IMPORT TARIFFS AND QUOTAS UNDER PERFECT COMPETITION

IMPORT TARIFFS AND QUOTAS UNDER PERFECT COMPETITION
8 1 A Brief History of the World Trade Organization 2 The Gains from Trade 3 Import Tariffs for a Small Country 4 Import Tariffs for a Large Country 5 Import Quotas 6 Conclusions IMPORT TARIFFS AND QUOTAS UNDER PERFECT COMPETITION

International Economics
Introduction We have established that international trade is beneficial to a nation as a whole, but the gains may be unevenly distributed In an economy there will always be someone opposed to free trade who wish to limit trade and call for protectionist measures to be enacted We will now be looking at trade policy issues – why do some want to limit trade and what is the effect on efficiency and distribution of income International Economics

A Brief History of the World Trade Organization When peace was reestablished following WWII, representatives of 44 countries met in Bretton Woods, NH, to discuss the rebuilding of Europe and issues with high trade barriers and unstable exchange rates. The outcome was an agreement outlining an international system of free trade, convertible currencies, and fixed exchange rates. As part of this Bretton Woods Agreement, the GATT was established in 1947 to reduce barriers to trade between nations. International Economics

A Brief History of the World Trade Organization
Under the GATT, countries met periodically to negotiate for lower trade barriers between them. Each meeting was named for the location where it took place and at the Uruguay Round, the WTO was established. The WTO greatly expanded GATT by adding rules that govern an expanded set of global interactions through binding agreements. The most recent round of the WTO was the Doha Round, in Doha, Qatar November 2001. International Economics

The Doha round…and round…and round
Trade in agricultural goods is the main problem International Economics

Some Articles of GATT which still govern trade in the WTO: A nation must extend the same tariffs to all trading partners that are WTO members. This is the “most favored nation” clause Tariffs may be imposed in response to unfair trade practices such as dumping Countries should not limit the quantity of goods and services that they import. Article XI states that countries should not maintain quotas against imports Countries should declare export subsidies provided to particular firms, sectors, or industries International Economics

Countries can temporarily raise tariffs for certain products. Article XIX is called the safeguard provision or the escape clause and is our focus in this chapter. The importing country can temporarily raise a tariff when domestic producers are suffering due to import competition. European governments strenuously objected to the U.S. steel tariffs, and filed a complaint against the U.S. with the WTO. A panel at the WTO ruled in favor of the European countries, entitling them to retaliate by placing tariffs of their own on $2.2 billion worth of U.S. exports. This lead President Bush to remove the steel tariffs in December 2003. International Economics

Regional trade agreements are permitted under Articles XXIV of the GATT Free trade areas Customs unions International Economics

The Gains from Trade There will be winners and losers from the introduction of a tariff. Consumers generally lose while producers gain When analyzing welfare and distribution effects of trade policy measures, you need to master the consumer surplus, producer surplus and welfare The 1$ one vote principle is used. International Economics

The Gains from Trade Figure 8.1 (a) Adding up all the individual surplus for each point on the demand curve gives us total consumer surplus—the area between the demand and the price paid—up to the quantity sold The demand curve gives us the consumer’s value for each unit of the good. Given P1, consumers will buy a total of D1. A consumer who purchases D2 has a value of P2, but only has to pay P1 – that gives surplus equal to (P2-P1) Price Total Consumer surplus, CS P2 Surplus for consumer purchasing quantity D2 P1 Figure 8.1 (a) Consumer and Producer Surplus In panel (a), the consumer surplus from purchasing quantity D1 at price P1 is the area below the demand curve and above that price. The consumer who purchases D2 is willing to pay price P2 but has to pay only P1. The difference is the consumer surplus and represents the satisfaction of consumers over and above the amount paid. D D D Quantity International Economics

The Gains from Trade Figure 8.1 (b) A producer who sells S0 has a MC of P0, but gets P1. That gives surplus equal to (P1-P0) The supply curve gives us the consumer’s value for each unit of the good. Given P1, producers will sell a total of S1. Adding up all the individual surpluses for each point on the supply curve gives us total producer surplus—the area between the supply and the price received—up to the quantity sold. Price Total Producer surplus, PS S P1 Figure 8.1 (b) Consumer and Producer Surplus In panel (b), the producer surplus from supplying the quantity S1 at the price P1 is the area above the supply curve and below that price. The supplier who supplies unit S0 has marginal costs of P0 but sells it for P1. The difference is the producer surplus and represents the return to fixed factors of production in the industry. Surplus for firm producing quantity S0 P0 S S Quantity International Economics

The Gains from Trade Figure 8.2 (a) No-Trade Price No-trade equilibrium CS S PA A PS Figure 8.2 (a) The Gains from Free Trade at Home With Home demand of D and supply of S, the no-trade equilibrium is at point A, at the price PA producing Q0. With free trade, the world price is PW, so quantity demanded increases to D1 and quantity supplied falls to S1. Since quantity demanded exceeds quantity supplied, Home imports D1 − S1. Consumer surplus increases by the area (b + d), and producer surplus falls by area b. The gains from trade are measured by area d. D Q Quantity International Economics

The Gains from Trade Free Trade for a Small Country Suppose Home can now engage in trade. The world price PW is determined by the supply and demand in the world market (shown in in figure 8.2 (b)). Suppose Home is a small country. Price taker in the world market Faced a fixed price at PW Assume PW is below the Home no-trade price PA. At the lower price, Home quantity demanded will increase to D1 and Home quantity supplied will decrease to S1. Home will be an importer of the product at the world price. International Economics

The Gains from Trade Figure 8.2 At the free trade price of PW, Home supply will fall to S1 and Home demand will rise to D1. (b) Free Trade Price S PA PW Figure 8.2 (b) The Gains from Free Trade at Home With Home demand of D and supply of S, the no-trade equilibrium is at point A, at the price PA producing Q0. With free trade, the world price is PW, so quantity demanded increases to D1 and quantity supplied falls to S1. Since quantity demanded exceeds quantity supplied, Home imports D1 − S1. Consumer surplus increases by the area (b + d), and producer surplus falls by area b. The gains from trade are measured by area d. Imports will make up for the excess demand and will equal (D1 – S1) D S D Quantity Imports International Economics

The Gains from Trade Figure 8.2 At lower world price, consumer surplus increases to a+b+d  an increase of b+d from no-trade (b) Free Trade Price S At lower world price, producer surplus falls to c  a decrease of b from no-trade a PA PW b Gain in trade is triangle d with area equal to ½(M1)(PA-PW) d Figure 8.2 (b) The Gains from Free Trade at Home With Home demand of D and supply of S, the no-trade equilibrium is at point A, at the price PA producing Q0. With free trade, the world price is PW, so quantity demanded increases to D1 and quantity supplied falls to S1. Since quantity demanded exceeds quantity supplied, Home imports D1 − S1. Consumer surplus increases by the area (b + d), and producer surplus falls by area b. The gains from trade are measured by area d. c D S D Quantity Imports, M1 International Economics

The Gains from Trade Consumers gain more than the producers lose indicating total Home welfare increased. By looking at the changes in surplus we see: Rise in consumer surplus +(b+d) Fall in producer surplus -b Net effect on Home welfare d d is a measure of the gains from trade for the importing country due to free trade. We can measure this gain directly using the formula for the area of the triangle = ½ bh Welfare increase = ½ (M1)(PA-PW) International Economics

The Gains from Trade Home Import Demand Curve We can derive the import demand curve, shown in figure 8.3 The relationship between the world price of a good and the quantity of imports demanded by Home consumers. At the no-trade equilibrium, there are zero imports This is shown as point A′ in panel (b). At the world price of PW, the quantity demanded is greater than quantity supplied, and we import M1. This is point B in panel (b). Joining A′ and B gives import demand curve M. International Economics

The Gains from Trade Figure 8.3 (a) (b) No-trade equilibrium Each point on the import demand curve is a point that corresponds to Home imports at a given Home price Price Price S A' PA PW A Figure 8.3 Home Import Demand With Home demand of D and supply of S, the no-trade equilibrium is at point A, with the price PA and import quantity Q0. Import demand at this price is zero, as shown by the point A‘ in panel (b). At a lower world price of PW, import demand is M1 = D1 − S1, as shown by point B. Joining up all points between A' and B, we obtain the import demand curve, M. B Import demand curve, M D S Q D Quantity M Imports Imports, M1 International Economics

Import Tariffs for a Small Country
Figure 8.4 Home price rises by the amount of the tariff. Home supply increases and Home demand decreases  Imports fall to M2 No-trade equilibrium Price Price S A M2 C X*+t PW+t S D2 Figure 8.4 Tariff for a Small Country Applying a tariff of t dollars will increase the import price from PW to PW + t. The domestic price of that good also rises to PW + t. This price rise leads to an increase in Home supply from S1 to S2, and a decrease in Home demand from D1 to D2, in panel (a). Imports fall due to the tariff, from M1 to M2 in panel (b). As a result, the equilibrium shifts from point B to C. B Foreign export supply, X* PW D M S D1 Quantity M1 Imports M2 International Economics

Figure 8.5 (a.1) No-trade equilibrium Lost consumer surplus due to the higher price with the tariff is equal to the shaded area (a+b+c+d) Price S A a b d c PW+t PW Figure 8.5 (a) Effect of Tariff on Welfare The tariff increases the price from P W to P W + t. As a result, consumer surplus falls by (a + b + c + d). Producer surplus rises by area a, and government revenue increases by the area c. Therefore, the net loss in welfare, the deadweight loss to Home, is (b + d), which is measured by the two triangles b and d in panel (a). D S S D2 D Quantity M2 International Economics

Figure 8.5 (a.2) No-trade equilibrium The gain in producer surplus due to the higher price with the tariff is equal to the shaded area (a) Price S A b d PW+t PW a c Figure 8.5 (a) Effect of Tariff on Welfare The tariff increases the price from P W to P W + t. As a result, consumer surplus falls by (a + b + c + d). Producer surplus rises by area a, and government revenue increases by the area c. Therefore, the net loss in welfare, the deadweight loss to Home, is (b + d), which is measured by the two triangles b and d in panel (a). D S S D2 D Quantity M2 International Economics

Effect of the Tariff on Government Revenue In addition to the tariff’s impact on consumers and producers, it also affects government revenue. The amount of revenue collected is the tariff t times the quantity of imports (D2 – S2). In figure 8.5 panel (a.3), the revenue is shown by area c. The collection of revenue is a gain for the government in the importing country. International Economics

Figure 8.5 (a.3) The gain in government revenue due to the tariff is equal to the shaded area (c) This equals the tariff, t, times the quantity of imports, M2 No-trade equilibrium Price S A b d PW+t PW a c Figure 8.5 (a) Effect of Tariff on Welfare The tariff increases the price from P W to P W + t. As a result, consumer surplus falls by (a + b + c + d). Producer surplus rises by area a, and government revenue increases by the area c. Therefore, the net loss in welfare, the deadweight loss to Home, is (b + d), which is measured by the two triangles b and d in panel (a). D S S D2 D Quantity M2 International Economics

Overall Effect of the Tariff on Welfare We can now summarize the total impact of the tariff on the welfare of the Home importing country by adding the gains and losses for each party. Note, we do not care whether the consumers facing higher prices are rich or poor, and do not care whether the specific factors in the industry earn a lot or a little. Under this approach, transferring one dollar from consumer to producer surplus will have no impact on overall welfare. We are simply evaluating the efficiency of the tariff. International Economics

Overall Effect of the Tariff on Welfare The overall impact of the tariff in the small country can be summarized as follows: Fall in consumer surplus -(a+b+c+d) Rise in producer surplus +a Rise in government revenue +c Net effect on Home welfare -(b+d) The areas b and d in figure 8.5 (a) correspond to the triangle (b+d) in figure 8.5 (b) and is the net welfare loss. We refer to this area as a deadweight loss—it is not offset by a gain elsewhere in the economy. International Economics

Figure 8.5 (a) The deadweight loss is the loss to Home that is not offset by a corresponding gain No-trade equilibrium Price S a is a transfer from consumers to producers c is a transfer from consumers to government (b+d) is deadweight loss—losses not offset by other gains A b d PW+t PW a c Figure 8.5 (a) Effect of Tariff on Welfare The tariff increases the price from P W to P W + t. As a result, consumer surplus falls by (a + b + c + d). Producer surplus rises by area a, and government revenue increases by the area c. Therefore, the net loss in welfare, the deadweight loss to Home, is (b + d), which is measured by the two triangles b and d in panel (a). D S S D2 D Quantity M2 International Economics

Figure 8.5 (b) M1 Imports X* M Price M2 X*+ t Dead weight loss due to tariff, b+d C Figure 8.5 (b) Effect of Tariff on Welfare The tariff increases the price from P W to P W + t. As a result, consumer surplus falls by (a + b + c + d). Producer surplus rises by area a, and government revenue increases by the area c. Therefore, the net loss in welfare, the deadweight loss to Home, is (b + d), which is measured by the single (combined) triangle b + d in panel (b). International Economics

Overall Effect of the Tariff on Welfare The area a is effectively a transfer from consumers to producers via the higher domestic prices induced by the tariff. The area c, the gain in government revenue, is a transfer from consumers to the government. The deadweight loss, (b+d), is measured by the two triangles b and d. The two triangles can each be given a precise interpretation. International Economics

Production Loss The base of b is the net increase in Home supply due to the tariff, from S1 to S2. The height of this triangle is the increase in marginal costs due to the increase in supply. The fact that marginal costs are greater than world price means that this country is producing the extra supply inefficiently. Fewer resources would be used if imported rather than produced at home. The area of b is the production loss or efficiency loss—due to producing at marginal costs above world price. International Economics

Consumption Loss The triangle d also has a precise definition. Due to the tariff, the price increase from, PW to PW+t reduces quantity consumed at Home from D1 to D2. The area of the triangle can be interpreted as the drop in consumer surplus for those individuals who are no longer able to consume the units from D1 to D2 because of the higher price. We refer to this drop in consumer surplus as the consumption loss for the economy. International Economics

Why are Tariffs Used? Finding that tariffs always lead to deadweight losses for small countries explains why most economists are opposed to them. Why then do so many countries use tariffs? One idea is that developing countries do not have any other source of revenue. Import tariffs are “easy-to-collect” because every country has customs agents at major ports checking the goods crossing the borders. However, to the extent that developing countries recognize that tariffs have a higher deadweight loss, we would expect that over time they will shift away from such “easy-to-collect” taxes. International Economics

Why are Tariffs Used? Why then do so many countries use tariffs? A second reason is politics. If the government cares more about producer surplus than consumer surplus, it might decide to use the tariff despite the deadweight loss it incurs. The benefits to producers (and their workers) are typically more concentrated on specific firms and states than the costs to consumers which are spread nationwide. International Economics

Import Tariffs for a Large Country
Under the small country assumption that we have used so far, the importing country is always harmed due to the tariff. The small country is a world price taker. If we consider a large enough importing country or a large country, however, then we might expect that its tariff will change the world price. Their imports are large enough that they can affect world price with a change in their imports. International Economics

Foreign Export Supply If the Home country is large, then the Foreign export supply curve X* is no longer horizontal at the world price PW. We need to derive the foreign export supply curve using the Foreign market demand and supply curves. In panel (a) of figure 8.6, we show the Foreign demand curve D* and supply curve S*, giving price of PA* at A*. At this point, Foreign exports are zero. International Economics

Foreign Export Supply Suppose the world price is PW above PA*. At the higher price, Foreign quantity demanded is lower at D1*, but quantity supplied by foreign firms is higher at S1*. Foreign excess supply of X1* = S1* - D1*, will be exported at the price of PW at point B*. Connecting A* and B* gives the upward sloping Foreign export supply curve, X*. Combining with Home import demand, M, we get an equilibrium at PW and X1*. * International Economics

Figure 8.6 (a) Foreign Mkt (b) World Mkt World price increases to PW, increasing exports to X1* This gives us our Foreign export supply curve for the large country Price Price At the world price, PA*, exports are zero at A*’ Foreign export supply, X* D* S* B* X1* PW D1* S1* Figure 8.6 Foreign Export Supply In panel (a), with Foreign demand of D* and Foreign supply of S*, the no-trade equilibrium in Foreign is at point A*, with the price of PA*. At this price, the Foreign market is in equilibrium and Foreign exports are zero—point A* in panel (a) and point A*’ in panel (b), respectively. When the world price, PW, is higher than Foreign’s no-trade price, the quantity supplied by Foreign, S*1, exceeds the quantity demanded by Foreign, D*1, and Foreign exports X*1 = S*1 − D*1. In panel (b), joining up points A*' and B*, we obtain the upward-sloping export supply curve X*. With the Home import demand of M, the world equilibrium is at point B*, with the price PW. Home import demand, M A* A*' PA* Quantity Exports Foreign exports, X1* International Economics

Figure 8.7 (without welfare effects) (a) Home market (b) Foreign market Price Price No-trade equilibrium X*+t S A t X* C P*+t t t PW B* Figure 8.7 Tariff for a Large Country The tariff shifts up the export supply curve from X* to X* + t. As a result, the Home price increases from PW to P* + t, and the Foreign price falls from PW to P*. The deadweight loss at Home is the area of the triangle (b + d), and Home also has a terms-of-trade gain of area e. Foreign loses the area (e + f), so the net loss in world welfare is the triangle (b + d + f). P* C* D M S1 S D2 D Quantity M2 M1 Imports M2 M1 International Economics

Home Welfare Fall in consumer surplus -(a+b+c+d) Rise in producer surplus +a Rise in government revenue +(c + e) Net effect on Home welfare e – (b+d) + (e) The triangle (b+d) is the deadweight loss due to the tariff. But notice, there is a source of gain, e, that offsets part of the loss. If e > (b+d), then Home is better off. If e < (b+d), then Home is worse off. International Economics

Figure 8.7 (with welfare effects) If the gain of e is greater than the loss of (b+d), Home gains (a) Home market (b) Foreign market No-trade equilibrium Price Price X*+t S b+d t X* A C Figure 8.7 Tariff for a Large Country The tariff shifts up the export supply curve from X* to X* + t. As a result, the Home price increases from PW to P* + t, and the Foreign price falls from PW to P*. The deadweight loss at Home is the area of the triangle (b + d), and Home also has a terms-of-trade gain of area e. P*+t PW P* a c b d B* e C* e D M S1 S D2 D Quantity M2 M1 Imports International Economics

Figure 8.7 (with welfare effects) Foreign loses (e+f) as loss of Foreign producer surplus, from selling fewer goods at a lower price (a) Home market (b) Foreign market No-trade equilibrium Price Price X*+t S b+d t X* A C Figure 8.7 Tariff for a Large Country The tariff shifts up the export supply curve from X* to X* + t. As a result, the Home price increases from PW to P* + t, and the Foreign price falls from PW to P*. The deadweight loss at Home is the area of the triangle (b + d), and Home also has a terms-of-trade gain of area e. Foreign loses the area (e + f), so the net loss in world welfare is the triangle (b + d + f). P*+t PW P* a c b d B* e e f D C* M S1 S D2 D Quantity M2 M1 Imports International Economics

Import quotas An alternative to a tariff is an import quota, which is a direct quantitative limitation on imports Quotas are frequently used, for example in agriculture, but they are also used for industrial goods The welfare effects of a quota can be analysed using the standard framework Quotas artificially create shortages, giving raise to economic rents. Who captures these rents is important International Economics

Import Quotas Figure 8.9 (without quota) At PW, Home Supplies S1, Demands D1, and Imports M1 In free trade equilibrium for a small country, Foreign faces a horizontal export supply curve, X*, at the world price PW No-trade equilibrium S Price Price A PW Foreign export supply, X* B M1 Figure 8.9 Under free trade, the Foreign export supply curve is horizontal at the world price PW, and the free-trade equilibrium is at point B with imports of M1. Home import demand, M D S D Quantity Imports (a) Home market (b) Import market International Economics

Import Quotas Figure 8.9 (with quota) Consumers loses surplus of (a+b+c+d), producers gain (a). Welfare of Home depends on what happens to (c). The new Export Supply curve crosses the Import Demand curve at a new price and quantity of imports At the new higher price P2, Home Supply increases to S2, Demand decreases to D2 and imports fall to M2 Always have a deadweight loss of (b+d) like the tariff With the Quota, the Foreign export supply becomes vertical at the quota quantity No-trade equilibrium S Price Price Foreign export supply with quota A c a d b+d b P2 C S2 D2 Foreign export supply, X* Figure 8.9 Quota for a Small Country Under free trade, the Foreign export supply curve is horizontal at the world price PW, and the free-trade equilibrium is at point B with imports of M1. Applying an import quota of M2 < M1 leads to the vertical export supply curve with the equilibrium at point C. The quota increases the import price from PW to P2. There would be the same impact on price and quantities if instead of the quota, a tariff of t = P2 − PW had been used. B PW M2 Home import demand, M D S1 D1 Quantity M1 Imports (a) Home market (b) Import market International Economics

Import Quotas There are four possible ways these rents can be allocated. Giving the Quota to Home Firms: Quota licenses can be given to Home firms Permits to import the quantity allowed under the quota system. The net effects on Home welfare due to the quota are then as follows: Fall in consumer surplus -(a+b+c+d) Rise in producer surplus +a Quota rents earned at Home +c Net effect on Home welfare: -(b+d) This is the same loss we saw with a tariff. (b+d) is still a deadweight loss associated with the quota. International Economics

Import Quotas Rent Seeking Because of the gains associated with owning a quota license, firms have an incentive to engage in inefficient activities in order to obtain them. How licenses are allocated matters. If licenses are allocated in proportion to each firm’s production, Home firms will likely produce more than they can sell just to obtain the import licenses for the following year. Firms might engage in bribery or other lobbying activities to obtain the licenses. International Economics

Import Quotas Some suggest that the waste of resources devoted to rent seeking could be as large as the value of the rents themselves, c. If rent seeking occurs, welfare loss of quota is: Fall in consumer surplus -(a+b+c+d) Rise in producer surplus +a Net effect on Home welfare: -(b+c+d) This loss is larger than a tariff. It is thought rent seeking is worse in developing countries. International Economics

Import Quotas Auctioning the Quota The government of the importing country to auction off the quota licenses. In a well-organized, competitive auction, the revenue collected should exactly equal the value of the rents. Fall in consumer surplus -(a+b+c+d) Rise in producer surplus +a Auction revenue earned at Home +c Net effect on Home welfare: -(b+d) This is the same loss as the tariff. International Economics

Import Quotas “Voluntary” Export Restraint The importing country can give authority for implementing the quota to the exporting government. This is often called a “voluntary” export restraint (VER) or a “voluntary” restraint agreement (VRA). In the 1980s the U.S. used this type of arrangement to restrict imports of Japanese automobiles. The Japanese government told each Japanese firm how much it could export to the U.S. International Economics

Import Quotas With VERs, quota rents are earned by foreign producers, making Home welfare: Fall in consumer surplus -(a+b+c+d) Rise in producer surplus +a Net effect on Home welfare: -(b+c+d) This is of course higher than with a tariff, Why would we do this? It is typically political—the exporting country is less likely to retaliate since they gain the area c. This can often avoid a tariff or quota war. International Economics

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