Lecture 6 - Tariffs

Econ 102 --- The World Economy

Simon Fraser University

Summer 2015

Instructor: Yang Wang

Topic 6: Tariffs and Quotas

Outline:

Supply, demand, and surplus

Trade barriers Tariffs

Nontariff barriers (NTBs) Quotas

Nontariff measures

The World Economy 2

Supply, Demand and Surplus

Demand: the quantity of a good or service consumers would buy at each possible price Marginal benefit = marginal willingness to pay Consumer surplus: value received by consumers in excess of the price they pay Supply: the quantity of a good or service firms are willing to supply at each possible price Producer surplus: value received by producers in excess of the minimum price at which they are willing to produce Deadweight loss:

destruction of value that is not compensated by a gain somewhere else

The World Economy 3

Effects of Tariffs: Barriers to trade:

Quota: direct limit on imports: regulate the quantity of imports Tariff: indirect limit on imports: impose a tax on imports Others

Two main types of tariff Ad valorem: % of value Specific: $ per unit

Assumptions: the world price

(Pw) Foreign producers are willing to supply us with all of the units of the good we want at that price

Effects of tariffs: Two cases:

Small country: Too small for its behavior to matter for the world price Large country: Large enough (in market for this good) that its behavior may change world price

Short run effects, long run effects

The World Economy 4

Effects of Tariffs (small country):

The World Economy 5

Autarky price = Pa

Free trade price = world price =

Effects of Tariffs (small country)

Now suppose that

Importers will still be able to buy the good from foreign producers for Pw, total pay = Pw+ t=Pt

The World Economy 6

t tariff revenue

Short-run Welfare and Efficiency Effects of Tariffs (small country)

The World Economy 7

Domestic price rises by full amount of tariff Domestic demand/consumption falls Domestic output/production rises (employment also rises in this industry) Import (= demand-supply) falls Total surplus (= CS + PS + government revenue) falls, thus national welfare falls.

DWL=b+d

(CS)

(PS)

Long-run Effects of Tariffs (small country)

1. The loss of export markets through the retaliation of trading partners:

Assume that country 1 imports good A from country 2, and exports good B to country 2. To protect firms producing good A from foreign competition, Country 1 places tariffs on its import of good A, then its trading partner country 2 retaliate by imposing tariffs on good B.

As a result, hurt export markets of good B, lose jobs in that industry

Retaliation can escalate rapidly, trade declines, welfare falls

2. Slower innovation:

tariffs reduce competitive pressures on domestic firms and thus their incentives to innovate and improve the quality of existing products

3. Increased rent seeking:

Rent seeking: any activity that uses resources to try to capture more income without actually producing a good or service (e.g., firms hire lobbyists to maintain tariff protection)

If it is easier to lobby a government for tariff protection than it is to become more competitive, then firm will use rent seeking tactics.

Political systems that do not easily provide tariffs are more likely to avoid rent seeking

The World Economy 8

Effects of Tariffs (large Country)

If the country is large, then

when it reduces its imports of the good from the world market

the world price will fall

Why?

Because, with less import demand by large country, world demand shifts left.

In theory, large countries can improve their national welfare by imposing a tariff as long as their trading partners do not retaliate

The World Economy 9


The World Economy 10

Pw + t

t

Domestic price rises from Pw to Pw*+t Domestic demand/consumption falls from Q2 to Q2* Domestic output/production rises from Q1 to Q1* Import falls from Q1Q2 to Q1*Q2* Consumers are worse off as CS , producers are better off as PS . Government revenue (post-tariff) = c + g, DWL= b+d


Results due to fall in world price:

Domestic price rises, but by less than the tariff

Compared to the same tariff in a small country Output rises by less (employment rises by less as well)

The benefit to producer is smaller

Demand falls by less

The harm to consumers is smaller

Imports falls by less

Tariff revenue is larger

As long as g > b + d, a large country can improve its welfare by imposing a tariff (assuming there is no retaliation, rent seeking, or harmful effects on innovation)



The model assumes perfect competition All buyers and sellers are too small, individually, to affect price

Answers could be different if firms had monopoly power

A tariff by a large country drives down the world price of its imports

Harms the other country

Lowers world welfare. Thus the rest-of-world loses more than the tariff-levying country gains

Effective v.s. Nominal Rates of Protection The amount of protection given to any product depends not only on the tariff on the imports but also on tariffs on the imported inputs used to produce the good

its input hurts it


Effects of Tariffs (large Country) Effective v.s. Nominal Rates of Protection (continued)

Nominal rate of protection: tariff rate levied on a given product

Effective rate of protection: nominal rate + tariffs on intermediate inputs

Value added: price of a good minus the costs of intermediate goods used to produce it.

Value added measures the contributions of labor and capital at a given stage of production.

effective rate of protection = (VA* - VA) / VA x 100%

where VA = amount of domestic value added under free trade;

VA* = domestic value added after taking into account all

tariffs (on both final goods and intermediate inputs)

Alternatively, effective rate of protection = (to-ati)/(1-a)

where to = ad valorem tariff on output

t i = ad valorem tariff on input

a = value of input as share of value of output



p(free trade) = $1000, input= $600, a=60%, VA = $400 Under free trade: VA* = VA = $400, effective rate of protection = (400-400)/400=0 with tariff (output: 20%, input: 0): p=$1000x(1+20%)=$1200, VA* =($1200-$600)=$600, effective rate of protection = (600-400)/400 x 100% = 50%. Alternatively, effective rate of protection = (20%-0.6%x0)/(1-60%)=50%.

So a 20% tariff provides 50% protection. With tariff (output: 20%, input: 50%): p=$1200, input*=$600 x (1+50%)=$900, VA*=($1200-$900)=$300, effective rate of protection = (300-400)/400 x 100% = -25%. Alternatively, effective rate of protection = (20%-0.6x50%)/(1-60%)=-25%. In this case, American laptop markers receive negative protection because the tariff on the final product is more than offset by the tariffs on the intermediate products.


Nontariff Barriers (NTBs) Trade barriers

Tariffs

Nontariff barriers (NTBs)

What are NTBs? Any kind of trade barriers that reduces imports without imposing a tax functions

Any institutional or policy arrangement that interferes with trade, other than tariffs

Types of NTBs Quotas: quantity limit on imports

Nontariff measures: hidden, non-transparent forms of protection; any regulatory or policy rule other than tariffs and quotas that limits imports.

excessively complicated customs procedures,

environmental and consumer health and safety precautions,

technical standards,

government procurement rules,

limits imposed by state trading companies

others


Quotas An import quota is a direct quantitative restriction on the quantity of imports

Types of quotas

outright limitation on the quantity of imports (most transparent)

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

For example, until 2005, HK and Haiti had different limits on each type of apparel that they could export to the U.S.

Import licensing requirement:

forcing importers to obtain government licenses for their imports;

government regulates the number of licenses available

Less transparent than quotas because governments usually do not publish information on the total allowable quantity of imports.

Voluntary export restraint (VER) (or voluntary restraint agreement, VRA)

the period

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


Quotas Effects of quotas

Under perfect competition, If permitted quantity is above what would be imported anyway, then no effect at all.

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

Two cases

Small country

Large country


Effect of Quotas (small country)

With free trade, world price is set at Pw, domestic production is Q1, demand is Q2, and imports are Q1Q2.

Now suppose quota limits imports to Q1Qa, which is less than initial imports Q1Q2.


Qa

Effect of Quotas (small country)

Then price must rise until D - S = quota

Price is Pq, domestic production is Q1*, demand is Q2*, imports =Q1*Q2*= Q1Qa = quota

Effects on welfare: same as tariff, except c Producers gain area (a)

Consumers lose area (a+b+c+d)

Area (c) -----


Qa

a b d

Effect of Quotas (small country) Quota rents:

Extra profit due to the higher prices: the profit from buying at world price PW, and selling at higher domestic price PQ Who gets quota rents?

Foreign producers

If government auction import licenses, quota rents go to government as revenue from sale of licenses.. Government gives import licenses away to domestic people/firms, those people/firms get the rent

Two circumstances that can limit the ability of foreign producers to earn 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


Effect of Quotas (small country) Effects of quota compared to tariff

Similarities between quotas and tariffs Both lead to a reduction in imports, a fall in domestic consumption, and an increase in domestic production Effects on price and quantity are the same,

hence

Differences between quotas and tariffs Unlike tariffs, quotas do not generate tariff revenue for the government.

Effect on welfare is different if quota rents are accrue to foreign producers In that case, importing country loses more from quota than from equivalent tariff, there are greater profit for foreign producers (quota rents).

Over time, as demand for the good increases and quota remains fixed: increase in consumer demand, increases the price paid by consumers, increases in producer surplus garnered by domestic firms (Assuming the country is relative small)

In contrast, an increase in consumer demand for an item that has an import tariff increases the quantity of imports and leaves the price intact


Effect of Quotas (large country)


S

D

P

Q

c d e

What if country is large? Same as for tariff But if quota rent goes to foreigner producers, importing country cannot gain.

Domestic Country: producers gain: Consumers lose: -------------------------------------------------- Net effect on country ( Foreign Country: License holders gain +( (foreign producers also lose)

Effect of Quotas

Other effects of quotas: 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 a fall in world price


Lecture 6 - Tariffs

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