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Ch 5 – Tariffs Free trade, one of the greatest blessings which a government can confer on a people, is in almost every country unpopular. Lord Thomas Macauley.

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Presentation on theme: "Ch 5 – Tariffs Free trade, one of the greatest blessings which a government can confer on a people, is in almost every country unpopular. Lord Thomas Macauley."— Presentation transcript:

1 Ch 5 – Tariffs Free trade, one of the greatest blessings which a government can confer on a people, is in almost every country unpopular. Lord Thomas Macauley

2 Ch 5 - Tariffs Tariff - Tax, or duty, levied on a product when it crosses a nations boundaries. Import Tariff Most common Imposed on imported goods Export Tariff Imposed on exported goods Unconstitutional in US Protective Tariff Designed to protect domestic producers from import competition Not total prohibition, just an edge for domestic industries Revenue Tariff Imposed specifically to raise tax revenues

3 Ch 5 - Tariffs Methods of Tariff Application 1. Specific Tariff Fixed dollar amount per physical unit of product. Easy to administer ex, $50 00 tariff for every television, regardless of the cost of the TV. Problems: Degree of protection will vary inversely with import prices. Higher priced imports will pay a lower % of tariff on goods. Will discourage lower priced goods more than higher priced goods.

4 Ch 5 - Tariffs Methods of Tariff Application 2. Ad Valorem Tariff Fixed percentage of value of product. Can distinguish small differences in quality as reflected by price of good. Constant degree of protection for domestic producers during changing prices. 3. Compound Tariff Used for goods with raw materials subject to tariffs. Combination of specific tariff for protection in raw material industry, and ad valorem for final product.

5 Ch 5 - Tariffs Methods of Tariff Valuation 1. Free on board (FOB) Tariff applied to products value as it leaves the exporting country. 2. Cost-Insurance-Freight (CIF) Based on commoditys total value, including transport costs.

6 Effective Rate of Protection A nominal tariff rate gives a general idea of level of protection, but a final good can include domestic AND imported components. Degree of protection granted by a tariff reflects extent to which domestic price can rise above foreign. Need to know effective rate to determine actual degree of protection. Effective rate = total increase in domestic production activities (value added) that a tariff structure makes possible (how much more expensive the domestic good can be). Ch 5 - Tariffs

7 Effective Rate of Protection Domestic radio industry uses imported components to assemble radios. 20% of radios final value comes from domestic assembly (value added) Components are imported duty-free. Costs are the same in both countries. Foreign radios pre-tariff price = $100. Nominal tariff on imported radios = 10%. Assume: Ch 5 - Tariffs

8 Effective Rate of Protection Foreign RadioCost Domestic Radio Cost Components$ 80Components$80 Assembly$ 20 Sub Total Nominal Tariff $100 $ 10$ 30 Price$110Price$110 Amount of value that can now be added Domestic producers can be 50% more costly in their assembly process after tariff is imposed. ($30-$20)/$20 =.5 = 50% effective rate of protection Ch 5 - Tariffs

9 Effective Rate of Protection Ch 5 - Tariffs Where: e = effective rate of protection n = nominal tariff rate on final product a = ratio of value of imported input to value of final product (what % of final good is imported?) b = nominal tariff rate on imported component

10 Effective Rate of Protection Ch 5 - Tariffs

11 Effective Rate of Protection Ch 5 - Tariffs EXAMPLE – To produce $500,000 worth of a certain type of cloth, the textile industry imports $400,000 worth of raw cotton. The nominal tariff rates for importing these goods is 5% for the cotton and 15% for the finished cloth. What is the effective rate of protection for the textile industry?

12 Effective Rate of Protection Ch 5 - Tariffs Domestic producer of cloth can increase the value added portion (ie, assembly of imported components) up to 55% and still be competitive with foreign textile market.

13 Effective Rate of Protection Ch 5 - Tariffs EXAMPLE – A DVD player costs $500 in US and Canada prior to the imposition of tariffs. In US, $150 of value is added to imported components. The nominal tariff on the imported components is 10%. After the imposition of a nominal tariff rate of 20% on imported DVDs, what is the effective rate of protection for domestic DVD producers?

14 Effective Rate of Protection Ch 5 - Tariffs Domestic producer of DVD players can increase the value added portion of their product by up to 43% and match the price of the foreign DVD player. This DOES NOT MEAN costs went up by that much, just the price!

15 Effective Rate of Protection Ch 5 - Tariffs What happens to effective rate as a increases? Effective rate increases Domestic producer can enjoy a greater degree of protection by increasing the imported component of their product.

16 Effective Rate of Protection Ch 5 - Tariffs What happens to effective rate as b increases? Effective rate decreases Domestic producer can enjoy a greater degree of protection if the nominal tariff on imported component is reduced.

17 Effective Rate of Protection Ch 5 - Tariffs When inputs enter a country at a low tariff rate, and final good is protected at a high tariff rate, the effective rate of protection tends to be high (nominal rate understates degree of protection). BUT, if tariff on inputs is greater than tariff on final good, the nominal rate would overstate the effective rate.

18 Effective Rate of Protection Ch 5 - Tariffs Which will prevail? Depends on whether a nation wants to protect the suppliers of raw materials or producers of the end product.

19 Effective Rate of Protection Ch 5 - Tariffs Tariff Escalation Tariff structure where a nation tends to have higher nominal rates for each subsequent stage of production (ex, raw materials have low nominal tariffs while end products have high nominal tariffs). Nominal Rate Raw MaterialsFinal GoodsStages of Production

20 Tariff Escalation Ch 5 - Tariffs Industrialized nations tend to engage in tariff escalation. Tariff escalation encourages developing nations to specialize in raw materials, and discourages entry into higher stages of production. If nations push for lower tariffs for their raw products, the effective rate is magnified for the producers of the final product (manufacturing sector), worsening chance of entry into higher stages of production for the developing nations.

21 Production Sharing / Offshore Assembly Ch 5 - Tariffs Production sharing occurs when different phases of a products manufacture are performed in more than one country. Example, US makes electronic components, ships them to Mexico for assembly with lower labor costs, then the final product is sent back to the US for distribution. Benefits Provides a way for domestic manufacturers of goods with labor-intensive phases to take advantage of lower costs abroad while maintaining competitiveness and market share domestically. Easier penetration into foreign markets where trade barriers restrict direct export of the final product.

22 Production Sharing / Offshore Assembly Ch 5 - Tariffs OAP (offshore-assembly provision) provides favorable treatment for goods assembled abroad from US-manufactured components. When a final good comes into the US, the tariff is applied only to the portion of the good that originated elsewhere. Incentive for US producers to seek cheaper off- shore labor for assembly process. Encourages countries that want to export to the US to buy components from US.

23 Postponing Import Duties Ch 5 - Tariffs Bonded Warehouses Customs facility where imported goods can be stored. No tariff is levied until goods leave the warehouse. Importer can avoid lump costs until goods are sold. Foreign Trade Zones (FTZs) Seaports, inland distribution points. Manufacturing process can take place. Tariff is deferred until final good is shipped out of the FTZ. No tariff on scrap or waste.

24 Trade Welfare Effects Ch 5 - Tariffs Small Nation Model Nations imports make up a small fraction of world market supply Nation is a price taker, not important enough to impact the world market.

25 Trade Welfare Effects - Small Nation Model Ch 5 - Tariffs PEPE QEQE Before Trade Nation consumes and produces at equilibrium price and quantity (E) Consumer surplus Producer surplus S DOM D DOM Q P E

26 Trade Welfare Effects - Small Nation Model Ch 5 - Tariffs PEPE QEQE With Free Trade Nation consumes at F, domestic producers reduce output to Q S-DOM Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT Q S - DOM Q D- FREE F E imports Increased welfare

27 Trade Welfare Effects - Small Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) Nation consumes at G, domestic producers increase output to Q S-TARIFF Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT QSQS Q D- FREE F E imports S WORLD-TARIFF PTPT $1,000 G Q S-TARIFF Q D-TARIFF Loss of consumer welfare

28 Trade Welfare Effects - Small Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT QSQS Q D- FREE F E imports S WORLD-TARIFF PTPT $1,000 G Q S-TARIFF Q D-TARIFF Redistributive Effect Surplus shifted from consumer to producer No loss of welfare, just transfer. A

29 Trade Welfare Effects - Small Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT QSQS Q D- FREE F E imports S WORLD-TARIFF PTPT $1,000 G Q S-TARIFF Q D-TARIFF Protective Effect Loss of resources used to produce additional output at higher cost, less efficient. Loss of welfare to economy. A B

30 Trade Welfare Effects - Small Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT QSQS Q D- FREE F E imports S WORLD-TARIFF PTPT $1,000 G Q S-TARIFF Q D-TARIFF Revenue Effect Transfer of welfare from private to public sector (tariff x imports). No gain or loss of welfare. A BC

31 Trade Welfare Effects - Small Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT QSQS Q D- FREE F E imports S WORLD-TARIFF PTPT $1,000 G Q S-TARIFF Q D-TARIFF Consumption Effect Consumption decreased due to higher prices (law of demand). Loss of welfare. A BC D

32 Trade Welfare Effects - Small Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) A and C – Transfers of welfare, no gain or loss to economy B and D – Deadweight loss to economy, loss of welfare Net effect of tariff – loss to economy equal to B + D. S DOM D DOM Q P S WORLD-FREE TRADE P FT QSQS Q D- FREE F E imports S WORLD-TARIFF PTPT $1,000 G Q S-TARIFF Q D-TARIFF A BC D

33 Trade Welfare Effects Ch 5 - Tariffs Large Nation Model Nations imports make up a relatively large portion of world market supply Nation is a price maker, large enough to impact the world market. If US imposes tariff, price increases for domestic consumers, quantity demanded falls. May lead to exporting nation lowering prices to US to limit loss of sales. Burden of tariff is shared between consumers and foreign producers. Terms of trade may improve for importing nation with price reduction. Therefore, large nation can make itself better off with appropriate tariff policy.

34 Trade Welfare Effects - Large Nation Model Ch 5 - Tariffs PEPE QEQE Before Trade Nation consumes and produces at equilibrium price and quantity (E) Consumer surplus Producer surplus S DOM D DOM Q P E

35 Trade Welfare Effects – Large Nation Model Ch 5 - Tariffs PEPE QEQE With Free Trade Nation consumes at F, domestic producers reduce output to Q S-DOM Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT Q S - DOM Q D- FREE F E imports Increased welfare

36 Trade Welfare Effects - Large Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to Q S-TARIFF Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT QSQS Q D- FREE F E imports S WORLD-TARIFF PTPT $1,000 G Q S-TARIFF Q D-TARIFF Loss of Consumer Welfare

37 Trade Welfare Effects - Large Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to Q S-TARIFF Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT QSQS Q D- FREE F E imports S WORLD-TARIFF PTPT $1,000 G Q S-TARIFF Q D-TARIFF A Redistributive Effect Surplus shifted from consumer to producer No loss of welfare, just transfer.

38 Trade Welfare Effects - Large Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to Q S-TARIFF Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT QSQS Q D- FREE F E imports S WORLD-TARIFF PTPT $1,000 G Q S-TARIFF Q D-TARIFF B A Protective Effect Loss of resources used to produce additional output at higher cost, less efficient. Loss of welfare to economy.

39 Trade Welfare Effects - Large Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to Q S-TARIFF Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT QSQS Q D- FREE F E imports S WORLD-TARIFF PTPT $1,000 G Q S-TARIFF Q D-TARIFF B A C Revenue Effect Transfer of welfare from private to public sector (tariff x imports). No gain or loss of welfare.

40 Trade Welfare Effects - Large Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to Q S-TARIFF Consumer surplus Producer surplus S DOM D DOM Q P S WORLD-FREE TRADE P FT QSQS Q D- FREE F E imports S WORLD-TARIFF PTPT $1,000 G Q S-TARIFF Q D-TARIFF B A C D Consumption Effect Consumption decreased due to higher prices (law of demand). Loss of welfare.

41 Trade Welfare Effects - Large Nation Model Ch 5 - Tariffs PEPE With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to Q S-TARIFF If E>B+D, welfare increase If E=B+D, welfare constant If E

42 Arguments for Trade Restrictions Ch 5 - Tariffs Job Protection Argument: Cheap foreign goods undercut domestic production, resulting in loss of domestic jobs. Flaw: Ignores link between importing and exporting industries. Job losses are more conspicuous than gains. Trade barriers raise employment in protected industries, and in industries that are primary suppliers. BUT job losses occur in industries that purchase protected goods, costs passed along to consumers, reducing sales. Exporters pay for import tariffs.

43 Arguments for Trade Restrictions Ch 5 - Tariffs Protection Against Cheap Foreign Labor Argument: US wages are high relative to other countries. Tariffs should make up for the difference between labor costs to protect domestic jobs. Flaw: Ignores link between efficiency, wages, and unit costs. If domestic labor is more productive than cheaper foreign labor, domestic labor costs may still be competitive. Wages are based on MRP L (marginal revenue product of labor).

44 Arguments for Trade Restrictions Ch 5 - Tariffs Maintenance of Domestic Standard of Living Argument: Tariffs maintain a high level of income and unemployment, stimulate domestic activity, raising standard of living. Flaw: Assumes first two arguments are valid, and ignores redistribution of gains resulting from tariffs. A tariff that improves standard of living in one country does so at the expense of other countries. Nations adversely affected will retaliate, resulting in lower welfare for both nations. Beggar-thy-neighbor policies – tariffs designed to enhance standard of living at the expense of trading partners.

45 Arguments for Trade Restrictions Ch 5 - Tariffs Infant Industry Argument Argument: Mature foreign businesses can drive young domestic businesses out by being more efficient. Nations should temporarily shield new industries until they have developed enough to compete. Flaw: Industrialized nations typically dont have infant industries. Protective tariffs are difficult to remove once in place. Which industries can realize comparative advantage and merit protection? May be valid for developing nations to change their comparative advantage position.

46 Ch 6 – Non-Tariff Trade Barriers (NTBs) If you put the federal government in charge of the Sahara Desert, in five years there'd be a shortage of sand. Milton Friedman

47 Ch 6 – NTBs Quota – Quantitative restriction Import Quota Restriction on quantity of goods that can be imported during specific time period. Generally limits quantities below free trade level (much like price ceilings). Import quotas on manufactured goods outlawed by WTO. Current quotas usually agricultural. Global Quota Specified amount imported each year, but origin not specified. Example, 10 million pounds of sugar per year, no matter the country of origin. Selective Quota Allocations to specific countries Example, Canadas 4 million lbs + Mexicos 3 million lbs + Brazils 3 million lbs = 10 million total.

48 Ch 6 – NTBs Quota – Quantitative restriction Welfare Effects Supply side restriction Loss of consumer surplus from increase in domestic and imported price (same welfare concept as tariffs) Same deadweight losses (protective effect and consumption effect) Surplus transferred from consumers to producers. Revenue Effect Not a tariff, so revenue doesnt automatically go to the government. Will accrue to whomever has market power. If domestic buyers organize to buy goods at lower than market price, gain will go to them in form of profits. If foreign producers organize to sell to domestic distributors at already heightened price, they will accrue profits. Government CAN still accrue gains from revenue effect by selling import licenses.

49 Ch 6 – NTBs Quota – Quantitative restriction Government Can Sell Import Licenses Quotas push domestic price above world price. Profits can be enjoyed by domestic retailers if they buy low in world market and sell high in domestic market. Retailers would likely pay for the right to import a portion of the limit amount of goods. By auctioning licenses to import, government can transfer some or all of the gains to government revenue. Competition for the licenses would push the license price up to the point that eliminates all of the retailer profit and transfers to government revenue. This makes quota outcomes much like tariffs.

50 Ch 6 – NTBs Tariff-Rate Quota (aka 2-tier tariff) Certain number of goods are imported at one tariff rate, any quantity above that imported at a higher rate. Example: up to 5 tons of sugar can be imported at a 10% tariff, anything above 5 tons will be imported at 20% tariff rate. Quota in this case is 5 tons. Within-quota rate = 10% Over-quota rate = 20%

51 PEPE S DOM D DOM Q P S WORLD-TARIFF - 10% P FT imports S WORLD-TARIFF – 20% P 10% Tariff-Rate Quota (aka 2-tier tariff) Example: up to 5 tons of sugar can be imported at a 10% tariff, anything above 5 tons will be imported at 20% tariff rate. S WORLD-FREE TRADE P 20 % $400 $440 $480 Ch 6 – NTBs

52 PEPE S DOM D DOM Q P P FT Tariff-Rate Quota (aka 2-tier tariff) At 20% tariff rate, domestic production is 15 tons, domestic consumption is 30 tons, so imports = 15 tons. First 5 tons imported at 10% tariff rate, next 10 tons at 20% tariff rate. Even though different tariff rates are paid for the sugar, ALL of the sugar will be sold for the same price ($480). S WORLD-FREE TRADE $400 S WORLD-TARIFF - 10% P 10% $440 S WORLD-TARIFF – 20% P 20 % $480 imports Ch 6 – NTBs

53 PEPE S DOM D DOM Q P P FT Welfare Effects E = Redistributive effect F = Protective effect G = Consumption Effect F + G = deadweight loss to economy S WORLD-FREE TRADE $400 S WORLD-TARIFF - 10% P 10% $440 S WORLD-TARIFF – 20% P 20 % $480 imports GF E Revenue Effect Ch 6 – NTBs

54 PEPE S DOM D DOM Q P P FT Revenue Effects A = Import x 10% tariff (revenue from 1 st 5 tons) B+C = Import x 20% tariff (revenue from next 10 tons) D = Windfall profit S WORLD-FREE TRADE $400 S WORLD-TARIFF - 10% P 10% $440 S WORLD-TARIFF – 20% P 20 % $480 imports GF E AB CD Ch 6 – NTBs

55 PEPE S DOM D DOM Q P P FT Who Gets Windfall Profits (D)? If importers can buy all sugar at $400 then resell at $480, windfall profits will accrue to them. BUT, if suppliers have market power, and can push price up, some or all of windfall profits will accrue to them, representing a loss to the economy. S WORLD-FREE TRADE $400 S WORLD-TARIFF - 10% P 10% $440 S WORLD-TARIFF – 20% P 20 % $480 imports GF E AB CD Ch 6 – NTBs

56 Orderly Marketing Agreements (OMAs) Agreement negotiated between trading partners. Usually takes form of Voluntary Export Restraints (VERs), voluntary quotas. These deals usually struck to avoid more restrictive barriers. Revenue Effect Under standard import quota, revenue accrues to side with most market, or bargaining, power. With export quota, foreign exporter captures revenue because the restriction is purely supply side, drives up price. For this reason, exporters prefer negotiating their own export restrictions rather than facing levies of importing countries.

57 Ch 6 – NTBs Domestic Content Requirements Minimum % of goods total value must be produced domestically. Causes domestic input demand to increase, putting upward pressure on price of those inputs.

58 Ch 6 – NTBs Domestic Content Requirements Minimum % of goods total value must be produced domestically. Causes domestic input demand to increase, putting upward pressure on price of those inputs. S FOR1 D DOM P1P1 Q1Q1 S FOR2 P2P2 Q2Q2 P Q With no content requirement, importing nation (US) demands Q 1 at price P 1. Exporting nation (Japan, gets CD in revenue (Price x quantity). If US institutes content requirements, Japan will use US resources and begin to assemble cars in US. Price of cars will be pushed up because US resources are more costly, P 1 to P 2, Q 1 to Q 2. (How do we know that?) Market for Japanese Cars in US CD

59 Ch 6 – NTBs Domestic Content Requirements Minimum % of goods total value must be produced domestically. Causes domestic input demand to increase, putting upward pressure on price of those inputs. S FOR1 D DOM P1P1 Q1Q1 S FOR2 P2P2 Q2Q2 P Q Japanese resource owners (L) lose CD in income, and US resource owners (auto workers) gain AC income, less payments to Japans management and return on K. Consumer surplus falls by A+B B = deadweight loss A = welfare transferred from domestic consumers to domestic resource owners. Market for Japanese Cars in US CD AB

60 Ch 6 – NTBs Domestic Subsidies Granted to import-competing industries. Subsidies increase producer surplus, but also have deadweight loss to society. Usually, loss of welfare is less for subsidy than tariffs or quotas. Tariffs and quotas distort choices as consumers respond to higher prices. Subsidies dont increase prices for consumers so there is no distortion of consumer choices Subsidies have to be paid for ultimately from tax revenues, so burden is widespread, difficult to pinpoint. Subsidies Can take form of cash, tax concessions, insurance perks, low interest loans, etc.

61 Ch 6 – NTBs Export Subsidies Lowers price of goods in world market to increase competitiveness. Worsens terms of trade because price paid by foreign consumers is less than domestic, but export volume increases. Net effect depends on elasticity of good. (remember elasticity?) Subsidies Can take form of cash, tax concessions, insurance perks, low interest loans, etc.


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