Tutorial on Partial Equilibrium Modeling: Import Tariff by a Large Country Importer The Microeconomics of International Trade ECN 230 Roberto J. Garcia School of Economics and Business, UMB

2 Economic effects of a specific tariff Specific tariff A per unit tax on imports (e.g., 30kr/kg) such that the difference between the domestic price and the world price is equal to  0, i.e., (P D ) 1 - (P W ) 1 =  0. A tariff has implications for prices, which affects economic behavior and welfare. The economic effects are studied by analyzing the change in prices on: Production, consumption and trade patterns, and Producer and consumer welfare and government's budgetary position (i.e., expenditures and revenue).

3 Economic effects of a specific tariff Market analysis Analyzing the production, consumption and trade effects: the perspective of the importing country [P D ] 1 [P W ] 1 [Q S ] 1 [Q D ] 1 [Q M ] 1   [P D ] 1 [P W ] 1 World marketImporter's domestic market

4 Economic effects of a specific tariff Economic intuition and expectations Regardless of the reason a tariff is applied, the result is a reduction in the quantity imported (ED shifts to the left) The world price decreases (  P W ) because a large buyer on the international market reduces demand, i.e., a TOT effect. The internal price in the importer’s market increases (  P D ) because there is greater scarcity of the good in the domestic market. Producers and consumers react to the change in the domestic price, from P W to [P D ] 1. Producers respond to price increases by increasing output,  Q S. In partial equilibrium analysis, a price increase is expected to result in a decrease in consumption,  Q D. Government collects tariff revenue which is equal to the tariff rate, τ 0, times the quantity imported, [Q D - Q S ] 1.

5 Economic effects of a specific tariff Welfare analysis Analyzing economic costs and income transfers among producers, consumers, traders and the government: the importing country's perspective [P D ] 1 [P W ] 1 [Q S ] 1 [Q D ] 1 Importer's market Welfare analysis Δ CS Δ PS Δ G Δ NSW - (a+b+c+d) + (a) - (b+d) + (e) + (c+e) τ0τ0

6 Economic effects of a specific tariff Economic interpretation of welfare areas Area 'a' represents the value lost by consumers that is gained by producers, i.e., a tax on consumers; it is an income transfer from the consumer to the producer. Area 'b' represents a part of the total value lost by the consumers that is not transferred to any other economic agent in the economy; it is a "dead-weight loss" (DWL) in production. The DWL in production is the cost to society of producing more the good in which the country has a comparative disadvantage. The increased production reflects a misallocation of resources because resources are being used inefficiently. Area 'c' represents the value lost by consumers that is gained by government; it is an income transfer from the consumer to the government in the form of a tax.

7 Economic effects of a specific tariff Area 'd' represents part of the value lost by consumers that is not transferred to any other economic agent; it is a "dead-weight loss" (DWL) in consumption. The DWL in consumption is the cost to society of consuming less of the imported good as a result of distorted prices. The decreased expenditures reflects a misallocation of resources in consumption (ie, a non-optimal consumption mix). Area 'e' represents revenue that is collected by the government, along with area 'c', from the tariff; the total revenue is (c+e) which is equal to {[P D ] 1 – [P W ] 1 } x [Q M ] 1 ; however, area 'e' is an income transfer from the exporter to the government resulting from the TOT effect of the tariff (i.e., the policy-induced reduction in demand by a large international buyer that lowered P W ). The net effect of the tariff on the importer is uncertain because the negative DWLs can be offset by the income transfer from the exporting country.

8 Economic effects of a specific tariff Market analysis Analyzing the production, consumption and trade effects: the perspective of the exporting country Exporter's domestic marketWorld market  

9 Economic effects of a specific tariff Economic intuition and expectations Regardless of the reason a tariff is applied, the result is a reduction in the quantity imported. (Graphically, ED shifts to the left by the per unit rate of duty.) It is assumed that the export-country government does not take any policy action to counter the tariff. The world price decreases (  P W ) because a large buyer on the international market reduces demand. The internal price in the exporter’s market is the world price because no policy action has been taken. Producers and consumers react to the change in the domestic price, from P W to [P W ] 1. Producers respond to price decreases by decreasing output,  Q S. In partial equilibrium analysis, a price decrease is expected to result in an increase in consumption,  Q D. Because the export-country government took no action, there are no budgetary outlays on or revenues collected from the exported good.

10 Economic effects of a specific tariff Welfare analysis Analyzing economic costs and income transfers among producers, consumers, traders and the government: the exporting country's perspective Welfare analysis Δ CS Δ PS Δ G Δ NSW + (1) - ( ) - (2+3+4) 0 Exporter's domestic market

11 Economic effects of a specific tariff Economic interpretation of welfare areas Area '1' represents the value gained by consumers from the lower price; it is an income transfer from producers to consumers. Area '2' represents a part of the total value lost by the producer that is not transferred to any other economic agent in the economy; it is a "dead-weight loss" (DWL) in consumption. The DWL in consumption is the cost to society of consuming more the exportable good and becoming less reliant on trade. The increased consumption reflects a misallocation of resources because the world price has been distorted. Area '3' represents the value lost by producers that is gained by the importing government; it is an income transfer from the producer/exporter to the importer's government in the form of a tax as a result of the TOT effect.

12 Economic effects of a specific tariff Area '4' represents a part of the value lost by the producers that is not transferred to any other economic agent in the economy; it is the "dead-weight loss" (DWL) in production. The DWL in production in the exporting country is the cost to society of producing too little of the exportable good, the good in which the country has a comparative advantage. The decreased production reflects a misallocation of resources away from the export sector, stifling the specialization process. The net effect of the tariff on the exporting country is negative, resulting in the DWLs and an income transfer to the importing country

13 Economic effects of a specific tariff Net world welfare effects Internal domestic transfers, DWLs and international transfers Exporter's marketImporter's market Δ NSW Importer Exporter World - (b+d) + (e) - (b+d) - (2+4) - (2+4) - (3) (e) = (3)

14 Economic effects of a specific tariff Concluding comments The import tariff by a large country results in a TOT effect that affects importers and exporters differently: 1. A decrease in the world price benefits the importing country(ies) at the expense of the exporting country(ies) 2. The higher domestic price in the importing country is a price support to domestic producers which is paid by domestic consumers. 3. The lower world price in the importing country is a tax on producers/exporters, but benefits consumers in the exporting country. 4. Part of the revenue collected by the importing country's government is an international income transfer from the producers/exporters, i.e, it is a tax by the importer on the exporter. 5. The net effect of the tariff on the world economy is an international income transfer and a series of DWLs in production and consumption in both the importing and exporting country because prices have been distorted.