CHAPTER 6

Tariffs
International Economics, Second Edition by W. Charles Sawyer and Richard L. Sprinkle
Prepared by Iordanis Petsas

Chapter Organization
Introduction Types of trade barriers Tariffs: Preliminary details Arguments for tariffs The effective rate of protection Analyzing nominal protection Summary
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Introduction
This chapter is focused on the following questions:
What are the effects of various trade policy instruments?
Who will benefit and who will lose from these trade policy instruments?

What are the costs and benefits of protection?

Will the benefits outweigh the costs?

What should a nations trade policy be?

Example: Should the U.S. use a tariff or an import quota to protect its automobile industry against competition from Japan and South Korea?
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Types of Trade Barriers

1. Tariffs or duties = a tax on imports 2. Quotas = physical limitation on the amount that can be imported in a year. 3. Subsidies to exporters or import competing goods = direct or indirect payments to producers. 4. So called Buy national treatment = preferential treatment for domestic products in government contracts.
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Types of Trade Barriers (continued)

5. Packaging and labeling requirements 6. Antidumping and countervailing duties. 7. Intellectual property rights

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Tariffs: Some Preliminary Details

Tariff = a tax on imported good.
Purpose: to generate revenue or to protect a domestic industry from foreign competition

Revenue tariff = an tax levied on a good that is not domestically produced that generates revenue for governments. Most commonly used in developing countries Protective tariff = a tax levied on an import that is designed to protect domestic competitors.
In 2003, U.S. tariffs generated tax revenues of $19.9 billion.
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Tariffs: Some Preliminary Details

Tariffs can also be classified as:
Specific tariffs: Taxes that are levied as a
fixed charge for each unit of goods imported
A specific tariff is regressive.
Example: A specific tariff of $1,000 on each imported auto would yield a high percentage tariff relative to the imported price of low-priced Hyundais and a low percentage tariff relative to the imported price of high-priced Porsches.

A specific tariff encourages domestic producers to produce less expensive goods.

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Tariffs: Some Preliminary Details

Ad valorem tariffs: Taxes that are levied as
a fraction of the value of the imported goods
Example: A 5% ad valorem tariff on autos with an international price of $10,000 means that customs officials collect the fixed sum of $500. Importers have an incentive to under-invoice the price of the imported good. Ad valorem tariffs are more difficult for a country to administer than specific tariffs.

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Tariffs: Some Preliminary Details

Compound Duty (tariff): a combination of an ad valorem and a specific tariff Common on agricultural products whose prices tend to fluctuate.

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Tariffs: Some Preliminary Details

Table 6-1:Selected U.S. Tariffs

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Tariffs: Some Preliminary Details

Methods of Valuing Imports
Free alongside (F.A.S.) price
The price of the imported good as the foreign countrys market price before loading the good for shipment to the importing country

Free on Board (FOB) price

The price of the imported good as the foreign countrys market price plus the cost of loading the good in the means of conveyance
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Tariffs: Some Preliminary Details

Cost, Insurance, and Freight (C.I.F.) price
The price of the imported good as the foreign countrys market price plus the cost of loading the goods into the means of conveyance plus all intercountry transportation costs up to the importing countrys port of entry. Most countries use the C.I.F. price for calculating ad valorem tariffs.

BUT the U.S. uses the FOB price for calculating ad valorem tariffs.
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Arguments for Tariffs

Infant Government Argument
Developing countries use tariffs as a way to generate revenue.

National Defense Argument

Certain industries need to be protected from foreign competition to ensure an adequate output of the industry in the case of conflict. Two problems arise with this argument:
It is hard to identify the industries that are essential for national defense. A tariff is a costly means of protection. Instead, a domestic production subsidy should be used to encourage domestic production of the good.
The next slide depicts the effects of a domestic production industry.
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Arguments for Tariffs

Tariffs, Trade and Jobs
The imposition of a tariff in a particular industry produces more jobs in that particular industry but fewer jobs in other industries.
The overall level of employment is unchanged in the short-run whereas in the long-run it may decrease. An economy with a lot of tariffs will usually grow more slowly than a more open economy.

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Arguments for Tariffs

Infant Industries
From World War II until the 1970s many developing countries attempted to accelerate their development by limiting imports of manufactured goods to foster a manufacturing sector serving the domestic market. The most important economic argument for protecting manufacturing industries is the infant industry argument.

Senile Industry Protection

Many developed countries protect industries that are old.
For example, the apparel industry in most developed countries experience this type of protection.

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Analyzing protection
Distinguish between nominal and effective protection Nominal protection is the degree by a tariff allows a domestic import competitor to raise its price above the world price. Nominal protection is (PT PF)/PF
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The Effective Rate of Protection

Effective protection is a better measure since it nets out protection on a firms inputs from its protection on output . That is, a firm may need to pay above world prices for its inputs because of the tariff structure while it is able to set a price for its output that is above world prices.
ERP = (Tf aTc)/(1-a)
Where Tf = tariff rate on imported final product Tc = tariff rate on the imported components a = share of components in output value at free trade prices
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The Effective Rate of Protection

Effective Rate of Protection
One must consider both the effects of tariffs on the final price of a good, and the effects of tariffs on the costs of inputs used in production.
The actual protection provided by a tariff will not equal the tariff rate if imported intermediate goods are used in the production of the protected good.

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Example of ERP with different nominal protection on output and inputs

Suppose that: (1) the world price of a truck is $20,000; (2) inputs are $12,000 per truck; (3) labor costs are $4,000/truck and (4) profits are $4,000/truck. Compare these tariff structures Tf = 25%, Tc = 0% TO Tf = 25%, Tc = 25% TO Tf = 25%, Tc = 50% ERP = (25% - 0.6 x 0%)/(1-0.6) = 25%/40% = 62.5% ERP = (25% - 0.6 x 25%)/(1-0.6) = 10%/40% = 25% ERP = (25% -0.6 x 50%)/(1 0.6) = -5%/40% = -12.5% In each case, nominal protection on output is the same. However, effective protection falls as the nominal protection on inputs rises.

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The relationship among ERPS and nominal protection on output and inputs
If Tf > Tc = then ERP > Tf
This is known as tariff escalation and is common in many countries tariff structures. If Tf = Tc = then ERP = Tf If Tf < Tc = then ERP < Tf What is the meaning of a a negative ERP? If ERP<0, then the industry is effectively taxed rather than being effectively protected. This can happen with high tariffs on inputs or export taxes on products that are exported.

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The Effective Rate of Protection

Structure of Protection
Tariff escalation encourages the final processing of imported inputs to occur in developed countries It discourages the processing of intermediate products into final goods in the foreign country where the intermediate products are produced.
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Measuring Nominal Protection

We now return to nominal protection. First, we will examine the effects of a tariff. To do so, we need to review consumer and producer surpluses.

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Tariffs: Some Preliminary Details

Figure 6-1: Domestic Demand and Supply of Cloth With Consumer and Producer Surplus
Price of Cloth P1 Consumer Surplus E P P E Price of Cloth S

Producer Surplus P2 D Q Quantity of Cloth Q Quantity of Cloth

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The Welfare Effects of Trade in an Individual Product

Consumer Surplus
Measures the amount a consumer gains from a purchase by the difference between the price paid and the price willing to pay Derived from the market demand curve Graphically, it is equal to the area under the demand curve and above the price (triangular area P1EP) Example: Suppose a person is willing to pay $100 per jacket, but the price is only $50. Then, the consumer surplus gained by the purchase of a jacket is $50.
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The Welfare Effects of Trade in an Individual Product

Producer Surplus
Measures the amount a producer gains from a sale by the difference between the price received and the price willing to sell Derived from the market supply curve Graphically, it is equal to the area above the supply curve and below the price (triangular area P2FP) Example: A producer willing to sell a jacket for $20 but receiving a price of $50 gains a producer surplus of $30.
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The Welfare Effects of Trade in an Individual Product

Figure 6-2: Domestic Demand and Supply of Cloth with Consumer and Producer Surplus Price of Cloth P1 Consumer Surplus S

E P

Producer Surplus P2 Q
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Quantity of Cloth
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The Economic Effects of Tariffs Small and Large Country Cases

Useful definitions:
The terms of trade is the relative price of the exportable good expressed in units of the importable good. A small country is a country that cannot affect its terms of trade no matter how much it trades with the rest of the world.

The analytical framework will be based on either of the following:

Two large countries trading with each other A small country Copyright 2006 Pearson Education, Inc. trading with the rest of the world
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Small country Case

The Effects of a tariff for a Small Country
Let a government impose a specific tariff of T on cloth imports. In the absence of tariff, the world price of cloth (Pw) would be equalized in both countries. Assume the country is small. With the tariff in place, the domestic price of cloth rises to Pt

Home producers supply more and home consumers demand less due to the higher price, so that fewer imports are demanded. Thus, the volume of cloth traded declines due to the imposition of the tariff.
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The Economic Effects of Tariffs

Figure 6-4: Domestic Effects of a Tariff for a Small Country
Price of Cloth P1 S -a+b+c+d: loss in consumer
surplus - a: a transfer of consumer surplus to producer surplus - b: cost of resources transferred from their best use to the production of more cloth (Q1 to Q3) - c: tariff revenue that the domestic government collects - a + c: redistributed from consumers to the producers and D government - b+d: net loss to society (deadweight loss) of consumer welfare

P Pt
Tariff = T

Pw
P2 Q1

Q3

Q4

Q2

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Quantity of Cloth

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The Welfare Effects of Trade in an Individual Product

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The large country case of a tariff

If a country is large enough to influence world prices, then there may be a terms of trade gain that partially or fully offsets the deadweight losses of a tariff. Let the two supply curves on the left hand side of the next slide represent supply conditions at home and abroad.

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Deriving total supply

P P P

Home supply

Foreign supply

Total supply

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A confusing diagram to be explained in class

P
Share to importer Share to exporter

Losses

World supply + tariff World supply gains No tariff situation

Tariff situation

There are deadweight losses as the domestic price rises and terms of trades gains as exporters lower their prices.
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Calculating gains and losses

Label gains as x and y. Label losses as z. Then a tariff yields gains if z > x + y And losses if z < x + y.

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An example you might see

Suppose that a large country levies a tariff that causes deadweight losses of $100 million. However, the tariff causes import prices (net of the tariff) to fall by $10 per unit. How many units must the country import in order for the tariff to provide net gains? ANSWER: Losses = $100 million < Gains = $10 x imports. So imports must be > $100 million/$10 = 10 million units.
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Summary
A tariff is a tax on imports and it has important effects on consumption, production, and the structure of a domestic economy. There are several types of tariffs.
Revenue tariffs Protective tariffs Specific tariffs Ad valorem tariffs Compound tariffs
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Summary
The administration of tariffs is complicated because a countrys customs valuation can be based on one of three different methods of valuing imports.
The free alongside (F.A.S.) price The free on board (F.O.B.) price The cost, insurance, and freight (C.I.F.) price

The welfare effects of tariffs can be measured by using the concepts of consumer and producer surpluses.
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Summary
The imposition of a tariff raises the price of the imported good and results in the following:
Fewer imports A decrease in consumer surplus An increase in producer surplus An increase in government revenue

A large country might benefit from the imposition of the tariff whereas a small country that cannot affect the foreign export price will always lose from it.

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