The Theory of Tariffs and Quotas - Pablo Agnese · an introduction to the theory and policy of ......

Chapter 6

The Theory

of Tariffs

and Quotas

Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

and Quotas

Chapter Objectives

• Introduce the theory of tariffs

• Discuss the welfare and efficiency effects of

tariffs

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-2

tariffs

• Analyze the distinction between tariffs and

quotas

Introduction: Tariffs and Quotas

• This chapter and the next chapter provide an introduction to the theory and policy of tariffs and quotas


• This analysis is called commercial policy

• The inefficiency and expense of tariffs and quotas to protect industries and jobs are apparent once direct costs are measured

Analysis of a Tariff

• There are numerous barriers to trade, some

are obvious (transparent), others are not

(non-transparent)


– 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


from foreign to domestic goods

• This chapter 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

Consumer and Producer Surplus

• There are 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


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


Prices, Output, and Consumption

• Assume:

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

Pw)


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


Prices, 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.”


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

Prices, 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

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


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


TABLE 6.1

Economic Effects of the Tariff

in Figure 6.3


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


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 6.4

Average Tariff Rates, 1986-2007


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


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


(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


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 6.5

Tariffs in the Large Country Case


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


– 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 vs. Nominal Rates

of Protection (cont.)

• In sum, effective rate of protection =

(VA* - VA) / VA

- VA = amount of domestic value added under


- 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


Table 6.3 The Uruguay Round


Analysis of Quotas

• 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


– 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

Types of Quotas

1) 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

2) Import licensing requirement: forcing importers to


2) Import licensing requirement: forcing importers to obtain government licences for their imports; government regulates the number of licences available

3) 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


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

The Effect on the Profits

of Foreign Producers

• 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


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


competition may limit their ability to increase

prices

– The government can extract the extra profits from

foreign producers through an auction for import

licences

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


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


– Tariffs: impose a tax

– Non-tariff barriers (NTBs): quotas and non-tariff

measures

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)

Hidden Forms of Protection (cont.)

• Non-tariff measures are hidden, non-

transparent forms of protection, such as:

- excessively complicated customs procedures,

- environmental and consumer health and safety

precautions,

- technical standards,

- government procurement rules,

- limits imposed by state trading companies


Intellectual Property Rights

and Trade

• Intellectual property is usually divided into:

- Copyrights and related rights for literary and

artistic work,

- Industrial property rights for trademarks,

- Patents,

- Industrial designs,

- Geographical indications

- Layout of integrated circuits


Intellectual Property Rights

and Trade (cont.)

• There are rules for respecting intellectual

property rights as they relate to trade

• These rules were negotiated during the

Uruguay Round (1986-1994) with the Trade

Related Aspects Intellectual Property

Rights (TRIPS) agreement



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