Chapter 6 Theory of Tariffs and Quotas Learning

Chapter 6 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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -2

Learning Objectives (cont. ) • Differentiate effective from nominal rates of protection. • List and discuss at least three dynamic costs of protection. Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -3

Introduction: Tariffs and Quotas • This chapter and the next chapter provide an introduction to 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 © 2014 Pearson Education, Inc. All rights reserved. 6 -4

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -5

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 Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -6

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -7

FIGURE 6. 1 Consumer and Producer Surplus Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -8

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -9

FIGURE 6. 2 Domestic Supply and Demand for an Imported Good Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -10

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -11

FIGURE 6. 3 The Effects of a Tariff Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -12

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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -13

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 Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -14

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: Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -15

TABLE 6. 1 Economic Effects of the Tariff in Figure 6. 3 Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -16

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 Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -17

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. Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -18

FIGURE 6. 4 Average Tariff Rates, 1986 -2010 Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -19

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 Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -20

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 Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -21

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -22

FIGURE 6. 5 Tariffs in the Large Country Case Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -23

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -24

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) Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -25

TABLE 6. 2 Nominal and Effective Rates of Protection Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -26

Table 6. 3 The Uruguay Round Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -27

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -28

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 Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -29

Types of Quotas (cont. ) 2) Import licensing requirement: – forcing importers to obtain government licenses for their imports; – government regulates the number of licenses available Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -30

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 Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -31

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -32

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 foreign producers, called quota rents. Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -33

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -34

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -35

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 Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -36

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -37

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -38

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -39

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 Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -40

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 © 2014 Pearson Education, Inc. All rights reserved. 6 -41

Quiz • Given that tariffs and quotas cost consumers and that they are grossly inefficient means for creating or preserving jobs, why do citizens allow these policies to exist? Copyright © 2014 Pearson Education, Inc. All rights reserved. 6 -42