The Effective Rate

CHAPTER 6CHAPTER 6

International EconomicsInternational Economics, Second Editionby W. Charles Sawyer and Richard L.

Sprinkle

Prepared by Iordanis Petsas

TariffsTariffs

Copyright © 2006 Pearson Education, Inc. Slide 6-2

IntroductionTypes of trade barriersTariffs: Preliminary detailsArguments for tariffsThe effective rate of protectionAnalyzing nominal protection Summary

Chapter OrganizationChapter Organization


IntroductionIntroduction

This chapter is focused on the following questions:What are the effects of various trade policy instruments?

Who will benefit and who will lose from these trade policy instruments?

What are the costs and benefits of protection?Will the benefits outweigh the costs?

What should a nation’s trade policy be?Example: Should the U.S. use a tariff or an import quota to protect

its automobile industry against competition from Japan and South Korea?


Types of Trade BarriersTypes of Trade Barriers

1. Tariffs or duties = a tax on imports2. Quotas = physical limitation on the

amount that can be imported in a year. 3. Subsidies to exporters or import

competing goods = direct or indirect payments to producers.

4. So called ‘Buy national’ treatment = preferential treatment for domestic products in government contracts.


Types of Trade Barriers Types of Trade Barriers (continued) (continued)

5. Packaging and labeling requirements

6. Antidumping and countervailing duties.

7. Intellectual property rights


Tariffs: Some Tariffs: Some Preliminary DetailsPreliminary Details

Tariff = a tax on imported good.Purpose: to generate revenue or to protect a domestic

industry from foreign competitionRevenue tariff = an tax levied on a good that

is not domestically produced that generates revenue for governments. Most commonly used in developing countries

Protective tariff = a tax levied on an import that is designed to protect domestic competitors.In 2003, U.S. tariffs generated tax revenues of $19.9 billion.


Tariffs can also be classified as:Specific tariffs: Taxes that are levied as a

fixed charge for each unit of goods importedA specific tariff is regressive.

Example: A specific tariff of $1,000 on each imported auto would yield a high percentage tariff relative to the imported price of low-priced Hyundais and a low percentage tariff relative to the imported price of high-priced Porsches.

A specific tariff encourages domestic producers to produce less expensive goods.



Ad valorem tariffs: Taxes that are levied as a fraction of the value of the imported goodsExample: A 5% ad valorem tariff on autos with

an international price of $10,000 means that customs officials collect the fixed sum of $500.

Importers have an incentive to under-invoice the price of the imported good.

Ad valorem tariffs are more difficult for a country to administer than specific tariffs.



Compound Duty (tariff): a combination of an ad valorem and a specific tariffCommon on agricultural products whose

prices tend to fluctuate.



Table 6-1:Selected U.S. Tariffs



Methods of Valuing ImportsFree alongside (F.A.S.) price

The price of the imported good as the foreign country’s market price before loading the good for shipment to the importing country

Free on Board (FOB) priceThe price of the imported good as the foreign

country’s market price plus the cost of loading the good in the means of conveyance



Cost, Insurance, and Freight (C.I.F.) priceThe price of the imported good as the foreign

country’s market price plus the cost of loading the goods into the means of conveyance plus all inter-country transportation costs up to the importing country’s port of entry.

Most countries use the C.I.F. price for calculating ad valorem tariffs.

BUT the U.S. uses the FOB price for calculating ad valorem tariffs.



Arguments for TariffsArguments for TariffsInfant Government Argument

Developing countries use tariffs as a way to generate revenue.

National Defense ArgumentCertain industries need to be protected from foreign competition

to ensure an adequate output of the industry in the case of conflict.

Two problems arise with this argument:It is hard to identify the industries that are essential for national

defense.A tariff is a costly means of protection. Instead, a domestic

production subsidy should be used to encourage domestic production of the good.

The next slide depicts the effects of a domestic production industry.


Tariffs, Trade and JobsThe imposition of a tariff in a particular industry produces more

jobs in that particular industry but fewer jobs in other industries.The overall level of employment is unchanged in the short-run whereas

in the long-run it may decrease.An economy with a lot of tariffs will usually grow more slowly than a

more open economy.

Arguments for TariffsArguments for Tariffs


Infant IndustriesFrom World War II until the 1970s many developing countries

attempted to accelerate their development by limiting imports of manufactured goods to foster a manufacturing sector serving the domestic market.

The most important economic argument for protecting manufacturing industries is the infant industry argument.

Senile Industry ProtectionMany developed countries protect industries that are old.

For example, the apparel industry in most developed countries experience this type of protection.

Arguments for TariffsArguments for Tariffs


Analyzing protectionAnalyzing protection

Distinguish between nominal and effective protection

Nominal protection is the degree by a tariff allows a domestic import competitor to raise its price above the world price.

Nominal protection is (PT – PF)/PF


The Effective Rate of The Effective Rate of ProtectionProtection

Effective protection is a better measure since it nets out protection on a firm’s inputs from its protection on output . That is, a firm may need to pay above world prices for its inputs because of the tariff structure while it is able to set a price for its output that is above world prices.

ERP = (Tf – aTc)/(1-a)Where Tf = tariff rate on imported final product

Tc = tariff rate on the imported components a = share of components in output value at free

trade prices


The Effective The Effective Rate of ProtectionRate of Protection

Effective Rate of Protection One must consider both the effects of tariffs on

the final price of a good, and the effects of tariffs on the costs of inputs used in production.The actual protection provided by a tariff will not

equal the tariff rate if imported intermediate goods are used in the production of the protected good.


Example of ERP with different nominal protection Example of ERP with different nominal protection on output and inputson output and inputs

Suppose that: (1) the world price of a truck is $20,000; (2) inputs are $12,000 per truck; (3) labor costs are $4,000/truck and (4) profits are $4,000/truck.

Compare these tariff structures Tf = 25%, Tc = 0% TO Tf = 25%, Tc = 25% TO Tf = 25%, Tc = 50% ERP = (25% - 0.6 x 0%)/(1-0.6) = 25%/40% = 62.5%ERP = (25% - 0.6 x 25%)/(1-0.6) = 10%/40% = 25%ERP = (25% -0.6 x 50%)/(1 – 0.6) = -5%/40% = -12.5% • In each case, nominal protection on output is the same. However,

effective protection falls as the nominal protection on inputs rises.


The relationship among ERPS and The relationship among ERPS and nominal protection on output and nominal protection on output and

inputsinputs

If Tf > Tc = then ERP > Tf This is known as tariff escalation and is common in many countries’ tariff structures.

If Tf = Tc = then ERP = Tf

If Tf < Tc = then ERP < Tf

What is the meaning of a a negative ERP? If ERP<0, then the industry is effectively taxed – rather

than being effectively protected.This can happen with high tariffs on inputs or export taxes

on products that are exported.


The Effective The Effective Rate of ProtectionRate of Protection

Structure of ProtectionTariff escalation encourages the final

processing of imported inputs to occur in developed countries

It discourages the processing of intermediate products into final goods in the foreign country where the intermediate products are produced.


Measuring Nominal ProtectionMeasuring Nominal Protection

We now return to nominal protection.First, we will examine the effects of a

tariff.To do so, we need to review consumer

and producer surpluses.



Figure 6-1: Domestic Demand and Supply of Cloth With Consumer and Producer Surplus

D

P1

EP

Q

E

P2

Producer Surplus

Consumer Surplus

Price of Cloth

Quantity of Cloth

S

Quantity of Cloth

Price of Cloth

Q

P


Consumer SurplusMeasures the amount a consumer gains from a

purchase by the difference between the price paid and the price willing to pay

Derived from the market demand curveGraphically, it is equal to the area under the demand

curve and above the price (triangular area P1EP)

Example: Suppose a person is willing to pay $100 per jacket, but the price is only $50. Then, the consumer surplus gained by the purchase of a jacket is $50.

The Welfare Effects of Trade The Welfare Effects of Trade in an Individual Productin an Individual Product


Producer SurplusMeasures the amount a producer gains from a

sale by the difference between the price received and the price willing to sell

Derived from the market supply curveGraphically, it is equal to the area above the

supply curve and below the price (triangular area P2FP)

Example: A producer willing to sell a jacket for $20 but receiving a price of $50 gains a producer surplus of $30.




S

D

E

Price of Cloth

Quantity of Cloth

P1

Q

P

P2

Consumer Surplus

Producer Surplus

Figure 6-2: Domestic Demand and Supply of Cloth with Consumer and Producer Surplus


Useful definitions:The terms of trade is the relative price of the

exportable good expressed in units of the importable good.

A small country is a country that cannot affect its terms of trade no matter how much it trades with the rest of the world.

The analytical framework will be based on either of the following: Two large countries trading with each otherA small country trading with the rest of the world

The Economic Effects of Tariffs – The Economic Effects of Tariffs – Small and Large Country CasesSmall and Large Country Cases


The Effects of a tariff for a Small CountryLet a government impose a specific tariff of T on cloth

imports.In the absence of tariff, the world price of cloth (Pw) would be

equalized in both countries.Assume the country is small.With the tariff in place, the domestic price of cloth rises to Pt

Home producers supply more and home consumers demand less due to the higher price, so that fewer imports are demanded.

Thus, the volume of cloth traded declines due to the imposition of the tariff.

The next graph describes these effects

Small country CaseSmall country Case


The Economic Effects of TariffsThe Economic Effects of Tariffs

S

D

Price of Cloth

Quantity of Cloth

P1

P

P2

a b c

Q

d

Q4 Q2Q3Q1

Pw

Pt

Tariff = T

Figure 6-4: Domestic Effects of a Tariff for a Small Country

-a+b+c+d: loss in consumer surplus - a: a transfer of consumer surplus to producer surplus- b: cost of resources transferred from their best use to the production of more cloth (Q1 to Q3)- c: tariff revenue that the domestic government collects- a + c: redistributed from consumers to the producers and government- b+d: net loss to society (dead-weight loss) of consumer welfare


The large country case of a The large country case of a tarifftariff

If a country is large enough to influence world prices, then there may be a ‘terms of trade’ gain that partially or fully offsets the deadweight losses of a tariff.

Let the two supply curves on the left hand side of the next slide represent supply conditions at home and abroad.


Deriving total supplyDeriving total supply

P P P

Home supply Foreign supply Total supply


A confusing diagram – to be A confusing diagram – to be explained in classexplained in class

P

Q

World supply + tariff

World supply

No tariff situation

Tariff situation

Share to importer

Share to exporter There are deadweight losses as the

domestic price rises and terms of trades gains as exporters lower their prices.

Losses

gains


Calculating gains and lossesCalculating gains and losses

Label gains as x and y.

Label losses as z.

Then a tariff yields gains if z > x + y

And losses if z < x + y.


An example you might seeAn example you might seeSuppose that a large country levies a tariff that

causes deadweight losses of $100 million.However, the tariff causes import prices (net of the

tariff) to fall by $10 per unit.How many units must the country import in order for

the tariff to provide net gains?

ANSWER: Losses = $100 million < Gains = $10 x imports. So imports must be > $100 million/$10 = 10 million units.


SummarySummary

A tariff is a tax on imports and it has important effects on consumption, production, and the structure of a domestic economy.

There are several types of tariffs.Revenue tariffsProtective tariffsSpecific tariffsAd valorem tariffsCompound tariffs


SummarySummary

The administration of tariffs is complicated because a country’s customs valuation can be based on one of three different methods of valuing imports.The free alongside (F.A.S.) price The free on board (F.O.B.) priceThe cost, insurance, and freight (C.I.F.) price

The welfare effects of tariffs can be measured by using the concepts of consumer and producer surpluses.


SummarySummary

The imposition of a tariff raises the price of the imported good and results in the following:Fewer importsA decrease in consumer surplusAn increase in producer surplusAn increase in government revenue

A large country might benefit from the imposition of the tariff whereas a small country that cannot affect the foreign export price will always lose from it.

The Effective Rate

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