1. Study Unit 5
Ms. K Amusa

2. How to use these slides? While working through these slides:
Keep your study guide and textbook open next to you.
Ask questions if there is anything you do not understand.
These slides do not cover the entire chapter, only some of the important points. Make sure you also study the other parts as stipulated by your study guide.
Remember to make notes!

3. Follow us in your textbook…
11th ed. pg
10th ed. pg

4. This study unit covers:
Tariffs
Non- tariff barriers
Arguments for protection

5. Tariffs
A tariff is defined as a tax rate levied on imported goods as they cross national borders.
There are three types of tariffs:
Ad-valorem- levied as a percentage of the value of the commodity.
Specific tariff- levied as a fixed amount of the value of the commodity.
Compound tariff- a combination of an ad valorem and specific tariff.

6. Economic impact of a tariff.
In discussing the impact of a tariff, distinction has to be made between a large and small country.
A large country is one that can affect the world price of the commodity and therefore influence its terms of trade
A small country is one that cannot influence the world price of the commodity and as such cannot impact upon its terms of trade.
When discussing the economic impact of a tariff make sure your discussion comprises of price, consumption, production, revenue and terms of trade effects.

7. Effect of a tariff on a small country
Domestic price of the imported commodity increases by the full amount of the tariff.
Consumers pay more because of the higher price
Consumers will consume less of the imported commodity as they will switch to consuming less desirable domestic substitutes.
This constitutes a loss in consumer welfare

8. Producers experience an increase in production of the import competing commodity.
There is loss in production efficiency as resources are reallocated from more efficient production to less.
Government receives revenue from the tariff.
There is redistribution of real income from consumers to government and producers.

9. Partial equilibrium effect of a tariff
Figure 8.1 on pg.214 (follow animations in the textbook)
Nation 2: demand and supply of commodity X
At the free trade price of PX=$1, Nation 2 consumes 70X
PX($) DX SX E
Of which 10X is produced locally and 60X is imported 1
60X Imported 10 70 X

10. Partial equilibrium effect of a tariff
Figure 8.1 on pg.214 (follow animations in the textbook)
Nation 2: demand and supply of commodity X
With 100% import tariff on X, PX rises to $2 for Nation 2
PX($) DX SX E
Now Nation 2 consume 50X of which 20X is locally produced and 30X is imported 2
30X Imported 1 10 20 50 70 X

11. Partial equilibrium effect of a tariff
Figure 8.1 on pg.214 (follow animations in the textbook)
Nation 2: demand and supply of commodity X
Trade effect
PX($) DX SX E
Consumption effect
Production effect 2
$30 = Revenue Effect 1
-20X
-10XX 10 20 50 70 X

12. Economic impact of a tariff on a large country.
The domestic price of the imported commodity increases but not by the full amount of the tariff.
Consumption of the imported commodity declines as consumers switch to less desirable domestic substitutes.
Due to the big share in global demand for the commodity a large country has, the fall in their consumption forces the exporting nation to reduce its export price.
Therefore the tariff burden is shared by consumers in the large country and the exporting nation

13. Since the import price is now less, the terms of trade of the large nation improves.
NB:
Only a large country can improve its terms of trade (tot) by imposing a tariff.
For a large country imposing a tariff, the trade volume decline but the tot improves, whether the overall welfare of the nation increases or decreases depends on the net effect of the two forces.
For a small country imposing a tariff, trade volume falls, representing a decline in welfare, the tot remain unchanged. Therefore the nation experiences an overall decline in welfare.

14. Common effect of a tariff in an large and small country
Trade volumes declines
Domestic consumption declines
Consumers switch to less desirable domestic substitutes
Domestic production increases
Loss of production efficiency
Income is redistributed from consumers to government and producers
Government collects revenue
Increased employment In import competing industry
Increase in the return to the homogenous factor used intensively in the production of the substitute.
Difference in the effects of a tariff in a large and small country
Domestic price rises by the full amount of the tariff in a small country
In the large nation, the domestic price rises by less than the full amount of the tariff
The terms of trade of the large nation improves
The terms of trade of a small nation remains unchanged

15. Optimum tariff
This is the tariff rate that maximizes the difference between loss in trade volume and gains in terms of trade.
For a small country, because it can't influence world prices, it can't influence its tot either.
See the illustration on page 42 of the study guide on optimum tariff and welfare.

16. Effective rate of protection (ERP)
One of the reasons for imposing a tariff is to protect domestic producers
So the question is how effective is the tariff?
Nominal tariff is defined as the tariff imposed on the value of a final good.
Nominal tariff does not tell us anything about the protection given to domestic producers.
It is only for the consumers.
Effective rate of protection measures the degree of protection given to domestic production activities.
ERP takes into account the tariff on both the final good and the imported inputs used to produce it.

17. If the final good is taxed but the raw material used in producing it is not, the ERP will be high.
If the raw materials are taxed but the final good is not then the ERP will be low. Meaning the domestic producers are taxed rather than protected.
When the tariff on the final good exceeds that on the imported input, the ERP exceeds the nominal rate imposed on the good.
When the tariff rate on the imported input exceeds that on the final good, the ERP is less than the nominal rate imposed on the good.
If the nominal tariff on the final good = the nominal tariff on the imported input, ERP=the nominal tariff rate imposed on the good.

18. Do the following true or false questions
The revenue from an ad valorem tariff changes as the value of imports changes.
Only a large importing country can improve its terms of trade by levying a tariff.
In times of inflation, a specific tariff costs importers less then an ad valorem tariff, provided the physical quantities imported remain unchanged.
Kafayat do you have any specific questions on tariffs that you would like to include here? No

19. The non tariff barriers include: Import quotas
Voluntary export restraint
International cartels
Export subsidies local content requirement
Border tax adjustments

20. Import quotas
Are direct quantitative restrictions on the amount of a commodity that can be imported
Because quotas restrict imports, they cause an increase in the domestic price of the imported commodity just like a quota.
The there is no limit to the difference between the domestic and world prices with a quota.
Domestic consumption of the imported good falls as consumers switch to less desirable substitutes

21. Do the following questions
Name and describe the main forms of nontariff barriers.
Compare the partial equilibrium effect of an export subsidy to the effects of an import quota.

22. Arguments for protection
The argument for protection include
Infant industry argument
Scientific tariff argument
Strategic trade policy
Optimum tariff argument
NB: when discussing the arguments for protection make sure to explain each argument and also include any shortcomings/ criticisms the arguments may have.

23. Infant industry argument
Due to lack of know how an industry might not set up or even when it has set up, it might not be able to compete with established foreign industries.
Therefore, an industry should be protected when it is in its infancy to enable it to attain a level of economies of scale to make it competitive with foreign industries.
The protection must be temporary.
The return from the grown industry must be sufficient to offset high prices paid by consumers during its infancy stage.

24. The argument can however be abused
Some industries remain protected even though they are not efficient or competitive
The argument is more applicable to developing nations than developed
Production subsidy might be a better approach as it does not cost the consumers in terms of high prices paid during infancy.
It is difficult to determine which industry can be regarded as an infant industry.

25. Scientific tariff argument
This is the rate that will equalize wage rates across countries.
It is to enable domestic producers to meet foreign competition
It is meant to offset the competitive advantage of low wages in foreign countries
This argument however does not take into account productivity differentials.
There is not much that is scientific about the argument.
The argument also takes wages to be the only component of production costs.

26. Strategic trade policy
Argument that government needs to protect some large oligopolistic industries
This is done to increase their market share at the expense of foreign competitors
To increase the global share of domestic firms.
Strategic trade policy requires large capital, but as output increases marginal costs fall.
There is lack of information to help government make its decision.
There is also a loss of production efficiency.
Read more from the text book

27. Optimum tariff
This is the tariff that maximized the difference between loss in trade volume and improvement in tot.
The optimum tariff for a large country is positive
The optimum tariff for a small country is zero.
Only a large country can improve its tot by imposing a tariff.
When a large country imposes a tariff, it forces the exporting nation to lower its price. this leads to an improvement in the large country’s tot and a worsening of the small country’s tot.

28. Arguments against protection:
Output declines with protection
Production efficiency falls
Consumers pay more
Consumers choices decline under protection.

29. Local production of domestic substitute increases.
Production efficiency falls as resources are drawn from more efficient industries.
No revenue accrues to government. The revenue goes to the license holders.
Government only receives revenue if it auctions the import licenses.
A rise in demand causes the domestic price of the imported good to increase under a quota but the domestic price remains the same under a tariff.

30. Quotas vs. Monopolists
If a quota is imposed on an imported input, this raises the cost of production of the final good with no possibility of a rebate. While with a tariff, a rebate is given. A domestic monopolist can cause more harm to the economy under a quota than under a tariff.

31. Voluntary vs. Agreements
Voluntary export restraint
International commodity agreements
Here importing nation induces the exporting nation to voluntarily reduce its exports by threatening higher trade restrictions.
VER’s restrict supply thus increasing prices in the importing nation. So the effects are similar to that of a quota.
Are agreements between producing nations to stabilize commodity prices.

32. International cartels
Group of countries/ governments of countries with same industries agree to reduce /restrict trade in a commodity.
Most famous is OPEC
Cartels restrict output thus raising prices.
Cartels are harmful to the economy, much like a monopoly.
In the long run cartels cannot be sustained as a supplier can deviate

33. A portion of the final good must be produced domestically.
Local content requirement
Export subsidies
A portion of the final good must be produced domestically.
Are payments by government to a firm for each unit of the product shipped abroad

34. Do the following true or false questions
The infant industry argument only applies to industries which can eventually acquire a comparative cost advantage
An argument for tariffs on certain goods is that they help to reduce the pricing power of local monopolies over domestic consumers.
Strategic trade policy may justify protection in some highly competitive markets where local producers need time to acquire a comparative cost advantage.
Kafayat do you have any specific questions on protection that you would like to include here? No

35. End of study unit 5