Week 5: Economics and Politics of Import Restrictions According to what we learned in Week and 4, international trade should be beneficial to both importer and exporter countries. Nevertheless, only a handful of countries maintain a completely free trade policy. Most other countries restrict imports of certain products in order to protect domestic producers of competing goods. While the government can restrict imports in a number of ways, the most popular method is the imposition of import tariffs (also known as customs duties), which are a tax on imports. This note discusses: (1) how import tariffs affect domestic and foreign markets; (2) why import restrictions are so rampant; and as a case study, () the protection of domestic agriculture in advanced countries. Typology of Import Tariffs Import tariffs differ from a generalized sales tax in that the value of duties varies from one product to another. Although there are a variety of import tariffs, two representative types are ad valorem and specific tariffs. Figure 1. Types of import tariffs Ad valorem tariff pecific tariff omestic price ( ) omestic price ( ) 140 100 140 100 40 100 Import price ( ) 100 Import price ( ) Effective tax rate (%) Effective tax rate (%) 40 40 100 Import price ( ) 100 Import price ( ) 1
An ad valorem tariff is an import duty whose value is determined as ratio of the value of the imported good. For example, if a certain good is 100 in the world market but is subject to an ad valorem tariff of 40 percent, the after-tax import price is 100 + 0.4 100= 140. A specific tariff is an import duty whose value is set for each unit of good or service, such as 10 per ton or liter. If the government imposes a specific tax of 40 on a good whose international price is 100, the after-tax import price will be 100 + 40 = 140. The World Trade Organization (WTO), a body that monitors trade policies of member countries, regards specific tariffs less transparent and more problematic than ad valorem tariffs. As shown in the lower panels in Figure 1, a specific tariff is regressive in the sense that lower-priced goods are subject to proportionately higher taxes. ince the prices of goods tend to decline over time due to technological advancement and supplier competition, a specific tariff often provides domestic producers with an increasingly thick shield of protection. There are other types of import duties that are more complex and overtly protectionist. uch tariffs include the so-called compound tariff, which is a mixture of ad valorem and specific tariffs, and the tariff rate quota whose tax rate jumps up once the amount of imports exceeds an (often small) pre-specified quota. irect Effects of Import Tariffs Let us next consider how import tariffs affect international trade and the welfare of importing and exporting countries. As discussed in Week, switching from autarky to free trade increases the total surplus of both importer and exporter countries. To the extent that partial trade restriction is halfway between complete autarky and free trade, intuition suggests that the total surplus under import tariffs is smaller than under free trade but larger than under autarky. While this intuition is correct, there are some important subtleties. The top four panels in Figure 2 are reproductions of Figure in the Week Lecture Note. As we discussed there, shifting from autarky to free trade increases the total surplus of both importer and exporter countries by the area of the triangle A. In what follows, let us assume that we are discussing the market for rice, in which the UA has a comparative advantage while Japan has a comparative disadvantage. tarting from the situation of free trade, let us suppose that the Japanese government has decided to impose a specific tariff of T per kg of imported rice. 1 As depicted in the bottom part of Figure 2, this tariff has the effects of: (1) reducing the international price (and the domestic price in the UA) from P f w to P f w ; 2 (2) increasing Japan s domestic price from P f w to P f w + T; () reducing the amount of Japan s imports from the UA; (4) increasing the amount of production in Japan; and (5) decreasing the amount of production in the UA. The UA unambiguously suffers from Japan s import tariff, as reflected in the reduction of its total surplus by the area marked f. How about Japan? The analysis of Japan s welfare is a little complicated because the government collects tariffs in this market. As explained in Week 2, total surplus refers to the net economic value or well-being created in a particular market or industry. When the government does not intervene in the market, total surplus is simply the sum of consumer and producer surplus. But when the government receives revenue from that market, this revenue represents a new value that becomes a part of total surplus. As depicted in the bottom left panel, the imposition of the tariff reduces Japan s consumer surplus by the 1 The type of tariff is not important in the following analysis. If the government imposes an ad valorem tariff in the way that the after-tax price becomes P f w +T, the result is exactly the same. 2 The international price must fall because otherwise the amounts of Japan s imports and the UA s exports do not match each other. 2
trapezoid a+b+c+d. Therefore, Japanese consumers undoubtedly suffer from the import tariff. On the other hand, producer surplus increases by the area marked a; thus Japanese rice farmers undoubtedly gain from the tariff. ince the area a represents a transfer from Japanese consumers to producers, the import tariff is a policy that favors domestic producers at the expense of domestic consumers. Figure 2. Welfare effects of import tariffs Japan UA P f Autarky Free trade A Imports Exports A f Tariff c d a b e In addition, the Japanese government collects the tariff of the area c+e. c is a transfer from Japanese consumers to the Japanese government. This implies that a tariff has an aspect of a tax on domestic consumers. Lastly, a
comparison between the two bottom panels reveals that the area e is in fact a transfer from American rice farmers to the Japanese government. This implies that a tariff is also a tax on foreign producers. The overall effect of the rice tariff on Japan s total surplus is -( a + b + c+ d ) + a + (c + e) = e-(b + d), which may be positive or negative. This implies that import duties may in principle increase or decrease a country s social well-being. Nevertheless, this result needs to be supplemented with the following qualifications. First, imposing a tariff is likely to antagonize foreign countries. In our example, the U government will be unhappy about Japan s policy and may well impose a similar tariff on Japan s major exports. If this tariff war escalates, both countries are bound to lose. Moreover, in Figure 2 the sign of e-(b + d) depends on how much the world price P f w declines after the imposition of the tariff. If the fall in the price is minimal, the area e will be small and e-(b + d) will be negative. In the extreme situation in which P f w does not change at all (which may be the case if Japan s rice market is small relative to the amount of rice traded in the world), the net impact of the tariff on Japan s total surplus is -(b + d), which is clearly negative. This suggests that in practice, tariffs are likely to hurt both importer and exporter countries. Why the Government Protects Producers at the Expense of Everybody Else To the extent that import restrictions are bad for the country, you might wonder why so many countries resist free trade. The short answer is politics: politicians need to win elections to stay in office and protect domestic producers in order to win their votes. Figure illustrates how this votes-for-protection works. Let s suppose that Japanese politicians are now debating whether or not to liberalize importation of rice. Let us also assume that in Japan, there are 100 voters of whom are rice farmers. Once tariffs are abolished, these farmers will lose income by 1 million each. On the other hand, each of the other 97 voters will save 5,000 by gaining access to cheap foreign rice. Then the net benefit of liberalization for Japan as a whole is B A = 5,000 97-1,000,000 = 4,850,000-,000,000= 1,850,000, which is positive. This means that import liberalization is socially desirable. Net gain Figure. Voter payoffs from import liberalization 5,000 B 100 Voters A - 1,000,000 In March 2018, U President onald Trump announced that the UA would impose new ad valorem tariffs of 25 and 10 percent on imported steel and aluminum, respectively. This announcement upset a number of foreign countries, many of which immediately pledged to retaliate upon implementation of these measures. 4
ocial cost of protection (% of GP) adly, the desirability of a policy does not guarantee its implementation. In the present example, the three farmers will certainly oppose liberalization. What is at stake for these farmers is so large that they would be willing to expend a lot of money in the form of political donations, for example to block the liberalization. On the other hand, the other 97 voters are unlikely to show much interest since the saving for each consumer is only 5,000. To the extent that this is the case, a politician who takes side with the farmers will win three votes but lose no votes, whereas another politician who campaigns for liberalization will lose three votes but gain no new votes. Agriculture Protection in Advanced Countries As we discussed in Week 4, a country s comparative advantage depends in part on its stocks of factors of production. In the process of economic development, a country accumulates physical and human capital and gains comparative advantage in industries that intensively utilize these production factors. At the same time, this country will lose comparative advantage in labor-intensive agriculture unless it is exceptionally well endowed with cultivable land and climate that is hospitable to agriculture. This implies that advanced countries can protect domestic agriculture only at increasingly large social costs. This prediction is borne out in Figure 4. This figure compares the value added of domestic agriculture with the social cost of protecting this industry in a sample of OEC countries. Among the countries plotted in this graph, Australia, Chile, Mexico and the UA are well endowed with arable land whereas Japan, Korea and witzerland are poor in cultivable land. The social cost of protection includes not only the welfare loss due to tariffs and other import restrictions but also subsidies and other direct support to domestic farmers. Figure 4. Value added and social cost of agriculture in OEC countries (2014) 2 Korea Turkey 1 0 witzerland Japan Norway UA EU Australia Mexico Chile Iceland 0 1 2 4 5 6 7 8 9 Value added (% of GP) (Note) On the broken line, the gross value added of domestic agriculture equals the social cost of protection, which means this industry creates no net value. In the area left of the broken line, net value is negative. ource) OEC, Agricultural upport Estimates (http://www.oecd.org/tad/agricultural-policies/ producerandconsumersupportestimatesdatabase.htm); According to Figure 4, Australia and Chile, two major exporters of agricultural commodities, spend little to protect domestic farmers. These countries clearly possess a comparative advantage in agriculture due to their abundant land and/or suitable climate. On the other hand, some countries, such as Japan and witzerland, bear considerable costs to protect domestic farmers. In Japan, this cost is of the same magnitude as the value added of agriculture, suggesting that this sector in fact generates little or no genuine economic value. 5
Figure 5. Japan s tariffs as % of import prices (2016) (a) Agricultural products (b) Manufactured products Product category M aximum Average Product category M aximum Average Cereals & preparations 61 2. Leather, footwear, etc. 85 8.7 airy products 558 65.7 Textiles 25 5.4 Oilseeds, fats & oils 80 5.9 Clothing 1 9.0 Animal products 24 10.8 M anufactures, n.e.s. 8 1.2 Fruit, vegetables, plants 277 9.4 Chemicals 7 2.2 Other agricultural products 269.1 Electrical machinery 5 0.1 Coffee, tea 1 14. Non-electrical machinery 0 0.0 ugars and confectionery 50 20.6 Transport equipment 0 0.0 (Note) Non-ad valorem tariffs are converted to ad valorem equivalents in the same way as the lower panels of Figure 1. (ource) World Trade Organization, Tariff Profiles (http://stat.wto.org/home/wbhome.aspx?language=e). Although politicians justify agriculture protection for reasons of food security and rural development, their true motives are often elsewhere. In Japan, protection does not extend to the whole agriculture sector but is concentrated in a handful of commodities, such as rice, meat and dairy products, whose producers possess a particularly strong lobbying power. According to Figure 5, these goods are subject to import duties of exorbitant proportions that effectively deny consumers access to foreign products. uggested Readings: Reinert, Chap.6; awyer & prinkle, Chap. 8. 6