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Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 6 The Theory of Tariffs and Quotas.

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Presentation on theme: "Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 6 The Theory of Tariffs and Quotas."— Presentation transcript:

1 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 6 The Theory of Tariffs and Quotas

2 Guidelines to study Follow the book, ch. 6 Paragraphs excluded: effective vs. nominal rate of protection Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-2

3 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-3 Chapter Objectives Introduce the theory of tariffs Discuss the welfare and efficiency effects of tariffs Analyze the distinction between tariffs and quotas

4 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-4 Analysis of a Tariff There are numerous barriers to trade, some are obvious (transparent), others are not (non-transparent) –Quotas: direct limit on imports: regulate the quantity of imports –Tariffs: indirect limit on imports: impose a tax on imports –The so-called Non-tariff barriers such as health and environmental regulations

5 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-5 Analysis of a Tariff (cont.) Tariffs and quotas encourage –Consumers to switch to relatively cheaper domestic goods (without tariffs more expensive) or to drop out of the market –Producers to increase their output as demand switches from foreign to domestic goods This chapter is a partial equilibrium analysis of the effects of tariffs and quotas: considers only their impact on the industry on which they are imposed, rather than their economy-wide effects

6 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-6 Prices, Output, and Consumption Assume a super-simplified setting to understand the main effect (the results hold also in more general models): 1.There is only one price for a good (world price P w ) 2.Foreign producers are willing to supply us with all of the units of the good we want at that price Implicitly, this means that the home country demand for the good is relatively small and does not affect the price (VERY IMPORTANT POINT )

7 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-7 FIGURE 6.2 Domestic Supply and Demand for an Imported Good Domestic production Domestic demand Q2-Q1=imports

8 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-8 Prices, Output, and Consumption (cont.) Now assume: Government imposes a tariff of amount t. Importers will still be able to buy the good from foreign producers for P w, but they will have to pay the import tax of t. –The tax is subsequently tacked onto the price to domestic consumers: price to them is P w + t=P t –The consumption of the imported good subsequently decreases

9 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-9 FIGURE 6.2 Domestic Supply and Demand for an Imported Good P w =t+P w At the new price, imports decline and domestic production increases

10 Copyright © 2011 Pearson Addison-Wesley. All rights reserved Prices, Output, and Consumption (cont.) Furthermore, –The domestic production of the good increases as domestic firms are able to charge a higher price while remaining competitive vis-à-vis foreign firms. –Finally, imports of the good decrease

11 Copyright © 2011 Pearson Addison-Wesley. All rights reserved Resource Allocation and Income Distribution Besides the rise in prices and fall in imports, tariffs influence –inputs in domestic production: the increase in domestic production requires additional resources of land, labor, and capital to be reallocated from their prior uses. This can be costly, especially because less resources will be available in other (more productive) sectors. (this is a general eq. effect that cannot be seen in a 1-sector analysis) –Overall welfare effect and the income distribution between producers and consumers.

12 Tariff and Income Distribution The main distributive effect of a tariff is to transfer resources from consumers to producers. To see this let me introduce two concepts: –Consumer surplus: value received by consumers in excess of the price they pay, i.e. difference between the willingness to pay for the good (that depends on income, preferences, physical conditions, etc.) and the price –Producer surplus: value received by producers in excess of the minimum price at which they are willing to produce. –Consumer and producer surpluses can be measured only if the demand and, respectively, the supply curve are known. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-12

13 Copyright © 2011 Pearson Addison-Wesley. All rights reserved FIGURE 6.1 Consumer and Producer Surplus Consumer surplus Producer surplus Question: what happens to the producer and consumer surplus if the price increases?

14 Copyright © 2011 Pearson Addison-Wesley. All rights reserved FIGURE 6.3 The Effects of a Tariff Pre- tariff price The area c measures the tax collected with the tariff

15 Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 6.1 Economic Effects of the Tariff in Figure 6.3 tariff raises the price in the importing country: –consumer surplus decreases (consumers worse off) –producer surplus increases (producers better off). –the government collects tariff revenue equal to the tariff rate times the quantity of imports with the tariff. The net effect of the tariff on national welfare = gains to producers (a) + gains to government (c) - losses to consumers (a+b+c+d)= (a + b + c + d - a - c) = -(b + d) The tariff brings about a decline in the national welfare: The tariff distorts production and consumption decisions so that producers produce too much and consumers consume too little.

16 Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 6.1 Economic Effects of the Tariff in Figure 6.3

17 Copyright © 2011 Pearson Addison-Wesley. All rights reserved The Large Country Case Economists distinguish between small and large countries in analyzing the effect of a tariff -Large country: one that imports enough of a particular product so that if it imposes a tariff, the exporting country will reduce its price of the good in order to keep its share of the large country's market In theory, large countries can improve their national welfare by imposing a tariff (as long as their trading partners do not retaliate, I will clarify this point in policy lecture)

18 Copyright © 2011 Pearson Addison-Wesley. All rights reserved Analysis of Quotas Quota: A quantitative restriction that specifies a limit on the quantity of imports Differences between quotas and tariffs –Tariff limits imports by imposing a tax on them –Unlike tariffs, quotas do not generate tariff revenue for the government (but extra profits for foreign producers) Similarities between quotas and tariffs –Both lead to a reduction in imports, a fall in total domestic consumption, and an increase in domestic production

19 Copyright © 2011 Pearson Addison-Wesley. All rights reserved FIGURE 6.7 Analysis of a Quota: 2 In the case of a tariff, the government earned revenue from imports; in the case of a quota, foreign producers receive extra profits (c)

20 Copyright © 2011 Pearson Addison-Wesley. All rights reserved FIGURE 6.6 Analysis of a Quota: 1 Quota rents: Increased profits accruing to foreign producers from the use of quotas; take the place of tariff revenue

21 The Effect of quota and tariffs on profits Foreign producers prefer quota over tariffs as they can obtain quota rents. –Remember that: unlike tariffs, quotas do not generate tariff revenue for the government (but extra profits for foreign producers). –Put it differently, the advantages of protection go to the foreign producers that are selected to export and that can charge higher prices. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-21

22 Copyright © 2011 Pearson Addison-Wesley. All rights reserved The Effect of quota and tariffs on the profits Two circumstances that can limit quota rents (i.e. rents for foreign producers) –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

23 Copyright © 2011 Pearson Addison-Wesley. All rights reserved Types of Quotas 1) Limitation on the quantity of imports: e.g., 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 2) Import licensing requirement: forcing importers to obtain government licences for their imports; government regulates the number of licences available 3) Voluntary export restraint (VER) (or voluntary restraint agreement, VRA): the exporting country voluntarily agrees to limit its exports for a period

24 Copyright © 2011 Pearson Addison-Wesley. All rights reserved Types of Quotas: VERs VERs have similar effects as quotas –However, VERs are more popular, as they (1) do not require domestic legislative action; and (2) allow politicians to provide protection for domestic industry and to appear as proponents of free trade The use of VERs increased with the decline in tariffs that results from the global trade rounds; however, recent international negotiations have restricted the use of VERs (cars imports from Japan to the US in the 80s)

25 Copyright © 2011 Pearson Addison-Wesley. All rights reserved Open issues on protectionisms and free trade 1.Generally, tariff rates in developing nations are higher than developed nations. Why?

26 –For developing countries, tariffs are one of the few sources of government revenues needed to invest in infrastructures, health and public education. –Moreover, in developing countries, tariffs allow to protect the infant industry in presence of economies of scale. Germany and the US used extensively tariffs in the nineteen century to catch-up with the UK (see lecture on developing countries). Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-26

27 Copyright © 2011 Pearson Addison-Wesley. All rights reserved FIGURE 6.4 Average Tariff Rates,


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