Chapter Six Tariffs

Chapter Six Outline Introduction Why Would a Country Impose a Tariff? Types of tariffs and Ways to Measure Them What Happens when a Small Country Imposes an Import Tariff? What Happens when a Large Country Imposes an Import Tariff?

Chapter Six Outline How Does a Tariff Affect Factor Prices? Specific Factors and Stolper-Samuelson Tariffs and Economies of Scale The Effective Rate of Protection Off-Shore Assembly Provisions Taxing Exports

Introduction The policies countries use to restrict trade are called Barriers to Trade. Tariff is the most common. Tax imposed on a good as it crosses a national boundary. Use of tariffs has been declining recently due to international negotiations conducted under the WTO (successor to GATT).

Why Would a Country Impose a Tariff? Countries impose tariffs for any of four reasons: Tariff can discourage consumption of a particular good (oil). Generate revenue for government of tariff-imposing country. Fig. 6.1 shows decline of U.S. tariff revenues. Discourage imports in order to lower balance of trade deficit. Carry out a protectionist policy – a way to insulate domestic industries from foreign competition.

Figure 6. 1: Tariff Revenue as a Share of Total U. S Figure 6.1: Tariff Revenue as a Share of Total U.S. Federal Government Receipts, 1830–1990 Percent 100 90 80 70 60 50 40 30 20 10 1830 40 50 60 70 80 90 1900 10 20 30 40 50 60 70 80 1990 Year

Types of Tariffs Specific Tariffs Ad Valorem Tariffs Charge a specified amount for each unit of the tariffed good imported. Example: $1.09 per live goat. Ad Valorem Tariffs Charge a specified percentage of the value of the tariffed good. Example: 2.4% of a dog leash’s value.

Measurement of Tariffs U.S. tariff code contains 8,753 categories, on which tariffs range from 0% to 458%. Tariff rates vary across goods. Example: 200+ different rates apply to watches and clocks. How do you measure a country’s level of tariff protection? One technique: simple unweighted average of industry tariff rates. Country A imports two goods, X (25% tariff rate) and Y (50% tariff rate) – average equals 37.5%.

Measurement of Tariffs Most common way to measure tariffs is using a weighted-average. It involves weighting the tariff rate for each industry by that industry’s share of total imports. Example: If Country A imported $50 of X and $50 of Y, then A’s weighted-average tariff rate would equal ($50/$100)(0.25) + ($50/$100)(0.50) = 37.5%. Main problem with both types of average tariffs is that they ignore trade foreclosed by the tariff. An extreme case: a prohibitive tariff is one high enough to halt trade in a product. In general, non-WTO members and developing countries impose higher tariffs.

Tariffs in various countries Tariff rates have fallen in most countries over the past few decades Tariff rates are highest in South Asia and lowest in industrial countries. South Asia has rates close to 30% on average Industrialized countries average closer to 5%

Figure 6.2: Average Unweighted Tariff Rates by Region

What Happens when a Small Country Imposes an Import Tariff? In analyzing the effects of a tariff, the size of the country imposing it matters. First, look at case of small country. “Small” refers to economic size in world markets. Small country’s terms of trade are determined exogenously and the country makes its production and consumption decisions based on those terms of trade.

Figure 6.3: What Happens When a Small Country Imposes an Import Tariff? d E P Y G P 1 + t S w + t Y F P 1 S w Y D d Y 2 Y 4 Y Y 3 Y 1 Y

What Happens when a Small Country Imposes an Import Tariff? Effects on production, consumption, and price. Figure 6.3 clearly shows that the tariff increases the price of the good by the amount of the tariff, reduces domestic consumption, increases domestic production, and decreases imports. Effects on welfare Useful to separate effects on consumers from those on producers. Need to analyze consumer surplus and producer surplus.

Consumer and Producer Surplus Consumer surplus measures the satisfaction consumers receive from a good beyond what they pay to obtain it. Producer surplus measures the revenue producers receive beyond the minimum required to induce them to supply the good. Figure 6.3 illustrates both of these measures.

Figure 6.4: Consumer and Producer Surplus Y P Y E S Y Consumer Surplus F C P P Y Y Producer Surplus Expenditure on Y G Costs D Y Y Y Y (a) Consumer Surplus (b) Producer Surplus

Tariff’s Effect on Consumer and Producer Surplus Figure 6.5 shows the welfare effects of a tariff on imports by a small country as changes in consumer and producer surplus. Rectangle n is tariff’s revenue effect. Transfer from consumer surplus to the government that collects the tariff revenue. Area j is the tariff’s redistribution effect. Consumer surplus transferred to domestic producers.

Figure 6.5: How Does an Import Tariff by a Small Country Affect the Country’s Welfare? Y V G P 1 + t S w + t Y j n m r P 1 S w Y Z F D d Y 2 Y 4 Y Y 3 Y 1 Y

Tariff’s Effect on Consumer and Producer Surplus Triangle m is the tariff’s production effect. Units Y2 through Y4 are now (with the tariff) produced domestically rather than imported. Area m is a deadweight loss. Loss to the small country of consumer surplus not transferred to another group in the country, but lost through inefficient domestic production. Triangle r represents another deadweight loss. This consumption effect is the loss of consumer surplus that occurs because consumers can no longer obtain Y3 through Y1 at the pre-tariff price.

Tariff’s Effect on Consumer and Producer Surplus Net welfare loss to the small country as a whole from the import tariff equals the sums of areas m and r in Figure 6.5. The tariff taxes trade, encourages domestic production, and discourages domestic consumption and imports. Volume of trade falls under the tariff.

What Happens when a Large Country Imposes an Import Tariff? Large country constitutes a share of the world market sufficient to enable it to affect its terms of trade. Tariff may be used to improve its terms of trade. Effects on production, consumption, and price. Figure 6.5 illustrates the upward sloping total supply curve for a large country. Slopes upward because the large country, as it buys more of good Y, pushes up the world price.

Figure 6.6: Total Supply Equals Domestic Supply Plus Supply by the Rest of the World d + w + = Y Y Y (a) Domestic Supply (b) Supply by Rest of World (c) Total Supply

Figure 6.7: How Does an Import Tariff by a Large Country Affect the Country’s Welfare? d + w + t I H t S d + w P 1 Y j m n r P C Y F s P 2 Y D d G 1 3 2 Y Y Y Y Y

What Happens when a Large Country Imposes an Import Tariff? As shown in Figure 6.7, the tariff reduces consumption from Y0 to Y2, increases domestic production from Y1 to Y3, and decreases imports. The price domestic consumers pay rises, and the price foreign producers receive falls. Area j is a transfer from domestic consumers to domestic producers. Areas m and r are deadweight losses reflecting inefficient production and consumption, respectively. Area n is a transfer from domestic consumers to the government. Area s is a transfer from foreign producers to the domestic government.

What Happens when a Large Country Imposes an Import Tariff? When foreign producers face a substantially lower quantity demanded for their product, their opportunity costs of production fall, and so does price. This effect of the tariff is called the Terms-of-Trade Effect. Tariff has redistributive effect among countries. All of large-country gains comes at expense of trading partner, which must accept lower prices for its exports. Tariff has negative effect on world welfare regardless of the size of the countries involved.

Optimal Tariffs and Threat of Retaliation Imposition of tariff by a large country has 2 effects: Volume-of-trade effect occurs when tariff lowers welfare by discouraging trade. By lowering the price foreign producers receive, the tariff enhances welfare in tariff-imposing country. Optimal tariff is rate that maximizes net benefits to tariff-imposing country. Policies such as optimal tariffs that try to improve the welfare of the domestic country at the expense of others are called beggar-thy-neighbor polices.

How Does a Tariff Affect Factor Prices? In the long run, when all factors are mobile among industries, the tariff has the effects predicted by the Stolper-Samuelson theorem. A tariff, by raising the domestic price of the import good, tends to raise the real reward to the scarce factor and lower the real reward to the abundant factor.

Tariffs and Economies of Scale Tariffs can interfere with economies of scale. With widespread tariffs, each country must produce small quantities of all the goods domestic consumers want to consume, instead of specializing in the export good and producing a large quantity of it, thereby achieving economies of scale. This implies that the costs of tariffs can be even higher in industries characterized by economies of scale.

Effective Rate of Protection Relationship among tariffs in related markets and industries is called Tariff Structure. Cascading tariffs: raw materials tend to have lower tariff rates that the finished products ultimately produced with them. Figure 6.8 points this out -- in most countries, finished products face higher tariffs than do raw materials.

Figure 6.8: Tariffs Increase with the Level of Processing 10 Percent Product category 9.1 8 6.2 6 5.4 Pre-Uruguay Round Post-Uruguay Round 4 2.8 2.1 2 0.8 Semi- Finished Raw materials manufactures products

Effective Rate of Protection By ignoring the effect of tariff structure, the tariff rate on a final good may provide an inaccurate measure of the effective protection provided to domestic production. Effective Rate of Protection: alternative measure that accounts for the role of tariff structure. Takes Domestic Value-Added into account: difference between the world price of the finished good and the cost of the imported raw materials.

Effective Rate of Protection Effective rates of protection differ greatly from actual or nominal tariff rates for many industries. Actual tariff rates significantly underestimate the effective protection received by many industries. Trade barriers on inputs always lower the effective protection given to finished-goods producers.

Off-Shore Assembly Provisions Many countries have special tariff provisions that make tariff rates more complicated. Most common are off-shore assembly provisions. Allow reduced tariffs on goods assembled abroad from domestically produced components.

Sometimes a country places taxes on its own exports. Taxing Exports Sometimes a country places taxes on its own exports. In the U.S., export taxes are unconstitutional. Two basic reasons for these taxes: Response to pressure by domestic consumer groups to keep domestic price of a good low. Second reason applies only to large countries: may endeavor to exploit their own market power by using export taxes to raise the prices foreign buyers must pay.

Export Tax Imposed by a Small Country Figure 6.9 shows that the export tax encourages domestic consumption and discourages domestic production and exports. Consumers gain at the expense of domestic producers.

Figure 6.8: What Happens When a Small Country Imposes an Export Tax? d E P 1 D w X g j f h t P 1 – t D w – t X P X D d 2 4 3 1 X X X X X

Export Tax Imposed by a Large Country Figure 6.10 graphically depicts that the tax-imposing country suffers deadweight losses equal to area h+j and enjoys a gain in revenue from foreign consumers equal to are k. If (h+j) > k, the country suffers a net welfare loss from the tax. If (h+j) < k, the country enjoys a net welfare gain.

Figure 6.10: What Happens When a Large Country Imposes an Export Tax? d P 2 X k P X j f h g P 1 D d + w X t D d + w – t D d X 1 X 3 X 2 X X

Note for Case Three: China, Tariffs and the WTO Figure 6.11 indicates the regional sources of Chinese imports in 1996. Most Chinese imports come from Asia, including Hong Kong.

Figure 6.11: Regional Sources of Chinese Imports, 2000 (Billions $) $29.04 $7.68 $18.66 $9.14 $3.94 $4.72 $107.72 Asia (including Hong Kong)

Appendix A: Offer Curves and Tariffs Effects of an import tariff by Country A Figure 6A.1 shows that an import tariff of t% imposed by A reduces the volume of trade in which A wants to engage and shifts A’s offer curve inward to At. In exchange for Y0 units of imports, A reduces the amount of good X it is willing to export from X0 to X1. The difference goes to the government as tariff revenue.

Figure 6A.1a: Effect of an Import Tariff by Country A Imports of A A t Y by A Y C (a) Tariff Shifts Country A’s Offer Curve t X X Exports of 1 X by A

Figure 6A.1b: Effect of an Import Tariff by Country A Exports of Y by B, A B Imports of Y by A A t Y 2 (b) Effect of Tariff by a Small Country Y 3 X X Exports of X by A, 3 2 Imports of X by B

Appendix A: Offer Curves and Tariffs In panel (b) of Figure 6A.1, Country A’s smallness is represented by the straight-line shape of trading partner B’s offer curve. The slope of B’s offer curve determines the equilibrium terms of trade regardless of A’s action. The tariff imposed by A reduces the volume of trade from X2 and Y2 to X3 and Y3, but has no effect on the equilibrium terms of trade.

Appendix A: Offer Curves and Tariffs Effects of an import tariff by large country. Figure 6A.2 shows that A’s large size is represented by curved shape of trading partner B’s offer curve. In panel (a), imposition of tariff by A raises the relative price of X, A’s export good, as shown by the increased slope of straight line from origin through intersection of the two countries’ offer curves.

Figure 6A.2a: Effect of an Import Tariff by a Large Country Exports of Y by B, A Imports of Y by A (P /P ) tt X Y 1 A t (P /P ) tt X Y B (a) Tariff By Country A Exports of X by A, Imports of X by B

Appendix A: Offer Curves and Tariffs Retaliation by country B B may choose to impose an import tariff, shifting its offer curve to Bt, in panel (b). Retaliation further reduces the volume of trade. Net effect on terms of trade depends on relative sizes of the two countries’ tariffs and on the shapes of their offer curves. As drawn, B’s retaliatory tariff is too low to restore the terms of trade to their original, pre-tariff level.

Figure 6A.2b: Effect of an Import Tariff by a Large Country X /P Y ) tt pre-retaliation Exports of Y by B, Imports of Y by A A A (P /P ) tt t X Y post-retaliation B B t (b) Retaliation By Country B Exports of X by A, Imports of X by B

Appendix B: General-Equilibrium Tariff Effects in a Small Country As shown in Figure 6B.1, an import tariff imposed by a small country causes a loss of efficiency and a decrease in welfare. Consumption is inefficient, causing a further reduction in welfare.

Figure 6B.1: General-Equilibrium Effects of an Import Tariff by a Small Country c 1 c 2 U U 1 p 1 U 2 Slope = – [P w /(P w + t)] X Y Slope = p – (P /P ) w X Y X

Key Terms in Chapter 6 Barriers to trade Tariff Protectionist policy Specific tariff Ad valorem tariff Prohibitive tariff Consumer surplus

Key Terms in Chapter 6 Producer surplus Revenue effect Redistribution effect Production effect Deadweight loss Consumption effect Terms-of-trade effect

Key Terms in Chapter 6 Volume-of-trade effect Optimal tariff Beggar-thy-neighbor policy Tariff structure Cascading tariff Effective rate of protection (ERP) Domestic value-added (V) Off-shore assembly provision (OAP)