Economics of a Tariff
Lecture 6

Tariffs

1. Specific tariff – a tax is $ per good
   • Does not change slopes of demand and supply functions
   • Easy to apply and administer
   • Protection is low for high priced goods
   • Similar to an excise tax on gasoline, cigarettes, and liquor
2. Ad valorem tariff- tax is percentage of market value
   • Ad valorem – on the value
   • Provides constant degree of protection
   • More complex to administer; gov. has to know products' values
   • Changes slopes of demand and supply functions
   • Similar to a sales tax
3. Examples
   • Libya, Hong Kong, Macau, and Singapore have no tariffs
   • Entrepot - Hong Kong and Singapore import and then export products (like a middleman or intermediary)
   • Developed countries have low tariffs
   • Developing countries tend to have higher tariffs; governments depend on the tariff revenue or protects domestic industry
   • Most economists are free traders
4. Protection
   • Tariffs protect domestic industry
   • Promotes growth of monopolies - monopolies charge a higher price, reduce quantities to the market, and provide poor customer service
   • Tariffs may harm society through indirect effects
     • Tariffs may increase costs to the export industries if protected product is used as an input
       • Example - U.S. imposes tariff on imported steel; U.S. cars become more expensive which harms exports, because steel is more expensive
     • Tariffs cause higher prices; workers may strike or demand higher wages
       • Tariffs may hurt the poor more; tariffs causes prices for shoes, clothes, etc to be higher
     • Tariffs reduces a foreign country's earnings; foreigners have less money to buy imports from tariff country
     • Beg thy neighbor policy - a country imposes a tariff to boost the domestic industries; other countries may increase tariffs, triggering a tariff war
   • International trade promotes competition and efficiency

The Economics of a Tariff

1. Tariffs decrease the world’s social welfare
   1. A tariff creates a price wedge
      • Domestic consumers pay a greater price
        • Taxes and tariffs increase market prices
        • Law of Demand - consumers reduce quantity demanded
      • Exporting foreign firms receive a lower price
        • Foreign consumers could benefit from lower price
      • Government collects tariff revenue
        • tariff = price wedge = consumers' price - exporters' price
        • A large country could gain from tariffs
   2. Domestic producers benefit from tariffs
      • They expand production
      • They could earn greater profits
      • Producers could have ties to gov.
2. Tariffs for a Large Country

The Welfare Effects on the U.S. from the U.S. Government's Tariff

• • Free trade – United States
    • Consumers' surplus = a + b + c + d + e + f + g
    • Producers' surplus = h
    • Welfare = a + b + c + d + e + f + g + h
  • Tariff – United States
    • Consumers' surplus = a + b + c
    • Producers' surplus = d + h
    • U.S. gov. revenue = f + r
    • Welfare = a + b + c + d + f + h + r

The Welfare Effects on China from the U.S. Tariff

1. • Free trade – China
     • Consumers' surplus = m
     • Producers' surplus = n + q + r + s+ u + v + w + x + y
     • Welfare = m + n + q + r + s+ u + v + w + x + y
   • Tariff – China
     • Consumers' surplus = m + n
     • Producers' surplus = u + v + w + x + y
     • Welfare = m + n + u + v + w + x + y
   • Deadweight loss is e +g + q + s
   • Notice - U.S. received rent from China in the form of r

3. Small Country Case
   • A small country exports at P’ _w and imports at P’’ _w

The Imports and Exports for a Small Country

• • Welfare for small country
    • Small country - a price taker; cannot influence the world price
    • Creates a price wedge, P' _w - P'' _w
    • Trading partner sees no change in their price
    • Note – similar to large country case, except exporting country sees no reduction in its price

The Welfare Effects for a Small Country that Imposes a Tariff

• • Free trade
    • Consumers' surplus = a + b + c + d + e + f
    • Producers' surplus = g
    • Welfare = a + b + c + d + e + f + g
  • Tariff
    • Consumers' surplus = a + c
    • Producers' surplus = g + b
    • Gov. revenue = e
    • Welfare = a + b + c + e + g
    • Society lost d + f

The Optimal Tariff

• Only works for large country
  1. Large country forces exporting firms to lower their price
  2. Forces consumers within country to pay higher price
  3. Gov. gains by taking surplus from exporting countries

The Optimal Tariff for a Large Country

1. 4. Note – a tariff reduces the world’s welfare
   5. However, a large country can gain by imposing a tariff
      • Gov. gains r from tariff revenue from exporting country
      • However, that country loses e + g domestically
      • A large country does not look at q + s, because that is loss to exporting country
   6. Optimal tariff is a county gains from a tariff if r > e + g