1 Welcome to Econ 414 International Economics Study Guide Week Seven Chapter 6

2 Tax on imported goods Why? –Revenue for Government –Protect domestic suppliers of similar goods from foreign completion Protect jobs What is a tariff?

3 What are the types of tariff? 1.Specific tariffs Tax per unit specific tariff is regressive. Why? –A specific tariff of $1,000 on each imported auto a high percentage of the value of less expensive cars a low percentage of the value of high- priced cars

4 Under specific tariff, what type of cars will be imported less? Expensive cars? Cheap cars? Cheap cars –A specific tariff encourages domestic producers to produce less expensive goods.

5 2. Ad valorem tariffs –Taxes = fraction of the value of the imported goods A 5% tariff on an international price of $10,000 means that customs officials collect the fixed sum of _________. –Importers have an incentive to under-voice the price of the imported good. –Ad valorem tariffs are more difficult for a country to administer than specific tariffs. What are the types of tariff? $500

6 3. Compound tariffs – a combination of an ad valorem and a specific tariff –Common on agricultural products whose prices tend to fluctuate. What are the types of tariff?

7 1.Free alongside (FAS) price The price of the imported good in the exporting nation before loading the good for shipment to the importing country 2.Free on Board (FOB) price FAS + the cost of loading the good in the means of transportation What are different methods of valuing imports?

8 3. Cost, Insurance, and Freight (CIF) price FOB + all inter-country transportation costs up to the importing country’s port of entry. What are different methods of valuing imports?

9 What is consumer surplus (CS)? D P1P1 P Q Consumer Surplus Price Quantity The difference between the highest price consumers would be willing to pay (Price on demand curve) and the market price. Graphically, it is equal to the area under the demand curve and above the price The higher the CS the ___________ the consumers Better off

10 What is producer surplus (PS)? E P2P2 Producer Surplus S Quantity of Cloth Price of Cloth Q P The difference between the market price and lowest price producers will sell a good (price on the supply curve). Graphically, it is equal to the area under the price and above the supply curve The higher the PS the ___________ the producers Better off

11 The combined effect S D E Price Quantity P1P1 Q P P2P2 Consumer Surplus Producer Surplus

12 How does a free trade affect consumer surplus and producer surplus? Price Quantity Price Quantity D Exports Imports D E US India a b c d S S 10 4 a’ b’ c’ d’ 8 E’ 8 CS ↑ by b+ d, PS ↓ by b CS ↓ by b’, PS ↑ by b’ + d’

13 What are the economic effects of tariffs? 1.Case of small importing nation Note: A small nation can import as much as it likes at the same international price. –World Prices = € 8. –Domestic government imposes a specific tariff on imported good in the amount of € 2/unit –Domestic Price = = € 10

14 What are the economic effects of tariffs in a small importing nation? S D E Price Quantity 20 2 a b c d Tariff = 2 -a+b+c+d: loss in CS = €75 - a: added to PS= €25 - b: cost of resources transferred from their best use to the production of 5 more units of the good= €5 - c: government revenue = €40 -d: loss to consumers = €5 - a + c: redistributed effect - b+d: dead-weight loss

15 2. Case of large importing nation Note: A large nation can influence the international price. –World Prices = € 8. –Domestic government imposes a specific tariff on imported good in the amount of € 2. –World supplier reduces the price to € 7 –Domestic Price after tariff= 7+ 2 = € 9 What are the economic effects of tariffs

16 What are the economic effects of tariffs in a large importing nation? S D E Price Quantity 20 2 a b c d Tariff = 2 -a+b+c+d: loss in CS = € a: added to PS= € b: efficiency loss= €2.5 - c+ f: government revenue = €40 -d: loss to consumers = €2.5 - a + c: redistributed effect - b+d: dead-weight loss -f: loss in exporter’s revenue 7 f

17 The Effective Rate of Protection Effective Rate of Protection ERP = (T f – aT c )/(1-a) which, T f = tariff rate on imported final product T c = tariff rate on the imported components

18 The Effective Rate of Protection Example: Consider two DVD players; one produced in the U.S. and one produced in a foreign country. Both DVD players sell for $100 in the U.S. with half of that price represents the cost of components purchased from a third country. An ad valorem tariff of 20% imposed by the U.S. raises the value added from $50 to $70. Thus, the effective rate of protection is (70- 50)/50 = 40%.

19 Arguments for Tariffs Infant Government Argument –Developing countries use tariffs as a way to generate revenue. National Defense Argument –Certain industries need to be protected from foreign competition to ensure an adequate output of the industry in the case of conflict. –Two problems arise with this argument: It is hard to identify the industries that are essential for national defense. A tariff is a costly means of protection. Instead, a domestic production subsidy should be used to encourage domestic production of the good. –The next slide depicts the effects of a domestic production industry.

20 Infant Industries –From World War II until the 1970s many developing countries attempted to accelerate their development by limiting imports of manufactured goods to foster a manufacturing sector serving the domestic market. –The most important economic argument for protecting manufacturing industries is the infant industry argument. Senile Industry Protection –Many developed countries protect industries that are old. For example, the apparel industry in most developed countries experience this type of protection. Arguments for Tariffs

21 Arguments for Tariffs S D E Price of Cloth Quantity of Cloth P1P1 P P2P2 a b c Q d G F Q4Q4 Q2Q2 Q3Q3 Q1Q1 PwPw PtPt Tariff = T Figure 6-6: The Effects of a Domestic Production Subsidy S’ Subsidy

22 Tariffs, Trade and Jobs –The imposition of a tariff in a particular industry produces more jobs in that particular industry but fewer jobs in other industries. The overall level of employment is unchanged in the short-run whereas in the long-run it may decrease. An economy with a lot of tariffs will usually grow more slowly than a more open economy. Arguments for Tariffs