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Tariffs: Two Countries Udayan Roy September 2009.

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1 Tariffs: Two Countries Udayan Roy September 2009

2 Tariffs: Two Countries Case For a country that is so large that it can by itself affect the worldwide prices of the goods it imports, the gains from a tariff may exceed the losses and the country as a whole may benefit from the tariff. However, the imposition of the tariff will harm other countries more than the country imposing the tariff will gain. So, the world, as a whole, will be harmed by the tariff.

3 Prices after the tariff Suppose Japan imposes a tariff on its imports of European steel Then, Price in Japan = Price in Europe + Tariff –as long as some European steel continues to be imported into Japan even after the tariff Why?

4 Prices after the tariff Suppose the price of European steel in Europe = 4 per ton Suppose the tariff = 2 per ton Then the price of European steel in Japan = = 6 per ton Therefore, Japanese steel producers cant charge more than 6 in Japan But can they charge less than 6? Can they charge 5.40? No. I have assumed that some European steel continues to be imported into Japan even after the tariff. That would not have happened if Japanese steel was selling for less than European steel Therefore, the price of Japanese steel in Japan is also 6 In general, the Price (of both European steel and Japanese steel) in Japan = Price in Europe + Tariff

5 Demand, Before Tariff Under free trade, the price of steel in Japan is the same as in Europe Demand is Demand B When the price in Europe (and in Japan) is 6, the Japanese buy 10 tons of steel 6 10 Demand B Quantity in Japan Price (in Europe or Japan)

6 Effect of Tariff on Demand Demand B Demand A Quantity in Japan Price in Europe 1. Before Japan imposes a tariff, Japans demand curve is Demand B. When the price of steel in Europe is 6, so is the price in Japan, and the Japanese buy 10 tons of steel. 2. Then Japan imposes a tariff = 2 on European steel 3. Now, the Japanese will not buy 10 tons unless the price in Europe is This implies that the new demand in Japan after the tariff is Demand A. 5. That is, Japans demand corresponding to the price in Europe shifts downward by the exact extent of the tariff. 6. Japans demand corresponding to the price in Japan remains Demand B.

7 Effect of Tariff on Supply A similar logic shows that: –Japans supply (corresponding to the price in Europe) shifts downward by the exact extent of the tariff. –Japans supply (corresponding to the price in Japan) remains Supply B Supply B Supply A Quantity in Japan Price in Europe

8 Price in Europe, after Japans tariff As Japans demand shifts left, so does the Worlds demand As Japans supply shifts right, so does the Worlds supply Therefore, the free trade price of Europes exports must fall –Note that Japan is indeed a large country in this example Japan may potentially benefit, by forcing down the price of its imported good

9 Price EuropeJapanWorld+= Quantity Recall: The free trade worldwide price is the price at which excess demand in one country is equal to the excess supply in the other country.

10 Europe Japan Price Quantity The price in Europe decreases because of Japans tariff. 1. Japan imposes a tariff on its imports. 3. Therefore Japans Demand curve corresponding to the European price (broken line) will be below its Demand curve corresponding to the Japanese price (unbroken line) by the size of the tariff. 4. The same is true for the Supply curve. The price in Japan increases, but by less than the tariff. 2. As a result, the price in Japan exceeds the price in Europe by the size of the tariff.

11 A BC E D F G H IJK LMN O Free Trade Europe Japan Price Quantity The price in Europe after Japan imposes a tariff 1. Japan imposes a tariff on its imports. The price in Japan after Japan imposes a tariff 2. As a result, the price in Japan must exceed the price in Europe by the size of the tariff. Tariff 3. And Japans imports must equal Europes exports. Tariff

12 A BC E D F G H IJK LMN O Europe Japan Price Quantity The price in Europe after the tariff. Japan imposes a tariff on its imports. The price in Japan after the tariff. Worldwide free trade price In Europe, consumer surplus increases from A to AB. Producer surplus decreases from BCDE to DE. In Japan, consumer surplus decreases from FGHIJK to FG. Producer surplus increases from LO to HLO. And tariff revenue increases from zero to JM.

13 Tariffs: Two Countries Case EuropeJapan BeforeAfterBeforeAfter Consumer Surplus AABFGHIJKFG Producer Surplus BCDEDELOHLO Tariff Revenue -- JM Total Surplus ABCDEABDEFGHIJKLOFGHJLOM

14 Gains and Losses from Tariffs: Importing Country The loss to the country that imposes the tariff (Japan) include I and K, which represents the loss of the gains from trade. But, Japan also gains M, which represents the improvement in its terms of trade. Had Japan been a small country, it would not have been able to force a reduction in the price of its imported good. Therefore, tariffs would have had only losses and no gains.

15 Effects of TariffSmall Country C G A EDF B Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price with tariff Tariff Imports without tariff Price without tariff World price Imports after tariff Q S Q S Q D Q D Deadweight Loss

16 Effects of TariffLarge Country C G A E1E1 DF B Price of Steel 0 Quantity of Steel Domestic supply Price with tariff Tariff Imports without tariff World price before tariff Q S Q S Q D Q D World price after tariff Domestic demand E2E2 A large country can use tariffs to force down the price of its imported good. This leads to additional gain of E 2. If E 2 exceeds D+F, the country will be better off after imposing the tariff.

17 Gains and Losses from Tariffs: All Countries The country that imposes a tariff will gain (lose) if M exceeds (is less than) I plus K The other country will lose by the amount C C exceeds M. Therefore, the world as a whole loses

18 Retaliation The analysis so far has assumed that one country can impose tariffs on its imports without the other country retaliating with tariffs of its own If retaliation occurs, even the conditional support for tariffs outlined earlier has no basis


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