Jakob Steffen

Tariffs

Costs and Benefits

December 2005

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1. Introduction
Tariffs, quotas and other barriers are distorting trade around the world. In
2004/2005, the average import tariff rate in the EU was 4.2%, whereas it was about
3.7% in the USA. In developing countries, this rate was significantly higher: in India
it even reached 29.1%, for example1. And only recently Robert Portman, US trade
representative, and Peter Mandelson, EU trade commissioner, pleaded for maximum
tariff rates at 75% and 100%, respectively2. This essays aim is to examine and to
assess three of the arguments for and against protection (i.e., the imposition of trade
barriers). It will also focus on the import tariff (denoted by tariff in the following
text) which is yet only a small part of the range of protectionisms toolkit, including
import quotas, instruments restricting or encouraging exports, product standards,
domestic content requirements, etc. The evaluation of arguments will begin with the
most important one against trade distortions being the loss of welfare; also, the
exception to the rule when a tariff actually raises national welfare will be presented.
Finally, the text will move on to an interesting argument in favour of a tariff, the
developing government argument, and will close with a rather poor one, namely, the
income redistribution argument.

2. Evaluation of arguments
The main argument against trade barriers: loss of welfare

Provided the situation where a country is too small to influence the world price of
a commodity (the small-country case), all trade barriers and hence a tariff lead
unambiguously to a deadweight loss of welfare for the protectionist country and for
the world as a whole (though the developing government argument describes the
single situation where a tariff eventually can make the world better off, see below).
Deadweight loss means a loss of welfare suffered by one particular party which is
not compensated by the gain of another; thus, it is a net loss for the country imposing
a tariff. As far as welfare is concerned, this essay sticks to the traditionally applied
concepts of consumer- and producer surplus. In addition, this essay uses the

usually assumed yardstick of the one-pound-vote rule valuing equally each pound
lost or won by either consumers or producers to determine (national) welfare.

Under the further assumption that the analysed market is perfectly competitive,
the implementation of a tariff results in a loss of consumer surplus being represented
by areas a, b, c, and d in Figure 1A. Area a stands for the part of consumer surplus
merely changing hands between consumers and producers, whereas area c equals the
fraction of consumer surplus seized by the government in the form of the tariffs
revenues. Areas b and d show the elements of the deadweight loss of national welfare:
area b represents the waste of resources used up by the increased domestic production
which is inefficient compared with foreign producers (known as the production
effect of the tariff). Area d represents the part of consumption which has been made
up by imports whose price was below the consumers marginal willingness to pay and
which they are now made to forgo (the consumption effect of the tariff). The total
national welfare loss may also be shown on the world market (area b+d in Figure 1B).
Overall, the argument aiming at the loss of national welfare is very convincing: a
tariff cannot possibly be justified if it results in a poorer nation (poor in terms of the
definition of welfare used here).

Figure 1 Welfare loss from a tariff, small-country case, perfect competition

P

A. Domestic market

B. World market

Sd

Pa
P1
P0

b+d
a

c
b

S0

Sw: world supply curve

Sd: domestic supply curve
D1-S1: imports with tariff
P0: free trade price

D1

Sw

Dd

d
S1

Tariff

D0

Dw
0

Dw: demand curve for imports

Dd: domestic demand curve
D0-S0: imports with free trade
P1: free trade price + tariff

D1-S1

D0-S0

P: price
Q: quantity
Pa: price in autarky

-Figure is not drawn to scale-

However, a so called nationally optimal or optimal tariff (Bickerdike, 1906)3

may raise the welfare of a nation as a whole, too. To implement an optimal tariff, a
nation must be a monopsonist (i.e., it must dominate demand for a certain good). In
this situation, the large country is able to change the Terms of Trade (the number of
imported commodity units it gets for one exported unit) to its benefit by making
foreign exporters to cut their price by part of the tariff. The gain from that change
(amount of imports times the price-cut by foreign exporters, area e in Figure 2) may
outrank the still occurring deadweight loss of national welfare (again area b+d in
Figure 2). An optimal tariff, therefore, seems to be fairly attractive; nonetheless,
nations being large enough (like the United States) refrain from imposing it. The
reason for this reluctance lies in the very likely retaliation by the affected trade
partners; thus, it remains an only theoretically appealing concept. Furthermore, such a
tariff still makes the world worse off: foreign exporters receive no compensation for
their price-cut, and they face a deadweight loss of producer surplus (area f in Figure 2)
in addition to the self-inflicted deadweight loss of welfare in the protectionist country.

Figure 2 Welfare loss and Terms of Trade gain from an optimal tariff
P

World market

b+d

Sw

Pd
Tariff

P0

Dw

Pf

D1-S1

Sw: world supply curve

D0-S0: imports with free trade
P0: free trade price

D0-S0

Dw: demand curve for imports

D1-S1: imports with tariff
Pd: price for domestic consumers

Q
P: price
Q: quantity
Pf: price for foreign exporters
-Figure is not drawn to scale-

Arguments in favour of a tariff: the developing government argument

The developing government argument as presented by Lindert and Pugel (1996)4
is a very strong argument in favour of a tariff. In countries with a quite weak
government in terms of administrational power, a tariff becomes the most important
source of public revenues. Firstly, it is easy to collect. Since there is only a certain
number of main ports, airports, and other border crossings, it is comparatively
effortless to levy customs duties there (instead of implementing an income-tax, for
example). Secondly, the amount of money collected by means of a tariff is quite
substantial: Many low-income countries receive between one-quarter and three-fifths
of their public revenues from tariffs4.

When spent wisely, the revenues from a tariff help an emerging country to
increase the supply of otherwise heavily restricted public goods like health care or
education and thereby enhance that countrys stage of economic development. In the
long run, the additional welfare resulting from the improved economic status
surpasses the initial costs of the tariff for the world as whole. This insight is one of the
reasons why, after a series of trade rounds (of which the latest started in Doha,
December 2001), developing countries are allowed to be singularly protectionist.

Arguments in favour of a tariff: income redistribution

One of the most popular arguments in favour of a tariff concerns income

redistribution in order to iron out the sometimes vastly unjust allocation of the gains
and losses resulting from free trade. In particular, the supporters of this argument
often refer to the (real) wage rate in industrialised countries allegedly forced down by
competition from imports. Their main theoretical support comes from the famous
theorem devised by William F. Stolper and Paul A. Samuelson (1941)5 saying that a
rise in the relative price of a good leads to an increase in the real return of the factor
used relatively intensively in the production of that good. Hence, if a tariff is imposed
on relatively labour-intensive goods, the real wage rate ought to rise. Although the
logic of this first part of the argumentation is correct, its supporters fail to give a
reason why a tariff should be the best instrument to deal with the redistribution of the
results from free trade.

In fact, it is not. Instead, it is by far the worst tool to do so: a tariff always
downsizes the income pie to be distributed 6 (see the deadweight loss of national
welfare analysed above). The instruments of the modern welfare state (taxes and
transfer payments) are obviously far more efficient to solve the problem. Although
taxes are, strictly put, no better distortions than a tariff, they at least do not provoke
retaliation by other countries which leads inevitably to an even larger loss of welfare.

3. Conclusion
The strongest case for a tariff (and only for this specific trade barrier) is the
developing government argument. If the receipts from a tariff are used to improve
public services in a poor country (a basic requirement for economic development), a
tariff actually makes not only that country, but also the world better off. As the utmost
possible contrast, the income redistribution argument shows the uselessness of a tariff
when implemented as an indirect means to cope with a specific problem: the
distortions it produces in areas which are not involved in the problem whatsoever
outrank its benefits easily.

Foreign retaliation will, moreover, certainly harm the export sector of the
protectionist country; thus, a tariff endangers more jobs and production than it
protects in the first place. In general, the probability of retaliation is a very strong
argument against trade barriers: one restriction of trade is bad enough, but if it
develops into a net of trade distortions, the loss of welfare for the world as a whole is
even more disastrous. Therefore, how is it possible that trade barriers are still so
common? Dunn and Ingram (1996)7 give a clear and uncomfortable answer: almost
always, the particular interests of groups losing from free trade are very well
organised, whereas the general interest of society gaining from free trade (yet with
every individual gaining only a little) is advocated fairly badly.

References

Main reference
Lindert, Peter H. and Pugel, Thomas A. (1996) International Economics, 10th Edition,
Chicago & London: Irwin.

Other references
Dunn, Robert M. and Ingram, James C. (1996) International Economics, 4th Edition,
New York & Chichester (England): John Wiley & Sons.
Husted, S. and Melvin, M. (1998) International Economics, 4th Edition, New York &
Harlow (England): Addison-Wesley.
Krugman, Paul R. and Obstfeld, M. (1997) International Economics, 4th Edition, New
York & Harlow (England): Addison-Wesley.

Endnotes
1

WTO Statistics database Trade Profiles Column Applied 2004/2005.

[http://stat.wto.org/CountryProfile/WSDBCountryPFView.aspx?Language=
E&Country=E25,IN,US]

The Doha trade round - A stopped clock starts ticking again in The Economist,
Vol. 377, No. 8448, 15 October 2005, pp. 78, 79.

Bickerdike, Charles F. (1906) The Theory of Incipient Taxes, Economic Journal,

Vol. 16, pp. 529-35.

Lindert, Peter H. and Pugel, Thomas A. (1996) International Economics, 10th

Edition, Chicago & London: Irwin, p. 167.

Stolper, William F. and Samuelson, Paul A. (1941) Protection and Real Wages in
Review of Economic Studies, Vol. 9, pp. 58-73.

Lindert, Peter H. and Pugel, Thomas A. (1996) International Economics, 10th

Edition, Chicago & London: Irwin, p. 168.

Dunn, Robert M. and Ingram, James C. (1996) International Economics, 4th Edition,
New York & Chichester (England): John Wiley & Sons, p. 173.