Tariffs and Nontariff Barriers International Economics Chapter 4 Tariffs and Nontariff Barriers

Chapter 4 Tariffs and Nontariff Barriers 4.1 Theories for Trade Protection 4.2 Tariffs 4.3 Nontariff Trade Barriers

4.1 Theories for Trade Protection Infant Industry Argument This argument contends that for free trade to be meaningful, trading countries should temporarily shield their newly developing industries from foreign competition.

4.1 Theories for Trade Protection Some truths in the infant industry argument: Once a protective tariff is imposed, it is very difficult to remove, even after industrial maturity has been achieved. It is very difficult to determine which industries will be capable of realizing comparative advantage potential and thus merit protection. The argument generally is not valid for mature, industrialized countries. There may be other ways of insulating a developing industry from cutthroat competition. Rather than adopt a protective tariff, the government could grant a subsidy to the industry.

4.1 Theories for Trade Protection Terms of Trade Argument In some cases, the terms of trade benefits of a tariff outweigh its costs, so there is a terms-of-trade argument for a tariff. The terms of trade argument against free trade, then, is intellectually impeccable but of doubtful usefulness. In practice, it is emphasized more by economists as a theoretical proposition than it is used by governments as a justification for trade policy.

4.1 Theories for Trade Protection Domestic Market Failure Argument Theory of the second best When economists apply the theory of the second best to trade policy, they argue that imperfections in the internal functioning of an economy may justify interfering in its external economic relations. This argument accepts that international trade is not the source of the problem but suggests nonetheless that trade policy can provide at least a partial solution.

4.1 Theories for Trade Protection Strategic Trade Policy Because of the small number of firms, the assumption of perfect competition does not apply. There are only a few firms in effective competition in some industries. This argument locates the market failure that justifies government intervention in the lack of perfect competition. It is possible in principle for a government to alter the rules of the game to shift these excess returns from foreign to domestic firms.

Chapter 4 Tariffs and Nontariff Barriers 4.1 Theories for Trade Protection 4.2 Tariffs 4.3 Nontariff Trade Barriers

4.2 Tariffs A tariff is simply a tax (duty) levied on a product when it crosses national boundaries. Import tariff v.s. Export tariff Protective tariff v.s. Revenue tariff Types of Tariffs Specific Tariff Ad Valorem Tariff Compound Tariff

4.2 Tariffs Effective Rate of Protection (ERP) the percentage change in the value added in an industry because of the imposition of a tariff structure by the country rather than the existence of free trade.

4.2 Tariffs Calculation of ERP (Way I):

4.2 Tariffs Calculation of ERP (Way II):

4.2 Tariffs Three general rules about the relationship between nominal rates and effective rates of protection: If the nominal tariff rate on the final good is higher than the weighted average nominal tariff rate on the inputs, then the ERP will be higher than the nominal rate on the final goods; If the nominal tariff rate on the final good is lower than the weighted average nominal tariff rate on the inputs, then the ERP will be lower than the nominal rate on the final goods; If the nominal tariff rate on the final good is equal to the weighted average nominal tariff rate on the inputs, then the ERP will be equal to the nominal rate on the final goods.

4.2 Tariffs Two consequences of the effective rate calculation: The degree of effective protection increases as the value added by domestic producers declines. In the formula, the higher the value of aij is, the greater the effective protection rate for any given nominal tariff rate on the final product will be. A tariff on imports used in the production process reduces the level of effective protection. In the formula, as ti rises, the numerator of the formula decreases and hence ERP decreases.

4.2 Tariffs Conclusion when material inputs or intermediate products enter a country at a very low duty while the final imported commodity is protected by a high duty, the result tends to be a high protection rate for the domestic producers. The nominal tariff rate on finished goods thus understates the effective rate of protection. But should a tariff be imposed on imported inputs that exceeds that on the finished good, the nominal tariff rate on the finished product would tend to overstate its protective effect.

4.2 Tariffs Tariff Escalation The tariff structures have generally been characterized by rising rates that give greater protection to intermediate and finished products than to primary commodities. The tariff structures of the industrialized countries may indeed discourage the growth of processing, thus hampering diversification into higher value-added exports for the less developed countries, worsening the potential competitive position of the less-developed countries in the manufacturing and processing sectors.

Tariff Welfare Effects 4.2 Tariffs Tariff Welfare Effects Consumer Surplus Consumer surplus refers to the difference between the amount that buyers would be willing and able to pay for a good and the actual amount they do pay. Producer Surplus Producer surplus is the revenue producers receive over and above the minimum amount required to induce them to supply the good.

4.2 Tariffs

4.2 Tariffs Trade Welfare Effect of Tariff in a Partial Equilibrium Setting The Small-Nation Case

4.2 Tariffs The redistributive effect (Area a) the transfer of consumer surplus, in monetary terms, to the domestic producers of the import-competing product. The protective effect (Area b) the loss to the domestic economy resulting from wasted resources used to produce additional cloth at increasing unit costs. The domestic revenue effect (Area c) the tariff proceeds paid by country A’s consumers to its government. The consumption effect (Area d) arises from the decrease in consumption resulting from the tariff's artificially increasing the price. The deadweight loss (Areas b + d) represents a real cost to a community, not a transfer to other sectors of the economy.

Welfare Cost of a Tariff Imposed by a Small Nation 4.2 Tariffs Welfare Cost of a Tariff Imposed by a Small Nation Item Welfare Change (Area) Change in consumer surplus −a −b −c −d Change in producer surplus a Change in government revenue c Net welfare change Levying an import tariff, therefore, reduces a small country's welfare.

International Free-Trade Equilibrium 4.2 Tariffs The Large-Nation Case The equilibrium world price is defined as the price at which the quantity that consumers in Country A want to import is equal to the quantity that producers in Country B want to export. In the diagram, this price is denoted by PFT. International Free-Trade Equilibrium

4.2 Tariffs The size of the tariff equals the difference between the price consumers in country A pay for the product (PT) and the price producers in country B receive (P'). That is, the per unit tariff of t equals PT −P' .

4.2 Tariffs The redistributive effect (Area a) the transfer of consumer surplus, in monetary terms, to the domestic producers of the import-competing product. The protective effect (Area b) the loss to the domestic economy resulting from wasted resources used to produce additional cloth at increasing unit costs. The domestic revenue effect (Area c) the tariff proceeds paid by country A’s consumers to its government. The consumption effect (Area d) arises from the decrease in consumption resulting from the tariff's artificially increasing the price. The terms of trade effect (Area e) the amount of the tariff revenue paid by foreigners because the world price of their exports has fallen.

4.2 Tariffs The change in welfare in country A brought about by the imposition of a tariff equals e−(b+d). This amount could be positive or negative, depending on the relative sizes of the two terms. Optimal tariff : the tariff would be set to a level that maximizes the area e−(b+d).

4.2 Tariffs Trade Welfare Effect of Tariff in a General Equilibrium Setting The Small-Nation Case

The reduction in welfare comes from two effects: 4.2 Tariffs The reduction in welfare comes from two effects: The economy no longer produces at a point that maximizes the value of income at world prices. The budget constraint that passes through B1 lies inside the constraint passing through B0. Consumers do not choose the welfare-maximizing point on the budget constraint; they do not move up to an indifference curve that is tangent to the economy's actual budget constraint.

4.2 Tariffs The Large-Nation Case With the imposition of a tariff, Country I’s offer curve OCI shifts inward to OCI'.

4.2 Tariffs The Impact of a Tariff The equilibrium quantity of exports falls from OB1 to OB2, and the quantity of imports falls from OA1 to OA2. Country I’s terms of trade improve from TOT1 to TOT2.

Chapter 4 Tariffs and Nontariff Barriers 4.1 Theories for Trade Protection 4.2 Tariffs 4.3 Nontariff Trade Barriers

4.3 Nontariff Trade Barriers An Introduction to Nontariff Trade Barriers Import Quota An import quota is a physical restriction on the quantity of goods that may be imported during a specific period; the quota generally limits imports to a level below which imports would occur under free-trade conditions. A common practice to administer an import quota is for the government to require an import license. Each license specifies the volume of imports allowed, and the total volume allowed should not exceed the quota. Import quotas on manufactured goods have been outlawed by the World Trade Organization.

4.3 Nontariff Trade Barriers Tariff-Rate Quota: A Two-Tier Tariff a tariff-rate quota displays both tariff-like and quota-like characteristics. This device allows a specified number of goods to be imported at one tariff rate (the within-quota tariff rate), whereas any imports above this level face a higher tariff rate (the over-quota tariff rate). a tariff rate quota is a two-tier tariff.

4.3 Nontariff Trade Barriers Orderly Marketing Agreements An orderly marketing agreement (OMA) is a market-sharing pact negotiated by trading partners. Its main purpose is to moderate the intensity of international competition, allowing less efficient domestic producers to participate in markets that would otherwise have been lost to foreign producers who sell a superior product at a lower price. A typical OMA consists of voluntary quotas applied to exports. These controls are known as voluntary export restraints (VERs); they are sometimes supplemented by backup import controls to ensure that the restraints are effective.

4.3 Nontariff Trade Barriers Domestic Content Requirements To limit the practice of outsourcing, organized labor has lobbied for the use of domestic content requirements. The effect of content requirements is to pressure both domestic and foreign firms who sell products in the home country to use domestic inputs (workers) in the production of those products. Manufacturers generally lobby against domestic content requirements, because they prevent manufacturers from obtaining inputs at the lowest cost, thus contributing to higher product prices and loss of competitiveness.

4.3 Nontariff Trade Barriers Subsidies National governments sometimes grant subsidies to their producers to help improve their trade position. Governmental subsidies assume a variety of forms, including outright cash disbursements, tax concessions, insurance arrangements, and loans at below-market interest rates. Two types of subsidies: a domestic subsidy which is sometimes granted to producers of import-competing goods; an export subsidy which goes to producers of the goods that are to be sold overseas.

4.3 Nontariff Trade Barriers Dumping Dumping is recognized as a form of international price discrimination. It occurs when foreign buyers are charged lower prices than domestic buyers for an identical product, after allowing for transportation costs and tariff duties. Selling in foreign markets at a price below the cost of production is also considered dumping. Commercial dumping is generally viewed as sporadic, predatory, or persistent in nature. Each type is practiced under different circumstances.

4.3 Nontariff Trade Barriers The effects of an Import Quota In the absence of trade, equilibrium would occur at Point E with the domestic price of cloth equaling P. The free-trade equilibrium is located at Point F, the domestic price of cloth would fall to the world price PW. The imposition of the quota changes the amount of cloth supplied to the importing country, a new equilibrium is reached at G.

4.3 Nontariff Trade Barriers The country loses Areas b+c+d under a quota. The redistributive effect (Area a) The protective effect (Area b) The domestic revenue effect (Area c) Area c accrues to the foreign producers and makes them more profitable. The consumption effect (Area d) The deadweight loss (Areas b + d)

4.3 Nontariff Trade Barriers Two methods available for a government or community to capture Area c from foreign producers under a quota. The domestic government could auction quotas to importers in a free market. The limited quota supply would go to those importers most in need of the product who would pay the higher price. Convert the quota into an equivalent tariff.

4.3 Nontariff Trade Barriers Quota and equivalent tariff The losses for consumers and community are much larger in the case of a quota than in the case of a tariff when demand increases.

4.3 Nontariff Trade Barriers The Effects of an Export Subsidy Consumers lose Area a+b in the form of higher taxes. Producers gain Area a in profits. The cost to the community is Area b, that is the production deadweight cost of the subsidy. Subsidies are superior to protection in another way: they are more visible.