McGraw-Hill/Irwin © 2012 The McGraw-Hill Companies, All Rights Reserved Chapter 8: Analysis of a Tariff

The chapter has two major purposes: First, the analysis shows the effects of a tariff when the importing country is small, so that its import policies have no effect on world prices. Second, the analysis of a large importing country—one whose policies can affect world prices—shows that a large country can use a tariff to lower the price that it pays foreigners for its imports.

We begin by examining the effects of a tariff imposed by a small country (contrasted with free trade), using supply and demand within the importing country. Since foreign exporters do not change the price that they charge for the product, the domestic price of the imported product rises by the amount of the tariff. Domestic producers competing with these imports can also raise their domestic prices as the domestic price of imports rises.

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved. 8-4 Figure 8.1 The U.S. Market for Bicycles with Free Trade

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved. 8-5 Exports Plus Imports as a Percentage of GDP Figure 8.2 The Effect of a Tariff on Domestic Producers

Domestic consumers of the product are also affected by the imposition of the tariff. They must pay a higher price (for both imported and domestically produced products), they reduce the quantity that they buy and consume (a movement along the domestic demand curve), and they suffer a loss of consumer surplus. The government also collects tariff revenue, equal to the tariff rate per unit imported times the quantity that is imported with the tariff in place (less than the free-trade import quantity).

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved. 8-7 Figure 8.3 The Effect of a Tariff on Domestic Consumers

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved. 8-8 Figure 2.2 The Market for Motorbikes: Demand and Supply Figure 8.4 The Net National Loss from a Tariff in Two Equivalent Diagrams

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved. 8-9 Case study Taxing exports

For the large importing country, the imposition of the tariff causes a triangle of national loss (comparable to the one shown for the small country) but also a rectangle of national gain because the price paid to foreign exporters is lowered, for the units that the country continues to import. The net effect on the importing country depends on which of these two is larger.

For a suitably small tariff, the rectangle is larger, so the importing country has a net gain from imposing a tariff. A prohibitive tariff would cause a net national loss, because the rectangle would disappear. It is possible to determine the country’s optimal tariff— the tariff rate that makes the net gain to the importing country as large as possible. The optimal tariff rate is inversely related to the price elasticity of foreign supply of the country’s imports.

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved Figure 8.5 A Large Country Imposes a Small Tariff

The analysis is affected in important ways if the importing country is a large country, one that has monopsony power in world markets. A large country can gain from the terms-of- trade effect when it imposes a tariff. The tariff reduces the amount that the country wants to import, so foreign exporters lower their price (a movement along the foreign supply-of- exports curve). We analyze the large country case using the international market (imports and exports), and we show the tariff as driving a wedge between import demand and export supply, so the price to the import buyers exceeds the price received by foreign exporters by the amount of the tariff.

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved Figure 8.6 The Nationally Optimal Tariff

The optimal tariff causes a net loss to the whole world. The loss to the foreign exporting country is larger than the net gain to the importing country. And a country trying to impose an optimal tariff risks retaliation by the foreign countries hurt by the country’s tariff.

Copyright  2012 by The McGraw-Hill Companies, Inc. All rights reserved Illustrative Calculation of an Effective Rate of Production

World Trade Organization (WTO) Oversees the global rules for government policies toward international trade. More than 150 member countries. Established Succeeds and subsumes the General Agreement on Tariffs and Trade (“interim” agreement, 1947). Principles:  Reductions of barriers to trade  Nondiscrimination among countries, often called the most favored nation (MFN) principle  No unfair encouragement for exports

Source: Beugelsdijk et al. (2013)