1. 1 Chapter 6 Lecture - The Theory of Tariffs and Quotas

2. 22 Learning Objectives Show a supply and demand diagram to illustrate consumer and producer surplus. Draw a graph that shows the effects of tariffs and quotas on prices, output, and consumption. Explain in words and with a diagram the effects of tariffs and quotas on resource allocation and income distribution. Differentiate effective from nominal rates of protection. List and discuss at least three dynamic costs of protection.

3. 33 Analysis of a Tariff There are numerous barriers to trade, some are obvious (transparent), others are not (non- transparent) – Quotas: direct limit on imports: regulate the quantity of imports – Tariffs: indirect limit on imports: impose a tax on imports

4. 44 Analysis of a Tariff Tariffs and quotas encourage – Consumers to switch to relatively cheaper domestic goods or to drop out of the market – Domestic producers to increase their output as demand switches from foreign to domestic goods We look at a partial equilibrium nalysis of the effects of tariffs and quotas: Considers only their impact on the industry on which they are imposed, rather than their economy-wide effects

5. 55 Prices, Output, and Consumption Assume: 1.There is only one price for a good (world price P w ) 2.Foreign producers are willing to supply us with all of the units of the good we want at that price

6. 66 Prices, Output, and Consumption Now assume: Government imposes a tariff of amount “t.” Importers will still be able to buy the good from foreign producers for P w, but they will have to pay the import tax of “t.” – The tax is subsequently tacked onto the price to domestic consumers: price to them is P w + t=P t – The consumption of the imported good subsequently decreases

7. 7 The Effects of a Tariff

8. 8 Resource Allocation and Income Distribution Tariffs cause the domestic price to rise by the amount of the tariff, Domestic consumption falls, Domestic production rises, Imports fall. But, tariffs have more subtle effects than just a rise in prices and a fall in imports. - Inputs in domestic production: increase domestic production requiring additional resources of land, labor, and capital to be reallocated from their prior uses into the industry receiving protection under the tariff.

9. 9 Resource Allocation and Income Distribution When the price changes, consumer and producer surplus do too Deadweight loss- destruction of value that is not compensated by a gain somewhere else : area d is this type of loss. Efficiency loss- another deadweight loss which occurs on the production side: area b is this type of loss Summary- the net effect of the tariff on national welfare = gains to producers + gains to government - losses to consumers = (a + b + c + d - a - c) = b + d:

10. 10 Economic Effects of a Tariff

11. 11 Effects of a Tariff

12. 12 A Comparison of Tariff Rates The Doha Development Agenda of the World Trade Organization (WTO) is focused on the trade problems of developing countries At issue for many developing countries are the levels of tariffs and other industrial country barriers that block access to agriculture, clothing, and textile markets. However, developed nations often have highest tariffs in agriculture, textiles, and other labor-intensive products – the very products developing nations would like to export Industrial countries, the World Bank, and the WTO have argued major problem facing developing countries is the relatively high level of protection among themselves High tariffs limit the countries’ ability to sell into each other’s markets—and consequently their ability to follow their comparative advantage

13. 13 Average Tariff Rates, 1986-2010 United State Trade Commission Database of Tariffs http://dataweb.usitc.gov/scripts/tariff.asp

14. 14 Other Potential Costs A tariff may have effects that are less predictable and harder to quantify Retaliation by other countries: adds to the net loss of a tariff by hurting export markets of other industries; can escalate rapidly Innovation: tariffs reduce competitive pressures on domestic firms and thus their incentives to innovate and improve the quality of existing products Rent seeking: any activity that uses resources in order to capture more income without actually producing a good (e.g., firms hire lobbyists to maintain tariff protection) Political systems that do not easily provide tariffs are more likely to avoid rent seeking

15. 15 The Large Country Case Economists distinguish between small and large countries in analyzing tariffs – Large country: one that imports enough of a particular product so that if it imposes a tariff, the exporting country will reduce its price of the good in order to keep its share of the large country's market In theory, large countries can improve their national welfare by imposing a tariff as long as their trading partners do not retaliate

16. 16 Tariffs in the Large Country Case

17. 17 Effective versus Nominal Rates of Protection The amount of protection given to any one product depends not only on the tariff rate but also on tariffs on the inputs used to produce the good – Nominal rate of protection: tariff rate levied on a given product – Effective rate of protection: nominal rate + tariffs on intermediate inputs

18. 18 Effective versus Nominal Rates of Protection

19. 19 Nominal and Effective Rates of Protection

20. 20 The Uruguay Round

21. 21 Analysis of Quotas Quota: A quantitative restriction that specifies a limit on the quantity of imports Differences between quotas and tariffs – Tariff limits imports by imposing a tax on them – Unlike tariffs, quotas do not generate tariff revenue for the government Similarities between quotas and tariffs – Both lead to a reduction in imports, a fall in total domestic consumption, and an increase in domestic production

22. 22 Types of Quotas 1) Most transparent type of quota: – an outright limitation on the quantity of imports e.g., a limit on the quantity of imports from country x, or a limit on the quantity of imports from the rest of the world as a whole 2) Import licensing requirement: – forcing importers to obtain government licenses for their imports; – government regulates the number of licenses available 3) Voluntary export restraint (VER) (or voluntary restraint agreement, VRA) – the exporting country “voluntarily” agrees to limit its exports for a period

23. 23 Types of Quotas: VERs VERs have similar effects as quotas – However, VERs are more popular, as they (1) do not require domestic legislative action; and (2) allow politicians to provide protection for domestic industry and to appear as proponents of free trade The use of VERs increased with the decline in tariffs that results from the global trade rounds; however, recent international negotiations have restricted the use of VERs http://www.perc.org/articles/voluntary-export-restraints-automobiles

24. 24 The Effect on the Profits of Foreign Producers The main difference between tariffs and quotas is that there is no government revenue from quotas. In place of tariff revenue, there are greater profits for foreign producers, called quota rents. Two circumstances that can limit quota rents – If there is a large number of foreign producers, competition may limit their ability to increase prices – The government can extract the extra profits from foreign producers through an auction for import licences

25. 25 Quotas Effects of a quota – If permitted quantity is above what would be imported anyway, then no effect at all. (True only with perfect competition) – Otherwise, quota creates scarcity and raises price – Quota raises domestic price above world price For market to clear, domestic price must rise to the point that desired imports equal the quota See this with supply and demand First note example of US quota on sugar..

26. 26 Effects of a Quota: Small Country S D PWPW P Q QS0QS0 QD0QD0 PaPa Quota Suppose quota limits imports to this amount Quota which is less than initial imports

27. 27 Effects of a Quota: Small Country S D PWPW P Q QS0QS0 QD0QD0 PaPa Then price must rise until D-S=Quota Quota

28. 28 Effects of a Quota: Small Country S D PWPW P PQPQ Q QS0QS0 QD0QD0 PaPa Quota Thus price is… “Tariff Equivalent”

29. 29 Effects of a Quota: Small Country S D PWPW P PQPQ Tariff Equivalent Q QS0QS0 QS1QS1 QD1QD1 QD0QD0 PaPa Quota …and quantities are

30. 30 Effects of a Quota: Small Country S D PWPW P PQPQ Tariff Equivalent Q QS0QS0 QS1QS1 QD1QD1 QD0QD0 a b c d PaPa Effects on Welfare Same as tariff, except c Quota

31. 31 Effects of a Quota: Small Country Results – Suppliers gain area +a – Demanders lose area −(a+b+c+d) – Somebody gets area c, but who? Area c is called “quota rents” –It is the profit from buying at world price, P W, and selling at higher domestic price, P Q S D PWPW P PQPQ Q a b c d

32. 32 Effects of a Quota: Small Country Who gets quota rents? Depends on how quota is administered: – First-come, first-served: Rents go to whoever gets there before quota is exhausted – Sell (or “auction”) import licenses: Rents go to government as revenue from sale of licenses – Give import licenses away to domestic people or firms: those people or firms then get the rents – Give licenses away to foreign firms or governments: foreigners get the rents Most common is the last: Give away to foreigners in proportion to their historical exports

33. 33 Effects of a Quota: Rent Seeking “Rent Seeking” – Defined as the use of resources in effort to get rents – Examples Faster (thus more costly) transport to win race to border for 1 st -come-1 st -served quota Lobbying legislators to get quota allocations Inefficient production intended to get market-share-based quota allocations

34. 34 Effects of a Quota Effects of quota compared to tariff – Effects on price and quantity are the same hence “tariff equivalent” – Effect on welfare is different if quota rents are lost to rent seeking and/or accrue to foreigners: In that case, importing country loses more from quota than from equivalent tariff What if country is large? – Picture is also same as for tariff – But if quota rent is lost or goes to foreigners, importing country cannot gain

35. 35 Effects of Quota: Large Country (if Rent given to foreigners) Domestic Country: Suppliers gain+a’ Demanders lose−(a’+b’+c’+d’) Net effect on country = −(b’+c’+d’) Foreign Country: License holders gain+(c’+e’) (Supplier/Demanders also lose) Summary: S D P Q a’ b’ c’c’ d’ e’

36. 36 Effects of a Quota Other effects of a quota – Quality upgrading Limited to a fixed quantity, foreign exporters seek higher value by improving quality – Like a tariff, quota may induce foreign firms to produce here – Unlike a tariff, the quota becomes more restrictive if foreign supply increases or world price drops

37. 37 Other NTBs: Tariff-Rate Quota (TRQ) This is two tariffs, separated by a quota – Low (or zero) tariff applies to imports below the quota –High tariff applies to imports above the quota Used by US on many agricultural products Effect is like –a low tariff, –a quota, –or a high tariff, depending on levels of supply and demand Imports Tariff Quota

38. 38 Other NTBs: Voluntary Export Restraint (VER) Once More Restriction of exports – At request of importing country – Usually specified as maximum quantity This was the major form of protection for the US auto industry in the 1980s: US persuaded Japan to limit exports of cars to US Illegal since 1995 under WTO rules – But how to enforce – Examples in 2012 that look like VERs Effect is exactly like a quota allocated to foreigners

39. 39 Other NTBs: Variable Levies A tariff that is changed as necessary to keep domestic price at a specified level These are used extensively by the European Union as part of its Common Agricultural Policy (CAP) Effects are same as a tariff, except for behavior over time

40. 40 Other NTBs: Government Procurement Regulations Government favors domestic suppliers in buying goods and services – Buys only from domestic firms, or – Buys from domestic firms unless imports are, say, 10% cheaper US used to have a “Buy American” law – Some say we need it again, but would violate WTO Effect is like a tariff, except that loss to demander is now loss to government and thus taxpayer “Buy American” was part of the Stimulus Package of the US in 2009 – Congress would have imposed broad restrictions – Obama got them to restrict only when not contrary to US commitments under trade agreements – Even so, result was broadly restrictive, because purchasers were not sure of rules, so avoided imports – Result was also that other countries included similar provisions in their stimulus packages

41. 41 Other NTBs: Customs Procedures All countries also have standards, for – Health and safety (e.g., no lead paint) – Compatibility (e.g., 110 volt appliances) They become NTBs when biased against imports in – Substance of the requirement – Procedures for certifying compliance Other NTBs: Standards All countries have customs procedures for maintaining border security and collecting tariffs They become NTBs when – Excessive difficulty, or red tape, limits imports – Rules impose artificially high valuation for ad valorem tariffs

42. 42 Other NTBs: Unfair Trade Laws The (legal) threat and use of – Anti-Dumping Duties – Countervailing Duties We’ll say more about this later, in lecture about U.S. Trade Policies These are NTBs if – “Unfair trade” is actually normal trade (it usually is) – The threat of action discourages trade, even when duties are not levied (the “chilling effect”)

43. 43 Other NTBs: Export Taxes Simply a tax on exports, analogous to tariff on imports – Effects are similar – Not common, until recently, because countries think exports are good – Became common in mid-2008, as high world prices for agriculture led food exporters to protect their own consumers

44. 44 Subsidies Government assistance to producers – Export subsidy: paid only for exports – Domestic subsidy: paid for all production (but increases exports or reduces imports) Effect on the subsidizing country – In competitive industries, country loses – Subsidies usually are intended to benefit producers, not country – In non-competitive industries, result may be different (recall Boeing-Airbus example)

45. 45 Effects of a Subsidy on Foreign Countries Effect, if country is large, is to reduce the world price of the exported good Subsidy expands supply in subsidizing country (which is part of S W 0 ) World Market SW0SW0 DWDW SW1SW1 PW1PW1 PW0PW0 QWQW PWPW

46. 46 Subsidies: Are They Used? YES!! US, EU, Japan all have large subsidies on many agricultural products These reduce world prices and hurt producers of these products in developing countries Examples of US subsidies and whom they hurt: – Corn: Mexico – Sugar: Caribbean countries – Cotton: Certain African countries

47. 47 Hidden Forms of Protection Any trade barrier that reduces imports without imposing a tax has effects similar to those of a quota – Tariffs: impose a tax – Non-tariff barriers (NTBs): quotas and non-tariff measures Non-tariff measures are hidden, non-transparent forms of protection, such as: - excessively complicated customs procedures, - environmental and consumer health and safety precautions, - technical standards, - government procurement rules, - limits imposed by state trading companies

48. 48 Intellectual Property Rights and Trade Intellectual property (intellectual property rights) are usually divided into: – Copyrights and related rights for literary and artistic work, – Industrial property rights for trademarks, – Patents, – Industrial designs, – Geographical indications – Layout of integrated circuits There are rules for respecting intellectual property rights as they relate to trade These rules were negotiated during the Uruguay Round (1986-1994) with the Trade Related Aspects Intellectual Property Rights (TRIPS) agreement