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Chapter 6
The Theory
of Tariffs
and Quotas
Learning Objectives
• Draw a supply and demand diagram and
use it to illustrate consumer and producer
surplus.
• Draw a graph that shows the effects of
tariffs and quotas on prices, output, and
consumption.
• Explain in words and with a diagram the
effects of tariffs and quotas on resource
allocation and income distribution.
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6-2
Learning Objectives (cont.)
• Differentiate effective from nominal rates of
protection.
• List and discuss at least three dynamic costs
of protection.
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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
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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
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Analysis of a Tariff
(cont.)
• Tariffs and quotas encourage
– Consumers to switch to relatively cheaper
domestic goods or to drop out of the market
– Domestic producers to increase their output as
demand switches 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
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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 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)
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FIGURE 6.1 Consumer and Producer
Surplus
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Prices, Output, and Consumption
Assume:
1. There is only one price for a good (world price
P w)
2. Foreign producers are willing to supply us with
all of the units of the good we want at that
price
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FIGURE 6.2 Domestic Supply and
Demand for an Imported Good
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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.”
– 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
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FIGURE 6.3 The Effects of a
Tariff
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Prices, Output, and Consumption
(cont.)
• In Summary,
– tariffs cause the domestic price to rise by the
amount of the tariff,
– domestic consumption falls,
– domestic production rises,
– imports fall.
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Resource Allocation and
Income Distribution
• Tariffs have more subtle effects than just a
rise in prices and a fall in imports.
- Inputs in domestic production: increase
domestic production requiring additional
resources of land, labor, and capital to be
reallocated from their prior uses into the
industry receiving protection under the tariff.
- when the price changes, consumer and
producer surplus do too
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Resource Allocation and
Income Distribution (cont.)
• Deadweight loss- destruction of value
that is not compensated by a gain
somewhere else : area d is this type of loss.
• Efficiency loss- another deadweight loss
which occurs on the production side: area b
is this type of loss
Summary- 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:
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TABLE 6.1 Economic Effects of
the Tariff in Figure 6.3
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A Comparison of Tariff Rates
• The Doha Development Agenda of the World Trade
Organization (WTO) is focused on the trade
problems of developing countries
• At issue for many developing countries are the levels
of tariffs and other industrial country barriers that
block access to agriculture, clothing, and textile
markets.
• However, developed nations often have highest
tariffs in agriculture, textiles, and other laborintensive products – the very products developing
nations would like to export
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Comparison of Tariff Rates
(cont.)
• Industrial countries, the World Bank, and the
WTO have argued major problem facing
developing countries is the relatively high
level of protection among themselves
• High tariffs limit the countries’ ability to sell
into each other’s markets—and consequently
their ability to follow their comparative
advantage.
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FIGURE 6.4 Average Tariff
Rates, 1986-2010
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Other Potential Costs
• 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
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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
(e.g., firms hire lobbyists to maintain tariff
protection)
- Political systems that do not easily provide tariffs
are more likely to avoid rent seeking
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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
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FIGURE 6.5 Tariffs in the Large
Country Case
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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)
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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)
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TABLE 6.2 Nominal and Effective
Rates of Protection
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Table 6.3 The Uruguay Round
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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
– 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
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Types of Quotas
1) Most transparent type of quota:
– an outright 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
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Types of Quotas (cont.)
2) Import licensing requirement:
– forcing importers to obtain government licenses
for their imports;
– government regulates the number of licenses
available
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Types of Quotas (cont.)
3) Voluntary export restraint (VER) (or
voluntary restraint agreement, VRA)
– the exporting country “voluntarily” agrees to
limit its exports for a period
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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
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The Effect on the Profits
of Foreign Producers
• The main difference between tariffs and
quotas is that there is no government
revenue from quotas.
• In place of tariff revenue, there are greater
profits for foreign producers, called quota
rents.
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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
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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
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The Effect on the Profits
of Foreign Producers (cont.)
• Second important difference between tariffs and
quotas:
• Over time, as demand for the good increases and
quota remains fixed: increase in consumer demand,
increases the price paid by consumers, increases in
producer surplus garnered by domestic firms.
• In contrast, an increase in consumer demand for an
item that has an import tariff increases the quantity
of imports and leaves the price intact
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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)
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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 (NTBs): quotas and
non-tariff measures
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Hidden Forms of Protection
(cont.)
• Non-tariff measures are hidden, nontransparent 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
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Intellectual Property Rights
and Trade
• Intellectual property (intellectual
property rights) are 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
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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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