International Economics Li Yumei Economics & Management School of Southwest University

International Economics Chapter 8 Trade Restrictions: Tariffs

Organization 8.1 Introduction 8.2 Partial Equilibrium Analysis of a Tariff 8.3 The Theory of Tariff Structure 8.4 General Equilibrium Analysis of a Tariff in a Small Country 8.5 General Equilibrium Analysis of a Tariff in a Large Country 8.6 The Optimum Tariff Chapter Summary Exercises

8.1 Introduction International Trade Theories: Free Trade They explain that free trade maximizes world output (specialization) and benefits all nations (higher indifference curve ). In Practice: Trade Restrictions (or Protection ) All nations impose some restrictions ( such as tariffs, non-tariffs ) or regulations on the free flow of international trade to protect the domestic economy from the foreign competition. The most historically used trade restriction has been the tariff.

8.1 Introduction Tariff Tariff is a tax or duty levied on the traded commodity as it crosses a national boundary. It can be classified an import tariff a duty on the imported commodity) and an export tariff (a duty on the exported commodity). The import tariff is more important than export tariff, here the most of the discussion is the import tariff Export tariffs are often used by developing countries on their traditional exports to get better prices and raise revenues due to the ease of collection

8.1 Introduction Tariff Types Ad valorem tariff(从价税) expressed as a fixed percentage of the value of the traded commodity Specific tariff (从量税) expressed as a fixed sum per physical unit of the traded Compound tariff(复合税) A combination of an ad valorem and a specific tariff Before and After Multilateral Trade System See the following tables (data and case studies)

Developing Countries

8.2 Partial Equilibrium Analysis of a Tariff Partial Equilibrium Effects of a Tariff Effect of a Tariff on Consumer and Producer Surplus Costs and Benefits of a Tariff Conclusion

Partial Equilibrium Effects of a Tariff Tariff Partial Equilibrium Analysis is most appropriate a small country case The tariff will not affect world prices and the rest of the economy (price taker) Partial Equilibrium Effects of a Tariff See Figure 8.1 The nation is a small country DX is the demand curve and SX is the supply curve In the absence of trade, the equilibrium point E Under free trade, the domestic production and consumption of commodity X After a 100 percent ad valorem tariff on the imports of X, the domestic production and consumption of X

FIGURE 8-1 Partial Equlibrium Effects of a Tariff.

Partial Equilibrium Effects of a Tariff Tariff Effects of Figure 8.1 After the tariff, the domestic production (production effect ) increases while the domestic consumption (consumption effect ) of commodity X decrease; After the tariff, government revenue (revenue effect) increases and the trade volume (trade effect) decreases; Conclusion After the tariff in a small country case, production effect and revenue effect are the positive while the consumption effect and trade effect are negative. The consumer’s income redistributes to the domestic producer and government.

Effect of a Tariff on Consumer and Producer Surplus Consumer Surplus Consumer surplus is the difference between what consumers would be willing to pay for each unit of the commodity and what they actually pay. Graphically, consumer surplus is measured by the area under the demand curve above the going price. Higher prices mean the smaller consumer surplus. Producer Surplus Producer surplus refer to the payment that need not be made in long run in order to induce domestic producers to supply more disadvantageous commodity with the tariff. The increase in producer surplus also referred to as the subsidy of the tariff. Higher prices mean higher producer surplus.

FIGURE 8-2 Effect of Tariff on Consumer and Producer Surplus.

Costs and Benefits of a Tariff Consumer and producer surplus can be used to measure the costs and benefits of the tariff After the tariff, the consumer surplus decreases while the producer surplus increases The decreased consumer surplus includes four parts: Production effect Protection effect Revenue effect Consumption effect Costs and Benefits of a Tariff Costs: protection effect and consumption effect (deadweight loss) Benefits: Production effect and Revenue effect

FIGURE 8-3 Partial Equilibrium Costs and Benefits of a Tariff.

Costs and Benefits of a Tariff Conclusion Income redistribution Tariff redistributes income from domestic consumers (who pay higher prices for the commodity) to domestic producers of the commodity (which receive the higher price ) and from the nation’s abundant factor (producing exportable goods) to the nation’s scarce factor (producing importable goods) Economic inefficiency Tariff distorts the domestic resources to transfer from the most efficient production of exportable commodities to the less efficient production of importable commodities (deadweight loss) Case studies 8-3 and 8-4 (page 243-244)

Conclusion Partial equilibrium analysis of a tariff utilizes the nation’s demand and supply curves of the importable commodity and assume that the domestic price of the importable commodity rises by the full amount of the tariff. It measures the reduction in domestic consumption, increase in domestic production, reduction in imports, the revenue collected, and redistribution of income from domestic consumers (who pay higher price for the commodity) to domestic producers (who receive a higher price) as a result of the tariff. A tariff leads to inefficiencies referred to as protection cost or deadweight loss.

FIGURE 8-8 (Partial Equilibrium Effects of a Tariff in a Large Nation) Partial Equilibrium effects of a Tariff in a Large Nation (appendix A8.1 page 260) FIGURE 8-8 (Partial Equilibrium Effects of a Tariff in a Large Nation)

Explanation of Figure 8.8 SH refers to the home supply, SH+F refers to the total supply of X for the large nation; With free trade, the intersection point B is the equilibrium point of DH and SH+F, PX=$2 and QX=50 (of domestic supply is 20X=AC, foreign supply is 30X=CB); With a 50 percent ad valorem import tariff (T), the total supply will shift up by 50 percent and becomes SH+F+T. The new equilibrium point H , PX=$2.5 and QX=40 (of domestic supply is 25X=GJ, foreign supply is 15X=JH;

Explanation of Figure 8.8 Consumer surplus decreases: a+b+c+d, at the same time the nation’s government also collects e (terms of trade benefit) from foreign exporter ( because the nation is large nation, the smaller quantity of exports will be supplied at a lower price). The Welfare of the Large Nation with tariff – uncertain Net benefit: If e>b+d; Net loss: If e<b+d; No change: if e=b+d

Conclusion of Figure 8.8 One big difference from a small nation: the large nation can benefit from the terms of trade (because large nation can affect foreign export or world prices) while the small nation always incurs a net loss from a tariff equal to the protection cost or deadweight loss because the small nation does not affect foreign export or world price (e=0) Although the large nation can benefit from the terms of trade, foreigners are likely to retaliate with a tariff of their own. In the end both nations are likely to lose from the reduced level of trade and international specialization

8.3 The Theory of Tariff Structure The Rate of Effective Protection Generalization and Evaluation of the Theory of Effective Protection Conclusion

The Rate of Effective Protection Nominal Tariff & Effective Tariff Nominal Tariff It means the tariff on imports of a final commodity. Effective Tariff It means the tariff not only on imports of a final commodity also on imports of raw materials or intermediate goods for the production of a final commodity. Then calculating the real protection effect. The rate of effective tariff: calculated on the domestic value added , or processing, that takes place in the nation exceeds the nominal tariff rate (calculated on the value of the final commodity)

The Rate of Effective Protection The Formula of Effective Tariff G=(t-aiti)/1-ai G= the rate of effective protection to producers of the final commodity; t=the nominal tariff rate on consumers of the final commodity; ai= the ratio of the cost of the imported input to the price of the final commodity in the absence of trade; ti= the nominal tariff rate on the imported input Example page 245 Conclusion Whenever the imported input is admitted duty free or a lower tariff rate is imposed on the imported input than on the final commodity produced with the imported input, the effective rate of protection will exceed the nominal tariff rate.

Generalization and Evaluation of the Theory of Effective Protection If ai=0,g=t (the effective protection equals the nominal protection); Fore given values of ai and ti, g is larger the greater is the value of t; Fore given values of t and ti, g is larger the greater is the value of ai; The value of g exceeds, is equal to, or is smaller than t, as ti is smaller than, equal to, or larger than t; When aiti exceeds t, the rate of effective protection is negative

FIGURE 8-4 Pre- and Post-Uruguay Round Cascading Tariff Structure in Industrial Countries.

The nominal tariff is deceptive Tariff Escalation Conclusion The nominal tariff is deceptive Tariff Escalation Cascading tariff structure in most industrial nations: With very low or zero nominal tariffs on raw materials and higher and higher rates the greater is the degree of processing. Tariff escalation makes the rate of effective protection on a final commodity with imported inputs much greater than the nominal tariff rate would indicate. Tariff Theory The theory assumes that the international prices of the commodity and of imported inputs are not affected by tariffs and that inputs are used in fixed proportions in production.

8.4 General Equilibrium Analysis of a Tariff in a Small Country General Equilibrium Effects of a Tariff in a Small Country Illustration of the Effects of a Tariff in a Small Country The Stolper-Samuelson Theorem Conclusion

General Equilibrium Effects of a Tariff in a Small Country General equilibrium analysis is used to study the effects of a tariff on production, consumption, trade, and welfare when the nation is too small to affect world prices by its trading. There are some assumptions as follows: When a small nation imposes a tariff, it will not affect prices on the world market, the domestic price of the importable commodity will rise by the full amount of the tariff for individual producers and consumers in the small nation As for the whole of the small nation, its price remains constant The government of the small tariff-imposing nation uses the tariff revenue to subsidize public consumption and /or for general income tax relief

Illustration of the Effects of a Tariff in a Small Country Figure 8.5 (page 250) Nation 2’s PPF shows that it is a country with capital-abundance specializing in the production of commodity Y; Under free trade, if PX/PY=1 on the world market, it produces at Point B exchange 60Y for 60X with the rest of the world, its consumption at Point E on its indifference curve Ⅲ; With a 100 percent ad valorem tariff on imports of commodity X, the relative price of X rises to PX/PY=2 for domestic producers and consumers but at PX/PY=1 on the world market and for the nation as a whole. The domestic production is at Point F ( more production of importable X and less exportable Y). Its consumption at Point H’ ( but only 15 X for consumption, the remaining 15X is collect by the government in the 100 percent of import tariff on X)

FIGURE 8-5 General Equilibrium Effects of a Tariff in a Small Country.

Illustration of the Effects of a Tariff in a Small Country To summarize Figure 8.5 Production effect : More of importable goods and less of exportable goods Consumption effect : lower consumption than free trade Trade effect : the decrease of the trade volume Welfare effect: higher tariff will lead to return to its autarky point A in production and consumption. The tariff is called a prohibitive tariff

The Stolper-Samuelson Theorem Content The theory postulates that an increase in the relative price of a commodity raises the return or earnings of the factor used intensively in the production of the commodity. Thus, the real return to the nation’s scarce factor of production will rise with the imposition of a tariff. Explanation Tariff on the imported labor-intensive commodity X, PX/PY rises for domestic producers and consumers, and so the real wage of labor.

The Stolper-Samuelson Theorem Reason Import Tariff on scarce factor of production more of importable production and less of exportable production the change of L/K ratio the earnings of the scarce factor of production rises This theory explains that the small nation as a whole is harmed by the tariff, its scarce factor benefits at the expense of its abundant factor

Conclusion When a small nation imposes an import tariff, the domestic price of the importable commodity rises by the full amount of the tariff for individuals in the nation. As a result, domestic production of the importable commodity expands while domestic consumption and imports fall. However, the nation as a whole faces the unchanged world price since the nation itself collects the tariff. These general equilibrium effects of a tariff can be analyzed with the trade models developed in Part one and by assuming that the nation redistributes the tariff revenue fully to its citizens in the form of subsidized public consumption and /or general income tax relief.

Conclusion According to the Stolper-Samuelson theorem, an increase in the relative price of a commodity raises the return or earnings of the factor used intensively in its production. For example, if a capital-abundant nation impose an import tariff on the labor-intensive commodity, wages in the nation will rise. On the contrary, if a labor-intensive nation impose an import tariff on the capital-intensive commodity, rents in the nation will rise.

8.5 General Equilibrium Analysis of a Tariff in a Large Country General Equilibrium Effects of a Tariff in a Large Country Illustration of the Effects of a Tariff in a Large Country Conclusion

General Equilibrium Effects of a Tariff in a Large Country General equilibrium analysis is used to study the production, consumption, trade and welfare effects of a tariff for a large country case. Large Country It means it is large enough to affect the world price. Offer curves When a nation imposes a tariff, its offer curve shifts or rotates toward the axis measuring its importable commodity by the amount of the import tariff. To reduce the volume of trade but improve the nation’s terms of trade Nation’s welfare actually rises or falls depends on the net effect of trade volume and terms of trade

Illustration of the Effects of a Tariff in a Large Country Figure 8.6 With free trade, the equilibrium point of two nations’ offer curves is at E ; After the imposition by Nation 2 of a 100 percent ad valorem tariff on its imports of Commodity X is reflected in Nation 2’s offer curve rotating to offer curve 2’ , the tariff-distorted offer curve 2’ is at every point 100 percent or twice as distant from the Y-axis as offer curve 2 . The new equilibrium is at Point E’, Nation 2’s terms of trade improves (PX/PY=0.8) while Nation1’s deteriorates (PX/PY=1.25). The steeper or less elastic Nation 1’s offer curve is , the more its terms of trade deteriorate and Nation 2’s improve

FIGURE 8-6 General Equilibrium Effects of a Tariff in a Large Country.

Illustration of the Effects of a Tariff in a Large Country For Nation 2 as a whole, the import 50X by Nation 2 at equilibrium point E’, 25X is collected in kind by the government of Nation 2 as the 100 percent import tariff on commodity X and only the remaining 25X goes directly to individual consumers. Explanation of Figure 8.6 When large Nation 2 impose a tariff, the volume of trade declines but its terms of trade improve. For individual consumers and producers in Nation 2, PX/PY=PD=1.6, or twice as much as the price on the world market and for the nation as a whole Stolper-Samuelson theorem also holds in a large nation. If PX/PY falls, it is known as the Metzler paradox ( discussed in the appendix)

Conclusion When a large nation imposes an import tariff, its offer curve rotates toward the axis measuring its importable commodity by the amount of the tariff, reducing the volume of trade but improving the nation’s terms of trade. The Stolper-Samuelson theorem refers to the long run when all factors are mobile between the nation’s industries. Stopler-Samuelson theorem explains the reason of tariff imposition in nations: Import tariff can increase the real returns of the nation’s scarce factor of production.

8.6 The Optimum Tariff The Meaning of the Concept of Optimum Tariff and Retaliation Illustration of the Optimum Tariff and Retaliation Conclusion

The Meaning of the Concept of Optimum Tariff and Retaliation Optimum tariff is the rate of tariff that maximizes the net benefit resulting from the improvement in the nation’s terms of trade against the negative effect resulting from reduction in the volume of trade. Tariff Retaliation As the terms of trade of the nation imposing tariff improve, those of the trade partner deteriorate. As a result, the trade partner is likely to retaliate and impose an optimum tariff on its own. If the process continues, all nations usually end up losing all or most of the gains from trade. The world as a whole is worse off than under free trade.

Illustration of the Optimum Tariff and Retaliation FIGURE 8-7 The Optimum Tariff and Retaliation.

Conclusion The nation’s benefit comes at the expense of other nations, the latter are likely to retaliate, so that in the end all nations usually lose; An optimum tariff for a small country is zero (since a tariff will not affect its terms of trade and will only cause the volume of trade to decline (Figure 8.6 points E and H’). No tariff can increase the small nation’s welfare over its free trade position even if the trade partner does not retaliate; An optimum tariff for a large country is easy to arouse tariff retaliation.

Chapter Summary Tariff imposition has four effects: production effect, protection effect, revenue effect consumption; Tariff reduces the nation’s welfare and leads to the decline of trade volume; Tariff can increase the returns of the domestic scarce factor of production (Stolper-Samuelson); Tariff is easy to arouse the retaliation .

Exercises Discussion Problems: Page 258 to 259 from 1 to 14 questions

Exercises Additional Reading Comprehensive surveys of trade policies, in general, and the theory and measurement of tariffs, in particular, are: W.M.Corden, The Theory of Protection (London: Oxford University Press, 1971) J.N.Bhagwati, in R.C.Feenstra, ed., The Theory of Commercial Policy (Cambridge, Mass.: MIT Press, 1983) J.N.Bhagwat, Protectionism (Cambridge, Mass.: MIT Press, 1988) For measures of the cost of protection, see: G.H.Hufbauer, D. T. Berliner, and K. A.Elliott, Trade Protection in the United States: 31 Cases (Washington, D.C.: Institute for International Economics, 1986)

Internet Materials http://w3.access.gpo.gov/usbudget/fy2003/pdf/2002_erp.pdf http://www.state.gov http://www.ustr.gov/reports/index.shtml http://www.usitc.gov http://www.wto.org http://www.mkaccdb.edu.int http://www.infoexport.gc.ca