Import Tariffs and Quotas Under Perfect Competition 1 A Brief History of the World Trade...

Import Tariffs and Quotas Under Perfect Competition

1 A Brief History of the

World Trade Organization

2 The Gains from Trade

3 Import Tariffs for a

Small Country4

Import Tariffs for a Large Country

5 Import Quotas

6 Conclusions

8

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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Chapter Outline

• Introduction• A Brief History of the World Trade

Organization• The Gains from Trade

Consumer and Producer Surplus Home Welfare

No-Trade Free Trade for a Small Country Gains from Trade

Home Import Demand Curve


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Chapter Outline

• Import Tariffs for a Small Country Free Trade for a Small Country Effect of the Tariff

Effect of the Tariff on Consumer Surplus Effect of the Tariff on Producer Surplus Effect of the Tariff on Government Revenue Overall Effect of the Tariff on Welfare Production Loss Consumption Loss

Why are Tariffs Used?


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Chapter Outline

• Import Tariffs for a Large Country Foreign Export Supply Effect of the Tariff

Terms of Trade Home Welfare Foreign and World Welfare

• Import Quotas Import Quota in a Small Country

Free Trade Equilibrium Effect of the Quota Effect on Welfare

• Allocation of Quota


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Chapter Outline

Costs of Import Quotas in the US Growth in Exports from China Welfare Cost of MFA Import Quality Reaction of the United States and Europe

• Conclusions


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Learning Objectives

• Understand what a trade policy is and why it is used

• Understand the history of the World Trade Organization (WTO) and the General Agreement on Tariffs and Trade (GATT)

• Understand what a tariff is and why it is used• Understand and be able to explain the effect

of a tariff on a small country• Understand and be able to explain the effect

of a tariff on a large country


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Learning Objectives

• Understand how a large country could potentially gain from implementing a tariff

• Understand what a quota is and why it is used

• Understand and be able to explain the effects of a quota on a country

• Understand how the quota can have costs even greater than tariffs


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Introduction

• During the 2000 presidential campaign, President George W. Bush promised to consider implementing a tariff on the imports of steel

• This was a political move to secure votes in large steel-producing states as the tariffs would “protect” the domestic producers of steel

• The steel tariff is an example of a trade policy—a government action meant to influence the amount of international trade


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Introduction

• Because gains from trade are unevenly spread, producers often feel the government should help them limit losses due to competition from trade

• Trade policy can include the use of import tariffs (taxes on imports), import quotas (limits on imports), and subsidies for exports

• This chapter will focus on the use of tariffs and quotas as trade policy

• The international governing body, the World Trade Organization (WTO), acts as a forum for trade issues between countries


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Introduction

• We will look at the history of the WTO, beginning with its precursor, the General Agreement on Tariffs and Trade (GATT)

• We will then examine in detail the most commonly used trade policy, the tariff, looking at why they are used and the consequences of their use

• The chapter will also examine the use of import quotas, showing that although their costs are similar to tariffs, they can also be greater


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Introduction

• Given the potentially greater costs of quotas, they have been greatly reduced under the WTO

• We will assume that firms are perfectly competitive. They produce a homogeneous good and are small compared to the market

• Under perfect competition, each firm is a price-taker in its market

• Imperfect competition will be evaluated in the next chapter


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A Brief History of the World Trade Organization

• When peace was reestablished following WWII, representatives of 44 countries met in Bretton Woods, NH, to discuss the rebuilding of Europe and issues with high trade barriers and unstable exchange rates

• The outcome was an agreement outlining an international system of free trade, convertible currencies, and fixed exchange rates

• As part of this Breton Woods Agreement, the GATT was established in 1947 to reduce barriers to trade between nations


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• Under GATT, countries met periodically to negotiate for lower trade barriers between them

• Each meeting was named for the location where it took place and at the Uruguay Round, the WTO was established

• The WTO greatly expanded GATT by adding rules that govern an expanded set of global interactions through binding agreements

• The most recent round of the WTO was the Doha Round, in Doha, Qatar November 2001


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• Some Articles of GATT which still govern trade in the WTO:1. A nation must extend the same tariffs to all

trading partners that are WTO members. This is the “most favored nation” clause

2. Tariffs may be imposed in response to unfair trade practices such as dumping

3. Countries should not limit the quantity of goods and services that they import. Article XI states that countries should not maintain quotas against imports

4. Countries should declare export subsidies provided to particular firms, sectors, or industries


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5. Countries can temporarily raise tariffs for certain products. Article XIX is called the safeguard provision or the escape clause and is our focus in this chapter The importing country can temporarily raise a tariff

when domestic producers are suffering due to import competition

European governments strenuously objected to the US steel tariffs, and filed a complaint against the US with the WTO

A panel at the WTO ruled in favor of the European countries, entitling them to retaliate by placing tariffs of their own on $2.2 billion worth of US exports

This lead President Bush to remove the steel tariffs in December 2003


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6. Regional trade agreements are permitted under Articles XXIV of the GATT Free trade areas Customs unions


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The Gains from Trade

• We will now demonstrate the gains from trade using Home demand and supply curves, together with the concepts of consumer and producer surplus

• Consumer and Producer Surplus Figure 8.1 (a) shows the Home demand curve D,

consumers facing a price of P1

A person buying unit D2 is willing to pay P2, but only has to pay of P1

The individual obtains a surplus of (P2 – P1) from being able to purchase the good for less than their willingness to pay


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• Consumer and Producer Surplus For each unit before D1, the consumer’s value

exceeds the purchase price of P1

Adding up the surplus obtained on each unit purchased, from zero to D1, gives the total surplus The total satisfaction that consumers receive from the

purchased quantity D1, over and above the amount P1D1

that they have paid

Consumer surplus is then the shaded region between the demand curve and the market price, up to the total quantity purchased; D1 in this case


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D

P1

Price

D2 D1 Quantity

Total Consumer surplus, CS

P2

Surplus for consumer purchasing quantity D2

The demand curve gives us the consumer’s value for each unit of the good. Given P1, consumers will buy a total of D1.

A consumer who purchases D2 has a value of P2, but only has to pay P1 – that gives surplus equal to (P2-P1)

Adding up all the individual surplus for each point on the demand curve gives us total consumer surplus—the area between the demand and the price paid—up to the quantity sold

Figure 8.1 (a)


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• Part (b) of Figure 8.1 illustrates producer surplus

• At the price of P1, the industry will supply S1

• Remember that the supply curve represents a firm’s marginal cost of production

• The firm supplying unit S0 could produce it with a marginal cost of P0, but is able to sell it for P1

This gives the firm a surplus of (P1 – P0)


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• For each unit sold before S1, the marginal cost to the firm is less than the sale price of P1

• If we add up all these individual surpluses obtained for each unit sold from zero to S1, we get the total producer surplus (PS)

• Producer surplus is the area above the supply curve to the price received, up to the quantity sold

• We can also refer to PS as the return to fixed factors of production in the industry, and can loosely refer to it as “profit”.


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S

Price

S0 S1 Quantity

Total Producer surplus, PS

P0

P1

Surplus for firm producing quantity S0

Figure 8.1 (b)The supply curve gives us the consumer’s value for each unit of the good. Given P1, producers will sell a total of S1.

A producer who sells S0 has a MC of P0, but gets P1. That gives surplus equal to (P1-P0)

Adding up all the individual surpluses for each point on the supply curve gives us total producer surplus—the area between the supply and the price received—up to the quantity sold.


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• Home Welfare Again we consider the world of two countries,

Home and Foreign, with producers and consumers

Total Home welfare can be measured by adding up consumer and producer surplus

The greater the total surplus, the greater the total home welfare, the better off the country is

We will compare the welfare in a Home in no-trade and the free trade situations


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• No-Trade In Figure 8.2 (a), the no trade equilibrium occurs

at the autarky price of PA, where quantity demanded equals quantity supplied at Q0

Consumer and producer surplus are shown as the areas defined before. Adding these gives total surplus for Home before trade


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APA

D

Price

S

Q0 Quantity

CS

PS

No-trade equilibrium

(a) No-TradeFigure 8.2


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• Free Trade for a Small Country Suppose Home can now engage in trade in figure

8.2 (b) The world price PW is determined by the supply

and demand in the world market Suppose Home is a small country

Price taker in the world market Faced a fixed price at PW

Assume PW is below the Home no-trade price PA

At the lower price, Home quantity demanded will increase to D1 and Home quantity supplied will decrease to S1

Home will be an importer of the product at the world price


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PA

PW

Price

S1 D1 Quantity

S

D

Figure 8.2 At the free trade price of PW, Home supply will fall to S1 and Home demand will rise to D1.

Imports will make up for the excess demand and will equal (D1 – S1)

Imports

(b) Free Trade


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• Consumers gain more than the producers lose indicating total Home welfare increased

• By looking at the changes in surplus we see:

Rise in consumer surplus +(b+d)

Fall in producer surplus -b

Net effect on Home welfare d

• d is a measure of the gains from trade for the importing country due to free trade

• We can measure this gain directly using the formula for the area of the triangle = ½ bh Welfare increase = ½ (M1)(PA-PW)


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• Gains from Trade We can now measure the welfare effects for

producers and consumers under free trade Since price has fallen under trade, we would

expect this to be good for consumers and therefore consumer surplus to increase Consumer surplus increases by b+d in Figure 8.2 (b)

Similarly, a lower price is worse for producers so we would expect producer surplus to fall Producer surplus falls by b in Figure 8.2 (b)


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PA

PW


Price

S1 D1 Quantity

S

a

b

c

D

Figure 8.2At lower world price, consumer surplus increases to a+b+d an increase of b+d from no-trade

At lower world price, producer surplus falls to c a decrease of b from no-trade

Imports, M1

Gain in trade is triangle d with area equal to ½(M1)(PA-PW)

d

(b) Free Trade


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• Home Import Demand Curve We can now derive the import demand curve,

shown in Figure 8.3 The relationship between the world price of a good and

the quantity of imports demanded by Home consumers

At the no-trade equilibrium, there are zero imports This is shown as point A’ in panel (b)

At the world price of PW, the quantity demanded is greater than quantity supplied, and we import M1

This is point B in panel (b)

Joining A’ and B gives import demand curve M


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B


D

PA

PW

Price

S

S1 Q0 D1 Quantity

Price

M1 Imports

Import demand curve, M

A

A'


Imports, M1

Each point on the import demand curve is a point that corresponds to Home imports at a given Home price

Figure 8.3(a) (b)


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Import Tariffs for a Small Country

• We can also use the supply/demand framework to show what happens when a small country imposes a tariff

• Remember a small country is one where its imports does not have any effect on world price

• This means the price charged to Home consumers will increase by the amount of the tariff


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• Free Trade for a Small Country We start with the free trade equilibrium for the

Home country in figure 8.4 The Foreign export supply curve X* is horizontal

at the world price PW

This means that Home can import an amount at the price PW without having an impact on that price

In free trade equilibrium, home demand is D1, Home supply is S1, and imports are M1


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• Effect of the Tariff With an import tariff of t dollars, the export supply

curve facing Home shifts up by exactly the amount of the tariff

The new export supply curve shifts up to X*+t The new intersection now occurs at the price of

PW+t and the import quantity of M2

The import tariff has reduced the amount imported, from M1 under free trade to M2 under the tariff, due to the higher price


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• Effect of the Tariff At the higher import price, the quantity demanded

at Home falls and the quantity supplied at Home rises, from S1 to S2

However, as firms increase the quantity produced, the marginal costs of production rise

The home supply curve reflects marginal costs so the Home price rises along S until firms are supplying quantity S2 at a MC just equal to the new price, PW+t

The domestic price will equal the import price.


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• Effect of the Tariff Home price rises to PW+t thereby decreasing the

quantity of Home demand Higher prices increase the quantity of Home

supply Less excess demand therefore imports fall Foreign exporters still receive the “net of tariff”

price, PW

These changes affect producer and consumer surplus, and overall Home welfare


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Quantity M1 Imports

Foreign export supply, X*

B


M

Price

M2

C

Figure 8.4

A

D

X*+tPW+t

Price

S


M2

Home price rises by the amount of the tariff.

Home supply increases and Home demand decreases Imports fall to M2

PW

S1 D1 S2 D2


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• Effect of the Tariff on Consumer Surplus With the tariff, consumers now pay the higher

price, PW+t, and their surplus is the area under the demand curve and above the higher price, PW+t

The fall in consumer surplus due to the tariff is the area in-between the two prices and to the left of Home demand, (a+b+c+d) in panel (a.1) of figure 8.5

This area is the amount that consumers lose due to the higher price caused by the tariff


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PW+t

PW


A

D

Price

S

S1 S2 D2 D1 Quantity


M2

Lost consumer surplus due to the higher price with the tariff is equal to the shaded area (a+b+c+d)

a

b d

c

Figure 8.5 (a.1)


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• Effect of the Tariff on Producer Surplus With the tariff, producer surplus is the area above

the supply and below the higher price, PW+t Since the tariff increased Home price, firms can

sell more goods, and producer surplus increases This area, a in figure 8.5 (a.2), is the amount that

Home firms gain due to the higher price caused by the tariff.

Increases in producer surplus can benefit Home workers but at the expense of Home consumers


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PW+t

PW


A

D

Price

S



M2

The gain in producer surplus due to the higher price with the tariff is equal to the shaded area (a)

a

b d

c

Figure 8.5 (a.2)


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• Effect of the Tariff on Government Revenue In addition to the tariff’s impact on consumers and

producers, it also affects government revenue The amount of revenue collected is the tariff t

times the quantity of imports (D2 – S2)

In figure 8.5 panel (a.3), the revenue is shown by area c

The collection of revenue is a gain for the government in the importing country


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PW+t

PW


A

D

Price

S



M2

The gain in government revenue due to the tariff is equal to the shaded area (c)

This equals the tariff, t, times the quantity of imports, M2

a

b d

c

Figure 8.5 (a.3)


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• Overall Effect of the Tariff on Welfare We can now summarize the total impact of the

tariff on the welfare of the Home importing country by adding the gains and losses for each party

Note, we do not care whether the consumers facing higher prices are rich or poor, and do not care whether the specific factors in the industry earn a lot or a little

Under this approach, transferring one dollar from consumer to producer surplus will have no impact on overall welfare

We are simply evaluating the efficiency of the tariff


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• Overall Effect of the Tariff on Welfare The overall impact of the tariff in the small country

can be summarized as follows:

Fall in consumer surplus -(a+b+c+d)Rise in producer surplus +aRise in government revenue +cNet effect on Home welfare -(b+d)

• The areas b and d in figure 8.5 (a) correspond to the triangle (b+d) in figure 8.5 (b) and is the net welfare loss We refer to this area as a deadweight loss—it is

not offset by a gain elsewhere in the economy


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PW+t

PW


A

D

Price

S



M2

The deadweight loss is the loss to Home that is not offset by a corresponding gain

a

b d

c

Figure 8.5 (a)

a is a transfer from consumers to producers

c is a transfer from consumers to government

(b+d) is deadweight loss—losses not offset by other gains


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Figure 8.5 (b)

M1Imports

X*

M

Price

M2

X*+ tC

Dead weight loss due to tariff, b+d


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• Overall Effect of the Tariff on Welfare The area a is effectively a transfer from

consumers to producers via the higher domestic prices induced by the tariff

The area c, the gain in government revenue, is a transfer from consumers to the government

The deadweight loss, (b+d), is measured by the two triangles b and d

The two triangles can each be given a precise interpretation


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• Production Loss The base of b is the net increase in Home supply

due to the tariff, from S1 to S2 The height of this triangle is the increase in

marginal costs due to the increase in supply The fact that marginal costs are greater than

world price means that this country is producing the extra supply inefficiently Fewer resources would be used if imported rather than

produced at home

The area of b is the production loss or efficiency loss—due to producing at marginal costs above world price


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• Consumption Loss The triangle d also has a precise definition Due to the tariff, the price increase from, PW to

PW+t reduces quantity consumed at Home from D1 to D2

The area of the triangle can be interpreted as the drop in consumer surplus for those individuals who are no longer able to consume the units from D1 to D2 because of the higher price

We refer to this drop in consumer surplus as the consumption loss for the economy


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• Finding that tariffs always lead to deadweight losses for small countries explains why most economists are opposed to them

• Why then do so many countries use tariffs? One idea is that developing countries do not have

any other source of revenue Import tariffs are “easy to collect” because every country

has customs agents at major ports checking the goods crossing the borders

However, to the extent that developing countries recognize that tariffs have a higher deadweight loss, we would expect that over time they will shift away from such “easy to collect” taxes


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• Why then do so many countries use tariffs? A second reason is politics If the government cares more about producer

surplus than consumer surplus, it might decide to use the tariff despite the deadweight loss it incurs

The benefits to producers (and their workers) are typically more concentrated on specific firms and states than the costs to consumers which are spread nation-wide

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SIDE BAR

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Globalization and Developing Countries

• Developing countries rely on “easy to collect” tariffs over “hard to collect” income and value-added taxes

• As globalization expands, we would expect these countries to move away from tariffs to the more “hard to collect” revenues

• According to one research study, the ratio of tax revenue to GDP obtained from “easy to collect” taxes fell by about 20% in developing countries between 1980’s and 1990’s

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SIDE BAR


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Globalization and Developing Countries

• At the same time the ratio of tax revenue to GDP from “hard to collect” revenue rose by 9% in the developing countries

• The loss from “easy to collect” taxes was not enough to make up for the gain from “hard to collect” taxes It is harder to improve the performance of “hard to collect”

taxes than it is to shift away from the “easy to collect” taxes for low income countries

• High and middle income countries were able to obtain a net increase in tax revenue from this process

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APPLICATION


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U.S. Tariffs on Steel

• We can use our small country model from above to calculate a rough estimate of how costly these tariffs were in terms of welfare

• We will estimate the deadweight loss due to the US steel tariff in place from March 2002 to December 2003

• President Bush requested that the US International Trade Commission (ITC) initiate a Section 201 investigation into the steel industry

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APPLICATION


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• The ITC determined that the conditions were met and recommended that tariffs be put in place to protect the US steel industry

• The tariffs varied across products, ranging from 10 to 20%—shown in Table 8.1—then falling over time to be eliminated after 4 years

• The ITC decision showed that the losses from rising imports and falling prices met the conditions of “serious injury”

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APPLICATION


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• President Bush took the recommendation of the ITC but applied even higher tariffs, ranging from 8% to 30%

• Knowing the US trading partners would be upset by this, President Bush exempted some countries from the tariffs These included Canada, Mexico, Jordan, and

Israel, which all have free trade agreements with the US and 100 small developing countries that were exporting only a very small amount of steel to the US

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APPLICATION


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Table 8.1

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APPLICATION


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• Deadweight Loss due to the Steel Tariff We need to estimate the areas of triangle b+d we

found in figure 8.5 (b) The base is the change in imports, ΔM, and the

height is the increase in domestic price, ΔP = t. Deadweight loss then equals, DWL = ½ t ΔM It is convenient to measure the deadweight loss

relative to the value of imports, which is PW*M We will also use the percentage tariff, t/PW, and

the percentage change in the quantity of imports, %ΔM = ΔM/M

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APPLICATION


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PW

PW+t


Price

M2 M1 Imports

M

Deadweight loss due to the tariff, b+d

c

Figure 8.5 (b)

ΔM

t

We can measure DWL with the area of the triangle b+d from figure 8.5 (b)

DWL = ½ t ΔM

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APPLICATION


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• Using these definitions, the deadweight loss relative to the value of imports can be rewritten as:

MP

t

MP

Mt

MP

DWLWWW

%

2

1

2

1

• The most commonly used products had a tariff of 30%, so the percentage increase in the price is t/PW = 0.3, leading to %ΔM = 0.3

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APPLICATION


8


• This leads to a DWL of

%5.4)3.0)(3.0(2

1%

2

1

MP

t

MP

DWLWW

• The value of steel imports affected by the tariff was about $4.7 billion prior to March 2002 and $3.5 billion after March 2002 Average imports over the two years was then

$4.1 billion

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APPLICATION


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• Applying the DWL of 4.5% to the average import value of $4.1 billion gives the dollar magnitude of deadweight loss equal to $185 million

• This deadweight loss reflects the net annual loss to the US from applying the tariff A steel worker might think this is ok in order to

protect jobs, but consumers would probably not agree

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APPLICATION


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• Response of the European Countries The tariffs on steel most heavily affected Europe,

Japan, and South Korea, along with some developing countries

The countries in the European Union therefore took action by bringing the case to the WTO

The WTO has a formal dispute settlement procedure, under which countries can bring complaint and have it evaluated

The WTO ruled that the US had failed to prove its steel industry had been harmed by imports and therefore did not have the right to impose the tariffs

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APPLICATION


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• Response of the European Countries Even if we accept that there might be an

argument on equity or fairness grounds for temporarily protecting an industry facing import competition, it is hard to argue that such protection should occur due to a change in exchange rates

The appreciation of the dollar lowered prices for all other imports too, so many industries faced competition

Why should the steel industry be protected and not the others?

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APPLICATION


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• Response of the European Countries The WTO ruling entitled the European Union and

other countries to retaliate against the US by imposing tariffs of their own against US exports

The EU quickly began to draw up a list of products and naturally picked products that would have the greatest impact on the US

The threat of tariffs led President Bush to reconsider the US tariffs on steel, and on December 5, 2003, he announced that they would be suspended

You can see how these chain of events could lead to a tariff war

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HEADLINES


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Europe’s Little List

• How are steel and orange juice related?• When the WTO ruled that the US tariffs on

steel violated international trade law, it allowed the European Union to implement $2.2 billion in retaliatory taxes on US exports

• On the list were oranges and orange juice, big exports of Florida, a major swing state with Jeb Bush as Governor—the President’s brother

• Michigan and Wisconsin apples and California farm products were also on the list

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HEADLINES


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Europe’s Little List

• Another group targeted were makers of industrial farm equipment like John Deere and Caterpillar—both based in the key electoral state of Illinois

• Toilet paper might seem like an odd item for the hit list, but is part of the paper industry, which was targeted affecting many other important states


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• Under the small country assumption that we have used so far, the importing country is always harmed due to the tariff Small country is a world price taker

• If we consider a large enough importing country or a large country, however, then we might expect that its tariff will change the world price Their imports are large enough that they can

affect world price with a change in their imports


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• Foreign Export Supply If the Home country is large, then the Foreign

export supply curve X* is no longer horizontal at the world price PW

We need to derive the foreign export supply curve using the Foreign market demand and supply curves

In panel (a) of Figure 8.6, we show the Foreign demand curve D* and supply curve S*, giving price of PA* at A* At this point, Foreign exports are zero


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• Foreign Export Supply Now suppose the world price is PW above PA* At the higher price, Foreign quantity demanded is

lower at D1*, but quantity supplied by foreign firms is higher at S1*

Foreign excess supply of X1* = S1* - D1*, will be exported at the price of PW at point B*

Connecting A* and B* gives the upward sloping Foreign export supply curve, X*

Combining with Home import demand, M, we get an equilibrium at PW and X1*


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PricePrice

Quantity Exports

D* S*

Home import demand, M

D1* S1*

A* A*'

PA*

PW

B*

X1*

Foreign exports, X1*


World price increases to PW, increasing exports to X1*

Figure 8.6

This gives us our Foreign export supply curve for the large countryAt the world price, PA*,

exports are zero at A*’

(a) Foreign Mkt (b) World Mkt


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• Effect of the Tariff Figure 8.7 we show the effect when Home applies

a tariff of t dollars on imports The tariff increases the cost to Foreign producers

of supplying to the Home market Foreign export supply curve shifts up by exactly

the amount of the tariff, shifting from X* to X*+t The new supply crosses demand at C, giving a

new Home price However, notice that the price that Foreign

producers receive, P*, ends up below the original free trade price


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• Effect of the Tariff The price Home pays for its imports P*+t rises by

less than the amount of the tariff, t, as compared to the initial world price, PW

This is because the price received by foreign exporters, P*, has fallen as compared to the initial world price, PW

Foreign producers are essentially “absorbing” a part of the tariff, by lowering their price from PW to P*

The tariff drives a wedge between what Home consumers pay and what foreign producers receive, with the difference, t, going to the Home government


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M2

M1


A

Price

P*+t

S

Price

Imports

D

S1 S2 D2 D1 Quantity M2 M1

M

X*+t

(a) Home market

X*

B*

C

C*


t

(b) Foreign market

t t

Figure 8.7(without welfare effects)

PW

P*


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• Terms of Trade Remember terms of trade is the ratio of export

prices to import prices In order to measure terms of trade, we want to

use the net-of-tariff import price, P* Since P* is lower than PW, it follows that the Home

terms of trade has increased We might expect, therefore, that the Home

country gains from the tariff We need to analyze the impact of the tariff on

Home consumers, producers, and government


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• Home Welfare The higher Home price, makes consumers worse

off by lowering consumer surplus, shown by (a+b+c+d) in figure 8.7

Home firms are better off with the higher price and increased surplus, a

Revenue collected from the tariff equals the amount of the tariff, t, times the new amount of imports, M2, giving total revenue of (c+e)

Summing all the gains and losses, we obtain the overall impact of the tariff in the large country


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• Home Welfare

Fall in consumer surplus -(a+b+c+d)Rise in producer surplus +aRise in government revenue +(c + e)Net effect on Home welfare e – (b+d) + (e)

• The triangle (b+d) is the deadweight loss due to the tariff.

• But notice, there is a source of gain, e, that offsets part of the loss

• If e > (b+d), then Home is better off • If e < (b+d), then Home is worse off


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A

Price

a cP*+t PW

P*

S

b d

Price

Imports

eD


M

X*+t

e

X*

B*

C

C*

b+d


t

(a) Home market (b) Foreign market

Figure 8.7(with welfare effects)

If the gain of e is greater than the loss of (b+d), Home gains


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• Home Welfare We see that a large importer might gain due to

the application of a tariff However, for the large country, any net gain due

to the tariff comes at the expense of the Foreign exporters

Although Home might gain from the tariff, Foreign definitely loses


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• Foreign and World Welfare The Foreign loss, measured by (e+f) also in figure

8.7, is the loss in Foreign producer surplus from selling fewer goods to Home at a lower price

The area e is the terms of trade gain for Home but an equivalent terms of trade loss for Foreign

Additionally, there is an extra deadweight loss in Foreign of f, giving a combined total greater than the benefits to Home Therefore, it is sometimes called the “beggar thy

neighbor” tariff


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A

Price

a cP*+t PW

P*

S

b d

Price

Imports

eD


M

X*+t

e

X*

B*

C

C*

b+d


t

(a) Home market (b) Foreign market

Figure 8.7(with welfare effects)

Foreign loses (e+f) as loss of Foreign producer surplus, from selling fewer goods at a lower price

f


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• Foreign and World Welfare Adding together the change in Home and Foreign

welfare, e cancels out leaving a net loss to world welfare of -(b+d+f)

We saw this triangle in panel (b) of figure 8.7, which is the deadweight loss for the world

The fact that the large country tariff leads to a world deadweight loss, is another reason that most economists oppose the use of tariffs

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U.S. Tariffs on Steel Once Again

• Returning to the US tariff on steel, we can reevaluate the effect on US welfare in the large country case

• If the US is a large enough importer of steel, then the foreign export price will fall and the US import price will rise by less than the tariff It is possible that the US gained from the tariff

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• Optimal Tariff We can compute the deadweight loss (area b+d)

and the terms of trade gain (area e) for each imported steel product

This would give us the information to see if the US gained from the steel tariffs

Rather than do all these calculations, however, we can use the concept of the optimal tariff

This is the tariff that leads to the maximum increase in welfare for the importing country

We have shown that for a small tariff, a large country can gain. But if the tariff is too large, the country will still lose

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• Optimal Tariff Figure 8.8 graphs Home welfare against the level

of the tariff Free trade is at point B where the tariff is zero Starting at B, increasing the tariff can increase the

importer’s welfare, to a point If the tariff is too large, then welfare will fall below

the free trade level of welfare For example, a prohibitive tariff is one so high there are

no imports—this is point A Given this, you can see that the highest point of

welfare for the importing country is shown by C

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Free Trade

Importer’s Welfare

No Trade


B

A

C

Terms of trade gain exceeds deadweight loss

Terms of trade gain is less than deadweight loss

B'

Optimal Tariff

Prohibitive Tariff

Tariff

The Optimal tariff maximizes the Importer’s welfare, Point C

Too high of a tariff will decrease importer’s welfare and can increase to the point where there is no trade

Figure 8.8

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• Optimal Tariff Formula The optimal tariff depends on the elasticity of

Foreign export supply, EX* This is the percentage change in the quantity exported in

response to a percent change in the world price of the export

If the export supply curve is very steep, there is little response in quantity supplied—inelastic—EX* is low

If the export supply curve is very flat, there is a large response in quantity supplied—elastic—EX* is high

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• Optimal Tariff Formula

Optimal Tariff = 1/EX* For a small importing country, the elasticity of

Foreign export supply is infinite, and so the optimal tariff is zero

As the elasticity of Foreign export supply decreases, Foreign export supply curve is steeper, the optimal tariff is higher With a steep Foreign export supply curve, Foreign

exporters will lower their price more in response to the tariff

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• Optimal Tariffs for Steel If we apply this formula to the US steel tariffs, we

can see how the tariffs applied compare to the theoretical optimal tariff

Table 8.2 shows various steel products along with their respective elasticities of export supply to the US

We can compare the actual tariff to the optimal tariff to see where there were gains and where there were losses from the tariffs

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• For alloy steel flat-rolled products, its actual tariff was 30%, which is far below its optimal tariff The terms of trade gain for that product was

higher than the deadweight loss US welfare is above its free trade level

• In summary, two products had terms of trade greater than the deadweight loss, but the third had a larger deadweight loss The first two illustrate the large country case,

while the third illustrates the small country case

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Table 8.2

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• Even if there was an overall terms of trade gain for the US when adding up across all steel products, that gain would be at the expense of the European countries and other steel exporters

• By allowing exporting countries to retaliate with tariffs, the WTO prevents importers from using optimal tariffs to their own advantage


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Import Quotas

• On January 1, 2005 China was poised to become the world’s largest exporter of textiles and apparel On that date, the Multifibre Arrangement (MFA)

was abolished Under the MFA, import quotas restricted the

amount of nearly every textile and apparel product that was imported to Canada, Europe, and the US

The quotas were to protect their own domestic firms producing those products

With the end of the MFA, China was ready to enjoy greatly increased imports


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Import Quotas

• The threat of import competition from China led the US and Europe to negotiate new quotas with China

• These are not the first quotas Europe had a quota on the imports of bananas

that allowed for a greater number of bananas to enter from its former colonies in Africa than from Latin America (now a tariff)

• In the next section, we explain how quotas affect the importing and exporting countries, and examine the differences between quotas and tariffs

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Europe Reaches Deal on Banana Imports

• The European Union changed their trade barriers to allow banana imports from countries that were once European colonies and to restrict imports from other countries, primarily in Latin America

• The proposal was to implement one import tariff but no quotas on bananas except for former French, British, and Portuguese colonies which will continue to enjoy duty-free access

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Europe Reaches Deal on Banana Imports

• This change replaces the prior trade policy that was a mixture of tariffs and quotas, but is still higher than the Latin American countries are content with

• The European countries are split over what to do about these policies. Some want to protect their own growers’ interests

and others want to keep prices low for consumers

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Sweet Opportunity

• The current US sugar program guarantees that American sugar producers receive a set price for their product

• If they are not able to sell all their sugar at the “break-even” price after accounting for their loans, they can sell the excess to the US Department of Agriculture

• To keep from storing a large stock of sugar, the US regulates supply by imposing import quotas on sugar

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Sweet Opportunity

• But, the US price of sugar has been two to three times higher than the world price of sugar for about 25 years

• The longer the protection holds, the more inefficient the US producers become, and the more powerful they become as a special interest group

• Given that the current world price of sugar has increased and put foreign producers on par with the US, there is an opportunity to do away with the sugar program


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Import Quotas

• Import Quota in a Small Country• Free Trade Equilibrium

Figure 8.9 (a) shows the free trade equilibrium at a world price of PW, home quantity demanded of D1, quantity supplied of S1, with imports of M1 as before

Assuming the country is small, meaning the world price is not affected by the import quota, the Foreign export supply curve, X*, is horizontal at PW

We can see the free trade amount of imports in panel (b) as well: M1 at PW


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B

M1

M1

A

Import Quotas

S1 D1 Quantity

D

PriceS

Price

Imports


PW



(a) Home market (b) Import market

Figure 8.9(without quota) At PW, Home Supplies S1,

Demands D1, and Imports M1

In free trade equilibrium for a small country, Foreign faces a horizontal export supply curve, X*, at the world price PW


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Import Quotas

• Effect of the Quota Suppose the import quota of M2<M1 is imposed

Quantity imported cannot exceed this amount

The essentially gives us a vertical supply curve, X in panel b Fixes the import quantity at M2

The vertical export supply curve now intersects import demand at point C, which establishes the Home price of P2

In panel a, the price of P2 leads firms to increase the quantity supplied to S2 and consumers to decrease their quantity demanded to D2


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Import Quotas

• Effect of the Tariff The import quota leads to an increase in the

Home price, and a reduction in Home imports, just like the tariff

We can see what the equivalent tariff, the tariff that would be set to give the same quantity and price as the quota, would be: t = P2 – PW

For every level of import quota, there is an equivalent import tariff


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Import Quotas

• Effect on Welfare The rise in price from the quota leads to a fall in

consumer surplus: (a+b+c+d) The increase in price facing Home producers

leads to a gain in producer surplus: a What changes with the quota is the area c which

was government revenue under the tariff With a quota, whoever is actually importing the

good will be able to earn c, the difference between the world price and the higher Home price times the imports sold in the Home market


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Import Quotas

Figure 8.9(with quota)

B

A

Quantity

D

PriceS

Price

ImportsM1



P2

C


ca

d

b+d

c

b

(a) Home market (b) Import market

Foreign export supply with quota

X

With the Quota, the Foreign export supply becomes vertical at the quota quantity

The new Export Supply curve crosses the Import Demand curve at a new price and quantity of imports

At the new higher price P2, Home Supply increases to S2, Demand decreases to D2 and imports fall to M2

Always have a deadweight loss of (b+d) like the tariff

Consumers loses surplus of (a+b+c+d), producers gain (a).

Welfare of Home depends on what happens to (c).

PW

S1 S2 D2 D1 M2


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Import Quotas

• The difference between these two prices is the rent associated with the quota

• Area c represents the total quota rents• There are four possible ways these rents

can be allocated

1. Giving the Quota to Home Firms Quota licenses can be given to Home firms

Permits to import the quantity allowed under the quota system

The net effects on Home welfare due to the quota are then as follows:


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Import Quotas

Fall in consumer surplus -(a+b+c+d)

Rise in producer surplus +a

Quota rents earned at Home +c

Net effect on Home welfare:-(b+d)

• This is the same loss we saw with a tariff• (b+d) is still a deadweight loss associated

with the quota


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Import Quotas

2. Rent Seeking Because of the gains associated with owning a

quota license, firms have an incentive to engage in inefficient activities in order to obtain them

How licenses are allocated mattersa. If licenses are allocated in proportion to each firm’s

production, Home firms will likely produce more than they can sell just to obtain the import licenses for the following year

b. Firms might engage in bribery or other lobbying activities to obtain the licenses


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Import Quotas

• Rent Seeking Some suggest that the waste of resources

devoted to rent seeking could be as large as the value of the rents themselves – waste c

If rent seeking occurs, welfare loss of quota is:Fall in consumer surplus -(a+b+c+d)


Net effect on Home welfare: -(b+c+d) This loss is larger than a tariff It is thought rent seeking is worse in developing

countries


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Import Quotas

3. Auctioning the Quota The government of the importing country to

auction off the quota licenses In a well-organized, competitive auction, the

revenue collected should exactly equal the value of the rents



Auction revenue earned at Home +c

Net effect on Home welfare: -(b+d) This is the same loss as the tariff

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Auctioning Import Quotas in Australia and New Zealand

• During the 1980’s, Australia and New Zealand both auctioned the quota licenses to import specific goods

• Table 8.3 shows the value of imports covered by quotas curing 1981–1987

• In 1988, New Zealand announced plans to phase out import quotas as part of a liberalization of trade, and all quota licenses were eliminated by 1992

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• Table 8.3 also shows the value of bids for the quota licenses These are estimates of rents

• If we take the ratio of the value of bids to the value of imports covered by the quota, we obtain an estimate of the tariff equivalent to the quota These are shown in the final column of 8.3

• Since there was no penalty from not following through, some firms decided not to purchase the licenses after all

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Table 8.3

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• The government therefore did not collect all the winning bids as revenue

• For those that did buy their licenses, they could be resold and some were at much higher prices

• This makes it appear that the government was not collecting all of the rents in area c


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Import Quotas

4. “Voluntary” Export Restraint The importing country can give authority for

implementing the quota to the exporting government

This is often called a “voluntary” export restraint (VER) or a “voluntary” restraint agreement (VRA)

In the 1980’s the US used this type of arrangement to restrict imports of Japanese automobiles The Japanese government told each Japanese firm

how much it could export to the US


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Import Quotas

• With VER’s, quota rents are earned by foreign producers, making Home welfare:



Net effect on Home welfare: -(b+c+d)

• This is of course higher than with a tariff• Why would we do this?

It is typically political—the exporting country is less likely to retaliate since they gain the area c

This can often avoid a tariff or quota war


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Import Quotas

• Costs of Import Quotas in the US Table 8.4 presents some estimates of home

deadweight losses and quota rents for some major US quotas

In all cases except Dairy, the rents were earned by Foreign exporters

Adding up the costs in the table, the total US deadweight loss due to these quotas ranged from $8–$12 billion annually

Quota rents transferred another $7–$17 billion to foreigners

Some, but not all, of these costs are relevant today since many of the quotas are no longer in place


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Import Quotas

Table 8.4

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China and the Multifibre Arrangement

• One of the principles of GATT was that countries should not use quotas to restrict imports

• The MFA was a major exception to that which allowed the industrialized countries to restrict imports of textile and apparel products from the developing countries

• Organized under GATT, importing countries could join the MFA and arrange quotas bilaterally or unilaterally

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• While the amount of the quotas was occasionally revised upward, they did not keep up with the increasing ability of new supplying countries to sell

• Under the Uruguay round of WTO, developing countries were able to negotiate an end to this system of import quotas.

• Given that China was a large supplier of textiles, the expiration of the MFA meant that China could win big

• Some developing countries and large producers in importing countries were concerned with the potential of Chinese exports on their economies

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• Growth in Exports from China Immediately after January 1, 2005, exports of

textiles and apparel from China grew rapidly In 2005, China’s textile and apparel imports to the

US rose by more than 40% compared to 2004 Figure 8.10 (a) shows the change in the value of

exports of textiles and apparel from different countries. Note China

The increases from China came at the expense of some higher-cost exporters, some of whose exports to the US declined by 10 to 20%

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Figure 8.10

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• Panel (b) of Figure 8.10 shows the percentage change in the prices of textiles and apparel products from each country, depending on whether the products were subject to the MFA quota before January 1, 2005 or not

• China had the largest drop in the prices from 2004 to 2005

• Many other countries had a substantial fall in their prices due to the end of the MFA quota

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Figure 8.10

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• Welfare Cost of the MFA Given the drop in prices in 2005, it is possible to

estimate the welfare loss due to the MFA Quota rents were earned by foreign exporting

firms, giving a welfare loss to Home of area (b+c+d) shown in Figure 8.9 previously

Using the price drops from Figure 8.10 above, (b+c+d) for the US is estimated at $6.5 to $16.2 billion in 2005 from the MFA

Averaging out all losses and dividing among households gives an estimate of $100 per household, or 7% of total annual spending on apparel

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• Import Quality There was also an interesting pattern to the price

drops: the price dropped the most for the lowest priced items An inexpensive T-shirt had a greater drop in price than a

more expensively priced item

US demand shifted towards the lower-priced items imported from China: there was “quality downgrading” in the exports from China

When a quota like the MFA is applied, there is an effect on quality

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• Import Quality Remember that quotas are set on the quantity,

not the quality of items that are imported This means that exporting countries have an

incentive to upgrade the quality of the product Selling a higher value good for the same quantity

will still meet the quota limit but will bring more money back home

MFA’s bring “quality upgrading” in the exports Similarly, when the MFA is removed, you will see

“quality downgrading”

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• Reaction of the United States and Europe The EU threatened to impose new quotas on

Chinese exports In response, China agreed on June 11, 2005 to

”voluntarily” restrict exports limiting the growth of textile exports to about 10% per year through the end of 2008

The US had the ability to negotiate a new system of quotas since China had joined the WTO in 2001

The US deal limited growth to 7.5% until 2008


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Conclusions

• A tariff on imports is the most commonly used trade policy tool

• First considered a small country with no effect on world price Price faced by consumers and producers in the

importing country will rise by the full amount of the tariff

There is a drop in consumer surplus, a rise in producer surplus, and the government collects revenue

Net loss for the importing country


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Conclusions

• Why are tariffs used? Easy way for governments to raise revenue,

especially in developing countries The government might care more about

protecting firms than avoiding loses for consumers

The small-country assumption may not hold in practice—countries may be large enough to gain from a tariff

• If a country is large enough, they can have an effect on the world price


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Conclusions

In this case, prices rise by less than the full amount of the tariff

It is therefore possible for a small tariff to generate welfare gains for the importing country

This does come at the expense of the foreign exporters—“beggar thy neighbor” policy

Overall still have world losses

• Countries also may choose quotas, which restrict the quantity of imports into a country WTO has tried to restrict the use of quotas Deletion of MFA quotas still lead to new quotas

against China


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Conclusions

• Import quotas lead to similar welfare effects of tariffs Increase domestic price with loss for consumers

and gains for producers Quota rents instead of guaranteed government

revenues If resources are wasted by firms to gains rents,

additional deadweight losses are incurred More common for foreign exporters to earn the

quota rents - VER


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Key Points

1. The government of a country a can use laws and regulations, called trade policies, to affect international trade flows

2. The rules governing grade policies in most countries are outlined by the General Agreement on Tariffs and Trade (GATT), now the World Trade Organization (WTO)

3. In a small country, the world price faced is fixed, so the price faced by consumers and producers will rise by the full amount of the tariff


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Key Points

4. The use of a tariff by a small importing country always leads to a net loss in welfare

5. In a large country, the change in imports from a tariff will lower world price so the price to the importing country does not rise by the full amount of the tariff

6. The use of a tariff for a large country can lead to a net gain in welfare

7. The optimal tariff is the tariff amount that maximizes welfare for the importer

8. The formula for the optimal tariff depends inversely on the foreign export supply elasticity


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Key Points

9. Import quotas restrict the quantity of a particular import, thereby increasing the domestic price, benefiting domestic production and creating a benefit for those who are allowed to import the quantity allotted. Benefits are quota rents

10.Assuming perfectly competitive markets for goods, quotas are similar to tariffs since the restriction in the amount imported leads to a higher domestic price. Rents, however, can be earned by the foreign country and can create additional dead weight losses

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