Tariffs and Nontariff Barriers International Economics Chapter 4

Tariffs and Nontariff Barriers

International Economics

Chapter 4

Chapter 4 Tariffs and Nontariff Barriers

4.1 Theories for Trade Protection

4.2 Tariffs

4.3 Nontariff Trade Barriers


Infant Industry Argument This argument contends that for free trade to be

meaningful, trading countries should temporarily shield their newly developing industries from foreign competition.


Some truths in the infant industry argument:Once a protective tariff is imposed, it is very

difficult to remove, even after industrial maturity has been achieved.

It is very difficult to determine which industries will be capable of realizing comparative advantage potential and thus merit protection.

The argument generally is not valid for mature, industrialized countries.

There may be other ways of insulating a developing industry from cutthroat competition. Rather than adopt a protective tariff, the government could grant a subsidy to the industry.


Terms of Trade ArgumentIn some cases, the terms of trade benefits of a tariff

outweigh its costs, so there is a terms-of-trade argument for a tariff.

The terms of trade argument against free trade, then, is intellectually impeccable but of doubtful usefulness.

In practice, it is emphasized more by economists as a theoretical proposition than it is used by governments as a justification for trade policy.


Domestic Market Failure Argument Theory of the second best

When economists apply the theory of the second best to trade policy, they argue that imperfections in the internal functioning of an economy may justify interfering in its external economic relations.

This argument accepts that international trade is not the source of the problem but suggests nonetheless that trade policy can provide at least a partial solution.


Strategic Trade Policy Because of the small number of firms, the assumption

of perfect competition does not apply. There are only a few firms in effective competition in some industries.

This argument locates the market failure that justifies government intervention in the lack of perfect competition.

It is possible in principle for a government to alter the rules of the game to shift these excess returns from foreign to domestic firms.



4.2 Tariffs


4.2 Tariffs

A tariff is simply a tax (duty) levied on a product when it crosses national boundaries. Import tariff v.s. Export tariff Protective tariff v.s. Revenue tariff

Types of Tariffs Specific Tariff Ad Valorem Tariff Compound Tariff

4.2 Tariffs

Effective Rate of Protection (ERP)the percentage change in the value added in an

industry because of the imposition of a tariff structure by the country rather than the existence of free trade.

4.2 Tariffs

Calculation of ERP (Way I):

'VA VAERP

VA

Value added with free tradeVA

' Value added under protectionVA

'VA VAERP

VA

Value added with free tradeVA

4.2 Tariffs

Calculation of ERP (Way II):

1j ij ii

iji

t a tERP

a

the tariff rate on input iit

the free-trade value of input i

as a percentage of the free-trade value of the final good j

ija

summing over all the inputsi

the tariff rate on the final good jjt

4.2 Tariffs

Three general rules about the relationship between nominal rates and effective rates of protection: If the nominal tariff rate on the final good is higher than the

weighted average nominal tariff rate on the inputs, then the ERP will be higher than the nominal rate on the final goods;

If the nominal tariff rate on the final good is lower than the weighted average nominal tariff rate on the inputs, then the ERP will be lower than the nominal rate on the final goods;

If the nominal tariff rate on the final good is equal to the weighted average nominal tariff rate on the inputs, then the ERP will be equal to the nominal rate on the final goods.

4.2 Tariffs

Two consequences of the effective rate calculation:The degree of effective protection increases as the value add

ed by domestic producers declines.

In the formula, the higher the value of aij is, the greater the effective protection rate for any given nominal tariff rate on the final product will be.

A tariff on imports used in the production process reduces the level of effective protection.

In the formula, as ti rises, the numerator of the formula decreases and hence ERP decreases.

4.2 Tariffs

Conclusionwhen material inputs or intermediate products enter

a country at a very low duty while the final imported commodity is protected by a high duty, the result tends to be a high protection rate for the domestic producers. The nominal tariff rate on finished goods thus understates the effective rate of protection.

But should a tariff be imposed on imported inputs that exceeds that on the finished good, the nominal tariff rate on the finished product would tend to overstate its protective effect.

4.2 Tariffs

Tariff Escalation The tariff structures have generally been

characterized by rising rates that give greater protection to intermediate and finished products than to primary commodities. The tariff structures of the industrialized countries

may indeed discourage the growth of processing, thus hampering diversification into higher value-added exports for the less developed countries, worsening the potential competitive position of the less-developed countries in the manufacturing and processing sectors.

4.2 Tariffs

Tariff Welfare Effects Consumer Surplus

Consumer surplus refers to the difference between the amount that buyers would be willing and able to pay for a good and the actual amount they do pay.

Producer SurplusProducer surplus is the revenue producers receive

over and above the minimum amount required to induce them to supply the good.

4.2 Tariffs

P

QO

B

C

E

Demand(maximum price)

(actual price)

Consumer Surplus

P

QO

Producer Surplus

Supply(minimum price)

(actual price)A A

B

C

D

Total Expenditure Total

Variable Cost

(a) (b)

4.2 Tariffs

Trade Welfare Effect of Tariff in a Partial Equilibrium Setting

The Small-Nation Case P

0

Sd

Dd

E

Q1 Q3 QE Q4 Q2

PE

PW+t

PW

ta b c d

G

FSd+w

Sd+w+t

Q

4.2 Tariffs

The redistributive effect (Area a) the transfer of consumer surplus, in monetary terms, to the

domestic producers of the import-competing product. The protective effect (Area b)

the loss to the domestic economy resulting from wasted resources used to produce additional cloth at increasing unit costs.

The domestic revenue effect (Area c) the tariff proceeds paid by country A’s consumers to its

government. The consumption effect (Area d)

arises from the decrease in consumption resulting from the tariff's artificially increasing the price.

The deadweight loss (Areas b + d) represents a real cost to a community, not a transfer to other

sectors of the economy.

4.2 Tariffs

Levying an import tariff, therefore, reduces a small country's welfare.

Welfare Cost of a Tariff Imposed by a Small Nation

Item Welfare Change (Area)

Change in consumer surplus −a −b −c −d

Change in producer surplus a

Change in government revenue c

Net welfare change −b −d

4.2 Tariffs

The Large-Nation Case

The equilibrium world price is defined as the price at which the quantity that consumers in Country A want to import is equal to the quantity that producers in Country B want to export. In the diagram, this price is denoted by PFT.

International Free-Trade Equilibrium

P

PA

PFT

0 Q1 Q2

SA

DA

PFT

PB

0 Q1'

DB

SB

Q2'

(a) Country A (b) Country B

Q

P

Q

4.2 Tariffs

The size of the tariff equals the difference between the price consumers in country A pay for the product (PT) and the price producers in country B receive (P'). That is, the per unit tariff of t equals PT −P' .

P

PT

PFT

0 Q1 Q2

SA

DA

PFT

P'

0 Q1'

DB

SB

Q2'

(a) Country A (b) Country B

P'

Q3 Q4 Q3' Q4'

ta b c de

P

Q Q

4.2 TariffsThe redistributive effect (Area a)

the transfer of consumer surplus, in monetary terms, to the domestic producers of the import-competing product.

The protective effect (Area b)the loss to the domestic economy resulting from wasted resources used to produce additional cloth at increasing unit costs.

The domestic revenue effect (Area c)the tariff proceeds paid by country A’s consumers to its government.

The consumption effect (Area d)arises from the decrease in consumption resulting from the tariff's artificially increasing the price.

The terms of trade effect (Area e)the amount of the tariff revenue paid by foreigners because the world price of their exports has fallen.

4.2 Tariffs

The change in welfare in country A brought about by the imposition of a tariff equals e−(b+d). This amount could be positive or negative, depending on the relative sizes of the two terms.

Optimal tariff : the tariff would be set to a level that maximizes the area e−(b+d).

4.2 Tariffs

Trade Welfare Effect of Tariff in a General Equilibrium Setting The Small-Nation Case

Textiles

Agricultural GoodsX0

M0

B0

C0

C1

IC1

IC0

B1

1A

T

P

P t

0

A

T

P

P

1

A

T

P

P

4.2 Tariffs

The reduction in welfare comes from two effects:The economy no longer produces at a point that

maximizes the value of income at world prices. The budget constraint that passes through B1 lies inside the constraint passing through B0.

Consumers do not choose the welfare-maximizing point on the budget constraint; they do not move up to an indifference curve that is tangent to the economy's actual budget constraint.

4.2 Tariffs

The Large-Nation Case

With the imposition of a tariff, Country I’s offer curve OCI shifts inward to OCI'.

Good A

A2

A2'

A1

A1'

O B1' B2' B1 B2

W'

XX'

W

OCI'

TOT2

TOT1

Good B

OCI

4.2 Tariffs

The Impact of a Tariff

The equilibrium quantity of exports falls from OB1 to OB2, and the quantity of imports falls from OA1 to OA2. Country I’s terms of trade improve from TOT1 to TOT2.

Good A

A2

A1

O B1B2

E'E

OCI TOT2

TOT1

Good B

OCI’

OCII



4.2 Tariffs



An Introduction to Nontariff Trade Barriers Import Quota

An import quota is a physical restriction on the quantity of goods that may be imported during a specific period; the quota generally limits imports to a level below which imports would occur under free-trade conditions.

A common practice to administer an import quota is for the government to require an import license. Each license specifies the volume of imports allowed, and the total volume allowed should not exceed the quota.

Import quotas on manufactured goods have been outlawed by the World Trade Organization.


Tariff-Rate Quota: A Two-Tier Tariff a tariff-rate quota displays both tariff-like and

quota-like characteristics. This device allows a specified number of goods to be imported at one tariff rate (the within-quota tariff rate), whereas any imports above this level face a higher tariff rate (the over-quota tariff rate).

a tariff rate quota is a two-tier tariff.


Orderly Marketing Agreements An orderly marketing agreement (OMA) is a market-

sharing pact negotiated by trading partners. Its main purpose is to moderate the intensity of

international competition, allowing less efficient domestic producers to participate in markets that would otherwise have been lost to foreign producers who sell a superior product at a lower price.

A typical OMA consists of voluntary quotas applied to exports. These controls are known as voluntary export restraints (VERs); they are sometimes supplemented by backup import controls to ensure that the restraints are effective.


Domestic Content Requirements To limit the practice of outsourcing, organized labor has

lobbied for the use of domestic content requirements. The effect of content requirements is to pressure both

domestic and foreign firms who sell products in the home country to use domestic inputs (workers) in the production of those products.

Manufacturers generally lobby against domestic content requirements, because they prevent manufacturers from obtaining inputs at the lowest cost, thus contributing to higher product prices and loss of competitiveness.


Subsidies National governments sometimes grant subsidies to their

producers to help improve their trade position. Governmental subsidies assume a variety of forms,

including outright cash disbursements, tax concessions, insurance arrangements, and loans at below-market interest rates.

Two types of subsidies:

– a domestic subsidy which is sometimes granted to producers of import-competing goods;

– an export subsidy which goes to producers of the goods that are to be sold overseas.


Dumping Dumping is recognized as a form of international price

discrimination. It occurs when foreign buyers are charged lower prices

than domestic buyers for an identical product, after allowing for transportation costs and tariff duties. Selling in foreign markets at a price below the cost of production is also considered dumping.

Commercial dumping is generally viewed as sporadic, predatory, or persistent in nature. Each type is practiced under different circumstances.


The effects of an Import Quota

P S

S+Q

D

E

G

F

P

PQ

PW

0 Q1 Q3 Q4 Q2 Q

a b c d

Quota

In the absence of trade, equilibrium would occur at Point E with the domestic price of cloth equaling P.

The free-trade equilibrium is located at Point F, the domestic price of cloth would fall to the world price PW.

The imposition of the quota changes the amount of cloth supplied to the importing country, a new equilibrium is reached at G.


The country loses Areas b+c+d under a quota. The redistributive effect (Area a) The protective effect (Area b) The domestic revenue effect (Area c)

Area c accrues to the foreign producers and makes them more profitable.

The consumption effect (Area d) The deadweight loss (Areas b + d)


Two methods available for a government or community to capture Area c from foreign producers under a quota.

– The domestic government could auction quotas to importers in a free market. The limited quota supply would go to those importers most in need of the product who would pay the higher price.

– Convert the quota into an equivalent tariff.


Quota and equivalent tariff The losses for consumers and community are much larger in

the case of a quota than in the case of a tariff when demand increases.

PS

S+Q

D

E

G

F

P

PT=PQ

PW

O Q1 Q3 Q4 Q2 Q

b c d

Quota

PQ'

QuotaD'

t


The Effects of an Export Subsidy

P

QO

S'

S

D

PW SW

Q0 Q1

PW+t

Subsidy=t

ta b d

Q2

c

Consumers lose Area a+b in the form of higher taxes.

Producers gain Area a in profits.

The cost to the community is Area b, that is the production deadweight cost of the subsidy.

Subsidies are superior to protection in another way: they are more visible.

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Tariffs and Nontariff Barriers International Economics Chapter 4