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2.1 — Tariffs

ECON 324 • International Trade • Spring 2023

Ryan Safner
Associate Professor of Economics
safner@hood.edu
ryansafner/tradeS23
tradeS23.classes.ryansafner.com

Outline

Tariffs

Effects of an Import Tariff in a Small Country

Effects of an Import Tariff in a Large Country

Optimal Tariff Theory

The Effective Rate of Protection

Tariffs

Tariffs, According to POTUS 45

But It's Not Just a Trump Thing...

...Or Just A Recent Thing

Tariffs, According to Professional Economists

Source: IGA Experts Poll (2012)

Tariffs, According to Professional Economists

Source: IGA Experts Poll (2012)

International Trade Policies

  • Economists generally agree that free trade best enhances overall social welfare

  • Yet free trade is rare in the world

  • Two questions:

    1. Why is free trade rare? Or, why are trade restrictions common?
    2. What are the consequences of restricting trade?

International Trade Policies

This was in 2015, before the Trump Administration!

Tariffs

Tariffs

  • Most common way to restrict trade is through a tariff (historically called a “duty”), a tax specifically targeted towards internationally-traded goods

  • Import tariff: tax on imported goods

    • This is by far the most common type of trade restriction

  • Export tariff: tax on exported goods

    • Rare in developed countries but sometimes occurs in developing countries as a way to generate government revenue

Types of Tariffs

  • Ad valorem tariff taxes a fixed percentage of the value of a good

    • e.g. 25% U.S. tariff on (prices of) imported trucks

  • Specific tariff taxes a fixed sum per unit of a good

    • e.g. $3/barrel of oil

  • Compound tariff combines ad valorem and specific tariffs

    • Rare in developed countries but sometimes occurs in developing countries as a way to generate government revenue

Tariff Schedule

U.S. tariff schedule on imported woven flax fabrics, Harmonized Tariff Schedule, United States International Trade Commission Chapter 53, p. 53-4

Tariff History

Tariff History

Effects of an Import Tariff in a Small Country

Import Tariff Effects in a Small Country

  • To analyze effects of a tariff (on imports), need to compare two cases:

  1. Effect of a tariff in a “small” country

    • “Small” ⟹ its domestic market is too small to affect world prices
    • Effectively, it is a price-taker: it can import as much as it wants and not drive up the price

  2. Effect of a tariff in a “large” nation

    • “Large” ⟹ changes in the country’s domestic market can affect world prices

Import Tariff Effects in a Small Country

  • Consider, for example, the sugar market in Belgium

Import Tariff Effects in a Small Country

  • Consider, for example, the sugar market in Belgium

  • Domestic Demand for sugar in Belgium

Import Tariff Effects in a Small Country

  • Consider, for example, the sugar market in Belgium

  • Domestic Demand for sugar in Belgium

  • Domestic Supply of sugar in Belgium

Import Tariff Effects in a Small Country

  • Consider, for example, the sugar market in Belgium

  • Domestic Demand for sugar in Belgium

  • Domestic Supply of sugar in Belgium

  • Autarky price: 10¢/lb, 10 billion lbs exchanged within Belgium

Import Tariff Effects in a Small Country

  • Consider, for example, the sugar market in Belgium

  • Domestic Demand for sugar in Belgium

    • Consumer surplus = WTP - p*

  • Domestic Supply of sugar in Belgium

  • Autarky price: 10¢/lb, 10 billion lbs exchanged within Belgium

Import Tariff Effects in a Small Country

  • Consider, for example, the sugar market in Belgium

  • Domestic Demand for sugar in Belgium

    • Consumer surplus = WTP - p*
    • = 0.5(10-0)($0.20-$0.10) = $0.5 billion

  • Domestic Supply of sugar in Belgium

  • Autarky price: 10¢/lb, 10 billion lbs exchanged within Belgium

Import Tariff Effects in a Small Country

  • Consider, for example, the sugar market in Belgium

  • Domestic Demand for sugar in Belgium

    • Consumer surplus = WTP - p*
    • = 0.5(10-0)($0.20-$0.10) = $0.5 billion

  • Domestic Supply of sugar in Belgium

    • Producer surplus = p* - WTA

  • Autarky price: 10¢/lb, 10 billion lbs exchanged within Belgium

Import Tariff Effects in a Small Country

  • Consider, for example, the sugar market in Belgium

  • Domestic Demand for sugar in Belgium

    • Consumer surplus = WTP - p*
    • = 0.5(10-0)($0.20-$0.10) = $0.5 billion

  • Domestic Supply of sugar in Belgium

    • Producer surplus = p* - WTA
    • = 0.5(10-0)($0.10-$0.00) = $0.5 billion

  • Autarky price: 10¢/lb, 10 billion lbs exchanged within Belgium

Import Tariff Effects in a Small Country

  • Consider, for example, the sugar market in Belgium

  • Domestic Demand for sugar in Belgium

  • Domestic Supply of sugar in Belgium

  • Suppose Belgium opens up to international trade

  • World Supply of sugar at 4¢/lb

Import Tariff Effects in a Small Country

  • At 4¢/lb:
    • Belgian consumers want to consume 16 bn lbs

Import Tariff Effects in a Small Country

  • At 4¢/lb:
    • Belgian consumers want to consume 16 bn lbs
    • Belgian producers will produce 4 bn lbs

Import Tariff Effects in a Small Country

  • At 4¢/lb:
    • Belgian consumers want to consume 16 bn lbs
    • Belgian producers will produce 4 bn lbs
    • Belgium will import 12 bn lbs from the rest of the world

Import Tariff Effects in a Small Country

  • Under international trade:

  • Consumer surplus = WTP - p*

    • = 0.5(16-0)($0.20-$0.04) = $1.280 billion

Import Tariff Effects in a Small Country

  • Under international trade:

  • Consumer surplus = WTP - p*

    • = 0.5(16-0)($0.20-$0.04) = $1.280 billion

  • Producer surplus = p* - WTA

    • = 0.5(4-0)($0.04-$0.00) = $0.080 billion

Import Tariff Effects in a Small Country

  • Under international trade:

  • Consumer surplus = WTP - p*

    • = 0.5(16-0)($0.20-$0.04) = $1.280 billion

  • Producer surplus = p* - WTA

    • = 0.5(4-0)($0.04-$0.00) = $0.080 billion

  • Trade benefits Belgian consumers at expense of Belgian sugar producers

    • But gain is much bigger than loss!

Import Tariff Effects in a Small Country

  • We can trace Belgium’s import demand from the world based on the world price

  • Note at a price of ¢10 there is no import demand, all sugar can be produced in Belgium

Import Tariff Effects in a Small Country

  • We can trace Belgium’s import demand from the world based on the world price

  • Note at a price of ¢10 there is no import demand, all sugar can be produced in Belgium

  • We have been assuming the world supply of sugar is perfectly elastic at 4¢

  • Sets equilibrium amount of imports in Belgium, 12 bn lbs imported

Import Tariff Effects in a Small Country

  • Suppose the government levies a 4¢/lb tariff on sugar imports

Import Tariff Effects in a Small Country

  • Suppose the government levies a 4¢/lb tariff on sugar imports

  • At new domestic sugar price of 8¢/lb

Import Tariff Effects in a Small Country

  • Suppose the government levies a 4¢/lb tariff on sugar imports

  • At new domestic sugar price of 8¢/lb

    • Belgian consumers want to consume 12 bn lbs (less than before)

Import Tariff Effects in a Small Country

  • Suppose the government levies a 4¢/lb tariff on sugar imports

  • At new domestic sugar price of 8¢/lb

    • Belgian consumers want to consume 12 bn lbs (less than before)
    • Belgian producers will produce 8 bn lbs (more than before)

Import Tariff Effects in a Small Country

  • Suppose the government levies a 4¢/lb tariff on sugar imports

  • At new domestic sugar price of 8¢/lb

    • Belgian consumers want to consume 12 bn lbs (less than before)
    • Belgian producers will produce 8 bn lbs (more than before)
    • Belgium will import 4 bn lbs from the rest of the world (less than before)

Import Tariff Effects in a Small Country

  • Suppose the government levies a 4¢/lb tariff on sugar imports

  • At new domestic sugar price of 8¢/lb

    • Belgian consumers want to consume 12 bn lbs (less than before)
    • Belgian producers will produce 8 bn lbs (more than before)
    • Belgium will import 4 bn lbs from the rest of the world (less than before)

  • Tariff is a tax, so government earns revenue:

    • 4 bn lbs $\times $ 0.04/lb = $0.160 bn

Import Tariff Effects in a Small Country

  • Under the tariff:

  • Consumer surplus = WTP - p*

    • = 0.5(12-0)($0.20-$0.08) = $0.720 billion
    • Less than before (free trade)

Import Tariff Effects in a Small Country

  • Under the tariff:

  • Consumer surplus = WTP - p*

    • = 0.5(12-0)($0.20-$0.08) = $0.720 billion
    • Less than before (free trade)

  • Producer surplus = p* - WTA

    • = 0.5(8-0)($0.08-$0.00) = $0.320 billion
    • More than before (free trade)

Import Tariff Effects in a Small Country

  • Under the tariff:

  • Two new sources of market inefficiency created, “deadweight loss (DWL)”

Import Tariff Effects in a Small Country

  • Under the tariff:

  • Two new sources of market inefficiency created, “deadweight loss (DWL)”

    1. Inefficient domestic production (cheaper for foreigners to produce sugar)
    • 0.5(8-4)($0.08-$0.04) = $0.080 Billion

Import Tariff Effects in a Small Country

  • Under the tariff:

  • Two new sources of market inefficiency created, “deadweight loss (DWL)”

    1. Inefficient domestic production (cheaper for foreigners to produce sugar)
    • 0.5(8-4)($0.08-$0.04) = $0.080 Billion
    1. Lost gains from exchange (consumers wanted to buy more from world)
    • 0.5(16-12)($0.08-$0.04) = $0.080 Billion

Import Tariff Effects in a Small Country

  • Can also see this in the import market

  • Decline of imports at higher price in Belgium

  • Size of DWL in import market = sum of both DWL triangles in Belgian market ($0.160 bn)

Import Tariff Effects in a Small Country

  • Domestic consequences of tariff:

  1. Decrease in consumer surplus:

    • $0.720 bn-$1.280 bn = -$0.460 bn

  2. Increase in producer surplus:

    • $0.320 bn-$0.080 bn = $0.240 bn

  3. Government tax revenue:

    • $0.160 bn

  4. Deadweight losses

    • $-0.080 bn - $0.080 bn = -$0.160 bn

Import Tariff Effects in a Small Country

  • Domestic consequences of tariff:

  • A $240m gain to a small group of domestic sugar producers at a $460m expense to consumers

  • Concentrated benefit, dispersed cost each consumer pays $0.04/lb more for sugar

  • Harm to foreigners: hurts exporters and consumers in other countries from lost trade

Tariff Effects in a Large Country

Large Countries in International Trade

  • A “large country” has a sufficiently large domestic demand to affect international prices

  • The decrease in domestic demand from an import tariff (from higher import price) is sufficiently large to lower the world price of the good

  • This is called the “terms of trade effect” of a tariff

    • can provide a benefit to domestic country
    • harms foreign exporters due to lower world price

Import Tariff Effects in a Large Country

  • Consider, for example, the sugar market in the U.S.

  • Autarky price: 10¢/lb, 10 billion lbs exchanged within U.S.

Import Tariff Effects in a Large Country

  • Suppose U.S. opens up to international trade

  • World Supply of sugar at 4¢/lb:

Import Tariff Effects in a Large Country

  • Suppose U.S. opens up to international trade

  • World Supply of sugar at 4¢/lb:

    • U.S. consumers want to consume 16 bn lbs
    • U.S. producers will produce 4 bn lbs
    • U.S. will import 12 bn lbs from the rest of the world

Import Tariff Effects in a Large Country

  • We can trace U.S.’s import demand from the world based on the world price

  • Because U.S. is a large country, the world supply curve (exports from other countries) to U.S. is upward sloping

    • sufficiently high demand from U.S. stimulates production abroad for export to U.S.

  • Imagine autarky equilibrium price in exporting countries is 2¢; once they can get higher price in U.S., start exporting

  • Sets equilibrium amount of imports in U.S., 12 bn lbs imported at 4¢

Import Tariff Effects in a Large Country

  • Now suppose U.S. imposes a 4¢/lb tariff on imported sugar

  • Increase in costs to world sugar exporters decreases world export supply by 4¢/lb

  • New equilibrium is for U.S. to import 6 bn lbs at 7¢/lb

    • But 4¢/lb of the imports are paid to U.S. government as tariffs

  • Exporters to U.S. recieve net price (after taxes) of 3¢/lb

  • Important: raise in price to U.S. consumers is less than the full 4¢/lb!

    • Tariff on the massive U.S. market has lowered the world price of sugar because of decreased world supply, the terms of trade effect

Import Tariff Effects in a Large Country

  • Now suppose U.S. imposes a 4¢/lb tariff on imported sugar

  • Due to the terms of trade effect, world price of sugar will fall from less U.S. demand (to 3¢/lb)

Import Tariff Effects in a Large Country

  • Now suppose U.S. imposes a 4¢/lb tariff on imported sugar

  • Due to the terms of trade effect, world price of sugar will fall from less U.S. demand (to 3¢/lb)

  • The 4¢/lb is levied on this new, lower world price of sugar, raising price of sugar in U.S. to 7¢/lb

Import Tariff Effects in a Large Country

  • At new domestic price of 7¢/lb:
    • U.S. consumers want to consume 13 bn lbs (less than before)

Import Tariff Effects in a Large Country

  • At new domestic price of 7¢/lb:
    • U.S. consumers want to consume 13 bn lbs (less than before)
    • U.S. producers will produce 7 bn lbs (more than before)

Import Tariff Effects in a Large Country

  • At new domestic price of 7¢/lb:

    • U.S. consumers want to consume 13 bn lbs (less than before)
    • U.S. producers will produce 7 bn lbs (more than before)
    • U.S. will import 6 bn lbs from rest of the world (less than before)

  • Note the changes are not as much as it was to the small country

    • U.S. “market power” forces down world price

Import Tariff Effects in a Large Country

  • Loss to U.S. consumer surplus (but less than for small country)

  • Gain to U.S. producer surplus (but less than for small country)

    • Transfer of some CS to PS

Import Tariff Effects in a Large Country

  • Tariff will collect revenue for government
    • 4¢/lb × 6 bn lbs = $0.240 bn

Import Tariff Effects in a Large Country

  • Tariff will collect revenue for government

    • 4¢/lb × 6 bn lbs = $0.240 bn

  • DWLs from productive and consumption inefficiencies

    • 2 × $-0.045 bn = -$0.090 bn

Import Tariff Effects in a Large Country

  • Tariff will collect revenue for government

    • 4¢/lb × 6 bn lbs = $0.240 bn

  • DWLs from productive and consumption inefficiencies

    • 2 × $-0.045 bn = -$0.090 bn

  • But: gain in tariff revenue exceeds inefficiency (DWL)!

    • Tariff brings a net increase in U.S. national welfare!

Import Tariff Effects in a Large Country

  • Area D is the Terms of trade gain for U.S. (loss to world) due to tariff

  • U.S. deadweight loss (A+B) < U.S. tariff revenue (C+D)

  • Foreign loses deadweight loss (F) from lost export opportunities

Import Tariff Effects in a Large Country

  • Welfare changes:

    • To US: (C+D)-(A+B), net gain!
    • To Rest of World: -(D+E), net loss
    • Whole World: C-(A+B+E), net loss

  • A “beggar thy neighbor” approach to increasing national welfare

Big vs. Small Comparisons

  • Both countries start out with same world price, imports, domestic demand and supply

  • With free trade:

Country p∗ q∗ Domestic q Imports CS PS Tax Revenue DWL
Both $0.04 16 bn 4 bn 12 bn $1.280 bn $0.080 bn $0 $0

Big vs. Small Comparisons

  • Both countries start out with same world price, imports, domestic demand and supply

  • With free trade:

Country p∗ q∗ Domestic q Imports CS PS Tax Revenue DWL
Both $0.04 16 bn 4 bn 12 bn $1.280 bn $0.080 bn $0 $0
  • With same 4¢ tariff on imports:
Country p∗ q∗ Domestic q Imports Δ CS Δ PS Tax Revenue DWL Δ Net Welfare
Small (Belgium) $0.08 12 bn 8 bn 4 bn -$0.560 bn $0.240 bn $0.160 bn -$0.160 bn -$0.160 bn
Large (U.S.) $0.07 13 bn 7 bn 6 bn -$0.435 bn $0.165 bn $0.240 bn -$0.090 bn $0.030 bn

Optimal Tariff Theory

Optimal Tariff Theory

  • For a large country, a tariff decreases volume of trade but improves country’s terms of trade

    • Gain of tariff revenue (C+D)
    • Loss of deadweight loss (A+B)

  • Net effect is a slight increase in (big) country’s welfare

    • Note tariffs always are a net harm to a small nation!

  • Thus, there exists some optimal tariff τ>0 that maximizes net gains from tradeoff between terms of trade improvements against decline in trade

Optimal Tariff Theory (in a Large Country)

  • τ=0: free trade

  • For low levels of τ, terms of trade gain exceed deadweight loss

    • (C+D) > (A+B)

  • For high levels of τ, deadweight loss exceeds terms of trade gain

    • (C+D) < (A+B)

  • Extremely high levels of τ will close off trade completely

  • Some optimal τ⋆ that maximizes welfare gain to importer

Optimal Tariff: Inversely Related to Supply Elasticity

τ⋆=1εx

  • The optimal tariff is inversely related to the price elasticity of foreign export supply εx=%Δqs%Δp
    • More elastic: flatter curve, lower tariff
    • Less elastic: steeper curve, higher tariff
  • Note: for a small country, foreign export supply is perfectly elastic (εx=∞), so no tariff is optimal

Optimal Tariff: Inversely Related to Supply Elasticity

Optimal Tariff Theory vs. the Real World

  • Economic theory shows the theoretical possibility of how tariffs might increase national welfare

  • Regardless, tariffs harm welfare of trading partners (exporting countries)

  • Politically and practically, trading partners might retaliate against tariffs with their own tariffs

    • Might degenerate into a trade war where potential gains from trade are lost

The Effective Rate of Protection

The Effective Rate of Protection

  • How much do tariffs protect domestic industry?

  • Seems logical to just count the percent an ad valorem tariff raises price over free trade price

    • This is the nominal rate of protection: the % increase in price
    • e.g. a 50% ad valorem tariff raises price 50%
    • for specific tariffs, divide price with tariffprice without tariff

The Effective Rate of Protection

  • Two problems with nominal rate of protection:

  1. If the country is “large”, part of the tariff’s effect will be to lower foreign export prices rather than just raise domestic prices

  2. Tariffs may have different effects on different stages of production for a good

The Effective Rate of Protection

  • Better to think about the effective rate of protection as the percent change in domestic value added

  • Example: Suppose cars sell on world market for $8,000, and car parts sell for $6,000. If a country buys car parts and assembles them into cars, the domestic value added is: $8,000−$6,000=$2,000

The Effective Rate of Protection: Example

  • Suppose Home wants to develop a domestic auto assembly industry

    • Domestic value added from imports is: $8,000−$6,000=$2,000

  • Home places a 25% tariff on imported cars, raising the price of cars in Home to $10,000

    • Domestic value added from imports is: $10,000−$6,000=$4,000

  • Domestic value added changes by: $4,000−$2,000$2,000×100=100%

The Effective Rate of Protection: Example

  • Suppose Home instead wants to develop a domestic car parts industry

    • Domestic value added from imports is: $8,000−$6,000=$2,000

  • Home places a 25% tariff on imported car parts, raising the price of car parts in Home to $7,500

    • Domestic value added for car parts manufacturers is: $7,500
  • Changes by: $7,500−$6,000$6,000×100

The Effective Rate of Protection: Example

  • Suppose Home instead wants to develop a domestic car parts industry

    • Domestic value added from imports is: $8,000−$6,000=$2,000

  • What about for assemblers of cars?

    • Domestic value added for car assemblers is: $8,000−$7,500=$500
  • Changes by: $500−$2,000$2,000×100

The Effective Rate of Protection: Example

  • We can see that the structure of tariffs often impact different stages of the production process differently

  • Here, a tariff on car parts gave 25% more protection to domestic car parts producers, at the expense of a 75% loss to domestic car assemblers

The Effective Rate of Protection

  • In general, we see that effective rate of protection ≠ nominal tariff rate

    • May be higher or lower, or even negative

  • Tariffs on foreign inputs generate negative effective rates of protection, and tariffs on final products generate positive eeffective rates of protection for a country’s domestic industry

Outline

Tariffs

Effects of an Import Tariff in a Small Country

Effects of an Import Tariff in a Large Country

Optimal Tariff Theory

The Effective Rate of Protection

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