1 An Introduction to International Economics Second Edition Trade Restrictions: Tariffs Dominick Salvatore John Wiley & Sons, Inc. CHAPTER F I V E

2 Movements away from free trade While it is generally accepted that free trade best enhances societal welfare, complete free trade is seldom practiced. This situation generates two questions: Why is complete free trade seldom practiced? What are the effects of deviating from free trade? This chapter considers the second question by considering the effects of employing one common tool of deviating from free trade – the tariff.

3 Types of tariffs Import vs. export tariffs An import tariff is a tax (or duty) on imported goods or services. This is the most common form of tariff. An export tariff is a tax on exported goods or services. This is rarely seen in developed countries but is occasionally practiced in developing countries to generate government revenue.

4 Types of tariffs Import vs. export tariffs Ad valorem tariff A fixed percentage tax on the traded commodity.

5 Types of tariffs Import vs. export tariffs Ad valorem tariff Specific tariff A fixed sum tax per unit of a traded commodity.

6 Types of tariffs Import vs. export tariffs Ad valorem tariff Specific tariff A compound tariff A combination of an ad valorem and specific tariff.

7 Types of tariffs Import vs. export tariffs Ad valorem tariff Specific tariff A compound tariff Tariff rates The U.S. International Trade Commission provides a searchable index of tariff rates. WWW link

8 Small vs. large The implications of interfering with trade differ depending on the nature of the country. The key distinction is between whether the country is “small” or “large.”

9 Small vs. large The implications of interfering with trade differ depending on the nature of the country. A “small” country is one where changes in its domestic market do not alter the international price of the commodity. In the case of a tariff, this means that the imposition of a tariff does not alter the international price. In other words, the country acts as a “price- taker” in the international market.

10 Small vs. large The implications of interfering with trade differ depending on the nature of the country. A “small” country is one where changes in its domestic market do not alter the international price of the commodity. A “large” country is one where changes in its domestic market do alter the international price of the commodity. In the case of a tariff, this means that the imposition of a tariff does alter the international price.

11 Effects of a tariff: small country The effects of a tariff are easily seen in a market supply and demand diagram. In this market, the autarky equilibrium occurs a price of $50 and quantity of 50.

12 Effects of a tariff: small country In this market, if the international price is $20, the country will be an importer of the item. Domestic production will fall from 50 to 20. Domestic consumption will rise from 50 to 80. These changes generate imports of 60 units.

13 Effects of a tariff: small country If a 50% ad valorem tariff is placed on imports, the domestic price rises from $20 (the international price) to the tariff price of $30. Domestic production increases from 20 to 30. Domestic consumption falls from 80 to 70. Imports fall to 40.

14 Effects of a tariff: small country The final effect is that the government will begin collecting tariff revenue in this market. The amount of the revenue is $10 x 40 = $400 per unit of time.

15 Welfare effects: small country To show the welfare changes from the tariff the concepts of consumer and producer surplus must be considered. Consumer surplus is the difference between what consumers are willing to pay for a specific amount of a commodity and what they actually pay for it. Graphically, consumer surplus is the area under the demand curve and above the price paid on every unit purchased.

16 Welfare effects: small country To show the welfare changes from the tariff the concepts of consumer and producer surplus must be considered. Producer surplus is the extra payment received by producers above what needed to have been paid to cause them to produce the commodity. Graphically, producer surplus is the area below the price received and above the supply curve on every unit sold.

17 Welfare effects: small country Consumer surplus at autarky is given by the indicated region. When the nation moves to free trade this surplus increases. The imposition of a tariff reduces this surplus by the difference between the international and the tariff price.

18 Welfare effects: small country Producer surplus at autarky is given by the shaded region. Opening the economy to free trade reduces the surplus to the smaller shaded region. Imposing a tariff increases the producer surplus.

19 Welfare effects: small country The losses and gains from the imposition of a tariff exist in the shaded region. The entire region is lost consumer surplus. The dollar value of this region is ($10 x 70) + (½ x $10 x 10) or $750.

20 Welfare effects: small country The entire region is lost consumer surplus. Of this, the portion above the supply curve is gained by producers. The dollar value of this region is ($10 x 20) + (½ x $10 x 10) or $250.

21 Welfare effects: small country The entire region is lost consumer surplus. Of this, the portion above the supply curve is gained by producers. The rectangular area is gained by the government as tariff revenue. The dollar value of this region is $10 x 40 or $400.

22 Welfare effects: small country This leaves a net welfare loss to society of the two triangular shaded regions. These regions are known as the deadweight loss of a tariff. These have a dollar value of $750 - $250 (gained by producers) - $400 (gained by the government) or $100.

23 Effects of a tariff: large country The effects of a tariff on a large country differ from that in a small country because the imposition of a tariff results in a fall in import demand that lowers the international price. This is known is as the terms of trade effect.

24 Effects of a tariff: large country In this case, the 50% tariff results in a drop of the international price from $20 to $15. This takes the tariff price to $22.50 per unit. The effects of this change are more clearly seen through a narrowing of focus in the graph.

25 Effects of a tariff: large country With the tariff and improvement in the terms of trade, production rises from 20 to 22.5 units. Consumption falls from 80 to 77.5 units. Imports fall from 60 to 55 units.

26 Welfare effects: large country Consumer surplus declines by the shaded region. This has a dollar value of ($2.50 x 77.5) + (½ x $2.50 x 2.5) = $

27 Consumer surplus declines by the shaded region. Producer surplus increases by the shaded region offsetting part of the consumer loss. This has a dollar value of ($2.50 x 20) + (½ x $2.50 x 2.5) = $ Welfare effects: large country

28 Consumer surplus declines by the shaded region. Producer surplus increases by the shaded region offsetting part of the consumer loss. Government revenue increases by $ 7.5 x 55 or $. Welfare effects: large country

29 The net effect is a welfare gain. Consumer surplus falls by $ Producer surplus rises by $ Government revenue increases by $412.5 This generates a net gain of $162.5 for this case. Welfare effects: large country

30 This result arises as the improvement in the terms of trade more than offsets the potential deadweight loss of the tariff. Welfare lost Welfare gained Welfare effects: large country

31 Optimum tariff The previous example demonstrates that it is possible for the imposition of a tariff in a large county to improve societal welfare. An optimal tariff is the tariff rate that maximizes the benefit resulting from the imposition of a tariff. The gain comes from the improvement in the terms of trade. Positive welfare gains are always possible from tariff imposition in large countries.

32 A concern about the optimal tariff By itself, the existence of an optimum tariff appears to be a strong argument for interfering with free trade. It is important to note that the positive welfare gains exist only if no retaliation in other markets occurs following the imposition of a tariff. History does not support the no retaliation assumption.

33 Nominal tariffs vs. effective protection The nominal tariff is the percentage increase in the price of the final commodity. A 50% ad valorem tariff raises the price of the commodity by 50% generating a 50% nominal tariff.

34 Nominal tariffs vs. effective protection The nominal tariff is the percentage increase in the price of the final commodity. The effective rate of protection is calculated on the increase in domestic value added offered by tariff protection. The effective rate of protection offers a better measure of the protection offered producers as it takes into account the cost to producers of tariffs on input markets.

35 Examples of effective protection Suppose a product sells for $10,000 but has input costs of $5,000 per unit. In this case, its value added is $5,000. The imposition of a 10% ad valorem tariff raises the sales price from $10,000 to $11,000.

36 Examples of effective protection The imposition of a 10% ad valorem tariff raises the sales price from $10,000 to $11,000. This raises the value added from $5,000 to $6,000 and offers an effective rate of protection of 20%. $1,000 (gain in value added) ÷ $5,000 (original value added) = 20% Gain

37 Examples of effective protection Using the starting point, assume that a 20% ad valorem tariff is placed on the inputs. This raises the input cost from $5,000 to $6,000.

38 Examples of effective protection Using the same example, assume that a 20% ad valorem tariff is placed on the inputs. This raises the input cost from $5,000 to $6,000. This decreases the value added from $5,000 to $4,000 and offers an effective rate of protection of - 20%. - $1,000 (loss in value added) ÷ $5,000 (original value added) = - 20% Loss

39 Examples of effective protection As a final example, consider the effective rate of protection offered by combing the previous two policies – a 20% tariff on the inputs and a 10% tariff on the final output.

40 Examples of effective protection This increases both input cost and final price by $1,000 and leaves an effective rate of protection of zero. As is seen, the effective level of protection may differ greatly from the rate of the nominal tariff. Loss Gain