The Theory of Tariffs and Quotas · FIGURE 6.1 Consumer and Producer Surplus . ... •Similarities...

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 6

The Theory

of Tariffs

and Quotas

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 6-2

Chapter Objectives

• Introduce the theory of tariffs

• Discuss the welfare and efficiency effects of

tariffs

• Analyze the distinction between tariffs and

quotas


Introduction

• Chapters 6 and 7 provide an introduction to the theory and policy of tariffs and quotas

• In general, tariffs have been negotiated down to very low levels by the GATT/WTO members

• However, tariffs on agriculture, textiles, and apparel continue to have relatively high barriers

– Many developing countries have a comparative advantage in these areas and would benefit from tariff reductions


Analysis of a Tariff

• There are numerous barriers to trade

– Transparent barriers and non-transparent ones

– Quotas: direct limit on imports: regulate the quantity

of imports

– Tariffs: indirect limit on imports: impose a tax on

imports


Analysis of a Tariff (cont.)

• Tariffs and quotas encourage – Consumers to switch to relatively cheaper domestic goods or

to drop out of the market

– Producers to increase their output as demand switches from foreign to domestic goods

• Chapter 6 is a partial equilibrium analysis of the effects of tariffs and quotas: considers only their impact on the industry on which they are imposed, rather than their economy-wide effects


Analysis of a Tariff (cont.)

• Two key concepts in the analysis of the impact of

tariffs

– Consumer surplus: value received by consumers in excess

of the price they pay (can be measured only if the demand

curve is known)

– Producer surplus: value received by producers in excess of

the minimum price at which they are willing to produce (can

be measured only if the supply curve is known)


FIGURE 6.1 Consumer and

Producer Surplus


The Effect of a Tariff on Price,

Output, and Consumption

• Assume

1. There is only one price for a good (world price Pw)

2. Foreign producers are willing to supply us with all

of the units of the good we want at that price


FIGURE 6.2 Domestic Supply

and Demand for an Imported Good



Output, and Consumption (cont.)

• Now assume: Government imposes a tariff of

amount “t.” Importers will still be able to buy the

good from foreign producers for Pw, but they will

have to pay the import tax of “t.”

– The tax is subsequently tacked onto the price to domestic

consumers: price to them is Pw + t=Pt

– The consumption of the imported good subsequently

decreases



Output, and Consumption (cont.)

• Furthermore,

– The domestic production of the good increases as

domestic firms are able to charge a higher price

while remaining competitive vis-à-vis foreign firms

– Finally, imports of the good decrease


Tariff’s Effect on Resource

Allocation and Income Distribution

• Besides the rise in prices and fall in imports, tariffs influence

– Inputs in domestic production: the increase in domestic production requires additional resources of land, labor, and capital to be reallocated from their prior uses

– Consumer surplus

– Producer surplus


FIGURE 6.3 The Effects of a Tariff


TABLE 6.1 Economic Effects of

the Tariff in Figure 6.3

• The net effect of the tariff on national welfare = gains to

producers + gains to government - losses to consumers =

(a + b + c + d - a - c) = b + d


Other Potential Costs of a Tariff

• A tariff may have effects that are less predictable and harder to quantify

– Retaliation by other countries: adds to the net loss of a tariff by hurting export markets of other industries; can escalate rapidly

– Innovation: tariffs reduce competitive pressures on domestic firms and thus their incentives to innovate and improve the quality of existing products


Other Potential Costs of a Tariff

(cont.)

– Rent seeking: any activity that uses resources in

order to capture more income without actually

producing a good or survive (e.g., firms hire

lobbyists to maintain tariff protection)

• Political systems that do not easily provide tariffs are more

likely to avoid rent seeking


The Large Country Case

• Economists distinguish between small and large

countries in analyzing tariffs

– Large country: one that imports enough of a particular

product so that if it imposes a tariff, the exporting country

will reduce its price of the good in order to keep its share of

the large country´s market

• In theory, large countries can improve their national

welfare by imposing a tariff as long as their trading

partners do not retaliate


FIGURE 6.4 Tariffs in the Large

Country Case


A Comparison of Tariff Rates

• Since the mid-90s tariff rates in most countries have fallen

• Generally, tariff rates in developing nations are higher than developed nations

• However, developed nations often have highest tariffs in agriculture, textiles, and other labor-intensive products – the very products developing nations would like to export


FIGURE 6.5 Average Tariff Rates,

1986-2003


Effective versus Nominal Rates of

Protection

• The amount of protection given to any one product depends not

only on the tariff rate but also on tariffs on the inputs used to

produce the good

– Nominal rate of protection: tariff rate levied on a given product

– Effective rate of protection: nominal rate + tariffs on intermediate inputs

– Value added: price of a good minus the costs of intermediate goods used

to produce it (the contributions of labor and capital at a given stage of

production)


Effective versus Nominal Rates of

Protection (cont.)

• In sum, effective rate of protection =

(VA* - VA) / VA

– VA = amount of domestic value added under free

trade; VA* = domestic value added after taking into

account all tariffs (on both final goods and

intermediate inputs)


TABLE 6.2 Nominal and Effective

Rates of Protection


Analysis of a Quota

• Quota: a quantitative restriction that specifies a limit on the quantity of imports

• Differences between quotas and tariffs – Tariff limits imports by imposing a tax on them

– Unlike tariffs, quotas do not generate tariff revenue for the government

• Similarities between quotas and tariffs – Both lead to a reduction in imports, a fall in total domestic

consumption, and an increase in domestic production


Analysis of a Quota (cont.)

• Both quotas and tariffs limit imports

• However, the net loss from quotas can exceed

that from tariffs

– This occurs when the lost tariff revenue resulting

from quotas ends up in the hands of foreign

producers as they raise their prices to match supply

to demand


Types of Quotas

• Limitation on the quantity of imports: e.g., a limit on the quantity

of imports from country x, or a limit on the quantity of imports

from the rest of the world as a whole

• Import licensing requirement: forcing importers to obtain

government licences for their imports; government regulates the

number of licences available

• Voluntary export restraint (VER) (or voluntary restraint

agreement, VRA): the exporting country “voluntarily” agrees to

limit its exports for a period


Types of Quotas: VERs

• VERs have similar effects as quotas

– However, VERs are more popular, as they (1) do not require domestic legislative action; and (2) allow politicians to provide protection for domestic industry and to appear as proponents of free trade

• The use of VERs increased with the decline in tariffs that results from the global trade rounds; however, recent international negotiations have restricted the use of VERs


FIGURE 6.6 Analysis of a

Quota: 1

• Quota rents: increased profits accruing to foreign producers from the use of quotas; take the place of tariff revenue


FIGURE 6.7 Analysis of a

Quota: 2

• In the case of a tariff, the government earned revenue from imports; in the case of a quota, foreign producers receive extra profits (c)


The Effect on the Profits

of Foreign Producers (cont.)

• Domestic firms prefer quotas over tariffs: post-

quota increase in consumer demand increases

the price paid by consumers and thus the

quantity of producer surplus

– In contrast, increase in demand for a good with an

import tariff increase the quantity of imports and

leaves the price of the good intact


The Effect on the Profits

of Foreign Producers (cont.)

• Two circumstances that can limit quota rents

– If there is a large number of foreign producers,

competition may limit their ability to increase prices

– The government can extract the extra profits from

foreign producers through an auction for import

licences


Hidden Forms of Protection

• Any trade barrier that reduces imports without

imposing a tax has effects similar to those of a quota

– Tariffs: impose a tax

– Non-tariff barriers: quotas and non-tariff measures

• Non-tariff measures: hidden, non-transparent forms of protection (e.g.,

discriminatory government procurement; unclear safety standards;

excessive bureaucratic regulations; local content requirements)

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