International Economics

Tariffs and Its Implication

Some slides have been taken and modified from

http://carbaugh.swcollege.com
Tariffs

Why restrict trade?

◼ Benefits of free trade come in the long

term, and are usually spread widely across
society
◼ Costs of free trade are felt rapidly and are
usually concentrated in specific sectors of
the economy (in which companies face
losses and workers lose their jobs)
Tariffs

Defining tariffs
◼ A tariff is a tax (duty) levied on products as
they move between nations
◼ Import tariff - levied on imports
◼ Export tariff - levied on exported goods as they
leave the country
◼ Protective tariff - designed to insulate domestic
producers from competition
◼ Revenue tariff - intended to raise funds for the
government (no longer important in industrial
countries)
Tariffs

Types of tariff

◼ Specific tariff
◼ Fixed monetary fee per unit of the product
◼ Ad valorem tariff
◼ Levied as a percentage of the value of the product
◼ Compound tariff
◼ A combination of the above, often levied on finished
goods whose components are also subject to tariff if
imported separately
Effective rate of Protection
◼ The impact of a tariff is often different from its
stated amount. Nominal tariff rate gives only general
idea about protection.
◼ Different tariff rates on raw materials, intermediary
goods and final goods have to be taken into
consideration to understand their combined effect on
the domestic production and to comprehend the
actual level of protection.
◼ The effective tariff rate measures the total increase in
domestic production that the tariff makes possible,
compared to free trade
Tariffs

Effective rate of protection (cont’d)

◼ When tariff rates are low on raw materials

and components, but high on finished
goods, the effective tariff rate on finished
goods is actually much higher than it
appears from the nominal rate
◼ This is referred to as tariff escalation
 Effective rate of Protection (cont’d)
Example:
Foreign Radio Import Domestic Competing Radio
Component (cost) $80 $80
Assembly Activity (Vl. Add) 20 30(?)
Nominal tariff 10
Import Price 110 Domestic price 110
The nominal tariff rate is 10% but the country enjoys the protection
level of 50% and hence the effective rate of protection of 50%. How?
Under the protective environment, domestic producers can afford to
pay upto $30 for assembly and total price remains as $110.
So, domestic assembly cost rises up to a level of 50% above in a
protective environment: ($30-$20)/$20=0.5
Effective rate of Protection (cont’d)
Formula:
e= (n-ab)/(1-a), Where
e=effective rate of protection, n= nominal rate on final product,
a= ratio of value of the imported input to the total value of the
product
b= the nominal rate on input
Some interesting observations
n a b (n-ab) (1-a) e
0.1 0.8 0 0.1 0.2 0.5
0.1 0.8 0.05 0.06 0.2 0.3
0.1 0.9 0 0.1 0.1 1
0.1 0.9 0.05 0.055 0.1 0.55
Effective rate of Protection (cont’d)

• Higher the import content greater is the effective rate of

protection given a nominal rate.
• Higher nominal tariff rate on the the intermediate
products smaller is the effective rate of protection
• Generally, it has been observed that inputs attract a very
low rate of duty and final products enjoy high duty. This is
called Tariff Escalation.
Avoiding and postponing tariffs (US)

◼ Production sharing and special treatment

for foreign assembly
◼ Bonded warehouses
◼ Foreign trade zones
Tariffs

Tariff welfare effects

◼ Consumer surplus
◼ The difference between the price buyers
would be willing to pay and what they
actually pay
◼ Producer surplus
◼ The revenue producers receive above the
minimum amount required to induce them to
produce a good
 Tariffs

Consumer and Producer Surplus

Price ($)

Price ($)
5
Supply
5
B 4 Producer
(minimum price)
Consumer surplus
4 surplus
3
3
C (actual price) 2
A C (actual price)
A 2 Total
expen Demand 1 Total
1 diture (maximum variable cost
D E price) B0 D
0
0 2 4 6 8 10
0 2 4 6 8 10

Gasoline (gallons) Gasoline (gallons)

Tariff, Trade and Welfare effects
12,000 Before Tariff C.S= a+b+c+d+e+f+g
11,500
11,000 After tariff C.S= e+f+g
D Sd
Price ($)

10,500
10,000
9,500
g
9,000 E
8,500
e f G
8,000 Sd+w+t
7,500 a b c d F
7,000 Sd+w
6,500 h
6,000
0 10 20 30 40 50 60 70 80 90 100 D110
d
Quantity of autos

Before tariff P.S= h, after tariff P.S= a+h. Govt. Rev= c

 Tariff trade and welfare effects
Revenue Effect= C
Redistributive Effect= a= increase in P.S
Protective Effect= b= loss of domestic economy
resulting from wasted resources used to produce additional
units of the good at increasing cost

Consumption Effect=d= loss in consumer surplus, is

the residual not accounted for. This is a welfare loss
because of the increased price and lower consumption.

Deadweight Loss=b+d
Welfare effects of tariffs

Tariff trade and welfare effects

Large nation model
Price ($)

Sd

E
9,600
G Sd+w+t
8,800
a c F
8,000
b d Sd+w
7,800 e

Dd
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Quantity of autos
Stolper-Samuelson Theorem
Stolper-Samuelson Theorem demonstrates that the effects of a
tariff are unambiguous within the context of the standard trade
model. Following the Heckscher-Ohlin reasoning, we can say
that a country exports that good which it produces primary with
the help of its abundant factor of production. A tariff will
decrease production of exportables and lead to an increase in
production of the import-competing good, and benefit the scarce
factor-that used intensively in the import sector. Thus a tariff will
benefit a country’s scarce factor of production in an unambiguous
fashion and cause real income of the abundant factor to fall.
Tariff effects

Who pays for import restrictions?

◼ Domestic consumers face increased costs

◼ Low income consumers are especially hurt by
tariffs on low-cost imports
◼ Overall net loss for the economy
(deadweight loss)
◼ Export industries face higher costs for inputs
◼ Cost of living increases
◼ Other nations may retaliate, further
restricting trade
Reasons for tariffs

Arguments for trade restrictions

◼ Job protection
◼ Protect against cheap foreign labor
◼ Fairness in trade - level playing field
◼ Protect domestic standard of living
◼ Equalization of production costs
◼ Infant-industry protection
◼ Political and social reasons
Reasons for tariffs

Politics of protectionism

◼ “Supply” of protectionism (trade policy)

depends on:
◼ the cost to society of restricting trade
◼ the political importance of the import-
competing industries
◼ Magnitude of the adjustment costs from free
trade
◼ Public sympathy for those sectors hurt by free
trade
Reasons for tariffs

Politics of protectionism

◼ “Demand” for protectionism depends on:

◼ The amount of the import-competing
industry’s comparative disadvantage
◼ The level of import penetration
◼ The level of concentration in the affected
sector
◼ The degree of export dependence in the sector