will need to pay more for domestic substitutes due to scarcity or lack of competition in the domestic market.

Tariffs when domestic consumers fully pay Because tariffs generally raise the domestic price of imported products, domestic import-competing firms can respond by raising the prices of their own products, producing and selling more of their own products, doing both. By making imported products less “competitive” in the domestic market, a tariff should make domestic import-competing firms better off.

Tariffs when domestic consumers fully pay Because tariffs allow the government (customs officials) to collect money/revenue, it should be better off. It can use this money/revenue to pay for various projects or simply to pay customs officials higher salaries. Because administering and enforcing the tariff uses real resources (ex., people), the government can self-finance the administration and enforcement with tariff revenue.

Tariffs when domestic consumers fully pay We can represent these ideas through a simple supply- demand diagram:

Tariffs when domestic consumers fully pay Price of citrus fruit Domestic demand In this case, we assume that domestic consumers pay all of the tariff, so the price in the domestic market rises by the full amount of the tariff. Domestic supply Price with tariff Q S Q D Tariff World price Price without tariff Q S Q D Imports with tariff Quantity of citrus fruit Imports without tariff

Tariffs when domestic consumers fully pay Price of citrus fruit Domestic demand Consumer surplus before tariff Domestic supply Producer surplus before tariff Price without tariff World price Q S Q D Quantity of citrus fruit Imports without tariff

Tariffs when domestic consumers fully pay Price of citrus fruit A B Domestic demand Consumer surplus after tariff Domestic supply Producer surplus after tariff Price with tariff C G Q S Q D Tariff Price without tariff World price Q S Q D Imports with tariff Quantity of citrus fruit Imports without tariff

Tariffs when domestic consumers fully pay Price of citrus fruit Domestic demand Domestic supply Tariff revenue Price with tariff Imports with tariff Q S D E Tariff Price without tariff World Q S Q D price Quantity of citrus fruit Imports without tariff

Tariffs when domestic consumers fully pay Price of citrus fruit Losses from some consumers who are forced to buy more expensive domestic citrus fruit. A Domestic demand Domestic supply Losses from consumers who are no longer able to afford citrus fruit. B Price with tariff C G D F Q S E Q D Tariff Price without tariff World Q S Q D Imports with tariff price Quantity of citrus fruit Imports without tariff

Tariffs when domestic consumers fully pay Consumers lose because some consumers can no longer afford to buy the product. The loss for these consumers is represented by area F. some consumers buy a product that was produced less efficiently and more expensively by domestic producers. The loss from less efficient production and more expensive products is represented by areas C + D, which is called the efficiency loss of the tariff. some consumers must pay a higher price for imported products with the tariff instead of buying from foreign firms duty free. The loss for these consumers is represented by area E and is called the import markup loss.

Tariffs when domestic consumers fully pay The full loss for consumers is C + D + E + F and is called the consumption loss of the tariff. Losses C and E for consumers are offset by gains from producers and from tariff revenue. But losses D and F are not offset: they are called deadweight losses.

Tariffs when domestic consumers fully pay Tariffs benefit some groups, which is principally why they are used, even though they create deadweight losses for the economy. The government collects tariff revenue, which is represented by area E. Area E is directly above Q2D – Q2S , the distance representing the smaller amount of imports. Import-competing producers are able to increase their prices and sell more, the benefit of which is represented by area C. The distance Q2S – Q1S represents increased domestic production and sales, and part of the reduction of imports.

Tariffs when domestic consumers fully pay This analysis assumes that each group’s welfare is equally weighted. We view and measure the (monetary) value of benefits and losses of consumers, producers and the government equally and objectively. One group’s or person’s loss is not weighted more than one group’s or person’s benefit.

Tariffs when domestic consumers fully pay But in practice some people favor one group more than the other. Since the government sets policy, it might favor its own interests over the interests of consumers and increase a tariff for its benefit. If import-competing firms are politically influential, they can lobby the government to increase a tariff for their benefit at the expense of consumers. Millions of consumers, however, have difficulty organizing and lobbying for lower tariffs.

Tariffs when foreign producers partially pay When a country is large and important in a market, its actions can affect the market price. In particular, if it sets a tariff on a product, the price in international markets can fall because (quantity) demand(ed) of the product falls significantly due to the more expensive price that domestic consumers must pay.

Tariffs when foreign producers partially pay Foreign firms might respond to a tariff by reducing their prices for domestic consumers, because they believe this is necessary to maintain the market share in the domestic market. or because the demand of their products has significantly decreased. For example, if the US place a tariff on the cars from Korea, Korean producers/sellers might have to lower their prices due to the loss in the (quantity) demand(ed) in the US market, which is large and important for the Korean producers/sellers.

Tariffs when foreign producers partially pay Formally, economists say that a buyer with power to influence the market price has monopsony power. A single buyer in a market, which would have the maximum amount of power, is called a monopsony. A large and important country, one with monopsony power, can cause foreign sellers to lower their prices and earn tariff revenue at the same time. Even in competitive markets, a large reduction in demand can force sellers to lower their prices.

Tariffs when foreign producers partially pay On the other hand, foreign firms might respond to a tariff simply by selling fewer exports (domestic imports) instead of reducing prices. When foreign firms do not change their prices at all, then domestic consumers fully pay for the tariff. In this case, buyers in the domestic market (and the government that represents them) have no monopsony power.

Tariffs when foreign producers partially pay But tariffs set by a large and important country still have costs. As long as the prices with the tariffs increase in the domestic market, domestic consumers will lose. In particular, there are still losses from less efficient/more expensive production and from the fact that some consumers can no longer afford to buy the more expensive products. However, if price increases are smaller relative to a case where foreign sellers do not lower their prices, then the losses for consumers are smaller.

Tariffs when foreign producers partially pay Price of citrus fruit A Domestic demand Consumer surplus after tariff Domestic supply Tariff burden for domestic consumers Producer surplus after tariff B Tariff burden for foreign sellers Price paid by domestic consumers Higher price paid by domestic consumers Q S Q D C E1 Price without tariff Tariff Q S Q D G E2 Lower price received by foreign sellers Price accepted by foreign firms Imports with tariff Quantity of citrus fruit Imports without tariff

Tariffs when foreign producers partially pay Price of citrus fruit Losses from some consumers who are forced to buy more expensive domestic citrus fruit. A Domestic demand Domestic supply Losses from consumers who are no longer able to afford citrus fruit. B Price paid by domestic consumers Higher price paid by domestic consumers Q S Q D C D F E1 Price without tariff Tariff Q S Q D G E2 Lower price received by foreign sellers Price accepted by foreign firms Imports with tariff Quantity of citrus fruit Imports without tariff

Tariffs when foreign producers partially pay As before, losses for domestic consumers result from being no longer able to afford more expensive domestic or foreign products (area F). being forced to buy a less efficiently and more expensively produced domestic product instead of a similar foreign product, and being forced to buy a more expensive domestic product due to scarcity or lack of competition, even if they bought the domestic product previously (areas C + D). being forced to pay more for the imported product (area E1).

Tariffs when foreign producers partially pay As before, some of these losses are offset by gains for others, but some are not. Domestic producers/sellers gain because domestic consumers are forced to buy a more expensive product. They can sell more and charge a more expensive price, a gain represented by area C. The domestic government earns tariff revenue, represented by area E1 + E2. But because foreign producers/sellers are willing to lower their prices, they effectively absorb some of the cost of the tariff and allow domestic consumers to save: E1 < E.

Tariffs when foreign producers partially pay Losses for foreign producers/sellers result from a decrease in the price (profit) of their exports (domestic imports), which makes them share the burden of the tariff with domestic consumers. a decrease the quantity of their exports (domestic imports), which also results in a loss in profit. We can measure this loss in profit by the loss in revenue (the full price x quantity that could have been sold) minus the (marginal) cost of production for the units not sold.

Tariffs when foreign producers partially pay We can represent the losses for foreign producers/ sellers and for domestic consumers that are not offset by representing the (marginal) cost of production for foreign producers/ sellers, represented by an export supply function. the (marginal) willingness to buy/pay by domestic consumers, represented by an import demand function.

Tariffs when foreign producers partially pay Price of citrus fruit Tariff burden for domestic consumers: cost due to higher prices paid Domestic demand of imports Foreign supply of exports Price paid by domestic consumers represents the marginal cost of production (lower than for domestic firms) E1 Quantity of imports with tariff Price without tariff E2 Quantity of imports without tariff Price in accepted by foreign firms Tariff burden for foreign producers/sellers: cost due to lower prices (profit) received represents the (marginal) willingness to pay/buy Quantity of citrus fruit

Tariffs when foreign producers partially pay Price of citrus fruit Losses for domestic consumers who no longer buy imports that are not offset by domestic firm gains or tariff revenue Domestic demand of imports Foreign supply of exports Price paid by domestic consumers represents the marginal cost of production (lower than for domestic firms) E1 Quantity of imports with tariff D+F Price without tariff E2 Quantity of imports without tariff H Price in accepted by foreign firms Losses for foreign producers/ sellers: decrease in profit from a decreased quantity of exports represents the (marginal) willingness to pay/buy Quantity of citrus fruit

Optimal tariff The smaller deadweight losses for domestic consumers could be completely offset by tariff revenue: The tariff revenue earned by the government that is effectively paid by foreign producers/sellers when they lower their prices (area E2) can be larger than consumer losses that are not offset by gains of others (areas D + F). So the domestic country as a whole can benefit from the tariff, at the expense of foreign firms who suffer from their own deadweight losses (area H) and losses from being forced to lower their prices (area E2).

Optimal tariff When the domestic government can take advantage of the willingness of foreign producers/sellers to lower their prices in response to a tariff, it can calculate the optimal tariff: the tariff that forces foreign firms to lower their prices the most so that losses for domestic consumers are the smallest relative to tariff revenue earned by the domestic government. However, this analysis assumes that foreign governments will not respond likewise. Such “retaliation” would hurt domestic firms, possibly erasing any gains from a tariff imposed by the domestic government.

marginal gains – marginal losses = 0 Optimal tariff To calculate the optimal tariff, we consider a change in the current tariff (possibly at zero) and the marginal (extra) gains from having foreign firms lower their prices relative to the marginal losses for consumers from a more expensive product. A rule from calculus says that when we have achieved the optimal tariff, then marginal gains – marginal losses = 0

Optimal tariff Let the current tariff be t0 and dt be a change in the tariff. M be the current quantity of imports and dM be the change in imports from a change in the tariff. P be the current price charged by (and received by) foreign firms and dP be the change in this price from a change in the tariff. P* be the price paid by consumers and received by foreign firms without a tariff (with free trade).

Optimal tariff then marginal gains from a change in the tariff, caused by foreign firms lowering the prices of their products, is represented by M ×dP/dt. total marginal losses from a change in the tariff, for domestic consumers buying less and foreign firms selling less, is represented by t0P ×dM/dt. domestic marginal losses from a change in the tariff, caused by domestic consumers buying less, is represented by ((P + t0P)–P*)×dM/dt.

Optimal tariff Setting the marginal gains equal to the total marginal losses and solving for t0 shows that t0 = (M ×dP/dt)/(P ×dM/dt) t0 = (M/P) ×(dP/dt)/(dM/dt) Setting the marginal gains equal to only domestic marginal losses and solving for t0 shows that: ((P + t0P)–P*)×dM/dt = M ×dP/dt (P + t0P)–P* = M ×(dP/dt)/(dM/dt) t0 = (M/P) ×(dP/dt)/(dM/dt) + P*/P – 1

Optimal tariff Price of citrus fruit Domestic marginal losses of a higher tariff from domestic consumers buying fewer imports Total marginal losses of a higher tariff for domestic consumers and foreign firms Domestic demand of imports Foreign supply of exports ((P + t0P) – P*) represents the marginal cost of production (lower than for domestic firms) t0P Marginal gains of higher tariff from foreign firms lowering the prices of their products. dP/dt P dM/dt represents the (marginal) willingness to pay/buy M Quantity of citrus fruit

Effective rate of protection Tariffs can be applied to products that compete with those which a firm sells, as well as to inputs to production—materials and components—that a firm buys to make its products. The tariffs on competing products allow a firm to increase its price and its income/revenue. The tariffs on the inputs increase the costs of the producer. The effective rate of protection compares the tariffs on products that compete with those which a firm sells with the tariffs on inputs to production that a firm buys.

Effective rate of protection To calculate the effective rate of protection for a firm, we calculate the change in the price earned and the cost paid from a change in tariffs: where ∆Psell = change in price earned as a seller ∆Cbuy = change in cost paid as a buyer Psell_0 = original price earned as a seller Cbuy_0 = original cost paid as a buyer

Effective rate of protection The difference between the price that a producer sells a product for and the cost that it pays for its inputs to production is called value added. It represents the additional value created in a good or service from the production process. It also represents the value of the income/revenue earned by the firm for producing and selling the product. The original value added equals Psell_0 – Cbuy_0 The new value added equals Psell_1 – Cbuy_1 where ∆Psell = Psell_1 - Psell_0 where ∆Cbuy = Cbuy_1 - Cbuy_0

Effective rate of protection with tariffs effect of both tariffs value added per unit sold: income earned by producers without tariffs value added per unit sold: income earned by producers effect of the tariff on inputs to production costs of inputs to production costs of inputs to production

Effective rate of protection The effective rate of protection can also be calculated with value added: where v 1 = Psell_1 - Cbuy_1 v 0 = Psell_0 - Cbuy_0

Effective rate of protection The effective rate of protection can be negative, implying that the prices on the inputs to production increase more than the prices on the products that the firm sells. or implying that the prices on the products that the firm sells decrease more than the prices on the inputs to production.

Summary Tariffs are taxes/duties on imported products that raise their prices for domestic consumers. Tariffs also raise the prices of domestic substitutes and allow importing-competing firms to produce more with less competition. Tariffs allow the government to raise revenue, which it can use to finance the administration/enforcement of the tariff or to finance other projects.

Summary Tariffs create various kinds of losses for domestic consumers: some can no longer afford to buy imported products or domestic substitutes because the prices of both increase. some must pay more for imported products. some must buy less efficiently and more expensively produced domestic products instead of imported products. some continue to buy domestic products, but must pay more due to scarcity or lack of competition in the domestic market.

Summary The efficiency loss of the tariff represents the fact that some domestic consumers must buy less efficiently and more expensively produced domestic products instead of imported products. continue to buy domestic products, but must pay more due to scarcity or lack of competition in the domestic market. The import markup loss of the tariff represents the fact that some domestic consumers must pay more for imported products.

Summary The deadweight loss of the tariff represents the fact that some domestic consumers can no longer afford to buy imported products or domestic substitutes because the prices of both increase. some domestic consumers must buy less efficiently and more expensively produced domestic products instead of imported products. some losses for domestic consumers are not offset by gains for domestic firms and the government. foreign firms are no longer able to profitably produce and sell as much with the tariff.

Summary If a country has monopsony power, its tariffs will force foreign firms to lower their prices, which will reduce losses for domestic consumers, while still allowing the domestic government to earn tariff revenue. A country can have so much monopsony power that its tariff revenue can be larger than deadweight losses for domestic consumers, and the country as a whole can gain at the expense of foreign firms.

Summary An optimal tariff is one that forces foreign firms to lower their prices so that losses for domestic consumers are the smallest relative to tariff revenue earned by the domestic government. At the optimal tariff, gains in tariff revenue from marginal changes in the tariff = domestic consumer losses from marginal changes in the tariff. However, when trying to use an optimal tariff, the domestic government needs to be careful about retaliation from foreign governments.

Summary The effective rate of protection compares the tariffs on the products that a firm sells with the tariffs on the inputs to production that a firm buys. The difference between the price that a producer sells a product for and the cost that it pays for its inputs to production is called value added.