The Basic Analysis of a Tariff

 

Overview 

This chapter begins the analysis of government policies that limit imports, by examining the tariff—a government tax on imports. The chapter has two major purposes. First, the analysis shows the effects of a tariff when the importing country is small, so that its import policies have no effect on world prices. Second, the analysis of a large importing country—one whose policies can affect world prices—shows that a large country can use a tariff to lower the price that it pays foreigners for its imports.

We begin by examining the effects of a tariff imposed by a small country (contrasted with free trade), using supply and demand within the importing country. Since foreign exporters do not change the price that they charge for the product, the domestic price of the imported product rises by the amount of the tariff. Domestic producers competing with these imports can also raise their domestic prices as the domestic price of imports rises. Domestic producers gain when the government imposes a tariff on competing imports. They get a higher price for their products, they produce and sell a larger quantity (a movement along the domestic supply curve), and they receive more producer surplus. (The effects of the entire tariff system on domestic producers can be more complicated than this, because other tariffs can raise the costs of materials and components. The box on "The Effective Rate of Protection" discusses this more complete analysis, focusing on the effects of the tariff system on value added per unit of domestic production.)

Domestic consumers of the product are also affected by the imposition of the tariff. They must pay a higher price (for both imported and domestically produced products), they reduce the quantity that they buy and consume (a movement along the domestic demand curve), and they suffer a loss of consumer surplus.

The government also collects tariff revenue, equal to the tariff rate per unit imported times the quantity that is imported with the tariff is imposed (less than the free-trade import quantity).

We thus have two domestic winners (domestic producers and the national government) and one domestic loser (domestic consumers) because of the imposition of a tariff. We can evaluate the net effect on the whole country, if we have some way of comparing winners and losers. As we did beginning in Chapter 2, we can, for instance, use the one-dollar-one-vote measure. Part of what consumers lose is matched by the gain to domestic producers, and another part is matched by the revenue gain to the government. But there is an additional amount that consumers lose and that is not a gain to the other groups. This is the net national loss from a tariff (for a small country). In the national market graph this loss is two triangles; equivalently, in the import-export graph this loss is one triangle.

If we look at the national market graph, we can see why these are deadweight losses. The consumption effect of the tariff is the loss of consumer surplus for those consumers who are squeezed out of the market because the tariff "artificially" raises the domestic price, even though foreigners remain willing to sell products to the importing country at the lower world price. The production effect of the tariff is the loss from using high-cost domestic production to replace lower-cost imports (available to the country at the unchanged world price). The high production cost is shown by the height of the supply curve, for each of the extra units produced because of the tariff.

The analysis is affected in important ways if the importing country is a large country, one that has monopsony power in world markets. A large country can gain from the terms-of-trade effect when it imposes a tariff. The tariff reduces the amount that the country wants to import, so foreign exporters lower their price (a movement along the foreign supply-of-exports curve). We analyze the large country case using the international market (imports and exports), and we show the tariff as driving a wedge between demand and supply, so the price to the import buyers exceeds the price received by foreign exporters by the amount of the tariff. For the large importing country, the imposition of the tariff causes a triangle of national loss (comparable to the one shown for the small country) but also a rectangle of national gain because the price paid to foreign exporters is lowered, for the units that the country continues to import.

The net effect on the importing country depends on which of these two is larger. For a suitably small tariff, the rectangle is larger, so the importing country has a net gain from imposing a tariff. A prohibitive tariff would cause a net national loss, because the rectangle would disappear. It is possible to determine the country's optimal tariff—the tariff rate that makes the net gain to the importing country as large as possible. The optimal tariff rate is inversely related to the price elasticity of foreign supply of the country's imports.

We conclude by pointing out that the optimal tariff causes a net loss to the whole world. The loss to the foreign exporting country is larger than the net gain to the importing country. And a country trying to impose an optimal tariff risks retaliation by the foreign countries hurt by the country's tariff

Objectives of the Chapter

This chapter explicitly explains the advantages and disadvantages of a tariff imposition. Except for some recognized exceptional cases, there is a rare consensus among economists that freer trade is better than protectionism. As illustrated in this chapter, economic analysis has consistently demonstrated that there are usually net gains from freer trade for the nation as well as for the world. A tariff helps import‑substituting producers, and the government collects some tariff revenue (import taxes). However, this can only be attained at the expense of a net loss to the whole nation, and particulatly to consumers.

After studying Chapter Seven you should be able to identify:

1.         The advantages and disadvantages of a tariff.

2.         How a tariff lowers the welfare of the world as a whole.

3.         Ad valorem tariff and specific tariff.

4.         Effective rate of protection.

5.         How demand‑supply analysis can be used to assess the gains and losses of a tariff, using both graphical and tabular expositions.

6.         Who gains and who loses from a tariff imposition.

Key Terms

Ad valorem tariff:       A tariff that is set as a percentage of the value of the goods when they reach the importing country.

Consumption effect:   The welfare loss to consumers in the importing nation that corresponds to their being forced to cut their total consumption as a result of the tariff.

Deadweight loss: 'the parts consumers lose as a result of a tariff that accrues to neither the government nor producers.

Effective rate of protection: The percentage by which the entire set of a nation's trade barriers raises the industry's value added per unit of output. (Abbreviated ex.p.)

Nationally optimal tariff: A tariff set at the rate which maximizes the gains for a large country (at the expense of foreign countries). Technically, the optimal rate, as a fraction of the price paid to foreigners, equals the reciprocal of the elasticity of supply of a country's imports.

Price‑taking countries:           "Small" countries that cannot affect the outside world price of the goods and services they trade. In these countries, the import supply curve is infinitely elastic.

Production effect:       The cost of shifting to more expensive home production in the import‑competing sector, which is protected by the tariff on foreign goods.

Prohibitive tariff:        A tariff which is set so high that it makes all imports unprofitable.

Specific tariff:  A tariff stipulated as a money amount per physical unit of import.

 

Warm‑up Questions

True or False? Explain

1. T / F Free trade is always a better policy than a tariff.

2. T / F An advantage of a specific tariff is that its protective value keeps pace with increases in the price of the imported good.

3. T / F While a tariff may be nationally optimal, it is not globally optimal.

4. T / F Ad valorem is just another way of saying ad nauseam.

 

Multiple Choice

1. The optimal tariff for a small (price taking) country:

A. Is zero.
B. Is a prohibitive tariff.
C. Is unambiguously positive.
D. Increases as that country's elasticity of demand increases.

2. An optimal tariff, which yields a net national welfare gain, requires that:

A. The nation be a "price taker."
B. There be no loss of consumer surplus.
C. Trading partner nations not be injured by the tariff.
D. The nation have monopsony power in the international market.

3. The imposition of a tariff

A. Generates revenue which is paid entirely by foreigners.
B. Always increases the domestic price in the exporting country.
C. Reduces the welfare of a "small" importing country relative to free trade.
D. Is always welfare‑increasing.

4. The effective rate of protection of an industry is:

A. Always more than the optimal tariff.
B. A measure of the jobs gained by the economy imposing a tariff.
C. More or less than the nominal tariff rate depending on the domestic output's share in GDP.
D. More or less than the nominal tariff rate depending on the tariffs on inputs.

5. The imposition of an import tariff by a large nation:

A. Increases the nation's welfare.
B. Reduces the nation's welfare.
C. Leaves the nation's welfare unchanged.
D. Any of the above is possible.

 Problems

1.         Consider a case in which the large country, Leinster, imposes a tariff on Saxon bread. This tariff reduces the volume of bread from 80 million loaves to 40 million loaves, and causes the "world" price to fall to 0.23 telephones per loaf of bread.

b.         Bread producer surplus in Leinster and in Saxony.
c.         National welfare in Leinster and in Saxony.
d.         "World" welfare.

2. Suppose the U.S. puts a 200 percent tariff on all imported wines. You have been asked to estimate the net national gain (or loss) from the tariff. Consider how your measure of net national gain (or loss) is affected by the different elasticities of demand and supply:

a.         Would a higher elasticity of U.S. demand for wine make the 200 percent tariff better or worse if we were a small, price‑taking country?

b.         Would a higher elasticity of U.S. wine supply make the 200 percent tariff better or worse for the U.S. as a whole if we were a small, price‑taking country?

c.         Would a higher elasticity of foreign wine supply make a 200 percent tariff better or worse for the United States as a whole?

3.         Assume the U.S. imposes a $1.50 tariff on each six pack of imported beer. (All beers are the same quality and all are sold in six packs.) Careful studies show the tariff has these effects:

 

 

With free trade

With $1.50 tariff

Domestic price

 

 

(dollars per six pack)

$3.00

$4.00

World price

$300

$2.50

(c.fi. Oakland)

 

 

Domestic demand

 

 

(millions of six packs per year)

3,200

2,800

Domestic supply

 

 

(millions of six packs per year)

2,000

2,500

Imports

1,200

300

(millions of six packs per year)

 

 

a.             Calculate the net national U.S. gain (or loss) from the tariff, assuming the "one‑dollar, one‑vote" standard.

 b.         Suppose that $2.00 of purchased nputs go into each six pack of domestic beer, with or without the tariff; the rest of the price is the industry's value added.

What is the effective rate of protection given to the beer industry? (There are no tariffs on barley, hops, mascots for advertising or other purchased inputs.)

4.         The United States currently imports baseball bats without tariff, with the results shown in the first column of numbers below. Suppose that Congress is thinking of imposing atariff of $35 per bat, and has asked you to estimate the gains and losses to different groups. You find that the $35 tariff would yield the prices and quantities shown in the right‑hand column. In the following questions explain your answers and give numerical results if possible:

 

Free-trade situation (no tariff)

Situation with $35 tariff on bats

U.S. domesticpriceofbats

$80

$100

Tariff

$0

$35

World price of bats

$80

$65

U.S. production of bats per year

160,000

-220,000

U.S. imports of bats per year

200,000

100,000

U.S. consumption of bats per year

360,000

- -

320,000

a.   What is the gain or loss to U.S. bat consumers from the tariff?
b.  What is the gain or loss to U.S. bat producers from the tariff?
c.  What is the government revenue from the tariff?
d.   What is the net gain or loss for the U.S. as a whole?
e.   What is the net gain or loss for other countries?
f.    What is the gain or loss for the world as a whole?

5.         The World Bank calculates that the effective rate of protection for Pakistani clothing producers is ‑30 percent. You are asked to advise the Pakistani government on their trade policy towards the clothing industry. Interpret the meaning of the ‑30 percent effective rate of protection and suggest the tariff changes that would most benefit the Pakistani clothing industry.

6.         The production of heating devices requires the use of copper wire. Suppose that 10 percent of the total value of a heating device is comprised of the value of copper wire. German firms that are producing heating devices import the copper wire that is used in production. If the German tariff on imported heating devices is 12 percent and the German tariff on imported copper wire is 10 percent, what is the effect rate of protection for the German heating device industry?

7.         Look back at the bread import and export curves that you derived for our hypothetical world in Problem 1 in Chapter Two. Does Leinster" demand for bread imports appear to be more or less elastic than Saxony's supply of bread exports? What does that tell you about impact of Leinsterian welfare of a tariff on imported bread?

 

Discussion Topics

1.         For a small country, economic theory says the imposition of a tariff will reduce the country's welfare. Why is it then that so many small countries do impose tariffs?

2.         A tariff increases producer welfare at the expense of consumer welfare, and is never economically "efficient." Is a tariff ever "equitable?"

ANSWERS

T/f: 1: F; 2: F; 3: T; 4: F

MULTIPLE CHOICE QUESTIONS:

1. A; 2. D; 3. C; 4. D; 5. D

Suggested answers to questions and problems (in the textbook)

2. Agree. The tariff raises the domestic price of the imported product, and domestic producers of the product raise their price when the domestic price of imports increases. Domestic consumers lose consumer surplus on the total amount that they consume, both imports and domestically produced product, because of the increase in domestic price. Domestic producers gain producer surplus on the amount that they produce and sell, because of the increase in domestic price. Consumers lose more because the domestic quantity consumed is larger than the domestic quantity produced.

4. The consumption effect of a tariff is the loss of consumer surplus for the units that consumers would consume with free trade but do not consume when the tariff increases the domestic price. The tariff "artificially" raises the domestic price and causes some consumers to buy less of the product. On a diagram like Figure 7.3 or 7.4A, it is the triangular area d.

6. For a small country the world price of $400 will not be affected by the tariff. The size of the net national loss from imposing a $40 tariff will depend on the shapes of the domestic supply and demand curves. The graph shows several possible domestic supply and demand curves. (We will assume that supply and demand are straight lines.)

The maximum net national loss occurs when the two triangles of deadweight loss are as large as possible. The maximum loss occurs when the $40 tariff just eliminates all imports, so that the country shifts to no trade with a domestic price of $440. The tariff imposes a full $40 price distortion on the full amount of free-trade imports of 0.4 million per year. In the graph, any curves like S1 and D1, which have free-trade at A and B and intersect each other at a price of $440, will cause a net national loss shown by the shaded triangle. The size of the loss is (½)×(1.4 - 1.0)×($40) = $8 million.

The maximum net national loss occurs when the two triangles of deadweight loss are as large as possible. The maximum loss occurs when the $40 tariff just eliminates all imports, so that the country shifts to no trade with a domestic price of $440. The tariff imposes a full $40 price distortion on the full amount of free-trade imports of 0.4 million per year. In the graph, any curves like S1 and D1, which have free-trade at A and B and intersect each other at a price of $440, will cause a net national loss shown by the shaded triangle. The size of the loss is (½)×(1.4 - 1.0)×($40) = $8 million.

8. If imports are 0.33 million bicycles, the tariff-inclusive price paid by domestic consumers must be $350, and the export price is $250, so the tariff is $100 per bicycle. The importing country gains the rectangle equal to $50×0.33 million = $16.7 million. It loses the triangle equal to (½)×$50×0.67 = $16.7 million. The net national gain is zero.

10. The formula is 1/sm, where sm is the foreign elasticity of export supply (foreign supply of our imports). If the foreign supply is infinitely elastic, then the optimal tariff is zero (= 1/¥).