Part 2 International Trade Policy Chapter 5 Trade Restrictions Tariffs Flashcard

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The Nature and Purpose of Tariffs Tariffsare taxes that are imposed on a nation’s imports and/or exports, although export tariffs are not constitutional in the US. The objectives of import tariffs include protection from foreign competition and the generation of tariff revenues. In more developed economies, import tariffs are primarily used to protect targeted industries from foreign competition because tariff revenues are small relative to the revenues collected through taxes on income and/or consumption. In developing countries, tariffs are used to not only protect specific economic industries, but also generate revenues for the government. Tariffs are currently relatively low in the more developed economies, averaging well under 5%. Developing economies, on the other hand, maintain relatively high average tariffs, with percentages often in the double-digit range. Although nations usually try to justify tariffs by appealing to the national interest, economists argue that tariffs generally aid some special interest group, but leave the world as a whole poorer.
The Effects of an Import Tariff in a Small Nation A tariff imposed by a small nation will have no effect on prices in world markets. Just as one consumer cannot affect the price of pencils or automobiles by buying more or less, one small nation cannot affect the price of a good it imports from the rest of the world by changing its consumption. For a small nation a tariff will raise the price of imports to domestic consumers by the amount of the tariff. This will shift purchases to domestic sources, driving their price up until it reaches the new higher price of imports. The tariff increases the price of both the imported good and its domestically produced substitute. Although domestic producers will gain from higher prices, there will be net losses for two reasons. First, domestic consumers will be buying some goods from domestic producers that could be supplied from abroad more cheaply. Second, consumers will buy fewer units of the good so the gains consumers previously received on these units will no longer occur. These net losses can be better described graphically.
The Effects of an Import Tariff in a Small Nation A tariff imposed by a small nation will have no effect on prices in world markets. Just as one consumer cannot affect the price of pencils or automobiles by buying more or less, one small nation cannot affect the price of a good it imports from the rest of the world by changing its consumption. For a small nation a tariff will raise the price of imports to domestic consumers by the amount of the tariff. This will shift purchases to domestic sources, driving their price up until it reaches the new higher price of imports. The tariff increases the price of both the imported good and its domestically produced substitute. Although domestic producers will gain from higher prices, there will be net losses for two reasons. First, domestic consumers will be buying some goods from domestic producers that could be supplied from abroad more cheaply. Second, consumers will buy fewer units of the good so the gains consumers previously received on these units will no longer occur. These net losses can be better described graphically. The SXcurve in Figure 5.1 is the supply of good X from domestic producers. The DXcurve in Fig. 5.1 is the demand for good X by domestic consumers. In the absence of trade, the price is $25, which is where quantity supplied equals quantity demanded. If the nation can buy good X at a world price of $15, shown as the flat line in Fig 5.1 at $15 (also labeled Pw), then the consumers of this nation will want to buy 600 units of good X while producers will want to produce 100 units of good X. The domestic excess demand at $15 is fulfilled by imports equal to 500 units. If, now, a tariff of $5 per unit is imposed on imports of good X, then the new price faced by domestic consumers is $20. With the small nation assumption, the world price of $15 is unchanged because the nation is too small to affect world prices. Thus, the world price remains at $15, so that after the tariff of $5 is added, the relevant price of X in the nation is now $20. With an increase in price from $15 to $20, producers increase production by 80 more units, for a total of 180 units supplied domestically. Consumers respond to the $20 price by buying 500 units. Now the amount imported is 320 units. The quantity imported falls as a result of the imposition of the tariff because domestic production has increased and the quantity demanded by domestic consumers has decreased. The government of the above nation will collect revenues from the tariff. With a quantity imported of 320 and a tariff of $5 per unit, the revenues from the tariff are $1600 and equal to area c in Fig. 5.1. Summarizing the effects of the tariff for the above case: The Effects of an Import Tariff in a Small Nation A tariff imposed by a small nation will have no effect on prices in world markets. Just as one consumer cannot affect the price of pencils or automobiles by buying more or less, one small nation cannot affect the price of a good it imports from the rest of the world by changing its consumption. For a small nation a tariff will raise the price of imports to domestic consumers by the amount of the tariff. This will shift purchases to domestic sources, driving their price up until it reaches the new higher price of imports. The tariff increases the price of both the imported good and its domestically produced substitute. Although domestic producers will gain from higher prices, there will be net losses for two reasons. First, domestic consumers will be buying some goods from domestic producers that could be supplied from abroad more cheaply. Second, consumers will buy fewer units of the good so the gains consumers previously received on these units will no longer occur. These net losses can be better described graphically. The SXcurve in Figure 5.1 is the supply of good X from domestic producers. The DXcurve in Fig. 5.1 is the demand for good X by domestic consumers. In the absence of trade, the price is $25, which is where quantity supplied equals quantity demanded. If the nation can buy good X at a world price of $15, shown as the flat line in Fig 5.1 at $15 (also labeled Pw), then the consumers of this nation will want to buy 600 units of good X while producers will want to produce 100 units of good X. The domestic excess demand at $15 is fulfilled by imports equal to 500 units. If, now, a tariff of $5 per unit is imposed on imports of good X, then the new price faced by domestic consumers is $20. With the small nation assumption, the world price of $15 is unchanged because the nation is too small to affect world prices. Thus, the world price remains at $15, so that after the tariff of $5 is added, the relevant price of X in the nation is now $20. With an increase in price from $15 to $20, producers increase production by 80 more units, for a total of 180 units supplied domestically. Consumers respond to the $20 price by buying 500 units. Now the amount imported is 320 units. The quantity imported falls as a result of the imposition of the tariff because domestic production has increased and the quantity demanded by domestic consumers has decreased. The government of the above nation will collect revenues from the tariff. With a quantity imported of 320 and a tariff of $5 per unit, the revenues from the tariff are $1600 and equal to area c in Fig. 5.1. Summarizing the effects of the tariff for the above case: The SXcurve in Figure 5.1 is the supply of good X from domestic producers. The DXcurve in Fig. 5.1 is the demand for good X by domestic consumers. In the absence of trade, the price is $25, which is where quantity supplied equals quantity demanded.
If the nation can buy good X at a world price of $15, shown as the flat line in Fig 5.1 at $15 (also labeled Pw), then the consumers of this nation will want to buy 600 units of good X while producers will want to produce 100 units of good X. The domestic excess demand at $15 is fulfilled by imports equal to 500 units.
If, now, a tariff of $5 per unit is imposed on imports of good X, then the new price faced by domestic consumers is $20. With the small nation assumption, the world price of $15 is unchanged because the nation is too small to affect world prices. Thus, the world price remains at $15, so that after the tariff of $5 is added, the relevant price of X in the nation is now $20.
With an increase in price from $15 to $20, producers increase production by 80 more units, for a total of 180 units supplied domestically. Consumers respond to the $20 price by buying 500 units. Now the amount imported is 320 units. The quantity imported falls as a result of the imposition of the tariff because domestic production has increased and the quantity demanded by domestic consumers has decreased. The government of the above nation will collect revenues from the tariff. With a quantity imported of 320 and a tariff of $5 per unit, the revenues from the tariff are $1600 and equal to area c in Fig. 5.1. Summarizing the effects of the tariff for the above case:
Consumption effectof a tariff = decrease in domestic units consumed = 100
Production effectof a tariff = increase in domestic units produced = 80
Trade effectof a tariff = decrease in units imported = 180
Revenue effectof a tariff = revenues produce by the tariff = $1600.

The welfare cost of the tariff is due to the effects of the higher price that must be paid by consumers. The loss to consumers is represented by the loss of consumer surplus, which is the area a+b+c+d, in Fig. 5.1.
The welfare benefit of the tariff is the gain in producer surplus plus the increased government revenues. The gain in producer surplus is indicated by area a in Fig. 5.1. The gain in revenues is area c, as explained previously. Essentially, consumers have lost a+b+c+d, of which area a has been redistributed to producers and area c has been redistributed to the government. The net result is a net loss equal to areas b+d. Area b represents the extra cost to consumers from buying domestically. Area d represents the consumer surplus that no longer is realized because units between 500 and 600 are no longer purchased. The losses represented by the area b+d is called the deadweight loss of the tariff because the area is not transferred anywhere; it no longer exists.
The Effects of an Import Tariff in a Large Nation In a small nation, the domestic price of the good increases by the full amount of the import tariff, so the tariff is completely shifted to domestic consumers.
The Effects of an Import Tariff in a Large Nation In a small nation, the domestic price of the good increases by the full amount of the import tariff, so the tariff is completely shifted to domestic consumers. For a large country the tariff reduces domestic consumption of the good and, because the country is large, this reduced demand causes world prices to drop. As a result of the tariff, domestic consumers will still pay more, but the price increase to domestic consumers is less than the size of the tariff because the tariff is added to the world price, which has fallen. Part of the tariff has been shifted to foreign sellers of the good because the price falls on the world market. This is shown in Figure 5.2. The tariff is assumed to lower the world price from $15 to $13, so consumers pay $3 of the $5 because consumers now pay $18 rather than $15. Foreign producers pay $2 of the $5 tariff because the world price has fallen from $15 to $13. The gains and losses are now: Loss of consumer surplus = area a+b+c+d Gain in producer surplus = a Gain in tariff revenues = c+e. The gains minus the losses are (a+c+e) – (a+b+c+d) = e – (b+d). If area e exceeds area b+dthen there is a gain to the nation imposing the tariff. If area e is less than area b+d, then there is a loss to the nation imposing the tariff. In the case of a large nation, a tariff can be beneficial, but is not necessarily so. Not all tariffs will increase the welfare of a large nation. In the extreme, suppose a tariff is imposed that prohibits all imports. This is called a prohibitive tariff. A prohibitive tariff cannot be welfare enhancing because no part of the tariff can be shifted to foreigners because there are no imports, so there is no area e. Thus, the tariff must be of the right size to improve the welfare of a large nation. The tariff that maximizes the welfare of a large nation is called the optimum tariff and is somewhere between zero and the prohibitive tariff. The Effects of an Import Tariff in a Large Nation In a small nation, the domestic price of the good increases by the full amount of the import tariff, so the tariff is completely shifted to domestic consumers. For a large country the tariff reduces domestic consumption of the good and, because the country is large, this reduced demand causes world prices to drop. As a result of the tariff, domestic consumers will still pay more, but the price increase to domestic consumers is less than the size of the tariff because the tariff is added to the world price, which has fallen. Part of the tariff has been shifted to foreign sellers of the good because the price falls on the world market. This is shown in Figure 5.2. The tariff is assumed to lower the world price from $15 to $13, so consumers pay $3 of the $5 because consumers now pay $18 rather than $15. Foreign producers pay $2 of the $5 tariff because the world price has fallen from $15 to $13. The gains and losses are now: Loss of consumer surplus = area a+b+c+d Gain in producer surplus = a Gain in tariff revenues = c+e. The gains minus the losses are (a+c+e) – (a+b+c+d) = e – (b+d). If area e exceeds area b+dthen there is a gain to the nation imposing the tariff. If area e is less than area b+d, then there is a loss to the nation imposing the tariff. In the case of a large nation, a tariff can be beneficial, but is not necessarily so. Not all tariffs will increase the welfare of a large nation. In the extreme, suppose a tariff is imposed that prohibits all imports. This is called a prohibitive tariff. A prohibitive tariff cannot be welfare enhancing because no part of the tariff can be shifted to foreigners because there are no imports, so there is no area e. Thus, the tariff must be of the right size to improve the welfare of a large nation. The tariff that maximizes the welfare of a large nation is called the optimum tariff and is somewhere between zero and the prohibitive tariff. For a large country the tariff reduces domestic consumption of the good and, because the country is large, this reduced demand causes world prices to drop. As a result of the tariff, domestic consumers will still pay more, but the price increase to domestic consumers is less than the size of the tariff because the tariff is added to the world price, which has fallen. Part of the tariff has been shifted to foreign sellers of the good because the price falls on the world market. This is shown in Figure 5.2. The tariff is assumed to lower the world price from $15 to $13, so consumers pay $3 of the $5 because consumers now pay $18 rather than $15. Foreign producers pay $2 of the $5 tariff because the world price has fallen from $15 to $13.

The gains and losses are now:

Loss of consumer surplus = area a+b+c+d
Gain in producer surplus = a
Gain in tariff revenues = c+e.

The gains minus the losses are (a+c+e) – (a+b+c+d) = e – (b+d). If area e exceeds area b+dthen there is a gain to the nation imposing the tariff. If area e is less than area b+d, then there is a loss to the nation imposing the tariff. In the case of a large nation, a tariff can be beneficial, but is not necessarily so.
Not all tariffs will increase the welfare of a large nation. In the extreme, suppose a tariff is imposed that prohibits all imports. This is called a prohibitive tariff. A prohibitive tariff cannot be welfare enhancing because no part of the tariff can be shifted to foreigners because there are no imports, so there is no area e. Thus, the tariff must be of the right size to improve the welfare of a large nation. The tariff that maximizes the welfare of a large nation is called the optimum tariff and is somewhere between zero and the prohibitive tariff.
The optimum tariff argument, however, assumes that foreign nations do not retaliate with tariffs of their own, which reduces the welfare of the nation initially imposing the tariff. The result may be a trade war through tariffs and retaliations that reduce the welfare of all nations involved.
Even in the absence of retaliation, though, a tariff never increases the total gains from trade. A tariff misallocates resources by increasing production in nations that do not have a comparative advantage thereby lowering world production. Although a large nation may gain from the tariff, its trading partners must necessarily lose more than the large nation gains.
The Effective Rate of Protection
Tariffs are generally intended to protect domestic industry from foreign competition but the degree to which they do so is often misestimated. If, for example, autos sell for $20,000 and use $15,000 of imported inputs, then there will be $5,000 of domestic activity that goes to produce the automobile. This is called domestic value added. If there is a tariff of 10% placed on automobiles, then the nominal tariff is 10%, but the rate of effective protection is quite different. Auto prices will increase to $22,000, which now makes domestic valued added equal to $7,000, which is a 40% increase over the original domestic value added. This increase in domestic value added is the rate of effective protection.
The rate of effective protection in an industry may also be negative. If a tariff is imposed on, say, steel to protect the steel industry, then protection to the auto industry will decrease. The higher cost of inputs means that for a given price of steel, the domestic valued added will drop.For most goods tariffs are cascaded, meaning that tariffs on the final produce are high relative to tariffs on inputs, in order to expand domestic value added. From an economic viewpoint, however, such protection reduces the welfare of a small nation due to the deadweight losses. For a large nation tariffs may increase the welfare of the large nation, but will misallocate resources and reduce world welfare.
Multiple Choice Questions
1. If a tariff is imposed on an imported good by a small nation, which of the following will occur?
a) Both the price of the imported good and the price of the domestic competing good will increase.
b) The quantity consumed by domestic consumers will increase.
c) Domestic consumers will gain.
d) The nation will gain.

2. If a prohibitive tariff is imposed on imports of automobiles, then
a) Imports will be zero.
b) Consumer surplus will be zero.
c) Domestic production will fall to zero.
d) Domestic consumption will fall to zero.





3. If the consumption effect of a tariff were 50 units and the production effect of a tariff were 40 units, then imports would
a) Increase by 10 units.
b) Increase by 90 units.
c) Decrease by 90 units.
d) Decrease by 10 units.
4. If a tariff in a small country produces a deadweight loss of $60, reduces consumer surplus by $200, and increases producer surplus by $40, which of the following is correct?
a) National welfare falls by $220.
b) National welfare falls by $160.
c) Tariff revenues equal $100.
d) The price of the imported good must have fallen.

5. Which of the following must be true if a large nation imposes a tariff on an imported good?
a) The price received by domestic producers will fall.
b) The price received by foreign producers will fall.
c) Domestic consumers will gain.
d) The nation will gain.

6. A large nation imposes a tariff on an imported good, which causes the world price to fall by $4. At the new world price the large nation has deadweight losses of $500 and imports of 300. Which of the following must be true?
a) The large nation has gained.
b) Domestic producer surplus has fallen.
c) Domestic consumer surplus has increased.
d) Total tariff revenues must be less than the deadweight loss.
7. If a tariff of $10 per unit reduces the world price by $4, then
a) The nation imposing the tariff must be a small nation.
b) Domestic consumers pay $6 of the $10 per unit tariff.
c) Foreign producers pay $6 per unit of the $10 per unit tariff.
d) The nation imposing the tariff must necessarily lose.




8. Given that the imposition of a tariff will improve the welfare of a large nation, which of the following is true?
a) World welfare will increase if all large nations impose the tariff.
b) The large nation’s gains are equal to its trading partners’ losses.
c) World welfare will fall.
d) Large nations should impose a prohibitive tariff.

9. If a nation imposes a tariff on steel, an important input in the production of automobiles then
a) The nominal tariff on automobiles will increase.
b) The rate of effective protection on steel will decrease.
c) The rate of effective protection on automobiles will decrease.
d) Employment in the auto industry will increase.

10. If a nation imposes an import tariff of 20% on a final good that uses imported inputs, then
a) The effective rate of protection will be 20%.
b) The effective rate of protection will be greater than 20%.
c) The nominal rate of protection will be less than 20%
d) The nominal rate of protection will equal the effective rate of protection.


Problems and Discussion Questions

7. If a tariff of $10 per unit reduces the world price by $4, then a) The nation imposing the tariff must be a small nation. b) Domestic consumers pay $6 of the $10 per unit tariff. c) Foreign producers pay $6 per unit of the $10 per unit tariff. d) The nation imposing the tariff must necessarily lose. 8. Given that the imposition of a tariff will improve the welfare of a large nation, which of the following is true? a) World welfare will increase if all large nations impose the tariff. b) The large nation’s gains are equal to its trading partners’ losses. c) World welfare will fall. d) Large nations should impose a prohibitive tariff. 9. If a nation imposes a tariff on steel, an important input in the production of automobiles then a) The nominal tariff on automobiles will increase. b) The rate of effective protection on steel will decrease. c) The rate of effective protection on automobiles will decrease. d) Employment in the auto industry will increase. 10. If a nation imposes an import tariff of 20% on a final good that uses imported inputs, then a) The effective rate of protection will be 20%. b) The effective rate of protection will be greater than 20%. c) The nominal rate of protection will be less than 20% d) The nominal rate of protection will equal the effective rate of protection. Problems and Discussion Questions 1. Figure 5.3 shows the effect of an import tariff. Answer the following based on Figure 5.3. a) Is the demand curve in Figure 5.3, the demand by domestics, or the demand for domestic products? b) What is the dollar amount of the tariff per unit? c) Is the nation depicted in Figure 5.3 a small nation or a large nation? d) After all adjustments, what happens to the price of domestic production of good X as a result of the import tariff? 2. Using the numbers given in Figure 5.3, indicate the size of each of the following. a) Consumption effect of the tariff. b) Production effect of the tariff. c) Trade effect of the tariff. d) Revenue effect of the tariff. 3. Use Figure 5.3 to answer the following. a) What is the dollar value of the welfare cost of the tariff to consumers? b) What is the dollar value of the welfare benefit of the tariff to producers? c) What is the dollar value of the tariff revenues? d) Compare total benefits of the tariff to the costs to consumers and determine the dollar value of net losses from the tariff. Identify the net losses graphically in Fig. 5.3. e) Calculate the area of triangles b and d in Fig. 5.3. 4. Table 1 gives the effect of a tariff on cotton sweaters. (Assume there is no difference between domestically produced sweaters and foreign produced sweaters.) Table 1 Free Trade With a $4.00 Tariff World Price of sweaters Tariff per sweater Domestic Price of sweaters Sweaters consumed domestically (million sweaters/year) Sweaters produced domestically (million sweaters/year) Sweaters imported (million packs/year $42.00 0 $42.00 60 12 48 $42.00 $4.00 $46.00 52 18 34 a) Using an upward sloping domestic supply curve and a downward sloping demand curve, calculate the losses to domestic consumers from the tariff. b) Calculate the net effect on the country's welfare as a result of the tariff. c) Based on the information given in Table 1, would the optimum import tariff on sweaters be negative, zero, or positive? Why? 5. Laptop computers are produced domestically and imported. The price of laptop computers is $1000 and domestic producers use $600 of imported inputs per laptop computer produced. What is the rate of effective protection if a 20% tariff is imposed on imports of laptop computers? Assume the nation is small. 6. As in Question 5, the price of laptop computers is $1,000 in a small nation, and laptops are both produced domestically and imported. If domestic producers use $600 worth of imported inputs, what is the effective rate of protection if a 20% tax is imposed on imported inputs?1. Figure 5.3 shows the effect of an import tariff. Answer the following based on Figure 5.3.
a) Is the demand curve in Figure 5.3, the demand by domestics, or the demand for domestic products?

b) What is the dollar amount of the tariff per unit?

c) Is the nation depicted in Figure 5.3 a small nation or a large nation?

d) After all adjustments, what happens to the price of domestic production of good X as a result of the import tariff?
2. Using the numbers given in Figure 5.3, indicate the size of each of the following.
a) Consumption effect of the tariff.

b) Production effect of the tariff.

c) Trade effect of the tariff.

d) Revenue effect of the tariff.


3. Use Figure 5.3 to answer the following.
a) What is the dollar value of the welfare cost of the tariff to consumers?

b) What is the dollar value of the welfare benefit of the tariff to producers?

c) What is the dollar value of the tariff revenues?

d) Compare total benefits of the tariff to the costs to consumers and determine the dollar value of net losses from the tariff. Identify the net losses graphically in Fig. 5.3.

e) Calculate the area of triangles b and d in Fig. 5.3.


4. Table 1 gives the effect of a tariff on cotton sweaters. (Assume there is no difference between domestically produced sweaters and foreign produced sweaters.)

Table 1
Free Trade With a $4.00 Tariff World Price of sweaters
Tariff per sweater
Domestic Price of sweaters
Sweaters consumed domestically (million sweaters/year)
Sweaters produced domestically (million sweaters/year)
Sweaters imported (million packs/year $42.00
0
$42.00
60
12
48 $42.00
$4.00
$46.00
52
18
34
a) Using an upward sloping domestic supply curve and a downward sloping demand curve, calculate the losses to domestic consumers from the tariff.

b) Calculate the net effect on the country's welfare as a result of the tariff.

c) Based on the information given in Table 1, would the optimum import tariff on sweaters be negative, zero, or positive? Why?


5. Laptop computers are produced domestically and imported. The price of laptop computers is $1000 and domestic producers use $600 of imported inputs per laptop computer produced. What is the rate of effective protection if a 20% tariff is imposed on imports of laptop computers? Assume the nation is small.


6. As in Question 5, the price of laptop computers is $1,000 in a small nation, and laptops are both produced domestically and imported. If domestic producers use $600 worth of imported inputs, what is the effective rate of protection if a 20% tax is imposed on imported inputs?