The Instruments of Trade Policy:
Part I, Tariffs
• INTERNATIONAL
ECONOMICS,
ECO 486
• Harmonized tariff schedule
(HTS) of the United States:
http://www.usitc.gov/taffair
s.htm#HTS
1
2
Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
3
Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
4
Gains from Trade
• Static Gains (PPF doesn’t shift)
– Consumption gains
– Production gains
• Dynamic Gains (PPF does shift)
– Trade expands resources
– Trade may raise productivity
• Political Gains
5
Consumption & Production Gains
rF
C
TEXTILES, T (yards per year)
B
CIC2
CIC1
CIC0
A
X
0
SOYBEANS, S (bushels per year)
6
Consumption & Production Gains
rF
PS/PT = rS = |slope of terms of trade line|
C
TEXTILES, T (yards per year)
B
A to B shows consumption gains
B to C shows production gains
CIC2
CIC1
CIC0
A
X
0
SOYBEANS, S (bushels per year)
7
Dynamic Gains from Trade
• Trade may speed economic growth
8
Dynamic Gains from Trade
• Trade may speed economic growth
– When more K goods are imported than
produced in autarky, PPF shifts out.
– Trade diffuses new technology.
– Trade raises real income. Savings rise.
– Free trade an effective anti-trust policy
– Trade expands the market, allowing firms to
exploit IRS.
– When trade spurs development, decreasingcosts may occur.
9
Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
10
Commercial Policy
• Governments action that may change the
composition and volume of trade flows
– Tariffs
– Quotas
– Subsidies
– Other non-tariff barriers
• We’ll analyze the cost & benefits of these
11
Tariffs
• Taxes on
– Imports
– Exports
– Subsidies
• Components -- See HTS
– Ad valorem-- % of value
– Specific -- flat fee per unit
– Compound -- both
12
Positive Effects of Tariffs
• Revenue Effect -- provide tax revenue
• Protective Effect -- shelter domestic
producers from foreign competition
13
Tariff Terminology
• A pure-revenue tariff is one imposed on a
good not produced domestically
– A tariff on bananas imported to Iceland
• A prohibitive tariff is one that is so high that
none of the good is imported
– no revenue is collected
14
Uses of Tariffs
• Developing countries may rely on tariffs to
provide tax revenue
• Developed countries impose tariffs for their
protective effect
15
Tariffs as tools of int’l policy
• Most Favored Nation status, MFN
– granted as a reward, withheld as a punishment
• Generalized System of Preferences, GSP
– Most developed countries have GSP as means
of helping developing countries
• access to markets of developed countries
16
Welfare Cost Analysis
• Use (National) Supply and Demand
– Partial equilibrium
– One import or export good
• Measure Changes in Consumer Surplus and
Producer Surplus
• Start with a small country
– Its trade is too small to affect terms of trade
Price ($ per bushel of
grapes)
Gains from free trade -- imports 17
10
6
3
2
0
1
4
7
10
Quantity (millions bushels of grapes per year)
Price ($ per bushel of
grapes)
Gains from free trade -- imports 18
Domestic Supply
of grapes
10
6
a
b
c
3
2
World price of grapes
Domestic demand for grapes
0
1
4
7
10
Quantity (millions bushels of grapes per year)
Welfare of a Move to Free Trade
A Small Country’s Imports
Change in Consumer Surplus
Change in Producer Surplus
Net Welfare Change
19
Welfare of a Move to Free Trade
A Small Country’s Imports
Change in Consumer Surplus
+a +b +c
Change in Producer Surplus
-a
Net Welfare Change
+b +c
20
Price ($ per jar of
honey)
Gains from free trade -- exports 21
10
9
6
2
0
1
4
7
10
Quantity (millions jars of honey per year)
Price ($ per jar of
honey)
Gains from free trade -- exports 22
Domestic Supply
of honey
10
World price of honey
9
g
e
f
6
2
Domestic demand for honey
0
1
4
7
10
Quantity (millions jars of honey per year)
Welfare of a Move to Free Trade
A Small Country’s Exports
Change in Consumer Surplus
Change in Producer Surplus
Net Welfare Change
23
Welfare of a Move to Free Trade
A Small Country’s Exports
Change in Consumer Surplus
-e
Change in Producer Surplus
+e +f +g
Net Welfare Change
-f
+g
24
grapes)
Price ($ per bushel of
Welfare Cost of a Tariff
on Imports -- Small Country
10
5
3
2
0
1
3
5
7
10
Quantity (millions bushels of grapes per year)
25
grapes)
Price ($ per bushel of
Welfare Cost of a Tariff
on Imports -- Small Country
26
Domestic Supply
of grapes
10
World price + tariff $2/bu
5
a
c
b
3
2
d
World price of grapes
Domestic demand for grapes
0
1
3
5
7
10
Quantity (millions bushels of grapes per year)
Welfare Cost of a Tariff
on Imports -- Small Country
Change in Consumer Surplus
Change in Producer Surplus
Change in Gov't Revenue
Net Welfare Change
(a.k.a. Deadweight loss)
Loss = 0.5 x tariff x change in imports
27
28
Welfare Cost of a Tariff
on Imports -- Small Country
Change in Consumer Surplus
-a -b -c -d
Change in Producer Surplus
+a
Change in Gov't Revenue
Net Welfare Change
(a.k.a. Deadweight loss)
+c
-b
Loss = 0.5 x tariff x change in imports
-d
Welfare Cost of a Tariff
Small Country
grapes)
Price ($ per bushel of
29
Domestic Supply
of grapes
10
World price + tariff $2/bu
5
c
b
3
2
d
World price of grapes
Domestic demand for grapes
0
1
3
5
7
10
Quantity (millions bushels of grapes per year)
grapes)
Price ($ per bushel of
Welfare Cost of a Tariff
on Imports -- Small Country
Domestic Supply
of grapes
10
5
3
2
30
World price + tariff $2/bu
a1
a2
c
b
d
World price of grapes
Domestic demand for grapes
0
1
3
5
7
10
Quantity (millions bushels of grapes per year)
Price ($ per jar of
honey)
Export Tariff -- Small Country
31
Domestic Supply
of honey
10
9
6
2
Domestic demand for honey
0
1
4
7
10
Quantity (millions jars of honey per year)
Price ($ per jar of
honey)
Export Tariff -- Small Country
Domestic Supply
of honey
10
9
32
a b
c
PW
d
PW -T
6
2
Domestic demand for honey
0
1
4
7
10
Quantity (millions jars of honey per year)
Welfare Cost -- Export Tariff
Small Country Case
Change in Consumer
Surplus
+a
Change in Producer Surplus -a -b -c -d
Change in Gov't Revenue
Net Welfare Change in A
(a.k.a. Deadweight loss)
+c
-b
-d
33
Welfare Cost -- Export Tariff
Small Country Case
Change in Consumer
Surplus
+a
Change in Producer Surplus -a -b -c -d
Change in Gov't Revenue
Net Welfare Change in A
(a.k.a. Deadweight loss)
+c
-b
-d
34
35
Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
Price ($ per lb.)
Int’l Free Trade Eq.
Large Country
PA
PB
0
0
Quantity (lb. of Lobster per year)
36
Int’l Free Trade Eq.
37
Price ($ per lb.)
Large Country
A’s Supply
of L
B’s Supply
of L
PA
PFT
PFT
PB
A’s demand
for L
0
0
Q1
Q2
B’s demand
for L
Q1’
Quantity (lb. of Lobster per year)
Q2’
A’s Supply
of Lobster
PA
Price ($ per lb.)
Price ($ per lb.)
Import Demand
PA
PFT
PB
PB
A’s demand
for Lobster
0
0
M = QD - QS
Quantity (lb. of Lobster per year)
38
A’s Supply
of Lobster
PA
Price ($ per lb.)
Price ($ per lb.)
Import Demand
39
PA
PFT
PB
PB
A’s demand
for Lobster
0
A’s demand for imported
lobster (excess demand);
|slope| = rise/(sum of runs)
0
M = QD - QS
Quantity (lb. of Lobster per year)
40
Price ($ per lb.)
Export Supply
B’s Supply
of L
PA
PB
PB
0
0
X = QS - QD
B’s demand
for L
QD
Quantity (lb. of Lobster per year)
QS
41
Price ($ per lb.)
Export Supply
B’s Supply of exports,
excess supply;
slope = rise/(sum of runs)
B’s Supply
of L
PA
PB
PB
0
0
X = QS - QD
B’s demand
for L
QD
Quantity (lb. of Lobster per year)
QS
A’s Supply
of Lobster
Price ($ per lb.)
Price ($ per lb.)
42
Export Supply & Import Demand
PA
PA
PFT
PFT
Export Supply, X
PB
Import Demand, M
A’s demand
for Lobster
0
Q1
Q2
0
0
M = Q2 - Q1
Quantity (lb. of Lobster per year)
Price ($ per lb.)
43
Export Supply & Import Demand
B’s Supply
of L
Export Supply, X
PA
PFT
PFT
PB
PB
Import Demand, M
0
0
0
M = Q2 - Q1
X = Q2‘ - Q1 ‘
B’s demand
for L
Q1’
Quantity (lb. of Lobster per year)
Q2’
44
Optimal Tariffs
• Large countries may force foreign producer
to pay part of their tariff.
• Because they are important customers, they
force foreign suppliers to cut price.
• The optimal tariff maximizes the net
welfare change
• Retaliation is likely to offset this gain
Equilibrium with a Tariff
45
Price ($ per lb.)
Large Country
A’s Supply
of L
B’s Supply
of L
P”
PFT
PFT
P’
P’
A’s demand
for L
0
0
Q1 Q3
Q4 Q2
B’s demand
for L
Q1’ Q3’ Q4’ Q2’
Quantity (lb. of Lobster per year)
Equilibrium with a Tariff
Large Country
Price ($ per lb.)
P”
A’s Supply
of L
a
PFT
46
b c d
e
B’s Supply
of L
PFT
P’
P’
h
i
A’s demand
for L
0
0
Q1 Q3
Q4 Q2
e j
B’s demand
for L
Q1’ Q3’ Q4’ Q2’
Quantity (lb. of Lobster per year)
A’s Welfare Cost -- Import Tariff
Imposed by Large Country, A
Change in Consumer
Surplus
-a -b -c -d
Change in Producer Surplus +a
Change in Gov't Revenue
Net Welfare Change in A
(a.k.a. Deadweight loss)
+c
-b
+e
-d +e
47
A’s Welfare Cost -- Import Tariff
Imposed by Large Country, A
Change in Consumer
Surplus
-a -b -c -d
Change in Producer Surplus +a
Change in Gov't Revenue
Net Welfare Change in A
(a.k.a. Deadweight loss)
+c
-b
+e
-d +e
48
49
B’s Welfare Cost from A’s Tariff
Import Tariff Imposed by A
Change in Consumer
Surplus
+h
Change in Producer Surplus -h -i -e -j
Change in Gov't Revenue
Net Welfare Change in B
(a.k.a. Deadweight loss)
-i -e -j
50
B’s Welfare Cost from A’s Tariff
Import Tariff Imposed by A
Change in Consumer
Surplus
+h
Change in Producer Surplus -h -i -e -j
Change in Gov't Revenue
Net Welfare Change in B
(a.k.a. Deadweight loss)
-i -e -j
51
World Welfare Cost of A’s Tariff
Net Welfare Change in A
-b -d +e
Net Welfare Change in B
Net Welfare Change in
World
-e -i -j
-b -d
-i -j
52
World Welfare Cost of A’s Tariff
Net Welfare Change in A
-b -d +e
Net Welfare Change in B
Net Welfare Change in
World
-e -i -j
-b -d
-i -j
53
World Welfare Changes
• Tariff raises the price in A to P” = PW + T
• Tariff lowers the world price to P’ = PW
• Tariff reduces the quantity world trade
from Q1 Q2 to Q3 Q4
• A’s welfare change = – b – d + e
• B’s welfare change = – e – i – j
• World welfare change = – b – d – i – j
54
Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
B Subsidizes its Exports
55
Price ($ per lb.)
Large Country Case
A’s Supply
of L
B’s Supply
of L
P”
P”
PFT
PFT
P’
P’
A’s demand
for Lobster
0
0
Q3 Q1
Q2 Q4
B’s demand
for Lobster
Q3’ Q1’
Quantity (lb. of Lobster per year)
Q2’ Q4’
B Subsidizes its Exports
56
Price ($ per lb.)
Large Country Case
A’s Supply
of L
B’s Supply
of L
P”
P”
a
PFT
P’
h
i
j
PFT
P’
k
b
e
A’s demand
for Lobster
0
0
Q3 Q1
Q2 Q4
c
f
d
g
B’s demand
for Lobster
Q3’ Q1’
Quantity (lb. of Lobster per year)
Q2’ Q4’
B’s Welfare Cost
from its Export Subsidy
Change in Consumer
Surplus
Change in Producer Surplus
Change in Gov't Revenue
Net Welfare Change in B
57
B’s Welfare Cost
from its Export Subsidy
Change in Consumer
Surplus
-a -b
Change in Producer Surplus +a +b +c
Change in Gov't Revenue
Net Welfare Change in B
-b -c -d
-e -f -g
-b
-d
-e -f -g
58
A’s Welfare Cost
from B’s Export Subsidy
Change in Consumer
Surplus
Change in Producer Surplus
Change in Gov't Revenue
Net Welfare Change in A
59
A’s Welfare Cost
from B’s Export Subsidy
Change in Consumer
Surplus
+h +i +j +k
Change in Producer Surplus -h
Change in Gov't Revenue
Net Welfare Change in A
+i +j +k
60
World Welfare Cost
from B’s Export Subsidy
Net Welfare Change in A
Net Welfare Change in B
Net Welfare Change in
World
61
World Welfare Cost
from B’s Export Subsidy
Net Welfare Change in A
+i +j +k
Net Welfare Change in B
-b -d -e -f -g
Net Welfare Change in
World
-b -d +i +j +k
-e -f -g
62
63
World Welfare Changes
• Export subsidy raises price in B to P” = PW
+S
• Subsidy lowers the world price to P’ = PW
• World trade grows from Q1 Q2 to Q3 Q4
• B’s welfare change = – b – d – e – f – g
• A’s welfare gain = + i + j + k
• World welfare change = – b – d – e – f – g
+i+j+k
64
Learning Objectives
• Reprise the gains from trade
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Analyze export subsidies
• Explain the effective rate of protection
65
Nominal & Effective Rates of Protection
• t = tariff
• P = free-trade price of
good
• v = domestic value
added with free trade
• v’= domestic value
added with tariff
67
Effective Rate of Protection
ERP, g j 
t j  aij ti
1  aij
gj = Effective Rate of Protection on final product j
tj = nominal tariff rate on final product j
ti = nominal tariff rate on imported input i
aij = share of i in the total value of j in the absence of tariffs
68
Welfare Cost of Tariffs as a
Percentage of GDP
• Traditional: Square the tariff rate
– Ten percent tariff reduces GDP by 1%
• Tariffs & NTBs often exclude new goods
– GDP loss almost twice the tariff rate
69
Welfare Cost of Tariffs as a
Percentage of GDP
• Traditional: Square the tariff rate
– Ten percent tariff reduces GDP by 1%
• Tariffs & NTBs often exclude new goods
– GDP loss almost twice the tariff rate
– Ten percent tariff lowers GDP by 19.8%
– Twenty-five percent tariff lowers GDP by 47%
70
Consumers’ Surplus
• Consumers’ Surplus is the difference between
consumers’ maximum willingness-to-pay and the
amount they actually paid.
• The amount actually paid equals PQ.
• Graphically, Consumers’ Surplus (CS) is the area
under the demand curve above P.
71
Producer Surplus
• Producer surplus is the price of a good
minus the opportunity cost of producing it.
– Graphically, Producers’ Surplus (PS) is the area
under the Price line and above Supply.
Price ($ per lb.)
72
Export Supply + Specific Tariff, T
T
Export Supply, X
T
Import Demand, M
0
MFT
Quantity (lb. of Lobster per year)
Price ($ per lb.)
73
Export Supply + Specific Tariff, T
X + TARIFF, T
T
Export Supply, X
PA
PW +T
PFT
PW
f
g
T
PB
Import Demand, M
0
MT
MFT
Quantity (lb. of Lobster per year)
74
Graphing Tariffs
• Specific tariff raises the y-intercept of the export
supply curve,
p=a+bq
p+T=a+bq+T
• Ad-valorem tariff raises the slope and y-intercept
of the export supply curve
p=a+bq
p (1 + t) = (a + b q) (1 + t) = (1 + t) a + (1 + t) b q
Price ($ per lb.)
Export Supply
75
with Ad-Valorem Tariff, t
X(1+t)
Export Supply, X
PA
PW +T
PFT
PW
f
g
PB
Import Demand, M
0
MT
MFT
Quantity (lb. of Lobster per year)
76
Price Elasticity of Demand, ed
ed and slope are inversely related.
Q P
Q P
Q P
ed      
Q
P
Q P
P Q
e
d
1
P
1
P

 

P
Q
Slope Q
Q
77
The Price Elasticity of Supply, es
• The formula for price elasticity of supply,
es, at a point is shown below. Note that it’s
the same as the formula for ed , but lacks
the absolute value notation
Q P
1
P




es P Q Slope Q
78
Import Demand Elasticity, em
• The formula for price elasticity of import demand,
em, at a point is shown below. Q is the quantity
of imports; P is the price; P is the change in
price; Q is the change quantity imported
e
m
Q P
1
P




Q
P
Slope Q
79
Import Demand Elasticity, em
• The formula for price elasticity of import demand,
em, at a point is shown below
Qm is the quantity of imports; Qd is the quantity
demanded; Qs is the quantity supplied
Qd
Qs




em Q ed Q es
m
m
80
Interpreting em
• em is directly related to A’s ed and es
• em is inversely related to the share of imports in
A’s consumption and production
Qd
Qs




em Q ed Q es
m
m
81
Export Supply Elasticity, ex
• The formula for price elasticity of export supply,
ex, at a point is shown below. Q is the quantity of
exports; P is the price; P is the change in price;
Q is the change quantity exported
Q P
1
P




ex P Q Slope Q
82
Export Supply Elasticity, ex
• The formula for price elasticity of export supply,
ex, at a point is shown below.
– Qx is the quantity of exports; Qd is the quantity
consumed; Qs is the quantity produced
Qd
Qs




ex Q ed Q es
x
x
83
Interpreting ex
• ex is directly related to B’s ed and es
• ex is inversely related to the share of exports in
B’s consumption and production
Qd
Qs




ex Q ed Q es
x
x
84
Export Supply + Specific Tariff, T
PA
X + TARIFF, T
PW +T
PFT
PW
T
f
A’s burden, b
Export Supply, X
g
PB
Import Demand, M
0
MT
MFT
Quantity (lb. of Lobster per year)
Compare em and ex
to determine A’s burden, b; 0b1
• When em = ex , b = _____
• When em > ex , b _______
• When em < ex , b _______
b
1
e
m

1
ex
85
Compare em and ex
to determine A’s burden, b; 0b1
• When em = ex , b = 0.5
• When em > ex , b < 0.5
• When em < ex , b > 0.5
b
1
e
m

1
ex
86
87
Differing em
PA
X + TARIFF, T
PW +T
PW +T
PFT
PW
PW
T
A’s burden, b
B’s burden, 1- b
Export Supply, X
f
g
f
g
Elastic M
Inelastic M
0
MT
MT
MFT
Quantity (lb. of Lobster per year)
88
Differing ex
PA
Inelastic X + T
T
Inelastic X
PW +T
PFT
PW
PB
f
A’s burden, b
Elastic X
g
T
0
Elastic X + T
Import Demand, M
MT
MFT
Quantity (lb. of Lobster per year)
SUPACHAI CITES KEY
NEGOTIATING AREAS
• Trade liberalization and poverty reduction
– Welfare gains from eliminating trade barriers gains of up to
US$620 billion annually
• about one third to one half would go to developing countries.
• Tariff “peaks”
– agricultural products, textiles, clothing and footwear
• Marketaccess conditions key in trade in services
• Regional trade agreements
– 240 currently in force, perhaps 300 by 2005
• Increasing use of contingency measures
– e. g., anti-dumping
89
90
Learning Objectives
• Reprise the gains from trade
• Become familiar with tariffs
• Analyze the welfare cost of tariffs
• Determine the optimal tariff
• Explain the effective rate of protection
• Learn the imperfect substitutes model
91
Imperfect Substitutes
• Increased trade in final products relative to raw
materials and intermediate goods
• A final-good import and competing domestic
products are often imperfect substitutes
• Tariff increases demand for the domestic good
• Increased price of domestic good increases
demand for the import
• Welfare cost is more difficult to estimate
Imperfect Substitutes
92
Small Country -- Free Market
Price
Price of Import
SD
PD
SM
PM
DM
0
QM
Quantity of Imports
DD
0
QD
Quantity of Domestic Substitute
Imperfect Substitutes
93
Small Country -- Tariff
Price
Price of Import
SD
i
f
S’M
h
r
j
n
SM
g
DM
0
k
l
tariff
e
m
Q’M Q”M Q
M
Quantity of Imports
D’D
D’M
0
DD
QD
Q’D
Quantity of Domestic Substitute
Welfare Cost of a Tariff
Imperfect Substitutes
Change in Consumer
Surplus
Change in Producer
Surplus
Change in Government
Revenue
Net Welfare Change
(a.k.a. Deadweight loss)
94
Welfare Cost of a Tariff
Imperfect Substitutes
Change in Consumer
Surplus
-area
efig
Change in Producer
Surplus
Change in Government
Revenue
Net Welfare Change
(a.k.a. Deadweight loss)
+area
efir
-area
rgi
-area
lmkj
+area
lmkj
95
96
Review homework
Trade with a Tariff
Versus Autarky
grapes)
Price ($ per bushel of
97
Domestic Supply
of grapes
10
6
5
e
d
World price + tariff $2/bu
3
2
World price of grapes
Domestic demand for grapes
0
1
3
5
7
10
Quantity (millions bushels of grapes per year)
Price ($ per bushel of bananas)
Pure Revenue Tariff
98
Versus Free Trade
10
Domestic Supply
of grapes lies along y-axis
a
World price + tariff $2/bu
5
c
b
3
2
World price of bananas
Iceland’s demand for bananas
0
1
3
5
7
10
Quantity (millions bushels of bananas per year)
99
Differing em
PA
X + TARIFF, T
PW +T
PW +T
T
f
f
g
PFT
PW
PW
Export Supply, X
g
Elastic M
Inelastic M
0
MT
MT
MFT
Quantity (lb. of Lobster per year)