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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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-2 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-3 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-4 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-5 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) Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-6 FIGURE 6.1 Consumer and Producer Surplus Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-7 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-8 FIGURE 6.2 Domestic Supply and Demand for an Imported Good Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-9 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-10 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-11 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-12 FIGURE 6.3 The Effects of a Tariff Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-13 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-14 TABLE 6.1 Economic Effects of the Tariff in Figure 6.3 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-15 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-16 FIGURE 6.4 Average Tariff Rates, 1986-2007 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-17 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-18 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-19 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-20 FIGURE 6.5 Tariffs in the Large Country Case Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-21 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) Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-22 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) Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-23 TABLE 6.2 Nominal and Effective Rates of Protection Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-24 Table 6.3 The Uruguay Round Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-25 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-26 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-27 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-28 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-29 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-30 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-31 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-32 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) Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-33 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-34 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-35 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-36 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 6-37