Tariffs Two Countries Udayan Roy http myweb liu

Tariffs: Two Countries Udayan Roy http: //myweb. liu. edu/~uroy/eco 41 September 2009

Tariffs: Two Countries Case • For a country that is so large that it can by itself affect the worldwide prices of the goods it imports, the gains from a tariff may exceed the losses and the country as a whole may benefit from the tariff. • However, the imposition of the tariff will harm other countries more than the country imposing the tariff will gain. • So, the world, as a whole, will be harmed by the tariff.

Prices after the tariff • Suppose Japan imposes a tariff on its imports of European steel • Then, Price in Japan = Price in Europe + Tariff – as long as some European steel continues to be imported into Japan even after the tariff • Why?

Prices after the tariff • Suppose the price of European steel in Europe = 4 per ton • Suppose the tariff = 2 per ton • Then the price of European steel in Japan = 4 + 2 = 6 per ton • Therefore, Japanese steel producers can’t charge more than 6 in Japan • But can they charge less than 6? Can they charge 5. 40? • No. I have assumed that some European steel continues to be imported into Japan even after the tariff. That would not have happened if Japanese steel was selling for less than European steel • Therefore, the price of Japanese steel in Japan is also 6 • In general, the Price (of both European steel and Japanese steel) in Japan = Price in Europe + Tariff

Demand, Before Tariff • Under free trade, the price of steel in Japan is the same as in Europe • Demand is Demand. B • When the price in Europe (and in Japan) is 6, the Japanese buy 10 tons of steel Price (in Europe or Japan) 6 Demand. B 10 Quantity in Japan

Effect of Tariff on Demand Price in Europe 1. Before Japan imposes a tariff, Japan’s demand curve is Demand. B. When the price of steel in Europe is 6, so is the price in Japan, and the Japanese buy 10 tons of steel. 2. Then Japan imposes a tariff = 2 on European steel 6 Demand. B 4 Demand. A 10 Quantity in Japan 3. Now, the Japanese will not buy 10 tons unless the price in Europe is 4. 4. This implies that the new demand in Japan after the tariff is Demand. A. 5. That is, Japan’s demand corresponding to the price in Europe shifts downward by the exact extent of the tariff. 6. Japan’s demand corresponding to the price in Japan remains Demand. B.

Effect of Tariff on Supply • A similar logic shows that: – Japan’s supply (corresponding to the price in Europe) shifts downward by the exact extent of the tariff. – Japan’s supply (corresponding to the price in Japan) remains Supply. B. Price in Europe Supply. B 6 Supply. A 4 10 Quantity in Japan

Price in Europe, after Japan’s tariff • As Japan’s demand shifts left, so does the World’s demand • As Japan’s supply shifts right, so does the World’s supply • Therefore, the free trade price of Europe’s exports must fall – Note that Japan is indeed a “large country” in this example • Japan may potentially benefit, by forcing down the price of its imported good

Recall: The free trade worldwide price is the price at which excess demand in one country is equal to the excess supply in the other country. Price Europe + Japan = World Quantity

1. Japan imposes a tariff on its imports. 2. As a result, the price in Japan exceeds the price in Europe by the size of the tariff. 3. Therefore Japan’s Demand curve corresponding to the European price (broken line) will be below its Demand curve corresponding to the Japanese price (unbroken line) by the size of the tariff. Price 4. The same is true for the Supply curve. The price in Japan increases, but by less than the tariff. The price in Europe decreases because of Japan’s tariff. Europe Japan Quantity

1. Japan imposes a tariff on its imports. 2. As a result, the price in Japan must exceed the price in Europe by the size of the tariff. 3. And Japan’s imports must equal Europe’s exports. Tariff The price in Japan after Japan imposes a tariff Price F Tariff A B D Europe C E G H I L The price in Europe after Japan imposes a tariff J K M N Free Trade O Japan Quantity

Japan imposes a tariff on its imports. In Europe, consumer surplus increases from A to AB. In Japan, consumer surplus decreases from FGHIJK to FG. Producer surplus increases from LO to HLO. And tariff revenue increases from zero to JM. Price Producer surplus decreases from BCDE to DE. The price in Japan after the tariff. F A B D Europe H C Worldwide free trade price G I L J K M N O E The price in Europe after the tariff. Japan Quantity

Tariffs: Two Countries Case Europe Before After Japan Before After Consumer A AB FGHIJK FG Surplus Producer BCDE DE LO HLO Surplus Tariff ---JM Revenue Total ABCDE ABDE FGHIJKLO FGHJLOM Surplus

Gains and Losses from Tariffs: Importing Country • The loss to the country that imposes the tariff (Japan) include I and K, which represents the loss of the gains from trade. But, • Japan also gains M, which represents the improvement in its terms of trade. • Had Japan been a “small” country, it would not have been able to force a reduction in the price of its imported good. Therefore, tariffs would have had only losses and no gains.

Effects of Tariff—Small Country Price of Steel Domestic supply A Deadweight Loss B Price with tariff C 0 E D Price without tariff G Tariff F Imports after tariff S Q S Domestic demand D Q Q Imports without tariff D Q World price Quantity of Steel

Effects of Tariff—Large Country Price of Steel A large country can use tariffs to force down the price of its imported good. This leads to Domestic additional gain of E 2. If supply E 2 exceeds D+F, the country will be better off after imposing the tariff. A B Price with tariff C E 1 D F World price before tariff E 2 G 0 Tariff S Q S Domestic demand D Q Q Imports without tariff D Q World price after tariff Quantity of Steel

Gains and Losses from Tariffs: All Countries • The country that imposes a tariff will gain (lose) if M exceeds (is less than) I plus K • The other country will lose by the amount C • C exceeds M. Therefore, the world as a whole loses

Retaliation • The analysis so far has assumed that one country can impose tariffs on its imports without the other country retaliating with tariffs of its own • If retaliation occurs, even the conditional support for tariffs outlined earlier has no basis