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Global EconomicsEco 6367

Dr. Vera Adamchik

TariffsChapter 4

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A glance at any daily newspaper makes it clear that governments do not adhere to free trade despite the persuasive theoretical arguments pointing out the net welfare gains that result from unobstructed international trade. Policymakers have proven very resourceful in generating different devices for restricting the free flow of goods and services.

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Chapter outline

• Protecting domestic producers against import competition – an import tariff.

• Arguments for and against protection.

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An Import Tariff

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• A tariff is a tax on importing a good or service into a country, usually collected by customs officials at the place of entry.

• A specific tariff is stipulated as a money amount per unit of import.

• An ad valorem (on the value) tariff is a percentage of the estimated market value of the goods when they reach the importing country.

• A compound tariff is a combination of specific and ad valorem tariffs.

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• A protective tariff is designed to reduce the amount of imports entering a country, thus insulating import-competing producers from foreign competition.

• A revenue tariff is imposed for the purpose of generating tax revenues.

• A prohibitive tariff has a rate that is so high that it keeps imports from coming into the country.

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• Tariff rates have been declining, but they are still important.

• Only one country in the world, Singapore, has almost no tariffs. (+ two autonomous customs areas, Hong Kong and Macau, that have no tariffs.)

• Average tax rates are higher in most developing countries.

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In-class exercise

• Exercise # 1 (handout). Tariff rates in different countries.

• U.S. tariff rates (handout).

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Measurement of tariffs

• How do we determine the average tariff rate from a large number of different tariff rates on imported goods? Two techniques:

– unweighted-average tariff rate,

– weighted-average tariff rate.

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In-class exercise

• Exercise # 2 (handout). Unweighted- and weighted-average tariff rate.

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Nominal vs effective tariff rates

• The distinction between the nominal tariff rate and the effective tariff rate (more commonly known as the effective rate of protection, ERP) is important when countries are negotiating tariff rate reductions because the negotiation requires focusing on an appropriate rate.

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• The nominal rate is simply the rate listed in a country’s tariff schedule.

• The ERP is defined as the percentage change in the value added in a domestic import-competing industry because of the imposition of a tariff structure by the country rather than the existence of free trade.

• The whole tariff structure considers not only the tariff rate on the final good but also on the intermediate goods that go into making the final good.

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Value added

• Value added is the value of a firm’s production minus the value of the intermediate goods that the firms buys from other firms.

• Equivalently, value added is the sum of the incomes (including profits) paid to the resources used by the firm.

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Effective rate of protection

• In other words, the effective rate of protection measures the percent effect of the entire tariff structure on the value added per unit of output in each industry.

• This concept incorporates the point that incomes in any one industry are affected by the tariffs on many products.

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In-class exercise

• Exercise # 3 (handout). The effective rate of protection.

• Nominal and Effective Tariffs in the US and Japan (handout).

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Illustrative calculation of an Effective Rate of Protection (ERP)

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Conclusions

1. A given industry’s incomes, or value added, will be affected by trade barriers on its inputs as well as trade barriers on its output.

2. The effective rate of protection will be greater than the nominal rate when the industry’s output is protected by a higher duty than the tariff duties on its inputs.

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Conclusions (cont.)3. If the tariff rates on the inputs are the same

as the tariff rate on the output, then this rate is also the effective rate of protection.

4. The effective rate of protection can be negative. The tariff structure can penalize value added in the industry.

5. Export producers are penalized with something like negative effective protection if their costs are increased by tariffs on the inputs they use in production.

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An escalated tariff structure

• Rule (2) above incorporates an escalated tariff structure and reflects the situation when nominal tariff rates on imports of manufactured goods are higher than nominal tariff rates on intermediate inputs and raw materials.

• This situation has particular relevance to trade between developed and developing countries.

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• Tariff escalation forces the developing countries to continue to be suppliers of raw materials to and importers of manufactured goods from the developed countries when they would like to supply manufactured goods.

• Developing countries believe that this discriminates against their attempt to develop manufacturing and that it consigns the developing countries to exporting products at an early stage of fabrication.

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Offshore-assembly provisions

• Under offshore assembly provisions (OAP), now referred to as production-sharing arrangements by the U.S. International Trade Commission, the tariff rate in practice on a good is lower than the tariff rate listed on the tariff schedule.

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In-class exercise

• Exercise # 4 (handout).

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• Tariff avoidance – the legal utilization of the tariff system to one’s own advantage in order to reduce the amount of tariff.

• Tariff evasion – when individuals or firms evade tariffs by illegal means, such as smuggling imported goods into a country.

• Postponing import tariffs – a bonded warehouse; a foreign-trade zone,

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Tariff Welfare Effects:

Consumer Surplus and

Producer Surplus

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Consumer surplus

• Consumer surplus is additional benefit obtained by the buyer of a good.

• Consumer surplus is the difference between the maximum amount buyers are willing to pay for a given quantity of a good and the amount actually paid.

• Consumer surplus is illustrated as an area below the demand curve and above the market price.

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S

P

T-shirts 0 50

$6

$1

D

$9

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Consumer Surplus

• Equilibrium price = $6

• Equilibrium quantity = 50

• Producer surplus = $125 ($6-$1)*50/2 = $125

• Consumer surplus = $75 ($9-$6)*50/2 = $75

S

P

T-shirts 0 50

$6

$1

D

$9

Consumer Surplus

Amount paid

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Producer surplus

• Producer surplus is additional benefit obtained by the seller of a good.

• Producer surplus is the revenue producers receive over and above the minimum necessary for production (that is, the difference between the minimum that the seller is willing to accept and the actual price).

• Producer surplus is illustrated as an area above the supply curve and below the market price.

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Cost of Production

Producer Surplus

• Equilibrium price = $6

• Equilibrium quantity = 50

• Producer surplus = $125 ($6-$1)*50/2 = $125

S

P

T-shirts 0 50

$6

$1

D

$9

ProducerSurplus

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The Total Gains from Exchange

• Equilibrium price = $6• Equilibrium quantity = 50• Producer surplus = $125• Consumer surplus = $75• Total gains from exchange

equals consumer surplus plus producer surplus

• Gains from exchange = $125 + $75 = $200

S

P

T-shirts 0 50

$6

$1

D

$9

Consumer Surplus

Producer Surplus

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Consumer & Producer Surplus

When combined, the areas of consumer surplus and producer surplus represent the total welfare to the nation resulting from the sale of this good.

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Tariff Welfare Effects:

Small Country

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Small vs large country• In our analysis, we assume a small

country, one whose trade does not affect international price ratio.

• A large country is one whose trade can have an impact on the relative international price ratio.

• These definitions are based on the ability of the country to have a noticeable effect on one or more international prices.

• Even a country with a small economy can be a large country (Ghana – a major exporter of cocoa).

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Tariff Welfare Effects,

Small Country.

Illustration 1

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Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand

Equilibriumwithout trade

Welfare in autarky (no trade)

Consumer surplusin autarky

Producer surplusin autarky

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Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand

Imports free trade

Equilibriumwithout trade

Pricebefore tariff

Worldprice

QS QD

Welfare under free trade

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Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand

Imports free trade

Equilibriumwithout trade

Pricebefore tariff

Worldprice

QS QD

Producer surplusunder free trade

Welfare under free trade

Consumer surplusunder free trade

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Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand

Priceafter tariff Tariff

Imports free trade

Equilibriumwithout trade

Pricebefore tariff

WorldpriceImports

with tariff

QSQS QD QD

Consumer surplus after tariff

Consumer surplusafter tariff

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Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand

Priceafter tariff Tariff

Imports free trade

Equilibriumwithout trade

Pricebefore tariff

Worldprice

QS

Importsafter tariff

QS QD QD

Producer surplus after tariff

Producer surplusafter tariff

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c

Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand

Priceafter tariff Tariff

Imports free trade

Pricebefore tariff

Worldprice

QS

Importsafter tariff

QS QD QD

Tariff revenue

Government’s revenue from tariff

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Effects of tariff on social welfare

acb d

Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand

Pricewith tariff Tariff

Imports free trade

Pricewithout tariff

WorldpriceImports

after tariff

QSQS QD QD

Deadweight loss

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Tariff Welfare Effects:

Small Country

Illustration 2

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Tariff welfare effects

Before Trade (Autarky):U.S. consumer surplus is area in red.

U.S. producer surplus is area in green.

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With Free Trade:Consumer surplus increases by areas a,b,c,d,e,and f.

Producer surplus decreases by areas a and e.

The overall increase in welfare is b,c,d and f.

Tariff welfare effects

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With Tariff:c = revenue effect = lost consumer surplus now government rev.

a = redistributive effect = shift from consumer to producer surplus

b + d = deadweight loss = benefits lost to all parties b = protective effect d = consumption effect

Tariff welfare effects

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Tariff Welfare Effects,

Small Country.

Illustration 3

(Handout)

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The U.S. market for bicycles with free trade

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• Consumers lose Area a+b+c+d = $45 mil. (loss)

• Producers gain Area a = $21 mil.

• Government collects Area c = $18 mil.

-------------------------------

• Net national loss from tariff = Area b+d = $6 mil.

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Conclusions (compared to free trade)1. Overall, for a small importing country, a

tariff brings a net national loss. Total surplus decreases, because the loss to consumers is larger than the gains to the producers and to the government.

2. By raising the price on strictly domestic sales, a tariff redistributes incomes from consumers to producers (the redistributive effect). That is, domestic consumers are worse off, while domestic producers are better off.

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Conclusions (cont.)3. A tariff shifts some purchases from foreign

products to more expensive home products (the protective / production effect).

4. A tariff makes consumers pay tax revenue directly to the government (the revenue effect).

5. A tariff discourages some purchases (the consumption effect).

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Conclusions (cont.)

6. Both by shifting some purchases toward costly home products and by discouraging some purchases, the tariff costs the nation as a whole. The decrease in total surplus is called the deadweight loss of the tariff.

7. A tariff absolutely helps those groups tied closely to the production of import substitutes, even when the tariff is bad for the nation as a whole.

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Arguments for Protection

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• If analysis of economic efficiency indicates that import protection is often a bad policy and seldom the best policy, why do so many countries have so many import barriers?

• Why are import barriers high for some products and low for others?

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In-class exercise

• The effect of protection instruments on domestic prices (handout).

• Land of the free? (handout).

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• Trade policy is often conducted as a component of a policy package that is directed toward improving the well-being of different groups in society or reaching certain national and international objectives.

• Traditional arguments may be grouped into several key categories organized around the objectives of the action in question:

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TRADE POLICY AS PART OF A BROADER SOCIAL OBJECTIVES PACKAGE

1. Increase domestic production of the product2. Increase employment of labor and other resources in

this domestic production3. Reduce unemployment 4. Improve national defense5. Inspire and foster “National Pride” in key industries6. Increase government revenue7. Decrease domestic consumption of the “bad” product8. Alter the distribution of income or well-being in the

country to benefit a scarce factor of production (recall the Stolper-Samuelson theorem)

9. Improve the balance of trade (to reduce the trade deficit)

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PROTECTION AS A RESPONSE TO INTERNATIONAL POLICY

DISTORTIONS

1. Tariff to offset foreign dumping

2. Tariff to offset foreign subsidy

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STRATEGIC TRADE POLICY: Fostering Comparative Advantage

1. The infant industry argument

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1.Promoting domestic production

(the infant industry argument;

the dying industry argument)

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The infant industry argument

• U.S. motorcycle production

• Harley-Davidson, the only U.S.-owned producer by 1978

• in 1983 higher tariff rates for 5 years to develop a new line of production (the smaller cycles)

• the firm eventually became an exporter

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The dying industry argument

• Firms in import-competing (import-threatened) industries

• In the U.S. -- steel firms in the industrial Midwest and clothing firms in North Carolina

• Trade Adjustment Assistance: workers can petition the Department of Labor, receive an extra unemployment compensation, retraining, and subsidies for job search and moving expenses

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2. to increase employment in a particular industry

3. to reduce aggregate unemployment

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• Economists do not dispute that the tariff can augment employment in the industry or country. However, they question whether the tariff is the best method of increasing employment.

• An alternative instrument for providing jobs in the industry – a subsidy by the home government – can do the job at lower cost in a welfare sense.

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4. The national defense argument

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• This argument assumes that an industry is vital to a country’s security.

• It is not easy to identify such industries.

• The U.S. watch industry successfully obtained protection using this argument.

• Even the garlic and clothespin industries petitioned for protection using the national defense argument.

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5. Fostering “National Pride” in key industries

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• Nations desire symbols as much as individuals do.

• If it is the physical production itself that produces that pride, then it may warrant a policy interventions.

• However, a domestic production subsidy (not an import barrier) will be a more cost-effective way of achieving this goal.

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6. The developing government

(public revenue) argument

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Especially crucial for developing countries that do not have the institutional tradition of financing government expenditures with income, wealth, and property taxes. They thus rely on transaction taxes, most often of a consumption nature, to finance government programs. A number of countries rely on trade taxes because they are more easily collected upon import or export.

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• Developed countries: trade taxes provide an extremely small portion of total government revenue. Canada - 1.27% (2005); USA - 1.11% (2005); Norway - 0.19% (2005).

• Middle- and low-income countries: Swaziland - 48% (2003); Lesotho - 45% (2004); Bangladesh - 33% (2004); Russia - 24% (2005); India - 15% (2002).

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7. Trade barriers to decrease domestic consumption of the “bad” product

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• The problem of determining quality levels in the market is even greater than that of determining price levels, since information about quality is usually more difficult to obtain than information on prices.

• NTBs: Standards and safety

• http://www.wto.org/english/theWTO_e/whatis_e/tif_e/agrm4_e.htm

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8. The income redistribution argument

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• This argument is a more sophisticated and rigorous argument than many arguments for protection.

• It makes no claims that the country as a whole benefits from the protection; it is instead an argument for protection from the perspective of an individual factor of production.

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• Hence, a tariff could sometimes be defended on the grounds that it restores equity by favoring some wrongly disadvantaged group, even though it may reduce the overall size of the pie to be distributed among groups.

• Although the country as a whole suffers reduced welfare from the trade policy, the country’s scarce factor gains (recall the Stolper-Samuelson Theorem).

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• However, economists usually respond that a more efficient way is to undertake a direct transfer by taxing the abundant factor and awarding the tax revenues to the scarce factor.

• This direct process does not lead to the welfare loss associated with reducing the country’s participation in international trade.

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Political Economy of

Trade Barriers

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• In each country import barriers are adopted and maintained through a political process of decision making.

• Understanding the answers to questions about why import barriers exist require a mixture of political and economic insights.

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• There is a growing literature on the “political economy of trade barriers.” It focuses on activities by pressure groups and the self-interested behavior of political representatives who seek to maximize their chances of staying in office.

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• If everybody voted directly, the majority would probably vote against a tariff or non-tariff barrier because more people would be hurt as consumers than would be helped as producers of the product.

• Therefore, in order to explain why countries restrict trade we need to explain how it is that a MINORITY of people can so often get their government to impose trade policies that harm their fellow citizens and the citizens of foreign countries.

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• Why are potential losers from trade better politically organized than the winners from trade?

• The reason is that losses are usually concentrated among a few, but gains are usually dispersed among many. That is why potential losers from trade are better politically organized than the winners from trade.

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• Small special interest groups can have a disproportionately large influence on trade policies.

• The graph (see next slide) shows that the losses from a trade policy, say a ban on imports of bananas, substantially exceed the gains, but the gains are concentrated among 10 percent of the citizens of the economy (producers of competing fruits) and the losses are dispersed among the remaining 90 percent (consumers).

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• Banana consumers may not find it worth their while to lobby against the policy; but because each of the gainers gains a lot, and they are fewer in number, they are more likely to organize and lobby.

• Hence, if policy makers are not well informed about people’s preferences, then despite the excess of losses over gains, policies that favor concentrated groups willing to spend to promote their interests are likely to be enacted.

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“Relatively small groups organized around a common concern, such as producers in a particular industry, are well positioned and strongly motivated to communicate their wishes. On the other hand, the general consuming public is too large and too diverse to communicate a clear and consistent message through the political process… So when considering actions that would concentrate benefits on a particular industry while spreading the costs among all consumers, decision-makers will hear much from industry but will hear little or nothing from consumers. As a result, producer interests invariably trump consumer interests.” D. Lee, “Economic Protectionism,” Economic Insights 6:2, 2001,

Federal Bank of Dallas.