Eco 3024F Krugman & Obstfeld Ch 8 Tariff Instruments Eco 3024F Krugman & Obstfeld Ch 8

Outline LATER: Introduction: Relevance of tariffs Types of tariffs Partial equilibrium analysis of tariffs Costs and benefits of tariffs LATER: Analysis of Tariffs (GE framework) Trade policy in presence of monopolies 8-2

“Trade theory is about identifying whose hand is in whose pocket “Trade theory is about identifying whose hand is in whose pocket. Trade policy is about who should take it out” (Finger, 1981). “Tariff -- A scale of taxes on imports, designed to protect the domestic producer against the greed of his consumer”. From Ambrose Bierce, The Devil's Dictionary:

Why do we need to worry about tariffs and tariff policy? Tariffs a key policy instrument used for industrial development Department of trade and industry’s “National Industrial Policy Framework” Trade negotiations WTO negotiations African countries negotiating new “economic partnership agreements” (EPAs) with EU Regional integration schemes (SADC Customs union by 2010) 3. Business operations: imported goods used in production and consumption

Tariffs & other charges Goods imported into most countries are subject to different charges Customs duties Excise duties Levies Flue cured tobacco: 3.3c/kg + 75.9c/kg (special levy) Lentils: 9.60 R/T + 2.5 R/T (special levy) VAT or sales tax

Types of import tariffs (Customs duties) Ad valorem tariff : PD = PW (1 + t) Levied as a constant percentage of the monetary value of 1 unit of the imported good. Oranges: 5% But because it is based on the value of the good, an importer may understate the value while customs may overvalue as a counter measure. Specific tariff: PD = PW + t Import duty that assigns a fixed monetary (Rand) tax per physical unit of the good imported. Blue veined cheese: 500c/kg It may be collected with ease because only physical quantity of imports needs to be known and not their monetary value However, protection varies with value of imported good. So inflation lessens strength of tariff

Types of import tariffs (Customs duties) Compound tariffs Ad valorem PLUS specific tariff E.g. wheat flour :10% plus 29.4c/kg Mixed tariff Either ad valorem OR specific (normally the one which yields higher protection) E.g. Fish, fresh or chilled: 25% or 70c/kg

Supply, Demand & Trade in a Single Industry Assume Perfect competition in mkt for laptops. Two countries in world producing laptops – SA & US Initially No trade Price of laptops in US lower than in SA With trade SA will import laptops Import demand curve for laptops from SA With trade, US will export laptops Export supply curve for laptops from US 8-9

Import demand curve Import demand curve (MD): SA demand –SA supply= Import demand by SA (from US) Import demand curve is downward sloping....why? What happens if P is above A? 8-10

Export supply curve Export supply curve (XS): US supply – US demand = Exports supplied to SA (by US) B Export supply curve is upward sloping....why? What is happening at point B? 8-11

World Equilibrium At Pw , XS=MD in SA Will Pw be the mkt clearing price in US as well? 8-12

Partial equilibrium analysis of impact of tariffs

The Effects of a Tariff Suppose SA imposes tariff on computer imports This is like a tax on the price of good imported or like the effect of transport costs (Imported price=foreign price + tariff) Will introduce price wedge between domestic price (PT) and foreign price (P*T) PT – P*T = t What price adjusts, (PT) or (P*T)? As domestic price increases, quantity demanded falls in SA As quantity demanded falls, so quantity supplied by US falls leading to possible foreign price decrease 8-14

The Effects of a Tariff (cont.) Price of the good in foreign (US) markets should fall if there is a significant drop in the quantity demanded of the good caused by the domestic (SA) tariff. Extent of decline in foreign price depends on elasticity of foreign export supply and elasticity of import demand 8-15

The Effects of a Tariff (cont.) Domestic price rises and quantity of imports demanded falls Foreign price falls and quantity of exports supplied falls Gap between domestic and international price equals tariff wedge 8-16

Welfare: Who wins and who loses?

Welfare: Who wins and who loses?

Cost and Benefit using a small country model Assumptions Small country is unable to influence world price Pworld through changes in production and/or consumption Implies: small countries face horizontal (infinitely elastic) Export supply curves

Small country supply and demand Consumer surplus, no tariffs Consumer surplus, with tariffs Consumer surplus loss Price D S PW (1+t) Q3 Q2 B A D C PW Q4 Q1 Quantity Imports at PW

Small country supply and demand Producer surplus gain Price D Government revenue gain S PW +t Q3 Q2 B A D C Dead weight loss PW Q4 Q1 Quantity Consumer loss-producer gain - government revenue = dead weight loss (B+D)

Small country: conclusion Tariffs raise domestic production by raising the price received Consumers pay for this through higher prices Governments gain from tariff revenue, which they can transfer back to consumers But price distortions lead to inefficient allocation of resources for consumers and producers Whose hand is in whose pocket? Tariffs lead to a transfer of surplus from consumers to producers 8-23

Tariffs in large countries Price Consumer surplus loss D S PW* +t Q3 Q2 B A D C t PW Q4 Q1 PW* E Quantity

Tariffs in large countries Producer surplus gain Price D Government revenue gain S PW* +t Q3 Q2 t A B C D PW Q4 Q1 PW* E Quantity Consumer loss - producer gain - government revenue = B+D-E

Large country: conclusion Tariffs lower the world price Foreign producers bear some of cost of tariff through lower world prices Terms of trade improvement for Home Tariffs still cause production and consumption efficiency losses BUT, if terms of trade improvement are large enough (area E), then the economy can gain Would you advise such a strategy? Why not?