1Chapter 6 -- Tariffs

• INTERNATIONAL ECONOMICS,ECO 486

• Draft simplified harmonized uniform tariff schedule (HTS) for US:http://www.usitc.gov/sec/I0326w2m.htm

2Learning Objectives

• Reprise the gains from trade

• Become familiar with tariffs

• Analyze the welfare cost of tariffs

• Determine the optimal tariff

• Explain the effective rate of protection

• Learn the imperfect substitutes model

4Gains from Trade

• Static Gains (PPF doesn’t shift)– Consumption gains– Production gains

• Dynamic Gains (PPF does shift)– Trade expands resources– Trade may raise productivity

• Political Gains

5

SOYBEANS, S (bushels per year)

0

A

TE

XT

ILE

S, T

(yar

ds

per

yea

r)

CIC0

Consumption & Production Gains

CIC1

CIC2

F

B

C

X

7Dynamic Gains from Trade

• Trade may speed economic growth

10Commercial Policy

• Governments action that may change the composition and volume of trade flows

– Tariffs

– Quotas

– Subsidies

– Other non-tariff barriers

• We’ll analyze the cost & benefits of these

11Tariffs

• Taxes on– Imports– Exports– Subsidies

• Components -- See Table 6.1, page 153– Ad valorem-- % of value– Specific -- flat fee per unit– Compound -- both

12Positive Effects of Tariffs

• Revenue Effect -- provide tax revenue

• Protective Effect -- shelter domestic producers from foreign competition

13Tariff Terminology

• A pure-revenue tariff is one imposed on a good not produced domestically– A tariff on bananas imported to Iceland

• A prohibitive tariff is one that is so high that none of the good is imported– no revenue is collected

14Uses of Tariffs

• Developing countries may rely on tariffs to provide tax revenue

• Developed countries impose tariffs for their protective effect

15Tariffs as tools of int’l policy

• Most Favored Nation status, MFN– granted as a reward, withheld as a punishment

• Generalized System of Preferences, GSP– Most developed countries have GSP as means

of helping developing countries• access to markets of developed countries

17Welfare Cost Analysis

• Use (National) Supply and Demand– Partial equilibrium– One import or export good

• Measure Changes in Consumer Surplus and Producer Surplus

• Start with a small country– Its trade is too small to affect terms of trade

18Gains from free trade -- imports

3

6

10

0 1 4 10Quantity (millions bushels of grapes per year)

Pri

ce ($

per

bu

shel

of

gra

pes

)

7

2

20Welfare of a Move to Free Trade

A Small Country’s Imports

Change in Consumer Surplus

Change in Producer Surplus

Net Welfare Change

22Gains from free trade -- exports

9

6

10

0 1 4 10Quantity (millions jars of honey per year)

Pri

ce ($

per

jar

of

hon

ey)

7

2

24Welfare of a Move to Free Trade

A Small Country’s Exports

Change in Consumer Surplus

Change in Producer Surplus

Net Welfare Change

26Welfare Cost of a Tariffon Imports -- Small Country

3

5

10

0 1 10Quantity (millions bushels of grapes per year)

Pri

ce ($

per

bu

shel

of

gra

pes

)

7

2

3 5

28Welfare Cost of a Tariff on Imports -- Small Country

Change in Consumer Surplus

Change in Producer Surplus

Change in Gov't Revenue

Net Welfare Change (a.k.a. Deadweight loss)

Loss = 0.5 x tariff x change in imports

30Welfare Cost of a TariffSmall Country

3

5

10

0 1 10

b

Domestic demand for grapes

Domestic Supplyof grapes

c

Quantity (millions bushels of grapes per year)

Pri

ce ($

per

bu

shel

of

gra

pes

)

World price of grapes

7

2

World price + tariff $2/bu

3 5

d

32Export Tariff -- Small Country

9

6

10

0 1 4 10

Domestic demand for honey

Domestic Supplyof honey

Quantity (millions jars of honey per year)

Pri

ce ($

per

jar

of

hon

ey)

7

2

34Welfare Cost -- Export Tariff

Small Country Case

Change in Consumer Surplus

+a

Change in Producer Surplus -a -b -c -d

Change in Gov't Revenue +c

Net Welfare Change in A (a.k.a. Deadweight loss)

-b -d

37Int’l Free Trade Eq. Large Country

Quantity (lb. of Lobster per year)

0

Pri

ce ($

per

lb.)

PA

PB

0

39Learning Objectives

• Derive import demand & export supply

• Review the welfare cost of tariffs

• Learn elasticity of import demand & export supply

• Determine the incidence (burden) of a tariff

40

0

A’s demand for Lobster

A’s Supplyof Lobster

Pri

ce ($

per

lb.)

PA

PFT

Import Demand

Quantity (lb. of Lobster per year)

PB

0

Pri

ce ($

per

lb.)

PA

M = QD - QS

PB

42Export Supply

0

Quantity (lb. of Lobster per year)

Pri

ce ($

per

lb.)

PA

X = QS - QD

PB

B’s demand for L

B’s Supplyof L

QD QS

0

PB

44

0

A’s demand for Lobster

A’s Supplyof Lobster

Pri

ce ($

per

lb.)

PA

PFT

Q1 Q2

Export Supply & Import Demand

Quantity (lb. of Lobster per year)

0

PB

0

Pri

ce ($

per

lb.)

PA

PFT

M = Q2 - Q1

PFT

Export Supply, X

Import Demand, M

45Export Supply & Import Demand

0

Import Demand, M

Export Supply, X

Quantity (lb. of Lobster per year)

Pri

ce ($

per

lb.)

PA

PFT

0 M = Q2 - Q1

X = Q2‘ - Q1 ‘

PB

PFT

B’s demand for L

B’s Supplyof L

Q1’ Q2’0

PB

46Optimal Tariffs

• Large countries may “export” part of their tariff.

• Because they are important customers, they force foreign supplier to cut price.

• The optimal tariff maximizes the net welfare change

• Retaliation is likely to offset this gain

47Equilibrium with a Tariff Large Country

0

A’s demand for L

A’s Supplyof L

Quantity (lb. of Lobster per year)

Pri

ce ($

per

lb.)

PFT

Q1 Q2

PFT

B’s demand for L

B’s Supplyof L

0

P’P’

P”

Q1’Q3 Q4Q2’Q3’ Q4’

49A’s Welfare Cost -- Import Tariff

Imposed by Large Country, A

Change in Consumer Surplus

-a -b -c -d

Change in Producer Surplus +a

Change in Gov't Revenue +c +e

Net Welfare Change in A (a.k.a. Deadweight loss)

-b -d +e

51B’s Welfare Cost from A’s Tariff

Import Tariff Imposed by AChange in Consumer Surplus

+h

Change in Producer Surplus -h -i -e -j

Change in Gov't Revenue

Net Welfare Change in B (a.k.a. Deadweight loss)

-i -e -j

53World Welfare Cost of A’s Tariff

Net Welfare Change in A

-b -d +e

Net Welfare Change in B

-e -i -j

Net Welfare Change in World

-b

-d

-i

-j

55World Welfare Changes

• Tariff raises the price in A to PW + T

• Tariff lowers the world price to PW

• Tariff reduces the quantity world trade from MFT to MT

• Welfare loss area, f = b+d

• Welfare loss area, g = i+j

56Export Supply + Specific Tariff, T

0

Import Demand, M

Export Supply, X

Quantity (lb. of Lobster per year)

Pri

ce ($

per

lb.)

MFT

T

T

58Graphing Tariffs

• Specific tariff raises the y-intercept of the export supply curve, p = a + b q

p + T = a + b q + T

• Ad-valorem tariff raises the slope and y-intercept of the export supply curvep = a + b q

p (1 + t) = (a + b q) (1 + t) = (1 + t) a + (1 + t) b q

59Export Supply with Ad-Valorem Tariff, t

0

Import Demand, M

Export Supply, X

Quantity (lb. of Lobster per year)

Pri

ce ($

per

lb.)

PA

PFT

MFT

PB

X(1+t)

PW +T

PW

MT

gf

60Price Elasticity of Demand, ed

ed and slope are inversely related.

Q

P

SlopeQ

P

QP

Q

P

P

Q

P

P

Q

Q

P

P

Q

Q

d

d

e

e

11

61The Price Elasticity of Supply, es• The formula for price elasticity of supply,

es, at a point is shown below. Note that it’s

the same as the formula for ed , but lacks

the absolute value notation

seQ

P

P

Q Slope

P

Q

1

62Import Demand Elasticity, em

• The formula for price elasticity of import demand,

em, at a point is shown below. Q is the quantity

of imports; P is the price; P is the change in

price;Q is the change quantity imported

Q

P

SlopeP

P

Q

Qme

1

63Import Demand Elasticity, em

• The formula for price elasticity of import demand,

em, at a point is shown below

Qm is the quantity of imports; Qd is the quantity

demanded; Qs is the quantity supplied

eee sm

sd

m

dm Q

Q

Q

Q

64Interpreting em

•em is directly related to A’s ed and es

•em is inversely related to the share of imports in A’s consumption and production

eee sm

sd

m

dm Q

Q

Q

Q

65Export Supply Elasticity, ex

• The formula for price elasticity of export supply,

ex, at a point is shown below. Q is the quantity

of exports; P is the price; P is the change in

price;Q is the change quantity exported

Q

P

SlopeQ

P

P

Qex

1

66Export Supply Elasticity, ex

• The formula for price elasticity of export supply, ex, at a point is shown below.

– Qx is the quantity of exports; Qd is the quantity consumed; Qs is the quantity produced

eee sx

sd

x

dx Q

Q

Q

Q

67Interpreting ex

•ex is directly related to B’s ed and es

•ex is inversely related to the share of exports in B’s consumption and production

eee sx

sd

x

dx Q

Q

Q

Q

68Export Supply + Specific Tariff, T

0

Import Demand, M

Export Supply, X

Quantity (lb. of Lobster per year)

PA

PFT

MFT

PB

X + TARIFF, T

PW +T

PW

MT

T

g

fA’s burden, b

69Compare em and ex

to determine A’s burden, b; 0b1• When em = ex , b = _____

• When em > ex , b _______

• When em < ex , b _______

1

1

eeb

xm

71Differing em

0

Inelastic M

Export Supply, X

Quantity (lb. of Lobster per year)

PA

PFT

MFT

PB

X + TARIFF, T

PW +T

PW

MT

T

g

fA’s burden, b

Elastic MB’s burden, 1- b

72Differing ex

0

Import Demand, M

Elastic X

Quantity (lb. of Lobster per year)

PA

PFT

MFT

PB

Elastic X + T

PW +T

PW

MT

T

g

fA’s burden, b

Inelastic X

T

Inelastic X + T

74Nominal & Effective Rates of Protection

• t = tariff

• P = price of good

• v = domestic value added with free trade

• v’= domestic value added with tariff

76Effective Rate of Protection

gj = Effective Rate of Protection on final product j

tj = nominal tariff rate on final product j

ti = nominal tariff rate on imported input I

aij = share of I in the total value of J in the absence of tariffs

ERP gt a t

ajj ij i

ij

, 1

77Welfare Cost of Tariffs as a

Percentage of GDP• Traditional: Square the tariff rate

– Ten percent tariff reduces GDP by 1%

• Tariffs & NTBs often exclude new goods– GDP loss almost twice the tariff rate

80Imperfect Substitutes

• Increased trade in final products relative to raw materials and intermediate goods

• A final-good import and competing domestic products are often imperfect substitutes

• Tariff increases demand for the domestic good

• Increased price of domestic good increases demand for the import

• Welfare cost is more difficult to estimate

81Imperfect Substitutes Small Country -- Free Market

0

DM

Quantity of Imports

Pri

ce o

f Im

por

t

PM

QM QD

0

SM

Quantity of Domestic Substitute

DD

SD

PD

Pri

ce

83Welfare Cost of a Tariff

Imperfect Substitutes

Change in Consumer Surplus

Change in Producer Surplus

Change in Government Revenue

Net Welfare Change (a.k.a. Deadweight loss)