An Introduction to International Economics

Chapter 5: Trade Restrictions: Tariffs

Dominick Salvatore John Wiley & Sons, Inc.

Dale R. DeBoer University of Colorado, Colorado Springs

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Movements away from free trade

While it is generally accepted that free trade best enhances societal welfare, complete free trade is seldom practiced. This situation generates two questions
Why is complete free trade seldom practiced? What are the effects of deviating from free trade?

This chapter considers the second question by considering the effects of employing one common tool of deviating from free trade the tariff.
Dale R. DeBoer University of Colorado, Colorado Springs 5-2

Types of tariffs
Import vs. export tariffs
An import tariff is a tax (or duty) on imported goods or services.
This is the most common form of tariff.

An export tariff is a tax on exported goods or services.

This is rarely seen in developed countries but is occasionally practiced in developing countries to generate government revenue.

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Types of tariffs
Import vs. export tariffs Ad valorem tariff
A fixed percentage tax on the traded commodity.

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Types of tariffs
Import vs. export tariffs Ad valorem tariff Specific tariff
A fixed sum tax per unit of a traded commodity.

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Types of tariffs
Import vs. export tariffs Ad valorem tariff Specific tariff A compound tariff
A combination of an ad valorem and specific tariff.

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Types of tariffs
Import vs. export tariffs Ad valorem tariff Specific tariff A compound tariff Tariff rates
The U.S. International Trade Commission provides a searchable index of tariff rates. WWW link

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Small vs. large

The implications of interfering with trade differ depending on the nature of the country.
The key distinction is between whether the country is small or large.

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Small vs. large

The implications of interfering with trade differ depending on the nature of the country. A small country is one where changes in its domestic market do not alter the international price of the commodity.
In the case of tariff, this means that the imposition of a tariff does not alter the international price. In other words, the country acts as a price-taker in the international market.

Dale R. DeBoer University of Colorado, Colorado Springs

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Small vs. large

The implications of interfering with trade differ depending on the nature of the country. A small country is one where changes in its domestic market do not alter the international price of the commodity. A large country is one where changes in its domestic market do alter the international price of the commodity.
In the case of a tariff, this means that the imposition of a tariff does alter the international price.
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Effects of a tariff: small country

The effects of a tariff are easily seen in a market supply and demand diagram. In this market, the autarky equilibrium occurs a price of $50 and quantity of 50.
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Supply

Demand

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Effects of a tariff: small country

In this market, if the international price is $20, the country will be an importer of the item. Domestic production will fall from 50 to 20. Domestic consumption will rise from 50 to 80. These changes generate imports of 60 units.
Dale R. DeBoer University of Colorado, Colorado Springs

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0 10 20 30 40 50 60 70 80 90 100 110 120 International price

Supply

Demand

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Effects of a tariff: small country

If a 50% ad valorem tariff is placed on imports, the domestic price rises from $20 (the international price) to the tariff price of $30. Domestic production increases from 20 to 30. Domestic consumption falls from 80 to 70. Imports fall to 40.
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Tariff price

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Effects of a tariff: small country

The final effect is that the government will begin collecting tariff revenue in this market.
The amount of the revenue is $10 x 40 = $400 per unit of time.
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Supply

Tariff price

Demand

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Welfare effects: small country

To show the welfare changes from the tariff the concepts of consumer and producer surplus must be considered. Consumer surplus is the difference between what consumers are willing to pay for a specific amount of a commodity and what they actually pay for it.
Graphically, consumer surplus is the area under the demand curve and above the price paid on every unit purchased.
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Welfare effects: small country

Consumer surplus is the difference between what consumers are willing to pay for a specific amount of a commodity and what they actually pay for it. Producer surplus is the extra payment received by producers above what needed to have been paid to cause them to produce the commodity.
Graphically, producer surplus is the area below the price received and above the supply curve on every unit sold.
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Welfare effects: small country

Consumer surplus at autarky is given by the indicated region. When the nation moves to free trade this surplus increases. The imposition of a tariff reduces this surplus by the difference between the international and the tariff price.
Dale R. DeBoer University of Colorado, Colorado Springs

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Tariff price

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Welfare effects: small country

Producer surplus at autarky is given by the shaded region. Opening the economy to free trade reduces the surplus to the smaller shaded region. Imposing a tariff increases the producer surplus.
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Tariff price

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Welfare effects: small country

The losses and gains from the imposition of a tariff exist in the shaded region. The entire region is lost consumer surplus.
The dollar value of this region is ($10 x 70) + ( x $10 x 10) or $750.
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Supply

Tariff price

Demand

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Welfare effects: small country

The entire region is lost consumer surplus. Of this, the portion above the supply curve is gained by producers.
The dollar value of this region is ($10 x 20) + ( x $10 x 10) or $250.
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Supply

Tariff price

Demand

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Welfare effects: small country

The entire region is lost consumer surplus. Of this, the portion above the supply curve is gained by producers. The rectangular area is gained by the government as tariff revenue.
The dollar value of this region is $10 x 40 or $400.
Dale R. DeBoer University of Colorado, Colorado Springs

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0 10 20 30 40 50 60 70 80 90 100 110 120

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Tariff price

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Welfare effects: small country

This leaves a net welfare loss to society of the two triangular shaded regions. These regions are known as the deadweight loss of a tariff.
These have a dollar value of $750 - $250 (gained by producers) - $400 (gained by the government) or $100.
Dale R. DeBoer University of Colorado, Colorado Springs

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Tariff price

Demand

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Effects of a tariff: large country

The effects of a tariff on a large country differ from that in a small country because the imposition of a tariff results in a fall in import demand that lowers the international price.
This is known is as the terms of trade effect.
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Supply

Demand

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Effects of a tariff: large country

In this case, the 50% tariff results in a drop of the international price from $20 to $15.
This takes the tariff price to $22.50 per unit.
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0 10 20 30 40 50 60 70 80 90 100 110 120 International price

Supply

The effects of this change are more clearly seen through a narrowing of focus in the graph.
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Effects of a tariff: large country

With the tariff and improvement in the terms of trade, production rises from 20 to 22.5 units. Consumption falls from 80 to 77.5 units. Imports fall from 60 to 55 units.
40

30

20

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0
10 20 30 40 50 60 70 80 90

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Welfare effects: large country

Consumer surplus declines by the shaded region.
This has a dollar value of ($2.50 x 77.5) + ( x $2.50 x 2.5) = $196.875
40

30

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0
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Dale R. DeBoer University of Colorado, Colorado Springs

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Welfare effects: large country

Consumer surplus declines by the shaded region. Producer surplus increases by the shaded region offsetting part of the consumer loss.
This has a dollar value of ($2.50 x 20) + ( x $2.50 x 2.5) = $53.125
40

30

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0
10 20 30 40 50 60 70 80 90

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Welfare effects: large country

Consumer surplus declines by the shaded region. Producer surplus increases by the shaded region offsetting part of the consumer loss. Government revenue increases by $10 x 75 or $750.
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40

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Welfare effects: large country

The net effect is a welfare gain.
Consumer surplus falls by $196.875 Producer surplus rises by $53.125 Government revenue increases by $750 This generates a net gain of $500 for this case.
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30

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0
10 20 30 40 50 60 70 80 90

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Welfare effects: large country

This result arises as the improvement in the terms of trade more than offsets the potential deadweight loss of the tariff.
Welfare lost Welfare gained
40

30

20

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0
10 20 30 40 50 60 70 80 90

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Optimum tariff
The previous example demonstrates that it is possible for the imposition of a tariff in a large county to improve societal welfare. An optimal tariff is the tariff rate that maximizes the benefit resulting from the imposition of a tariff.
The gain comes from the improvement in the terms of trade.

Positive welfare gains are always possible from tariff imposition in large countries.
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A concern about the optimal tariff

By itself, the existence of an optimum tariff appears to be a strong argument for interfering with free trade. It is important to note that the positive welfare gains exist only if no retaliation in other markets occurs following the imposition of a tariff.
History does not support the no retaliation assumption.

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Nominal tariffs vs. effective protection

The nominal tariff is the percentage increase in the price of the final commodity.
A 50% ad valorem tariff raises the price of the commodity by 50% generating a 50% nominal tariff.

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Nominal tariffs vs. effective protection

The nominal tariff is the percentage increase in the price of the final commodity. The effective rate of protection is calculated on the increase in domestic value added offered by tariff protection.
The effective rate of protection offers a better measure of the protection offered producers as it takes into account the cost to producers of tariffs on input markets.

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Examples of effective protection

Suppose a product sells for $10,000 but has input costs of $5,000 per unit.
In this case, its value added is $5,000.
$12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 Free Trade
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Value Added

The imposition of a 10% ad valorem tariff raises the sales price from $10,000 to $11,000.

Input Cost

Examples of effective protection

The imposition of a 10% ad valorem tariff raises the sales price from $10,000 to $11,000. This raises the value added from $5,000 to $6,000 and offers an effective rate of protection of 20%.
$1,000 (gain in value added) $5,000 (original value added) = 20%
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$12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 Free Trade 10% Tariff
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Gain
Value Added

Value Added

Input Cost

Input Cost

Examples of effective protection

Using the starting point, assume that a 20% ad valorem tariff is placed on the inputs. This raises the input cost from $5,000 to $6,000.
$12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 Free Trade
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Value Added

Input Cost

Examples of effective protection

Using the same example, assume that a 20% ad valorem tariff is placed on the inputs. This raises the input cost from $5,000 to $6,000. This decreases the value added from $5,000 to $4,000 and offers an effective rate of protection of - 20%.
- $1,000 (loss in value added) $5,000 (original value added) = - 20%
$12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 Free Trade 10% Input Tariff
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Value Added

Value Added

Loss
Input Cost

Input Cost

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Examples of effective protection

As a final example, consider the effective rate of protection offered by combing the previous two policies a 20% tariff on the inputs and a 10% tariff on the final output.
$12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 Free Trade
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Value Added

Input Cost

Examples of effective protection

This increases both input cost and final price by $1,000 and leaves an effective rate of protection of zero. As is seen, the effective level of protection may differ greatly from the rate of the nominal tariff.
$12,000

Gain
$10,000 $8,000 $6,000 $4,000 $2,000 $0 Free Trade 10% Input Tariff
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Value Added

Value Added

Loss
Input Cost

Input Cost

Dale R. DeBoer University of Colorado, Colorado Springs