Study Unit 2.

1: Trade Barriers
Chapter 4: Tariffs
Study Unit 2.1 – Chapter 4
outcomes
At the end of this chapter you should be able to:
• Define specific tariff, ad valorem tariff, and compound tariff
• Discuss the effective rate of tariff protection and the process
of tariff escalation
• Explain how a tariff affects the welfare of a small importing
country and a large importing country
• Evaluate the arguments in favor of trade restrictions
Tariffs
• Free-Trade argument posits that open markets foster most
efficient use of world resources
• But free trade policies often meet resistance among
companies and workers who face losses in income and jobs
because of import competition
• Policymakers torn between global efficiency and needs of
voting public
The Tariff Concept
• Tariff
• A tax (duty) levied on a product when it crosses national boundaries
o Import tariff
- Tax levied on an imported product
- Most common; collected before shipment can be unloaded in domestic port
o Export tariff
- Tax imposed on an exported product
- Less common; illegal under U.S. Constitution
- Commonly used by developing nations
The Tariff Concept
• Protective tariff
• Protects domestic producers from foreign competition
o Facilitates increase in output of import-competing producers
• Revenue tariff
• Generates tax revenues by placing tariffs on either imports or
exports
• Many developing nations rely on tariffs as major source of income
The Tariff Concept
Table 4.1: Taxes on International Trade as a percentage of Government
Revenues – Selected countries (2013)
Developing Countries Percentage Advanced Countries Percentage
Bahamas 43.2 New Zealand 2.7
Ethiopia 29,8 Australia 1.8
Liberia 28.1 Japan 1.7
Bangladesh 26.7 United States 1.2
Grenada 25.4 Switzerland 1.0
Russian Federation 25.8 Norway 0.3
Philippines 19.9 Ireland 0.2
India 14.1 World average 3.8
Types of Tariffs
• Tariffs may be specific, ad valorem, or compound
• Specific tariff
o Fixed amount of money per physical unit of imported product (Ex:
15 cents/unit)
o Relatively easy to apply and administer
o Degree of protection varies inversely with changes in import prices
o Provides domestic producers increased protection during recession
(with falling prices)
Types of Tariffs
• Tariffs may be specific, ad valorem, or compound
• Ad valorem tariff
o Primarily used with manufactured goods because can be applied to
products with range of grade variations
o Fixed percentage of the value of imported product (Ex: 15%/unit)
o Maintains constant degree of protection for domestic producers
through the business cycle
o Customs valuation: determining value of imported product; is
complex, subject to disagreement
Types of Tariffs
• Tariffs may be specific, ad valorem, or compound
• Compound tariff
o Applied to manufactured products composed of raw materials
subject to tariffs
o The specific portion of the duty neutralises the cost disadvantage of
domestic manufactures that results from tariff protection granted to
domestic suppliers of raw materials
o The ad valorem portion of the duty grants protection to the finished
goods industry
Effective Rate of Protection
• Nominal and Effective tariff rates
• Nominal tariff rate: rate published in country’s tariff schedule
o Applies to value of finished product
• Effective tariff rate: takes into account not only nominal tariff on
finished good but any tariff applied to imported inputs
Effective Rate of Protection
• Effective tariff rate calculated as:
n  ab 
e
1  a 
• e = effective rate of protection
• n = nominal tariff rate on final product
• a = ratio of value of imported input to value of finished product
• b = nominal tariff rate on imported input
Effective Rate of Protection
• If tariff on finished product is less than tariff on imported
input
• Effective rate of protection is less than nominal tariff (may even be
negative)
• Tariff protects domestic suppliers of raw materials more than
domestic manufacturers
• If tariff on finished product exceeds tariff on imported input
• Effective tariff exceeds nominal tariff
Tariff Escalation
• Processed goods have higher import tariffs
• Raw materials often imported at zero or low tariff rates;
nominal and effective protection increases at each
production stage
Tariff Escalation
Table 4.5: Tariff escalation in advanced and developing
countries (2012)
Agricultural products Industrial products
Country Primary products Processed products Primary products Processed products
Bangladesh 17.5 23.0 9.1 15.4
Uganda 17.5 20.3 4.2 11.7
Argentina 5.7 11.5 2.0 9.5
Brazil 6.5 12.1 4.2 10.7
Russia 6.9 9.2 5.3 9.5
United States 1.0 2.8 1.3 2.8
Japan 4.5 10.9 0.5 1.9
Country 12.9 15.1 5.6 7.7
Dodging import tariffs: Tariff
Avoidance & Tariff Evasion
• Tariff avoidance
• Legal utilization of tariff system to one’s own advantage
• Tariff evasion
• Evading tariffs by illegal means such as smuggling
imported goods into a country
• Example: Ford strips its wagons to avoid high tariff
• Example: Smuggled steel evades U.S. tariffs
Tariff Effects
• As taxes on imports, tariffs make items more expensive for
consumers, reducing demand
• Buyers pay more for locally-made goods than they would for
imported goods under free trade
• Job loss in retail and transportation sectors that import foreign-
made goods
• Job loss in any domestic industry that suffers retaliatory tariffs
• Additional costs of imported inputs passed on to consumers
through goods and services that use such inputs in production
process
Tariff Welfare Effects: Producer
& Consumer Surplus
• Consumer Surplus (CS)
• Difference between what buyers are willing & able to pay and the
amount they actually pay
• Inverse relationship between change in market price and CS
• Producer surplus (PS)
• Difference between what producers are willing and able to receive
and the amount they actually receive
• Direct relationship between change in price and PS
 Tariff Welfare Effects: Producer
& Consumer Surplus
• Figure 4.1: Consumer and Producer Surplus

Producer surplus is area

above supply curve and
below market price

Consumer surplus is area

under demand curve and
above market price
Tariff Welfare Effects: Small
nation model
• Small nations import very small portion of world
market supply; unable to impact market price
• Is a price taker, facing constant world prices for products it
imports
• Tariff effects
o Raises home price of imported good by full amount of duty
o Results in higher domestic production & PS
o Lowers domestic consumption & decreases CS
Tariff Welfare Effects: Small
nation model
• A small nation tariff effects on nation’s welfare:
• Consumer surplus falls
• Additional tax revenues
• Benefits domestic producers
• Wastes resources
Tariff Welfare Effects: Small
nation model
• A small nation tariff effects on nation’s welfare:
• Revenue effect: Government’s collections of duty
• Redistributive effect: Transfer of consumer surplus to domestic
producers
• Protective effect: Loss to domestic economy from wasted
resources used to produce at increasing unit costs
• Consumption effect: Decrease in consumption resulting from
tariff’s artificially increasing price
• Deadweight loss: Protective effect and consumption combined
Tariff Welfare Effects: Large
nation model
• Tariffs may increase national welfare when imposed by importing
nation large enough that changes in its quantity of imports
influence world price (ex: U.S., Japan, EU)
• U.S. imposes tariff on automobile imports
• Prices increase for American consumers, quantity demanded decreases
• Effect shared between U.S. consumers, who pay higher price, and
Japanese firms, which receive lower price than under free trade
• Terms of trade improve for U.S. at Japan’s expense
Tariff Welfare Effects: Large
nation model
• Economic effects of an import tariff
• Redistributive effect: From domestic consumers to
domestic producers
• Deadweight loss: Consumption effect & Protective effect
• Revenue effect: Domestic revenue effect & Terms-of-trade
effect
The Optimal Tariff and Retalition
• Optimum tariff
• Maximizes positive difference between gain of improving terms of trade
and loss in economic efficiency from the protective effect and
consumption effect
• Only beneficial to importing nation
• Any benefit accruing to the importing nations through a lower import
price implies a loss to the foreign exporting nation, imposing an optimal
tariff is a beggar-thy-neighbor policy that could invite retaliation
How a tariff burdens exporters
• Effects of import tariffs on exporters
• Higher production costs from imported inputs and reduction in CS
o Can result in higher prices and, depending on elasticity of demand, reduce overseas
sales
• Raise cost of living
• International repercussions lead to reduction in domestic exports
• Welfare losses because of restrictions in output and employment in the
economy’s export industry may offset welfare gains enjoyed by import-
competing producers
Tariffs and the Poor: Regressive
Tariffs
• Tariffs are inequitable
• Impose most severe costs on low-income families – tend
to be regressive
• Higher tariffs imposed on cheap goods than on luxuries
• Affect different countries in different ways
• Tend to burden countries (e.g., poor countries in Asia and
Middle East) that specialise in production and sale of cheaper
goods
Arguments for Trade
Restrictions
• Free-trade argument
• If each nation produces what it does best and
permits trade, in long term, there will be lower
prices and higher levels of output, income, and
consumption
Arguments for Trade
Restrictions
• Job protection argument
• Job gains less visible than job losses
• Trade restrictions result in job gains for few
industries; job losses are spread out
• Saved jobs costs more than worker’s salary
Arguments for Trade
Restrictions
• Protection against cheap foreign labour
• Low wages abroad makes it hard for U.S. firms to compete
with firms using cheap foreign labour
• Fails to recognize links among efficiency, wages, and
production costs
• Low wages do not guarantee low costs
• Low-wage nations have competitive advantage only in
goods requiring greater labour and few other factor inputs
Arguments for Trade
Restrictions
• Fairness in Trade: Level Playing Field
• Domestic producers say import restrictions need to offset foreign
advantages, to create level playing field
o Rationale for restrictions is that foreign governments play by different
rules, giving foreign firms unfair competitive advantage
• Trade benefits domestic economy even if foreign nations impose
trade restrictions
• Fair trade argument overlooks potential impact of trade
restrictions on global trade
Arguments for Trade
Restrictions
• Maintenance of the Domestic Standard of Living
• Advocates of trade barriers often contend tariffs are
useful in maintaining high level of income and
employment in home nation
o However, one nation imposes a tariff that improves its income
and employment at the expense of its trading partner’s living
standard (beggar-thy-neighbor policy)
o May spark retaliatory tariffs, resulting in lower level of welfare
for all nations
Arguments for Trade
Restrictions
• Equalization of Production Costs
• Scientific tariff - to eliminate unfair competition from abroad
• Problems
o Different costs across business
o Higher domestic prices
- Benefit efficient domestic companies
- Domestic consumer subsidizing inefficient production
• Scientific tariff approximates prohibitive tariff
o Completely contradicts notion of comparative advantage & eliminates
basis/gains for/from trade
Arguments for Trade
Restrictions
• Infant-Industry Argument
• Trading nations temporarily shield newly
developing industries from foreign competition
• If protective tariff imposed, difficult to remove
oSpecial-interest groups - convince policy makers that
further protection is justified
Arguments for Trade
Restrictions
• Infant-Industry Argument
• Difficult to determine which industries will realise
comparative advantage in long-run
• Not valid for mature, industrialized nations
• Alternative=providing domestic industry subsidy
Arguments for Trade
Restrictions
• Noneconomic Arguments
• National security argument
oProtect essential industries
oWhat constitutes an “essential” industry? (Example:
Denel)
• Cultural and sociological considerations
• Assumption that national and individual’s welfare
enhanced by tariffs
Political Economy of
Protectionism
• Elected officials formulate policies to maximise
votes and remain in office
• Bias in the political system favours protectionism
Political Economy of
Protectionism
• Protection-biased sector
• Import competing producers
• Labor unions - in protected industry
• Suppliers of producers in protected industry
• Established firms in aging industry that could lose their
comparative advantage
• Free-trade-biased sector
• Exporting producers, their workers, and their suppliers