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Lecture 8

Import Tariffs and Quotas under Perfect Competition

Introduction
This chapter is focused on the following questions:
What is a trade policy?
What is WTO? What does it do?
What are the effects of various trade policy instruments?
Who will benefit and who will lose from each trade policy instrument?
What is a trade policy?
On September 11, 2009 President Barack Obama announced a tariff of 35% on
imports of tires made in China.
The steel and tire tariffs are examples of a trade policy, a government action
meant to influence the amount of international trade.
Because the gains from trade are unevenly spread, industries, and labor unions
often feel that the government should do something to help limit their losses (or
maximize their gains) from international trade.
That something is trade policy, which includes the use of import tariffs (taxes
on imports), import quotas (quantity limits on imports), and subsidies for
exports.
A Brief History of the World Trade Organization
Because trade policies in one country affect the trade flows and terms of trade of its
trading partners, there is an international governing body called the World Trade
Organization (WTO), which acts as a forum for countries to come to agreement on
trade policies among them and resolve policy-related disputes when they arise.

Following World War II, representatives of 45 countries met at the United Nations
Monetary and Financial Conference in Bretton Woods, New Hampshire, to discuss
the rebuilding of Europe and issues such as high trade barriers and unstable exchange
rates.
The outcome was an agreement (referred to as the Bretton Woods Agreement). The
trade component of this agreement, formalized as the GATT in 1947, was intended to
reduce barriers to trade between countries and, in general, to promote the goal of free
trade among nations as a means of fostering cooperation, integration and mutual gains
from trade.
Under the GATT, countries meet periodically for negotiations, called rounds, to lower
trade restrictions between countries.
The name of the GATT was changed on January 1, 1995 to the World Trade
Organization (WTO), as it is known today.
GATT is just a set of rules for how to conduct trade,
WTO -- formal international institution governing global interactions (including
trade in services and intellectual property protection) through binding agreements.

Some of the main stipulations are as follows:

Article I:
The most favored nation clause, states that every country belonging to the
WTO must be treated the same (i.e. same tariff)
Article VI
States an importing country may impose a tariff on goods being dumped into its
country by a foreign exporter.
Article XI
States countries should not maintain quotas against imports. There are many
exceptions to this rule.
Article XVI
States that countries should declare export subsidies provided to particular firms,
sectors or industries. The article states that countries should notify each other of
the extent of subsidies, and discuss the possibility of eliminating them.
Article XIX
States countries can temporarily raise tariffs for certain products. This article is
called the safeguard provision or the escape clause and is our focus in this
chapter. It lists the conditions under which a country can temporarily raise tariffs
on particular products. The importing country can temporarily raise the tariff
when domestic producers are suffering from import competition. The steel tariff
of March 2002 is an example of a tariff that was applied by the United States
under Article XIX of the GATT.
Articles XXIV
Recognizes the ability of blocks of countries to form two types of regional trade
agreements:
(i)
free trade areas, in which a group of countries voluntarily agree to
remove trade barriers between themselves, and
(ii)
customs unions, which are free trade areas that also adopt identical
tariffs between themselves and the rest of the world.
Key Provisions of the GATT
Article I

Most-Favored-Nation Treatment

Article VI

Anti-Dumping and Countervailing Duties

Article XI

General Elimination of Quantitative Restrictions

Article XVI

Subsidies

Article XIX

Emergency Action on Imports of Particular Products

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Article XXIV

Territorial ApplicationFrontier TrafficCustoms Unions and

Free-Trade Areas

Tariffs can be classified as:

Specific tariffs
Taxes that are levied as a fixed charge for each unit of goods imported
Example: A specific tariff of $10 on each imported bicycle with an
international price of $100 means that customs officials collect the fixed
sum of $10.
Ad valorem tariffs
Taxes that are levied as a fraction of the value of the imported goods
Example: A 20% ad valorem tariff on bicycles generates a $20 payment on
each $100 imported bicycle.
Some Basic Concepts: Consumer and Producer Surplus
Consumer surplus
It measures the amount a consumer gains from a purchase by the
difference between the price he actually pays and the price he would have
been willing to pay.
It can be derived from the market demand curve.
Graphically, it is equal to the area under the demand curve and above the
price.

Producer surplus
Graphically, it is equal to the area under the price line above the supply
curve. Note that area under the supply curve up the quantity exchanged, z,
is production cost to the firm but for the whole economy it represents
opportunity cost the value of other goods and services that are not
produced because resources are instead used to produce this product.
PS = revenue received - cost incurred (return to inelastic factors)
Price

CS

Price

S
PS

P1
D
D1
Consumer surplus

z
Quantity

S1
Producer surplus

Quantity

Trade in a Single Industry in a Small Open Economy

Measuring the Cost and Benefits (assuming there is no externalities)

Is it possible to add consumer and producer surplus? In general we cannot
compare the welfare effects on different groups without imposing our subjective
weights to the economic stakes of each group.
Economists have tended to resolve the matter by imposing a value judgment that
we shall call the one-dollar-one-vote metric: the value of any gain or loss is
treated equally regardless of how experiences it. Here we are assuming that at the
margin a dollars worth of gain or loss to each group is of the same social worth
(one-dollar, one vote metric). You need not accept this value judgment.
With this assumption we can (algebraically) add consumer and producer surplus.
Gains from Trade
Rise in Consumer Surplus:
+ (b + d)
Fall in Producer Surplus:
-d
_______________________________________
Net effect on Home Welfare:
+d

Import Demand Curve

To find the world price (Pw) and the quantity trade (Qw), two curves are defined:
Home import demand curve
Shows the maximum quantity of imports the Home country would like to
consume at each price of the imported good.
That is, the excess of what Home consumers demand over what Home
producers supply: M = D(P) S(P)
Properties of the import demand curve:
It intersects the vertical axis at the closed economy price of the importing country.
It is downward sloping.
It is flatter than the domestic demand curve in the importing country.

Costs and Benefits of a Tariff

A tariff raises the price of a good in the importing country
As a result of these price changes:
Consumers lose in the importing country and gain in the exporting country
Government imposing the tariff gains revenue
To measure and compare these costs and benefits, we need to define consumer
and producer surplus.
Loss from tariff
Fall in Consumer Surplus:
- (a + b + c + d)
Rise in Producer Surplus:
+a
Rise in government revenue
+c
___________________________________________
Net effect on Home Welfare:
- (b +d)
Measuring Deadweight due to Tariff: To measure the deadweight loss due to the
tariffs in steel, we need to estimate the area of the triangle b+d in the Figure above. The
base of this triangle is the change in imports due to the tariffs, or M=M2 M1. The
height of the triangle is the increase in the domestic price due to the tariff, or P = t. So
the deadweight loss equals: DWL = .t.M .
It is convenient to measure the deadweight loss relative to the value of imports, which is
PWM. We will also use the percentage tariff, which is t/PW, and the percentage change in
the quantity of imports, which is %M = M/M. The deadweight loss relative to the
value of imports can then be rewritten as:

Case Study: U.S. Tariffs on Steel

Tariff of steel = 30% => the percentage increase in the price, t/PW = 0.3.
The quantity of steel imports also fell by 30% in the first year so that %M = 0.3.
Therefore, the deadweight loss is:
DWL/P.M = 1/2 (0.3 x 0.3) = 0.045 or 4.5% of the import value.

$4.7 b -- value of steel imports in the year prior to March 2002

$3.5 b - -value of steel imports in the year after March 2002,
(4.7 + 3.5) = $4.1 b --average imports over the two years (tariffs not included)
PM = (4.7 - 3.5) = $1.2 b fall in import value = > M/M =1.2/4.1 = 30%

(DWL/P.M) x P.M = DWL= 0.045x 4.1 billion = $185 m

price of job protection of steel workers -- temporarily.
loss to consumer of steel such as firms producing automobiles did object to
the tariffs and encouraged President Bush to end them early.
Response of WTO members
The tariffs on steel most heavily affected Europe, Japan and South Korea, along with
some developing countries that were exporting a significant amount to the U.S.
These countries objected to the restriction on their ability to sell steel to the U.S.
The 25 EU countries plus Brazil, China, Japan, South Korea, New Zealand, Norway,
and Switzerland took action by bringing the case to the WTO.
The WTO has a formal dispute settlement procedure, under which countries who
feel that the WTO rules have not been followed can bring that complaint and have it
evaluated.
The WTO in early November, 2003, ruled that the U.S. had failed to prove that its
steel industry had been harmed by a sudden increase in imports, and therefore, it did
not have the right to impose safeguard tariffs.
The WTO ruling entitled the EU and other countries to retaliate against the U.S. by
imposing tariffs of their own against U.S. exports.
The EU countries drew up a list of products totaling some $2.2 billion in U.S.
exports against which they would apply tariffs.
The threat of tariffs being imposed on these products led President Bush to reconsider
the U.S. tariffs on steel, and on December 5, 2003, he announced that they would be
suspended, after being in place for only 19 months, rather than the three years as
initially planned.

Import Tariff for a Large Economy

Assumptions
There are two countries (Home and Foreign or rest of the world).
Both countries consume and produce a homogenous product under a CRTS
technology, which can be transported between the countries with no costs
There is no externalities in the production and consumption of the product.
In each country, the product is a competitive industry (many buyers and
sellers with no market power).

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Foreign Export Supply
Shows the maximum quantity of exports Foreign would like to provide the rest of the
world at each price.
That is, the excess of what Foreign producers supply over what foreign consumers
demand: X* = S*(P*) D*(P*)
It intersects the vertical axis at the closed economy price of the exporting country.

Effects of a Tariff for a Large Country

Assume that two large countries trade with each other.
Suppose Home imposes a tax of $t on every bushel of wheat imported.
Then shippers will be unwilling to move the wheat unless the price difference
between the two markets is at least $t.

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Figure 8.7: The tariff shifts up the export supply curve from X* to X*+t. As a result, the
Home price increases from PW to P*+t, and the Foreign price falls from PW to P*. The
deadweight loss at Home is the area of the triangle (b+d), and Home also has a terms of
trade gain of area e. Foreign loses the area (e+f), so the net loss in world welfare is the
triangle (b+d+f).

In Home: producers supply more and consumers demand less due to the higher
price, so that fewer imports are demanded.
In Foreign: producers supply less and consumers demand more due to the lower
price, so that fewer exports are supplied.
Thus, the volume of wheat traded declines due to the imposition of the tariff.
The increase in the domestic Home price is less than the tariff, because part of the
tariff is reflected in a decline in Foreigns export price.
If Home is a small country and imposes a tariff, the foreign export prices
are unaffected and the domestic price at Home (the importing country)
rises by the full amount of the tariff.

Cost and Benefits of Tariff for the Importing Country

Loss/Gain from tariff
Fall in Consumer Surplus:
- (a + b + c + d)
Rise in Producer Surplus:
+a
Rise in government revenue
+c+e
__________________________________________________
Net effect on Home Welfare:
e - (b +d)

The areas of the two triangles b and d measure the loss to the nation as a whole
(efficiency loss) and the area of the rectangle e measures an offsetting gain, ToT gain.
The efficiency loss arises because a tariff distorts incentives to consume and produce.
Producers and consumers act as if imports were more expensive than they
actually are.
Triangle b is the production distortion loss and triangle d is the
consumption distortion loss.
The terms of trade gain arises because a tariff lowers foreign export prices.
If the terms of trade gain is greater than the efficiency loss, the tariff increases welfare
for the importing country.
In the case of a small country, the tariff reduces welfare for the importing country.

Foreign and World Welfare:

While Home might gain from the tariff, Foreign, the exporting country, definitely
loses. In panel (b) of Figure 8.7, the Foreign loss is measured by the area (e+f).
Notice that the area e is the terms of trade gain for Home but an equivalent terms of
trade loss for Foreign; Homes gain comes at the expense of Foreign.

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In addition, the large country tariff incurs an extra deadweight loss in Foreign of f, so
that the combined total outweighs the benefits to Home. For this reason, we
sometimes call a tariff imposed by a large-country a beggar thy neighbor tariff.
Adding together the change in Home welfare and Foreign welfare, the area e cancels
out and we are left with a net loss in world welfare of (b+d+f), the triangle in panel
(b). This area is a deadweight loss for the world.

Optimum tariff for a large country

The tariff rate that maximizes national welfare
It is always positive but less than the prohibitive rate that would eliminate all
imports.
It is zero for a small country because it cannot affect its terms of trade.
At optimum tariff the marginal gain from improved TOT just equals the
marginal efficiency loss from production and consumption distortion.

Optimal Tariff Formula:

There is a simple formula for the optimal tariff. The formula depends on the elasticity
of Foreign export supply, which we call E*x
E*x -- the percentage change in the quantity exported in response to a percent change
in the world price of the export.

For a small importing country, the elasticity of Foreign export supply is infinite, and
so the optimal tariff is zero.
For a large importing country however, the Foreign export supply is less than infinite,
and we can use this formula to compute the optimal tariff.

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As the elasticity of Foreign export supply decreases (which means that the Foreign
export supply curve steepens), the optimal tariff is higher - Foreign exporters will
lower their price more in response to the tariff.
Example: If E*X from 3 to 2 => optimal tariff from = 33% to = 50%,
o Foreign producers are willing to lower their prices more, taking on a larger
share of the tariff burden.
o =>Home country obtains a larger terms of trade increase and hence the
optimal level of the tariff is higher.

Optimal Tariffs for Steel:

For the three product categories in the Table below where the U.S. applied tariffs:
in 2 products the ToT gain > DWL but in a third case the DWL is higher.
The first two products illustrate the large-country case for tariffs, when the welfare of
the importer can rise due to a tariff, while the third product illustrates the smallcountry case where the importer loses from the tariff.
From the information given in the Table below we do not know whether the U.S.
gained or lost overall from the steel tariffs: that calculation would require adding up
the gains and losses due to the tariff over all imported steel products, which we have
not done.
But in the end, we should keep in mind that any rise in U.S. welfare comes at the
expense of exporting countries.

Import Quotas: Theory

Import quotas are a restriction on the amount of a particular good that one country
can purchase from another country.
Example: The United States has a quota on imports of foreign cheese.
The restriction is usually enforced by issuing licenses to some group of
individuals or firms.
Example: The only firms allowed to import cheese are certain trading
companies.

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In some cases (e.g. sugar and apparel), the right to sell in the United States is
given directly to the governments of exporting countries.
Reasons for quotas
As insurance against further increases in import competition (protectionist
insurance) and import spending (Balance of Payment insurance) (with tariffs
results depend on elasticities of Import Demand and Export Supply)
give government officials greater administrative flexibility and power to deal
with domestic firms.
An import quota always raises the domestic price of the imported good.

Import Quota in a Small Country

Figure 8.9: Under free trade, the Foreign export supply curve is horizontal at the world
price PW, and the free trade equilibrium is at point B with imports of M1. Applying an
import quota of M2 < M1 leads to the vertical export supply curve, X , with the
equilibrium at point C. The quota increases the import price from PW to P2. There would
be the same impact on price and quantities if instead of the quota, a tariff of t = P2 PW
had been used.
Effect on Home Welfare:
Fall in consumer surplus:
(a+b+c+d)
Rise in producer surplus:
+a
Quota rents earned at Home:
+c
-------------------------------------------------------------Net effect on Home welfare:
(b+d)
Ways to allocate import licenses
Competitive auctions (the best way), revenues are received by the government
Fixed favoritism (the most arbitrary way)
Resource-using application procedure (very inefficient)

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Any procedure that forces firms or individuals to demonstrate the merit of

their claim to import licenses will cause them to use time and money
lobbying with government officials.
License holders are able to buy imports and resell them at a higher price in
the domestic market.
The profits received by the holders of import licenses are known as quota
rents.
Voluntary Export Restraint (the most costly way for the home country)

Ways to allocate import licenses

1. Giving the Quota to Home Firms
Quota licenses (i.e., permits to import the quantity allowed under the quota
system) can be given to Home firms: With home firms earning the rents c, the net
effect of the quota on Home welfare is
Fall in consumer surplus:
(a + b + c + d)
Rise in producer surplus:
+a
Quota rents earned at Home + c
---------------------------------------------------------Net effect on Home welfare: (b + d)
2. Rent Seeking
If licenses for the imported chemicals are allocated in proportion to each firms
production of batteries in the previous years, then the Home firms will likely
produce more batteries than they can sell (and at lower quality) just to obtain the
import licenses for the following year. Alternatively, firms might engage in
bribery or other lobbying activities to obtain the licenses.
These kinds of inefficient activities done to obtain quota licenses are called rent
seeking. If rent seeking occurs, the welfare loss due to the quota would be
Fall in consumer surplus:
(a + b + c + d)
Rise in producer surplus:
+a
------------------------------------------------------------Net effect on Home welfare: (b + c + d)
3. Auctioning the Quota
The government of the importing country auctions off the quota licenses.
In a well-organized, competitive auction, the revenue collected should exactly
equal the value of the rents, so that area c would be earned by the Home
government. Using the auction method to allocate quota rents, the net loss in
domestic welfare due to the quota becomes

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Fall in consumer surplus:
(a + b + c + d)
Rise in producer surplus:
+a
Auction revenue earned at Home
+c
---------------------------------------------------------------------Net effect on Home welfare:
(b + d)
4. Voluntary Export Restraint
The government of the importing country gives the authority of implementing the
quota to the government of the exporting country. Because the exporting country
allocates the quota among its own producers, this is sometimes called a
voluntary export restraint (VER), or a voluntary restraint agreement (VRA).
In the 1980s the United States used this type of arrangement to restrict Japanese
automobile imports. In this case, the quota rents are earned by foreign producers,
so the loss in Home welfare equals
Fall in consumer surplus:
(a + b + c + d)
Rise in producer surplus:
+a
---------------------------------------------------------Net effect on Home welfare: (b + c + d)
Costs of Import Quotas in the U.S.: The Table below presents some estimates of the
Home deadweight losses, along with the quota rents, for major U.S. quotas in the years
around 1985. In all cases except dairy, the rents were earned by Foreign exporters.

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Summary

A tariff drives a wedge between foreign and domestic prices, raising the domestic
price but by less than the tariff rate (except in the small country case).
In the small country case, a tariff is fully reflected in domestic prices.
The costs and benefits of a tariff or other trade policy instruments may be
measured using the concepts of consumer and producer surplus.
The domestic producers of a good gain
The domestic consumers lose
The government collects tariff revenue
The net welfare effect of a tariff can be separated into two parts:
Efficiency (consumption and production) loss
Terms of trade gain (is zero in the case of a small country)

Appendix
Local Content Requirements
This is a regulation that requires that a product assembled or produced in the
country must have a specified fraction of good produced domestically. This
fraction can be specified in physical units or in value terms. This limit the import
of materials and components
Local content laws have been widely used by developing countries trying to shift
their manufacturing base from assembly back into intermediate goods.
Local content laws do not produce either government revenue or quota rents.
Instead, the difference between the prices of imports and domestic goods gets
averaged in the final price and is passed on to consumers.
Example: Suppose that auto assembly firms are required to use 50% domestic
parts. The cost of imported parts is $6000 and the cost of the same parts
domestically is $10,000. Then the average cost of parts is $8000 (0.5 x $6000
+ 0.5 x $10,000).
Firms are allowed to satisfy their local content requirement by exporting instead
of using parts domestically.
A mixing requirement: Stipulates that an importer must buy a certain percentage
of the product locally.

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Optimal tariff and price elasticity of export supply
P
Extra loss
tP dM/dt

Extra gain
M dP/dt

SX:
Foreign Export Supply

tP
P

DM:
Home Import Demand
M

dM/dt

Optimal tariff is the one at which the extra TOT gain and the extra loss (due to less
consumption and production at home) are just equal. That is
Extra gains extra losses = M dP/dt t*PdM/dt =0
Or
t* = (dP/dt)/(dM/dt) M/P = 1/
Where is the Elasticity of SX = (dM/dt)/(dP/dt) P/M
Note that the first term on the RHS is the slope of SX
So optimal tariff (as a fraction of the world price the price paid to foreigners) is equal to
the inverse of the elasticity of foreign export supply
t*= 1/
infinity as t* 0
The larger the elasticity of foreign export supply the smaller the optimal tariff rate.