Chapter 6. The Theory of Tariffs and Quotas. Copyright 2008 Pearson Addison-Wesley. All rights reserved.

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1 Chapter 6 The Theory of Tariffs and Quotas

2 Chapter Objectives Introduce the theory of tariffs Discuss the welfare and efficiency effects of tariffs Analyze the distinction between tariffs and quotas 6-2

3 Introduction Chapters 6 and 7 provide an introduction to the theory and policy of tariffs and quotas In general, tariffs have been negotiated down to very low levels by the GATT/WTO members However, tariffs on agriculture, textiles, and apparel continue to have relatively high barriers Many developing countries have a comparative advantage in these areas and would benefit from tariff reductions 6-3

4 Analysis of a Tariff There are numerous barriers to trade Transparent barriers and non-transparent ones Quotas: direct limit on imports: regulate the quantity of imports Tariffs: indirect limit on imports: impose a tax on imports 6-4

5 Analysis of a Tariff (cont.) Tariffs and quotas encourage Consumers to switch to relatively cheaper domestic goods or to drop out of the market Producers to increase their output as demand switches from foreign to domestic goods Chapter 6 is a partial equilibrium analysis of the effects of tariffs and quotas: considers only their impact on the industry on which they are imposed, rather than their economy-wide effects 6-5

6 Analysis of a Tariff (cont.) Two key concepts in the analysis of the impact of tariffs Consumer surplus: value received by consumers in excess of the price they pay (can be measured only if the demand curve is known) Producer surplus: value received by producers in excess of the minimum price at which they are willing to produce (can be measured only if the supply curve is known) 6-6

7 FIGURE 6.1 Consumer and Producer Surplus 6-7

8 The Effect of a Tariff on Price, Output, and Consumption Assume 1. There is only one price for a good (world price P w ) 2. Foreign producers are willing to supply us with all of the units of the good we want at that price 6-8

9 FIGURE 6.2 Domestic Supply and Demand for an Imported Good 6-9

10 The Effect of a Tariff on Price, Output, and Consumption (cont.) Now assume: Government imposes a tariff of amount t. Importers will still be able to buy the good from foreign producers for P w, but they will have to pay the import tax of t. The tax is subsequently tacked onto the price to domestic consumers: price to them is P w + t=p t The consumption of the imported good subsequently decreases 6-10

11 The Effect of a Tariff on Price, Output, and Consumption (cont.) Furthermore, The domestic production of the good increases as domestic firms are able to charge a higher price while remaining competitive vis-à-vis foreign firms Finally, imports of the good decrease 6-11

12 Tariff s Effect on Resource Allocation and Income Distribution Besides the rise in prices and fall in imports, tariffs influence Inputs in domestic production: the increase in domestic production requires additional resources of land, labor, and capital to be reallocated from their prior uses Consumer surplus Producer surplus 6-12

13 FIGURE 6.3 The Effects of a Tariff 6-13

14 TABLE 6.1 Economic Effects of the Tariff in Figure 6.3 The net effect of the tariff on national welfare = gains to producers + gains to government - losses to consumers = (a + b + c + d - a - c) = b + d 6-14

15 Other Potential Costs of a Tariff A tariff may have effects that are less predictable and harder to quantify Retaliation by other countries: adds to the net loss of a tariff by hurting export markets of other industries; can escalate rapidly Innovation: tariffs reduce competitive pressures on domestic firms and thus their incentives to innovate and improve the quality of existing products 6-15

16 Other Potential Costs of a Tariff (cont.) Rent seeking: any activity that uses resources in order to capture more income without actually producing a good or survive (e.g., firms hire lobbyists to maintain tariff protection) Political systems that do not easily provide tariffs are more likely to avoid rent seeking 6-16

17 The Large Country Case Economists distinguish between small and large countries in analyzing tariffs Large country: one that imports enough of a particular product so that if it imposes a tariff, the exporting country will reduce its price of the good in order to keep its share of the large country s market In theory, large countries can improve their national welfare by imposing a tariff as long as their trading partners do not retaliate 6-17

18 FIGURE 6.4 Tariffs in the Large Country Case 6-18

19 A Comparison of Tariff Rates Since the mid-90s tariff rates in most countries have fallen Generally, tariff rates in developing nations are higher than developed nations However, developed nations often have highest tariffs in agriculture, textiles, and other laborintensive products the very products developing nations would like to export 6-19

20 FIGURE 6.5 Average Tariff Rates,

21 Effective versus Nominal Rates of Protection The amount of protection given to any one product depends not only on the tariff rate but also on tariffs on the inputs used to produce the good Nominal rate of protection: tariff rate levied on a given product Effective rate of protection: nominal rate + tariffs on intermediate inputs Value added: price of a good minus the costs of intermediate goods used to produce it (the contributions of labor and capital at a given stage of production) 6-21

22 Effective versus Nominal Rates of Protection (cont.) In sum, effective rate of protection = (VA* - VA) / VA VA = amount of domestic value added under free trade; VA* = domestic value added after taking into account all tariffs (on both final goods and intermediate inputs) 6-22

23 TABLE 6.2 Nominal and Effective Rates of Protection 6-23

24 Analysis of a Quota Quota: a quantitative restriction that specifies a limit on the quantity of imports Differences between quotas and tariffs Tariff limits imports by imposing a tax on them Unlike tariffs, quotas do not generate tariff revenue for the government Similarities between quotas and tariffs Both lead to a reduction in imports, a fall in total domestic consumption, and an increase in domestic production 6-24

25 Analysis of a Quota (cont.) Both quotas and tariffs limit imports However, the net loss from quotas can exceed that from tariffs This occurs when the lost tariff revenue resulting from quotas ends up in the hands of foreign producers as they raise their prices to match supply to demand 6-25

26 Types of Quotas Limitation on the quantity of imports: e.g., a limit on the quantity of imports from country x, or a limit on the quantity of imports from the rest of the world as a whole Import licensing requirement: forcing importers to obtain government licences for their imports; government regulates the number of licences available Voluntary export restraint (VER) (or voluntary restraint agreement, VRA): the exporting country voluntarily agrees to limit its exports for a period 6-26

27 Types of Quotas: VERs VERs have similar effects as quotas However, VERs are more popular, as they (1) do not require domestic legislative action; and (2) allow politicians to provide protection for domestic industry and to appear as proponents of free trade The use of VERs increased with the decline in tariffs that results from the global trade rounds; however, recent international negotiations have restricted the use of VERs 6-27

28 FIGURE 6.6 Analysis of a Quota: 1 Quota rents: increased profits accruing to foreign producers from the use of quotas; take the place of tariff revenue 6-28

29 FIGURE 6.7 Analysis of a Quota: 2 In the case of a tariff, the government earned revenue from imports; in the case of a quota, foreign producers receive extra profits (c) 6-29

30 The Effect on the Profits of Foreign Producers (cont.) Domestic firms prefer quotas over tariffs: postquota increase in consumer demand increases the price paid by consumers and thus the quantity of producer surplus In contrast, increase in demand for a good with an import tariff increase the quantity of imports and leaves the price of the good intact 6-30

31 The Effect on the Profits of Foreign Producers (cont.) Two circumstances that can limit quota rents If there is a large number of foreign producers, competition may limit their ability to increase prices The government can extract the extra profits from foreign producers through an auction for import licences 6-31

32 Hidden Forms of Protection Any trade barrier that reduces imports without imposing a tax has effects similar to those of a quota Tariffs: impose a tax Non-tariff barriers: quotas and non-tariff measures Non-tariff measures: hidden, non-transparent forms of protection (e.g., discriminatory government procurement; unclear safety standards; excessive bureaucratic regulations; local content requirements) 6-32