Ch 5 – Tariffs “Free trade, one of the greatest blessings which a

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

Ch 5 - Tariffs Tariff - Tax, or duty, levied on a product when it crosses a nation’s 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

Methods of Tariff Application
Ch 5 - Tariffs Methods of Tariff Application Specific Tariff Fixed dollar amount per physical unit of product. Easy to administer ex, $5000 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.

Methods of Tariff Application
Ch 5 - Tariffs Methods of Tariff Application 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. 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.

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

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

Ch 5 - Tariffs Effective Rate of Protection Foreign Radio Cost Domestic Radio Components $ 80 $80 Assembly $ 20 Sub Total Nominal Tariff $100 $ 10 $ 30 Price $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 Effective Rate of Protection 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

Ch 5 - Tariffs Effective Rate of Protection

Ch 5 - Tariffs Effective Rate of Protection 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?

Ch 5 - Tariffs Effective Rate of Protection 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.

Ch 5 - Tariffs Effective Rate of Protection 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 DVD’s, what is the effective rate of protection for domestic DVD producers?

Ch 5 - Tariffs Effective Rate of Protection 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!

Ch 5 - Tariffs Effective Rate of Protection 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.

Ch 5 - Tariffs Effective Rate of Protection 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.

Ch 5 - Tariffs Effective Rate of Protection 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.

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

Ch 5 - Tariffs Effective Rate of Protection 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 Materials Stages of Production Final Goods

Ch 5 - Tariffs Tariff Escalation 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.

Production Sharing / Offshore Assembly
Ch 5 - Tariffs Production Sharing / Offshore Assembly Production sharing occurs when different phases of a product’s 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.

Production Sharing / Offshore Assembly
Ch 5 - Tariffs Production Sharing / Offshore Assembly 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.

Postponing Import Duties
Ch 5 - Tariffs Postponing Import Duties 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 (FTZ’s) 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.

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

Trade Welfare Effects - Small Nation Model
Ch 5 - Tariffs Trade Welfare Effects - Small Nation Model Consumer surplus SDOM P E PE Producer surplus DDOM QE Q Before Trade Nation consumes and produces at equilibrium price and quantity (E)

Ch 5 - Tariffs Trade Welfare Effects - Small Nation Model Consumer surplus SDOM P E PE Increased welfare F PFT SWORLD-FREE TRADE Producer surplus DDOM QS - DOM QE QD-FREE Q imports With Free Trade Nation consumes at F, domestic producers reduce output to QS-DOM

Ch 5 - Tariffs Trade Welfare Effects - Small Nation Model Consumer surplus SDOM P E PE G PT SWORLD-TARIFF Producer surplus Loss of consumer welfare F $1,000 PFT SWORLD-FREE TRADE DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q imports With Tariff ($1,000) Nation consumes at G, domestic producers increase output to QS-TARIFF

Ch 5 - Tariffs Trade Welfare Effects - Small Nation Model Consumer surplus SDOM P Redistributive Effect Surplus shifted from consumer to producer No loss of welfare, just transfer. A E PE G PT SWORLD-TARIFF Producer surplus F $1,000 PFT SWORLD-FREE TRADE DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q imports With Tariff ($1,000)

Ch 5 - Tariffs Trade Welfare Effects - Small Nation Model Consumer surplus SDOM P Protective Effect Loss of resources used to produce additional output at higher cost, less efficient. Loss of welfare to economy. E PE G PT SWORLD-TARIFF Producer surplus A B F $1,000 PFT SWORLD-FREE TRADE DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q imports With Tariff ($1,000)

Ch 5 - Tariffs Trade Welfare Effects - Small Nation Model Consumer surplus SDOM P Revenue Effect Transfer of welfare from private to public sector (tariff x imports). No gain or loss of welfare. E PE G PT SWORLD-TARIFF Producer surplus A B C F $1,000 PFT SWORLD-FREE TRADE DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q imports With Tariff ($1,000)

Ch 5 - Tariffs Trade Welfare Effects - Small Nation Model Consumer surplus SDOM P Consumption Effect Consumption decreased due to higher prices (law of demand). Loss of welfare. E PE G PT SWORLD-TARIFF Producer surplus A B C D F $1,000 PFT SWORLD-FREE TRADE DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q imports With Tariff ($1,000)

Ch 5 - Tariffs Trade Welfare Effects - Small Nation Model SDOM P E PE G PT SWORLD-TARIFF A B C D F $1,000 PFT SWORLD-FREE TRADE DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q imports 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.

Trade Welfare Effects Large Nation Model
Ch 5 - Tariffs Trade Welfare Effects Large Nation Model Nation’s 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.

Trade Welfare Effects - Large Nation Model
Ch 5 - Tariffs Trade Welfare Effects - Large Nation Model Consumer surplus SDOM P E PE Producer surplus DDOM QE Q Before Trade Nation consumes and produces at equilibrium price and quantity (E)

Trade Welfare Effects – Large Nation Model
Ch 5 - Tariffs Trade Welfare Effects – Large Nation Model Consumer surplus SDOM P E PE Increased welfare SWORLD-FREE TRADE F PFT Producer surplus DDOM QS - DOM QE QD-FREE Q imports With Free Trade Nation consumes at F, domestic producers reduce output to QS-DOM

Ch 5 - Tariffs Trade Welfare Effects - Large Nation Model Consumer surplus SDOM P SWORLD-TARIFF E PE SWORLD-FREE TRADE PT G $1,000 Producer surplus Loss of Consumer Welfare F PFT DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q imports With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to QS-TARIFF

Ch 5 - Tariffs Trade Welfare Effects - Large Nation Model Consumer surplus SDOM P Redistributive Effect Surplus shifted from consumer to producer No loss of welfare, just transfer. SWORLD-TARIFF E PE SWORLD-FREE TRADE PT G $1,000 Producer surplus A F PFT DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q imports With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to QS-TARIFF

Ch 5 - Tariffs Trade Welfare Effects - Large Nation Model Consumer surplus SDOM P Protective Effect Loss of resources used to produce additional output at higher cost, less efficient. Loss of welfare to economy. SWORLD-TARIFF E PE SWORLD-FREE TRADE PT G $1,000 Producer surplus A B F PFT DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q imports With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to QS-TARIFF

Ch 5 - Tariffs Revenue Effect Transfer of welfare from private to public sector (tariff x imports). No gain or loss of welfare. Trade Welfare Effects - Large Nation Model Consumer surplus SDOM P SWORLD-TARIFF E PE SWORLD-FREE TRADE PT G $1,000 Producer surplus A C B F PFT DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q imports With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to QS-TARIFF

Ch 5 - Tariffs Consumption Effect Consumption decreased due to higher prices (law of demand). Loss of welfare. Trade Welfare Effects - Large Nation Model Consumer surplus SDOM P SWORLD-TARIFF E PE SWORLD-FREE TRADE PT G $1,000 Producer surplus A C B D F PFT DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q imports With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to QS-TARIFF

Ch 5 - Tariffs Terms of Trade Effect Large nation enjoys improved terms of trade, increase in welfare. Trade Welfare Effects - Large Nation Model SDOM P SWORLD-TARIFF E E PE SWORLD-FREE TRADE PT G $1,000 A C B D F PFT DDOM QS QS-TARIFF QD-TARIFF QD-FREE Q With Tariff ($1,000) Nation consumes at G, domestic producers reduce output to QS-TARIFF If E>B+D, welfare increase If E=B+D, welfare constant If E<B+D, welfare loss Optimum tariff = where positive difference between gains from improved terms of trade and loss of import trade volume is maximized. imports

Arguments for Trade Restrictions
Ch 5 - Tariffs Arguments for Trade Restrictions 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.”

Ch 5 - Tariffs Arguments for Trade Restrictions 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 MRPL (marginal revenue product of labor).

Ch 5 - Tariffs Arguments for Trade Restrictions 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.

Ch 5 - Tariffs Arguments for Trade Restrictions 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 don’t 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.

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

Quota – Quantitative restriction
Ch 6 – NTB’s 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, Canada’s 4 million lbs + Mexico’s 3 million lbs + Brazil’s 3 million lbs = 10 million total.

Ch 6 – NTB’s 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 doesn’t 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.

Ch 6 – NTB’s 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.

Tariff-Rate Quota (aka 2-tier tariff)
Ch 6 – NTB’s 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%

Ch 6 – NTB’s SDOM P DDOM PE $480 P20% SWORLD-TARIFF – 20% $440 P10% SWORLD-TARIFF - 10% $400 PFT SWORLD-FREE TRADE 5 10 15 20 25 30 35 40 Q imports 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.

Ch 6 – NTB’s SDOM P DDOM PE $480 P20% SWORLD-TARIFF – 20% $440 P10% SWORLD-TARIFF - 10% $400 PFT SWORLD-FREE TRADE 5 10 15 20 25 30 35 40 Q imports 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).

E F G Welfare Effects Revenue Effect Ch 6 – NTB’s SDOM P DDOM
PE $480 P20% SWORLD-TARIFF – 20% Revenue Effect E $440 P10% SWORLD-TARIFF - 10% F G $400 PFT SWORLD-FREE TRADE 5 10 15 20 25 30 35 40 Q imports Welfare Effects E = Redistributive effect F = Protective effect G = Consumption Effect F + G = deadweight loss to economy

D C E F A B G Revenue Effects Ch 6 – NTB’s SDOM P DDOM
PE $480 P20% SWORLD-TARIFF – 20% D C E $440 P10% SWORLD-TARIFF - 10% F A B G $400 PFT SWORLD-FREE TRADE 5 10 15 20 25 30 35 40 Q imports Revenue Effects A = Import x 10% tariff (revenue from 1st 5 tons) B+C = Import x 20% tariff (revenue from next 10 tons) D = Windfall profit

Who Gets Windfall Profits (D)?
Ch 6 – NTB’s SDOM P DDOM PE $480 P20% SWORLD-TARIFF – 20% D C E $440 P10% SWORLD-TARIFF - 10% F A B G $400 PFT SWORLD-FREE TRADE 5 10 15 20 25 30 35 40 Q imports 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.

Orderly Marketing Agreements (OMA’s)
Ch 6 – NTB’s Orderly Marketing Agreements (OMA’s) Agreement negotiated between trading partners. Usually takes form of Voluntary Export Restraints (VER’s), 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.

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

Ch 6 – NTB’s Domestic Content Requirements Minimum % of good’s total value must be produced domestically. Causes domestic input demand to increase, putting upward pressure on price of those inputs. With no content requirement, importing nation (US) demands Q1 at price P1. 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, P1 to P2, Q1 to Q2. (How do we know that?) P Market for Japanese Cars in US SFOR2 P2 Q2 P1 SFOR1 C D DDOM Q1 Q

Ch 6 – NTB’s Domestic Content Requirements Minimum % of good’s total value must be produced domestically. Causes domestic input demand to increase, putting upward pressure on price of those inputs. Japanese resource owners (L) lose CD in income, and US resource owners (auto workers) gain AC income, less payments to Japan’s management and return on K. Consumer surplus falls by A+B B = deadweight loss A = welfare transferred from domestic consumers to domestic resource owners. P Market for Japanese Cars in US SFOR2 P2 Q2 A B P1 SFOR1 C D DDOM Q1 Q

Subsidies Domestic Subsidies
Ch 6 – NTB’s Subsidies Can take form of cash, tax concessions, insurance perks, low interest loans, etc. 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 don’t 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 Export Subsidies
Ch 6 – NTB’s Subsidies Can take form of cash, tax concessions, insurance perks, low interest loans, etc. 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?)

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