Ch 5 Tariffs

1
Ch 5 Tariffs

• Free trade, one of the
• greatest blessings which a
• government can confer on a people,
• is in almost every country unpopular.Lord
  Thomas Macauley

2
Ch 5 - Tariffs

• Tariff - Tax, or duty, levied on a product when
  it crosses a nations boundaries.
• Import Tariff
• Most common
• Imposed on imported goods
• Export Tariff
• Imposed on exported goods
• Unconstitutional in US
• Protective Tariff
• Designed to protect domestic producers from
  import competition
• Not total prohibition, just an edge for domestic
  industries
• Revenue Tariff
• Imposed specifically to raise tax revenues

3
Ch 5 - Tariffs

• Methods of Tariff Application
• Specific Tariff
• Fixed dollar amount per physical unit of product.
• Easy to administer
• ex, 5000 tariff for every television, regardless
  of the cost of the TV.
• Problems
• Degree of protection will vary inversely with
  import prices.
• Higher priced imports will pay a lower of
  tariff on goods.
• Will discourage lower priced goods more than
  higher priced goods.

4
Ch 5 - Tariffs

• Methods of Tariff Application
• Ad Valorem Tariff
• Fixed percentage of value of product.
• Can distinguish small differences in quality as
  reflected by price of good.
• Constant degree of protection for domestic
  producers during changing prices.

• Compound Tariff
• Used for goods with raw materials subject to
  tariffs.
• Combination of specific tariff for protection in
  raw material industry, and ad valorem for final
  product.

5
Ch 5 - Tariffs

• Methods of Tariff Valuation
• Free on board (FOB)
• Tariff applied to products value as it leaves
  the exporting country.

• Cost-Insurance-Freight (CIF)
• Based on commoditys total value, including
  transport costs.

6
Effective Rate of Protection
Ch 5 - Tariffs

• A nominal tariff rate gives a general idea of
  level of protection, but a final good can include
  domestic AND imported components.
• Degree of protection granted by a tariff reflects
  extent to which domestic price can rise above
  foreign.
• Need to know effective rate to determine actual
  degree of protection.
• Effective rate total increase in domestic
  production activities (value added) that a tariff
  structure makes possible (how much more expensive
  the domestic good can be).

7
Effective Rate of Protection
Ch 5 - Tariffs
Assume

• Domestic radio industry uses imported components
  to assemble radios.
• 20 of radios final value comes from domestic
  assembly (value added)
• Components are imported duty-free.
• Costs are the same in both countries.
• Foreign radios pre-tariff price 100.
• Nominal tariff on imported radios 10.

8
Effective Rate of Protection
Ch 5 - Tariffs
Amount of value that can now be added
Domestic producers can be 50 more costly in
their assembly process after tariff is
imposed. (30-20)/20 .5 50 effective rate
of protection
9
Effective Rate of Protection
Ch 5 - Tariffs
Where e effective rate of protection n
nominal tariff rate on final product a ratio
of value of imported input to value of final
product (what of final good is imported?) b
nominal tariff rate on imported component
10
Effective Rate of Protection
Ch 5 - Tariffs
11
Effective Rate of Protection
Ch 5 - Tariffs
EXAMPLE To produce 500,000 worth of a certain
type of cloth, the textile industry imports
400,000 worth of raw cotton. The nominal tariff
rates for importing these goods is 5 for the
cotton and 15 for the finished cloth. What is
the effective rate of protection for the textile
industry?
12
Effective Rate of Protection
Ch 5 - Tariffs
Domestic producer of cloth can increase the value
added portion (ie, assembly of imported
components) up to 55 and still be competitive
with foreign textile market.
13
Effective Rate of Protection
Ch 5 - Tariffs
EXAMPLE A DVD player costs 500 in US and
Canada prior to the imposition of tariffs. In
US, 150 of value is added to imported
components. The nominal tariff on the imported
components is 10. After the imposition of a
nominal tariff rate of 20 on imported DVDs,
what is the effective rate of protection for
domestic DVD producers?
14
Effective Rate of Protection
Ch 5 - Tariffs
Domestic producer of DVD players can increase the
value added portion of their product by up to 43
and match the price of the foreign DVD player.
This DOES NOT MEAN costs went up by that much,
just the price!
15
Effective Rate of Protection
Ch 5 - Tariffs
What happens to effective rate as a increases?
Effective rate increases Domestic producer can
enjoy a greater degree of protection by
increasing the imported component of their
product.
16
Effective Rate of Protection
Ch 5 - Tariffs
What happens to effective rate as b increases?
Effective rate decreases Domestic producer can
enjoy a greater degree of protection if the
nominal tariff on imported component is reduced.
17
Effective Rate of Protection
Ch 5 - Tariffs
When inputs enter a country at a low tariff rate,
and final good is protected at a high tariff
rate, the effective rate of protection tends to
be high (nominal rate understates degree of
protection). BUT, if tariff on inputs is greater
than tariff on final good, the nominal rate would
overstate the effective rate.
18
Effective Rate of Protection
Ch 5 - Tariffs
Which will prevail? Depends on whether a nation
wants to protect the suppliers of raw materials
or producers of the end product.
19
Effective Rate of Protection
Ch 5 - Tariffs
Tariff Escalation Tariff structure where a nation
tends to have higher nominal rates for each
subsequent stage of production (ex, raw materials
have low nominal tariffs while end products have
high nominal tariffs).
Nominal Rate
Raw Materials
Final Goods
Stages of Production
20
Tariff Escalation
Ch 5 - Tariffs

• Industrialized nations tend to engage in tariff
  escalation.
• Tariff escalation encourages developing nations
  to specialize in raw materials, and discourages
  entry into higher stages of production.
• If nations push for lower tariffs for their raw
  products, the effective rate is magnified for the
  producers of the final product (manufacturing
  sector), worsening chance of entry into higher
  stages of production for the developing nations.

21
Production Sharing / Offshore Assembly
Ch 5 - Tariffs

• Production sharing occurs when different phases
  of a products manufacture are performed in more
  than one country.
• Example, US makes electronic components, ships
  them to Mexico for assembly with lower labor
  costs, then the final product is sent back to the
  US for distribution.
• Benefits
• Provides a way for domestic manufacturers of
  goods with labor-intensive phases to take
  advantage of lower costs abroad while maintaining
  competitiveness and market share domestically.
• Easier penetration into foreign markets where
  trade barriers restrict direct export of the
  final product.

22
Production Sharing / Offshore Assembly
Ch 5 - Tariffs

• OAP (offshore-assembly provision) provides
  favorable treatment for goods assembled abroad
  from US-manufactured components.
• When a final good comes into the US, the tariff
  is applied only to the portion of the good that
  originated elsewhere.
• Incentive for US producers to seek cheaper
  off-shore labor for assembly process.
• Encourages countries that want to export to the
  US to buy components from US.

23
Postponing Import Duties
Ch 5 - Tariffs

• Bonded Warehouses
• Customs facility where imported goods can be
  stored.
• No tariff is levied until goods leave the
  warehouse.
• Importer can avoid lump costs until goods are
  sold.
• Foreign Trade Zones (FTZs)
• Seaports, inland distribution points.
• Manufacturing process can take place.
• Tariff is deferred until final good is shipped
  out of the FTZ.
• No tariff on scrap or waste.

24
Trade Welfare Effects
Ch 5 - Tariffs

• Small Nation Model
• Nations imports make up a small fraction of
  world market supply
• Nation is a price taker, not important enough to
  impact the world market.

25
Trade Welfare Effects - Small Nation Model
Ch 5 - Tariffs
SDOM
P
E
PE
DDOM
QE
Q

• Before Trade
• Nation consumes and produces at equilibrium price
  and quantity (E)

26
Trade Welfare Effects - Small Nation Model
Ch 5 - Tariffs
SDOM
P
E
PE
F
SWORLD-FREE TRADE
PFT
DDOM
QE
Q
QS - DOM
QD-FREE
imports

• With Free Trade
• Nation consumes at F, domestic producers reduce
  output to QS-DOM

27
Trade Welfare Effects - Small Nation Model
Ch 5 - Tariffs
SDOM
P
E
PE
G
SWORLD-TARIFF
PT
1,000
F
SWORLD-FREE TRADE
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF
imports

• With Tariff (1,000)
• Nation consumes at G, domestic producers increase
  output to QS-TARIFF

28
Trade Welfare Effects - Small Nation Model
Ch 5 - Tariffs
SDOM
P
E
PE
G
SWORLD-TARIFF
PT
1,000
F
SWORLD-FREE TRADE
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF
imports
With Tariff (1,000)
29
Trade Welfare Effects - Small Nation Model
Ch 5 - Tariffs
SDOM
P
Protective Effect Loss of resources used to
produce additional output at higher cost, less
efficient. Loss of welfare to economy.
E
PE
G
SWORLD-TARIFF
PT
A
B
1,000
F
SWORLD-FREE TRADE
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF
imports
With Tariff (1,000)
30
Trade Welfare Effects - Small Nation Model
Ch 5 - Tariffs
SDOM
P
Revenue Effect Transfer of welfare from private
to public sector (tariff x imports). No gain or
loss of welfare.
E
PE
G
SWORLD-TARIFF
PT
A
B
C
1,000
F
SWORLD-FREE TRADE
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF
imports

• With Tariff (1,000)

31
Trade Welfare Effects - Small Nation Model
Ch 5 - Tariffs
SDOM
P
Consumption Effect Consumption decreased due to
higher prices (law of demand). Loss of welfare.
E
PE
G
SWORLD-TARIFF
PT
A
B
C
1,000
F
D
SWORLD-FREE TRADE
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF
imports

• With Tariff (1,000)

32
Trade Welfare Effects - Small Nation Model
Ch 5 - Tariffs
SDOM
P
E
PE
G
SWORLD-TARIFF
PT
A
B
C
1,000
F
D
SWORLD-FREE TRADE
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF
imports

• With Tariff (1,000)
• A and C Transfers of welfare, no gain or loss
  to economy
• B and D Deadweight loss to economy, loss of
  welfare
• Net effect of tariff loss to economy equal to B
  D.

33
Trade Welfare Effects
Ch 5 - Tariffs

• Large Nation Model
• Nations imports make up a relatively large
  portion of world market supply
• Nation is a price maker, large enough to impact
  the world market.
• If US imposes tariff, price increases for
  domestic consumers, quantity demanded falls. May
  lead to exporting nation lowering prices to US to
  limit loss of sales.
• Burden of tariff is shared between consumers and
  foreign producers.
• Terms of trade may improve for importing nation
  with price reduction. Therefore, large nation
  can make itself better off with appropriate
  tariff policy.

34
Trade Welfare Effects - Large Nation Model
Ch 5 - Tariffs
SDOM
P
E
PE
DDOM
QE
Q

• Before Trade
• Nation consumes and produces at equilibrium price
  and quantity (E)

35
Trade Welfare Effects Large Nation Model
Ch 5 - Tariffs
SDOM
P
E
PE
SWORLD-FREE TRADE
F
PFT
DDOM
QE
Q
QS - DOM
QD-FREE
imports

• With Free Trade
• Nation consumes at F, domestic producers reduce
  output to QS-DOM

36
Trade Welfare Effects - Large Nation Model
Ch 5 - Tariffs
SDOM
P
SWORLD-TARIFF
E
PE
SWORLD-FREE TRADE
PT
G
1,000
F
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF
imports

• With Tariff (1,000)
• Nation consumes at G, domestic producers reduce
  output to QS-TARIFF

37
Trade Welfare Effects - Large Nation Model
Ch 5 - Tariffs
SDOM
P
Redistributive Effect Surplus shifted from
consumer to producer No loss of welfare, just
transfer.
SWORLD-TARIFF
E
PE
SWORLD-FREE TRADE
PT
G
1,000
A
F
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF
imports

• With Tariff (1,000)
• Nation consumes at G, domestic producers reduce
  output to QS-TARIFF

38
Trade Welfare Effects - Large Nation Model
Ch 5 - Tariffs
SDOM
P
Protective Effect Loss of resources used to
produce additional output at higher cost, less
efficient. Loss of welfare to economy.
SWORLD-TARIFF
E
PE
SWORLD-FREE TRADE
PT
G
1,000
A
F
B
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF
imports

• With Tariff (1,000)
• Nation consumes at G, domestic producers reduce
  output to QS-TARIFF

39
Trade Welfare Effects - Large Nation Model
Ch 5 - Tariffs
Revenue Effect Transfer of welfare from private
to public sector (tariff x imports). No gain or
loss of welfare.
SDOM
P
SWORLD-TARIFF
E
PE
SWORLD-FREE TRADE
PT
G
1,000
A
C
F
B
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF
imports

• With Tariff (1,000)
• Nation consumes at G, domestic producers reduce
  output to QS-TARIFF

40
Trade Welfare Effects - Large Nation Model
Ch 5 - Tariffs
Consumption Effect Consumption decreased due to
higher prices (law of demand). Loss of welfare.
SDOM
P
SWORLD-TARIFF
E
PE
SWORLD-FREE TRADE
PT
G
1,000
A
C
F
D
B
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF
imports

• With Tariff (1,000)
• Nation consumes at G, domestic producers reduce
  output to QS-TARIFF

41
Trade Welfare Effects - Large Nation Model
Ch 5 - Tariffs
Terms of Trade Effect Large nation enjoys
improved terms of trade, increase in welfare.
SDOM
P
SWORLD-TARIFF
E
E
PE
SWORLD-FREE TRADE
PT
G
1,000
A
C
F
B
D
PFT
DDOM
Q
QS
QD-FREE
QS-TARIFF
QD-TARIFF

• With Tariff (1,000)
• Nation consumes at G, domestic producers reduce
  output to QS-TARIFF
• If EgtBD, welfare increase
• If EBD, welfare constant
• If EltBD, welfare loss
• Optimum tariff where positive difference
  between gains from improved terms of trade and
  loss of import trade volume is maximized.

imports
42
Arguments for Trade Restrictions
Ch 5 - Tariffs

• Job Protection
• Argument
• Cheap foreign goods undercut domestic production,
  resulting in loss of domestic jobs.
• Flaw
• Ignores link between importing and exporting
  industries.
• Job losses are more conspicuous than gains.
• Trade barriers raise employment in protected
  industries, and in industries that are primary
  suppliers.
• BUT job losses occur in industries that purchase
  protected goods, costs passed along to consumers,
  reducing sales.
• Exporters pay for import tariffs.

43
Arguments for Trade Restrictions
Ch 5 - Tariffs

• Protection Against Cheap Foreign Labor
• Argument
• US wages are high relative to other countries.
  Tariffs should make up for the difference between
  labor costs to protect domestic jobs.
• Flaw
• Ignores link between efficiency, wages, and unit
  costs.
• If domestic labor is more productive than cheaper
  foreign labor, domestic labor costs may still be
  competitive.
• Wages are based on MRPL (marginal revenue product
  of labor).

44
Arguments for Trade Restrictions
Ch 5 - Tariffs

• Maintenance of Domestic Standard of Living
• Argument
• Tariffs maintain a high level of income and
  unemployment, stimulate domestic activity,
  raising standard of living.
• Flaw
• Assumes first two arguments are valid, and
  ignores redistribution of gains resulting from
  tariffs.
• A tariff that improves standard of living in one
  country does so at the expense of other
  countries.
• Nations adversely affected will retaliate,
  resulting in lower welfare for both nations.
• Beggar-thy-neighbor policies tariffs designed
  to enhance standard of living at the expense of
  trading partners.

45
Arguments for Trade Restrictions
Ch 5 - Tariffs

• Infant Industry Argument
• Argument
• Mature foreign businesses can drive young
  domestic businesses out by being more efficient.
  Nations should temporarily shield new industries
  until they have developed enough to compete.
• Flaw
• Industrialized nations typically dont have
  infant industries.
• Protective tariffs are difficult to remove once
  in place.
• Which industries can realize comparative
  advantage and merit protection?
• May be valid for developing nations to change
  their comparative advantage position.

46
Ch 6 Non-Tariff Trade Barriers (NTBs)

• If you put the
• federal government in
• charge of the Sahara Desert, in
• five years there'd be a shortage of sand.
• Milton Friedman

47
Ch 6 NTBs

• Quota Quantitative restriction
• Import Quota
• Restriction on quantity of goods that can be
  imported during specific time period.
• Generally limits quantities below free trade
  level (much like price ceilings).
• Import quotas on manufactured goods outlawed by
  WTO. Current quotas usually agricultural.
• Global Quota
• Specified amount imported each year, but origin
  not specified.
• Example, 10 million pounds of sugar per year, no
  matter the country of origin.
• Selective Quota
• Allocations to specific countries
• Example, Canadas 4 million lbs Mexicos 3
  million lbs Brazils 3 million lbs 10 million
  total.

48
Ch 6 NTBs

• Quota Quantitative restriction
• Welfare Effects
• Supply side restriction
• Loss of consumer surplus from increase in
  domestic and imported price (same welfare concept
  as tariffs)
• Same deadweight losses (protective effect and
  consumption effect)
• Surplus transferred from consumers to producers.
• Revenue Effect
• Not a tariff, so revenue doesnt automatically go
  to the government. Will accrue to whomever has
  market power.
• If domestic buyers organize to buy goods at lower
  than market price, gain will go to them in form
  of profits.
• If foreign producers organize to sell to domestic
  distributors at already heightened price, they
  will accrue profits.
• Government CAN still accrue gains from revenue
  effect by selling import licenses.

49
Ch 6 NTBs

• Quota Quantitative restriction
• Government Can Sell Import Licenses
• Quotas push domestic price above world price.
• Profits can be enjoyed by domestic retailers if
  they buy low in world market and sell high in
  domestic market.
• Retailers would likely pay for the right to
  import a portion of the limit amount of goods.
• By auctioning licenses to import, government can
  transfer some or all of the gains to government
  revenue.
• Competition for the licenses would push the
  license price up to the point that eliminates all
  of the retailer profit and transfers to
  government revenue.
• This makes quota outcomes much like tariffs.

50
Ch 6 NTBs

• Tariff-Rate Quota (aka 2-tier tariff)
• Certain number of goods are imported at one
  tariff rate, any quantity above that imported at
  a higher rate.
• Example up to 5 tons of sugar can be imported at
  a 10 tariff, anything above 5 tons will be
  imported at 20 tariff rate.
• Quota in this case is 5 tons.
• Within-quota rate 10
• Over-quota rate 20

51
Ch 6 NTBs
SDOM
P
DDOM
PE
SWORLD-TARIFF 20
P20
480
P10
SWORLD-TARIFF - 10
440
PFT
SWORLD-FREE TRADE
400
Q
5
10
15
20
25
30
35
40
imports

• Tariff-Rate Quota (aka 2-tier tariff)
• Example up to 5 tons of sugar can be imported at
  a 10 tariff, anything above 5 tons will be
  imported at 20 tariff rate.

52
Ch 6 NTBs
SDOM
P
DDOM
PE
SWORLD-TARIFF 20
P20
480
P10
SWORLD-TARIFF - 10
440
PFT
SWORLD-FREE TRADE
400
Q
5
10
15
20
25
30
35
40
imports

• Tariff-Rate Quota (aka 2-tier tariff)
• At 20 tariff rate, domestic production is 15
  tons, domestic consumption is 30 tons, so imports
  15 tons.
• First 5 tons imported at 10 tariff rate, next 10
  tons at 20 tariff rate.
• Even though different tariff rates are paid for
  the sugar, ALL of the sugar will be sold for the
  same price (480).

53
Ch 6 NTBs
SDOM
P
DDOM
PE
SWORLD-TARIFF 20
P20
480
E
P10
SWORLD-TARIFF - 10
440
G
F
PFT
SWORLD-FREE TRADE
400
Q
5
10
15
20
25
30
35
40
imports

• Welfare Effects
• E Redistributive effect
• F Protective effect
• G Consumption Effect
• F G deadweight loss to economy

54
Ch 6 NTBs
SDOM
P
DDOM
PE
SWORLD-TARIFF 20
P20
480
C
D
E
P10
SWORLD-TARIFF - 10
440
G
F
A
B
PFT
SWORLD-FREE TRADE
400
Q
5
10
15
20
25
30
35
40
imports

• Revenue Effects
• A Import x 10 tariff (revenue from 1st 5 tons)
• BC Import x 20 tariff (revenue from next 10
  tons)
• D Windfall profit

55
Ch 6 NTBs
SDOM
P
DDOM
PE
SWORLD-TARIFF 20
P20
480
C
D
E
P10
SWORLD-TARIFF - 10
440
G
F
A
B
PFT
SWORLD-FREE TRADE
400
Q
5
10
15
20
25
30
35
40
imports
Who Gets Windfall Profits (D)? If importers can
buy all sugar at 400 then resell at 480,
windfall profits will accrue to them. BUT, if
suppliers have market power, and can push price
up, some or all of windfall profits will accrue
to them, representing a loss to the economy.
56
Ch 6 NTBs

• Orderly Marketing Agreements (OMAs)
• Agreement negotiated between trading partners.
• Usually takes form of Voluntary Export Restraints
  (VERs), voluntary quotas.
• These deals usually struck to avoid more
  restrictive barriers.
• Revenue Effect
• Under standard import quota, revenue accrues to
  side with most market, or bargaining, power.
• With export quota, foreign exporter captures
  revenue because the restriction is purely supply
  side, drives up price.
• For this reason, exporters prefer negotiating
  their own export restrictions rather than facing
  levies of importing countries.

57
Ch 6 NTBs

• Domestic Content Requirements
• Minimum of goods total value must be produced
  domestically.
• Causes domestic input demand to increase, putting
  upward pressure on price of those inputs.

58
Ch 6 NTBs

• Domestic Content Requirements
• Minimum of goods total value must be produced
  domestically.
• Causes domestic input demand to increase, putting
  upward pressure on price of those inputs.

• With no content requirement, importing nation
  (US) demands Q1 at price P1. Exporting nation
  (Japan, gets CD in revenue (Price x quantity).
• If US institutes content requirements, Japan will
  use US resources and begin to assemble cars in
  US.
• Price of cars will be pushed up because US
  resources are more costly, P1 to P2, Q1 to Q2.
  (How do we know that?)

P
Market for Japanese Cars in US
SFOR1
P1
C
D
DDOM
Q1
Q
59
Ch 6 NTBs

• Domestic Content Requirements
• Minimum of goods total value must be produced
  domestically.
• Causes domestic input demand to increase, putting
  upward pressure on price of those inputs.

• Japanese resource owners (L) lose CD in income,
  and US resource owners (auto workers) gain AC
  income, less payments to Japans management and
  return on K.
• Consumer surplus falls by AB
• B deadweight loss
• A welfare transferred from domestic consumers
  to domestic resource owners.

P
Market for Japanese Cars in US
A
B
SFOR1
P1
C
D
DDOM
Q1
Q
60
Ch 6 NTBs
Subsidies Can take form of cash, tax
concessions, insurance perks, low interest loans,
etc.

• Domestic Subsidies
• Granted to import-competing industries.
• Subsidies increase producer surplus, but also
  have deadweight loss to society.
• Usually, loss of welfare is less for subsidy than
  tariffs or quotas.
• Tariffs and quotas distort choices as consumers
  respond to higher prices.
• Subsidies dont increase prices for consumers so
  there is no distortion of consumer choices
• Subsidies have to be paid for ultimately from tax
  revenues, so burden is widespread, difficult to
  pinpoint.

61
Ch 6 NTBs
Subsidies Can take form of cash, tax
concessions, insurance perks, low interest loans,
etc.

• Export Subsidies
• Lowers price of goods in world market to increase
  competitiveness.
• Worsens terms of trade because price paid by
  foreign consumers is less than domestic, but
  export volume increases.
• Net effect depends on elasticity of good.
  (remember elasticity?)