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Chapter 6
The Theory
of Tariffs
and Quotas
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
Chapter Objectives
• Introduce the theory of tariffs
• Discuss the welfare and efficiency effects of
tariffs
• Analyze the distinction between tariffs and
quotas
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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
– 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
Pw)
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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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
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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
resources of land, labor, and capital to be
reallocated from their prior uses
– Consumer surplus
– Producer surplus
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FIGURE 6.3 The Effects of a Tariff
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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
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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
• Since the mid-90s tariff rates in most countries
have fallen
• Generally, tariff rates in developing nations are
higher than developed nations
• 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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FIGURE 6.4
Average Tariff Rates, 1986-2007
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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
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 or survive
(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 vs. 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) 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
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
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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
• 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
-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
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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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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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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
(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 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
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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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