Econ 102 --- The World Economy

Topic 6: Tariffs and Quotas

Simon Fraser University
Summer 2015
Instructor: Yang Wang

Outline:
Supply, demand, and surplus
Trade barriers
Tariffs
Nontariff barriers (NTBs)
Quotas
Nontariff measures

The World Economy

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

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:
Without trade, a goods autarky price would be above 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

Effects of Tariffs (small country):

Autarky price = Pa
Free trade price =
world price =

The World Economy

Effects of Tariffs (small country)

Now suppose that Government imposes a tariff of amount t
Importers will still be able to buy the good from foreign producers for
Pw, but they will have to pay the import tax of t. Now consumers
total pay = Pw+ t=Pt

tariff revenue

The World Economy

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

(CS)
(PS)

DWL=b+d

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.
The World Economy

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

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

Effects of Tariffs (large Country)

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
The World Economy

10

Effects of Tariffs (large Country)

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 World Economy

11

Effects of Tariffs (large Country)

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
A tariff on an industrys output helps it by raising its price, a tariff on
its input hurts it

The World Economy

12

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
ti = ad valorem tariff on input
a = value of input as share of value of output
The World Economy

13

Effects of Tariffs (large Country)

p(free trade) = $1000, input= $600, a=60%, VA = $400

Under free trade: VA* = VA = $400, effective rate of protection = (400400)/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.
The World Economy

14

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
The World Economy

15

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 exporting country voluntarily agrees to limit its exports for a 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
The World
Economy
16

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

The World Economy

17

Effect of Quotas (small country)

Qa

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.

The World Economy

18

Effect of Quotas (small country)

tariff
equivalent

Qa

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) ----- quota rents
The World Economy

19

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
The World Economy

20

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 tariff equivalent

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
The World Economy

21

Effect of Quotas (large country)

P

a b

c
e

What if country is large?

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

d
D
Q

Domestic Country:
producers gain: + (a)
Consumers lose: (a+b+c+d)
-------------------------------------------------Net effect on country = (b+c+d)
Foreign Country:
License holders gain
+(c+e)
(foreign producers also lose)

The World Economy

22

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

The World Economy

23