Global Economics Eco 6367 Dr. Vera Adamchik

1. Global EconomicsEco 6367Dr. Vera Adamchik Tariffs

2. A glance at any daily newspaper makes it clear that governments do not adhere to free trade despite the persuasive theoretical arguments pointing out the net welfare gains that result from unobstructed international trade. Policymakers have proven very resourceful in generating different devices for restricting the free flow of goods and services.

3. Chapter outline • Protecting domestic producers against import competition – an import tariff. • Arguments for and against protection.

4. An Import Tariff

5. A tariff is a tax on importing a good or service into a country, usually collected by customs officials at the place of entry. • A specific tariff is stipulated as a money amount per unit of import. • An ad valorem (on the value) tariff is a percentage of the estimated market value of the goods when they reach the importing country. • A compound tariff is a combination of specific and ad valorem tariffs.

6. A protective tariff is designed to reduce the amount of imports entering a country, thus insulating import-competing producers from foreign competition. • A revenue tariff is imposed for the purpose of generating tax revenues. • A prohibitive tariff has a rate that is so high that it keeps imports from coming into the country.

7. Tariff rates have been declining, but they are still important. • Only one country in the world, Singapore, has almost no tariffs. (+ two autonomous customs areas, Hong Kong and Macau, that have no tariffs.) • Average tax rates are higher in most developing countries.

8. In-class exercise • Exercise # 1 (handout). Tariff rates in different countries. • U.S. tariff rates (handout).

9. Measurement of tariffs • How do we determine the average tariff rate from a large number of different tariff rates on imported goods? Two techniques: • unweighted-average tariff rate, • weighted-average tariff rate.

10. In-class exercise • Exercise # 2 (handout). Unweighted- and weighted-average tariff rate.

11. Nominal vs effective tariff rates • The distinction between the nominal tariff rate and the effective tariff rate (more commonly known as the effective rate of protection, ERP) is important when countries are negotiating tariff rate reductions because the negotiation requires focusing on an appropriate rate.

12. The nominal rate is simply the rate listed in a country’s tariff schedule. • The ERP is defined as the percentage change in the value added in a domestic import-competing industry because of the imposition of a tariff structure by the country rather than the existence of free trade. • The whole tariff structure considers not only the tariff rate on the final good but also on the intermediate goods that go into making the final good.

13. Value added • Value added is the value of a firm’s production minus the value of the intermediate goods that the firms buys from other firms. • Equivalently, value added is the sum of the incomes (including profits) paid to the resources used by the firm.

14. Effective rate of protection • In other words, the effective rate of protection measures the percent effect of the entire tariff structure on the value added per unit of output in each industry. • This concept incorporates the point that incomes in any one industry are affected by the tariffs on many products.

15. In-class exercise • Exercise # 3 (handout). The effective rate of protection. • Nominal and Effective Tariffs in the US and Japan (handout).

16. Illustrative calculation of an Effective Rate of Protection (ERP)

17. Conclusions 1. A given industry’s incomes, or value added, will be affected by trade barriers on its inputs as well as trade barriers on its output. 2. The effective rate of protection will be greater than the nominal rate when the industry’s output is protected by a higher duty than the tariff duties on its inputs.

18. Conclusions (cont.) 3. If the tariff rates on the inputs are the same as the tariff rate on the output, then this rate is also the effective rate of protection. 4. The effective rate of protection can be negative. The tariff structure can penalize value added in the industry. 5. Export producers are penalized with something like negative effective protection if their costs are increased by tariffs on the inputs they use in production.

19. An escalated tariff structure • Rule (2) above incorporates an escalated tariff structure and reflects the situation when nominal tariff rates on imports of manufactured goods are higher than nominal tariff rates on intermediate inputs and raw materials. • This situation has particular relevance to trade between developed and developing countries.

20. Tariff escalation forces the developing countries to continue to be suppliers of raw materials to and importers of manufactured goods from the developed countries when they would like to supply manufactured goods. • Developing countries believe that this discriminates against their attempt to develop manufacturing and that it consigns the developing countries to exporting products at an early stage of fabrication.

21. Offshore-assembly provisions • Under offshore assembly provisions (OAP), now referred to as production-sharing arrangements by the U.S. International Trade Commission, the tariff rate in practice on a good is lower than the tariff rate listed on the tariff schedule.

22. In-class exercise • Exercise # 4 (handout).

23. Tariff avoidance – the legal utilization of the tariff system to one’s own advantage in order to reduce the amount of tariff. • Tariff evasion – when individuals or firms evade tariffs by illegal means, such as smuggling imported goods into a country. • Postponing import tariffs – a bonded warehouse; a foreign-trade zone,

24. Tariff Welfare Effects: Consumer Surplus and Producer Surplus

25. Consumer surplus • Consumer surplus is additional benefit obtained by the buyer of a good. • Consumer surplus is the difference between the maximum amount buyers are willing to pay for a given quantity of a good and the amount actually paid. • Consumer surplus is illustrated as an area below the demand curve and above the market price.

27. Equilibrium price = $6 • Equilibrium quantity = 50 • Producer surplus = $125 ($6-$1)*50/2 = $125 • Consumer surplus = $75 ($9-$6)*50/2 = $75 Amount paid

28. Producer surplus • Producer surplus is additional benefit obtained by the seller of a good. • Producer surplus is the revenue producers receive over and above the minimum necessary for production (that is, the difference between the minimum that the seller is willing to accept and the actual price). • Producer surplus is illustrated as an area above the supply curve and below the market price.

29. Equilibrium price = $6 • Equilibrium quantity = 50 • Producer surplus = $125 ($6-$1)*50/2 = $125 Cost of Production

30. Equilibrium price = $6 • Equilibrium quantity = 50 • Producer surplus = $125 • Consumer surplus = $75 • Total gains from exchange equals consumer surplus plus producer surplus • Gains from exchange = $125 + $75 = $200

31. Consumer & Producer Surplus When combined, the areas of consumer surplus and producer surplus represent the total welfare to the nation resulting from the sale of this good.

32. Tariff Welfare Effects: Small Country

33. Small vs large country • In our analysis, we assume a small country, one whose trade does not affect international price ratio. • A large country is one whose trade can have an impact on the relative international price ratio. • These definitions are based on the ability of the country to have a noticeable effect on one or more international prices. • Even a country with a small economy can be a large country (Ghana – a major exporter of cocoa).

34. Tariff Welfare Effects, Small Country. Illustration 1

35. Consumer surplus in autarky Domestic supply Producer surplus in autarky Equilibrium without trade Domestic demand Welfare in autarky (no trade) Price of Steel Quantity 0 of Steel

36. Domestic supply Equilibrium without trade Price World before tariff price Domestic demand S D Q Q Imports free trade Welfare under free trade Price of Steel Quantity 0 of Steel

37. Welfare under free trade Consumer surplus under free trade Domestic supply Producer surplus under free trade Equilibrium without trade Price World before tariff price Domestic demand S D Q Q Imports free trade Price of Steel Quantity 0 of Steel

38. Consumer surplus after tariff Consumer surplus after tariff Domestic supply Equilibrium without trade Price after tariff Price World before tariff price Imports Domestic with tariff demand S S D D Q Q Q Q Imports free trade Price of Steel Tariff Quantity 0 of Steel

39. Producer surplus after tariff Domestic supply Producer surplus after tariff Equilibrium without trade Price after tariff Price World before tariff price Imports Domestic after tariff demand S S D D Q Q Q Q Imports free trade Price of Steel Tariff Quantity 0 of Steel

40. Government’s revenue from tariff Domestic supply Tariff revenue Price after tariff c Price before tariff Imports Domestic after tariff demand S S D D Q Q Q Q Imports free trade Price of Steel Tariff World price Quantity 0 of Steel

41. Effects of tariff on social welfare Domestic supply Deadweight loss Price with tariff a b c d Price without tariff Imports Domestic after tariff demand S S D D Q Q Q Q Imports free trade Price of Steel Tariff World price Quantity 0 of Steel

42. Tariff Welfare Effects: Small Country Illustration 2

43. Tariff welfare effects Before Trade (Autarky): U.S. consumer surplus is area in red. U.S. producer surplus is area in green.

44. Tariff welfare effects With Free Trade: Consumer surplus increases by areas a,b,c,d,e,and f. Producer surplus decreases by areas a and e. The overall increase in welfare is b,c,d and f.

45. Tariff welfare effects With Tariff: c = revenue effect = lost consumer surplus now government rev. a = redistributive effect = shift from consumer to producer surplus b + d = deadweight loss = benefits lost to all parties b = protective effect d = consumption effect

46. Tariff Welfare Effects, Small Country. Illustration 3 (Handout)

47. The U.S. market for bicycles with free trade