IMPORT TARIFFS AND
QUOTAS UNDER
PERFECT COMPETITION
1
A Brief History of the World Trade Organization
2
The Gains from Trade
3
Import Tariffs for a Small Country
4
Import Tariffs for a Large Country
5
Import Quotas
Introduction
•
During the 2000 presidential campaign, President
George W. Bush promised to consider
implementing a tariff on the imports of steel.
•
This was a political move to secure votes in large
steel-producing states as the tariffs would
“protect” the domestic producers of steel.
•
The steel tariff is an example of a trade policy—a
Introduction
•
Because gains from trade are unevenly spread,
producers often feel the government should help
them limit losses due to competition from trade.
•
Trade policy can include the use of import tariffs
(taxes on imports), import quotas (limits on
imports), and subsidies for exports.
•
We will assume that firms are perfectly
competitive. They produce a homogeneous good
and are small compared to the market.
The Gains from Trade
•
We will now demonstrate the gains from trade using
Home demand and supply curves, together with the
concepts of
consumer surplus
and
producer
surplus.
•
Consumer and Producer Surplus
Figure 7.1 (a) shows the Home demand curve D where consumers face a price of P1.
Remember, CS is the difference between the price the consumer is willing to pay and the actual price.
Part (b) of figure 7.1 illustrates producer surplus.
The Gains from Trade
D
P1 Price
D2 D1 Quantity Total Consumer surplus, CS P2 Surplus for consumer purchasing quantity D2
The demand curve gives us the consumer’s value for each unit of the good. Given P1, consumers will buy a total of D1.
A consumer who purchases D2 has a value of P2, but only has to pay P1 – that gives surplus equal to (P2-P1)
Adding up all the individual surplus for each point on the demand curve gives us total consumer surplus—the area between the demand and the price paid—up to the quantity sold
The Gains from Trade
S Price
S0 S1 Quantity Total Producer
surplus, PS
P0 P1
Surplus for firm producing quantity S0
Figure 7.1 (b)
The supply curve gives us the consumer’s value for each unit of the good. Given P1, producers will sell a total of S1.
A producer who sells S0 has a MC of P0, but gets P1. That gives surplus equal to (P1-P0)
Adding up all the individual surpluses for each point on the supply curve gives us total
producer surplus—the area
APPLICATION
The Gains from Trade
• No trade equilibrium • Again we consider the
world of two countries, Home and Foreign, with producers and consumers.
• Total Home welfare can be measured by adding up
consumer and producer surplus.
• We will compare the welfare in Home in no-trade and free-no-trade situations.
A PA
D Price
S CS
PS
No-trade equilibrium
The Gains from Trade
•
Free Trade for a Small Country
Suppose Home can now engage in trade.
The world price PW is determined by the supply and
demand in the world market (shown in in figure 7.2 (b)).
Suppose Home is a small country.
Price taker in the world market Faces a fixed price at PW
Assume PW is below the Home no-trade price PA.
PA
PW
The Gains from Trade
Price
S1 D1 Quantity S a b c D Figure 7.2
At lower world price,
consumer surplus increases to a+b+d an increase of
b+d from no-trade
At lower world price,
producer surplus falls to c
a decrease of b from no-trade
Gain in trade is triangle d
with area equal to ½(M1)(PA
-PW)
d
The Gains from Trade
•
Home Import Demand Curve
We can derive the import demand curve, shown in figure 7.3
The relationship between the world price of a good and the quantity of imports demanded by Home consumers.
At the no-trade equilibrium, there are zero imports
This is shown as point A′ in panel (b).
At the world price of PW, the quantity demanded is
greater than quantity supplied, and we import M1.
This is point B in panel (b).
B
The Gains from Trade
D PA
PW Price
S
S1 Q0 D1 Quantity Price
M1 Imports Import demand curve, M
A
A' No-trade
equilibrium Each point on the import demand curve is a point that corresponds to Home imports at a given Home price
Figure 7.3
Import Tariffs for a Small Country
•
Free Trade for a Small Country
Since Home is a small country, the tariff does not affect world prices.
The Foreign export supply curve X* is horizontal at the world price PW.
•
Effect of the Tariff
The new export supply curve shifts up to X*+t.
Quantity demanded falls while quantity supplied rises
However, as firms increase the quantity produced, the marginal costs of production rise.
Quantity M1 Imports
Foreign export supply, X* B
Import Tariffs for a Small Country
M Price M2 C Figure 7.4 A D X*+t PW+t
Price
S No-trade
equilibrium
Home price rises by the amount of the tariff.
Home supply increases and Home demand decreases Imports fall to M2
PW
Import Tariffs for a Small Country
•
Effect of the Tariff on Consumer Surplus
With the tariff, consumers now pay the higher price, PW+t, and their surplus is the area under the demand
curve and above the higher price, PW+t.
The fall in consumer surplus due to the tariff is the area in-between the two prices and to the left of Home
demand, (a+b+c+d) in panel (a.1) of figure 7.5.
PW+t
PW
Import Tariffs for a Small Country
A
D Price
S
S1 S2 D2 D1 Quantity No-trade
equilibrium Lost consumer surplus due to the higher price with the tariff is equal to the shaded area (a+b+c+d)
a
b d
c
Import Tariffs for a Small Country
•
Effect of the Tariff on Producer Surplus
With the tariff, producer surplus is the area above the supply and below the higher price, PW+t.
Since the tariff increases Home price, firms can sell more goods, and producer surplus increases
This area, a in figure 7.5 (a.2), is the amount that Home firms gain due to the higher price caused by the tariff.
Import Tariffs for a Small Country
No-trade equilibrium
PW+t
PW
A
D Price
S
S1 S2 D2 D1 Quantity
The gain in producer surplus due to the higher price with the tariff is equal to the shaded area (a)
a
b d
c
Import Tariffs for a Small Country
•
Effect of the Tariff on Government Revenue
In addition to the tariff’s impact on consumers and producers, it also affects government revenue.
The amount of revenue collected is the tariff t times the quantity of imports (D2 – S2).
In figure 7.5 panel (a.3), the revenue is shown by area
c.
PW+t
PW
Import Tariffs for a Small Country
A
D Price
S
S1 S2 D2 D1 Quantity No-trade
equilibrium
The gain in government revenue due to the tariff is equal to the shaded area
(c)
This equals the tariff, t, times the quantity of imports, M2
a
b d
c
Import Tariffs for a Small Country
• Overall Effect of the Tariff on Welfare
• Note, we do not care whether the consumers facing higher prices are rich or poor, and do not care whether the
specific factors in the industry earn a lot or a little.
• The overall impact of the tariff in the small country can be summarized as follows:
Fall in consumer surplus -(a+b+c+d)
Rise in producer surplus +a
Rise in government revenue +c Net effect on Home welfare -(b+d)
• The areas b and d in figure 8.5 (a) correspond to the
triangle (b+d) in figure 8.5 (b) and is the net welfare loss.
We refer to this area as a deadweight loss—it is not offset by a
PW+t
PW
Import Tariffs for a Small Country
A
D Price
S
S1 S2 D2 D1 Quantity No-trade
equilibrium
The deadweight loss is the loss to Home that is not offset by a corresponding gain
a
b d
c
Figure 7.5 (a)
a is a transfer from consumers to producers
c is a transfer from consumers to government
(b+d) is deadweight loss—
losses not offset by other gains
b = production distortion
Import Tariffs for a Small Country
Figure 7.5 (b)
M1 Imports
X*
M Price
M2
X*+ t C
Why are Tariffs Used?
•
Why do so many countries use tariffs if they
always lead to deadweight losses?
One idea is that developing countries do not have any other source of revenue.
Import tariffs are “easy-to-collect” relative to income taxes.
However, to the extent that developing countries recognize that tariffs have a higher deadweight loss, we would expect that
over time they will shift away from such “easy-to-collect” taxes.
A second reason is politics.
The might government care more about producer surplus than consumer surplus.
The benefits to producers (and their workers) are typically more concentrated on specific firms and states than the costs to
APPLICATION
U.S. Tariffs on Steel
•
We will estimate the deadweight loss due to the
U.S. steel tariff in place from March 2002 to
December 2003.
•
President Bush requested that the U.S.
International Trade Commission (ITC) initiate a
Section 201 investigation into the steel industry.
•
The tariffs varied across products, ranging from
APPLICATION
U.S. Tariffs on Steel
•
President Bush took the recommendation of the
ITC but applied even higher tariffs, ranging from
8% to 30%.
•
Knowing the U.S. trading partners would be upset
by this, President Bush exempted some countries
from the tariffs.
These included Canada, Mexico, Jordan, and Israel,
APPLICATION
U.S. Tariffs on Steel
APPLICATION
U.S. Tariffs on Steel
• Deadweight Loss due to the Steel Tariff
We need to estimate the areas of triangle b+d we found in figure
8.5(b).
The base is the change in imports, ΔM, and the height is the
increase in domestic price, ΔP = t.
Deadweight loss then equals DWL = ½ t ΔM.
It is convenient to measure the deadweight loss relative to the value of imports, which is PW*M.
We will also use the percentage tariff, t/PW, and the percentage
APPLICATION
PW
PW+t
U.S. Tariffs on Steel
Price
M2 M1 Imports M
Deadweight loss due to the tariff, b+d
c
Figure 7.5 (b)
t
We can measure DWL with the area of the triangle b+d from figure 8.5 (b)
APPLICATION
U.S. Tariffs on Steel
•
Using these definitions, the deadweight loss
relative to the value of imports can be rewritten
as:
M
P
t
M
P
M
t
M
P
DWL
W WW
%
2
1
2
1
•
The most commonly used products had a
tariff of 30%, so the percentage increase in
APPLICATION
U.S. Tariffs on Steel
•
This leads to a DWL of
%
5
.
4
)
3
.
0
)(
3
.
0
(
2
1
%
2
1
M
P
t
M
P
DWL
W W•
The value of steel imports affected by the tariff
was about $4.7 billion prior to March 2002 and
$3.5 billion after March 2002.
Average imports over the two years were $4.1 billion.
Import Tariffs for a Large Country
•
Under the small country
assumption that we have
used so far, the importing country is always
harmed due to the tariff.
The small country is a world price taker.
•
If we consider
a large enough importing country or
a large country
, however, then we might expect
that its tariff will change the world price.
Import Tariffs for a Large Country
•
Foreign Export Supply
If the Home country is large, then the Foreign export
supply curve X* is no longer horizontal at the world price PW.
We construct the Foreign export supply curve in a fashion similar to the import demand curve.
In panel (a) of figure 7.8, we show the Foreign demand curve D* and supply curve S*, giving price of PA* at A*.
At this point, Foreign exports are zero. Suppose the world price is PW above PA*.
At the higher price, there is a Foreign excess supply of X1* = S1* - D1*, which will be exported at the price of PW
Import Tariffs for a Large Country
Price Price Quantity Exports D* S* Home import demand, MD1* S1*
A* A*'
PA* PW
B*
X1*
Foreign export supply, X*
World price increases to PW,
increasing exports to X1*
Figure 7.8
This gives us our Foreign export supply curve for the large country
At the world price, PA*,
exports are zero at A*’
Import Tariffs for a Large Country
•
Effect of the Tariff
Figure 7.9 we show the effect when Home applies a tariff of t dollars on imports.
Foreign export supply curve shifts up by exactly the amount of the tariff, shifting from X* to X*+t.
The Home price rises by less than t, and the Foreign producers receive, P*, which is less than PW.
The tariff drives a wedge between what Home
M2
Import Tariffs for a Large Country
A Price P*+t S Price Imports D
S1 S2 D2 D1 Quantity M2 M1
M
X*+t
(a) Home market
X* B* C C* No-trade equilibrium t (b) Foreign market
t t
Figure 7.9
(without welfare effects)
Import Tariffs for a Large Country
•
Home Welfare
Fall in consumer surplus -(a+b+c+d) Rise in producer surplus +a
Rise in government revenue +(c + e)
Net effect on Home welfare e – (b+d) + (e)
•
The triangle (b+d) is the deadweight loss due to
the tariff.
•
Area
e
offsets part of the loss.
•
If
e > (b+d),
then Home is better off.
Import Tariffs for a Large Country
A Price a c P*+t PW P* S b d Price e DS S D D Quantity M M
M X*+t e X* B* C C* b+d No-trade equilibrium t
(a) Home market (b) Foreign market
Figure 7.9
(with welfare effects)
Import Tariffs for a Large Country
• Home welfare may improve, but it comes at the expense of foreign exporters.
• Foreign and World Welfare
The Foreign loss, measured by (e+f) also in figure 7.9, is the loss in
Foreign producer surplus from selling fewer goods to Home at a lower price.
The area e is the terms-of-trade gain for Home (P*<PW) but an
equivalent terms-of-trade loss for Foreign.
Additionally, there is an extra deadweight loss in Foreign of f, giving a combined total greater than the benefits to Home.
Therefore, it is sometimes called the “beggar thy neighbor” tariff.
Import Tariffs for a Large Country
A Price a c P*+t PW P* S b d Price e DS S D D Quantity M M
M X*+t e X* B* C C* b+d No-trade equilibrium t
(a) Home market (b) Foreign market
Figure 7.9
(with welfare effects)
Foreign loses (e+f) as loss of Foreign producer surplus, from selling fewer goods at a lower price
APPLICATION
U.S. Tariffs on Steel Once Again
• Optimal Tariff
Compute the deadweight loss (area b+d) and the terms-of-trade gain (area e) for each imported steel product.
Rather than do all these calculations, however, we can use the concept of the optimal tariff.
The tariff that leads to the maximum increase in welfare for the importing country.
We have shown that for a small tariff, a large country can gain. But if the tariff is too large, the country will still lose.
APPLICATION
Free Trade Importer’s Welfare
No Trade
U.S. Tariffs on Steel Once Again
B
A C
Terms of trade gain exceeds deadweight loss
Terms of trade gain is less than deadweight loss
B'
Optimal Prohibitive Tariff
The Optimal tariff maximizes the Importer’s welfare, Point C
Too high of a tariff will decrease importer’s welfare and can
increase to the point where there is no trade
APPLICATION
U.S. Tariffs on Steel Once Again
•
Optimal Tariff Formula
The optimal tariff depends on the elasticity of Foreign export supply, EX*.
•
Optimal Tariff Formula
Optimal Tariff = 1/E
X*.
For a small importing country, the elasticity of Foreign export supply is infinite, and so the optimal tariff is zero.
As the elasticity of Foreign export supply decreases,
APPLICATION
U.S. Tariffs on Steel Once Again
•
Optimal Tariffs for Steel
If we apply this formula to the U.S. steel tariffs, we can see how the tariffs applied compare to the theoretical optimal tariff.
Table 7.2 shows various steel products along with their respective elasticities of export supply to the U.S.
We can compare the actual tariff to the optimal tariff to see where there were gains and where there were
losses from the tariffs.
APPLICATION
U.S. Tariffs on Steel Once Again
Import Quotas
•
On January 1, 2005, China was poised to become
the world’s largest exporter of textiles and
apparel.
On that date, the Multifibre Arrangement (MFA) was abolished.
Under the MFA, import quotas restricted the amount of nearly every textile and apparel product that was
imported to Canada, Europe, and the U.S.
The quotas were to protect their own domestic firms producing those products.
Import Quotas
•
Import Quota in a Small Country
Suppose the import quota of M2<M1 is imposed.
This essentially gives us a horizontal (vertical) supply curve, X in panel b (at prices above PW).
Fixes the import quantity at M2, price rises to P2.
Quantity supplied rises to S2 and quantity demanded falls to D2.
For every level of import quota, there is an equivalent import tariff
Import Quotas
Figure 7.11 (with quota) B A Quantity D Price S Price Imports M1 Foreign export supply, X* Home import demand, M P2 C No-trade equilibrium c a d b+d c bWith the Quota, the Foreign export supply becomes vertical at the quota quantity
The new Export Supply curve
crosses the Import Demand curve at a new price and quantity of imports
At the new higher price P2, Home Supply increases to S2, Demand decreases to D2 and imports fall to M2 Always have a deadweight loss of (b+d) like the tariff
Consumers loses surplus of (a+b+c+d), producers gain (a).
Welfare of Home depends on what happens to (c), the total quota rents.
PW
Import Quotas
• There are four possible ways these rents can be allocated.
1. Giving the Quota to Home Firms:
Quota licenses can be given to Home firms
Permits to import the quantity allowed under the quota system. The net effects on Home welfare due to the quota are then as
follows:
Fall in consumer surplus -(a+b+c+d)
Rise in producer surplus +a
Quota rents earned at Home +c
Net effect on Home welfare: -(b+d)
This is the same loss we saw with a tariff.
Import Quotas
2.
Rent Seeking
Because of the gains associated with owning a quota license, firms have an incentive to engage in
inefficient activities in order to obtain them.
How licenses are allocated matters.
a. If licenses are allocated in proportion to each firm’s
production, Home firms will likely produce more than they can sell just to obtain the import licenses for the following year.
Import Quotas
Some suggest that the waste of resources devoted to rent seeking could be as large as the value of the rents themselves, c.
If rent seeking occurs, welfare loss of quota is:
Fall in consumer surplus -(a+b+c+d)
Rise in producer surplus +a
Net effect on Home welfare: -(b+c+d)
This loss is larger than a tariff.
Import Quotas
3.
Auctioning the Quota
The government of the importing country to auction off the quota licenses.
In a well-organized, competitive auction, the revenue collected should exactly equal the value of the rents.
Fall in consumer surplus -(a+b+c+d)
Rise in producer surplus +a
Auction revenue earned at Home +c
Net effect on Home welfare: -(b+d)
APPLICATION
Auctioning Import Quotas in
Australia and New Zealand
•
During the 1980s, Australia and New Zealand
both auctioned the quota licenses to import
specific goods.
•
Table 8.3 shows the value of imports covered by
quotas curing 1981–1987.
•
In 1988, New Zealand announced plans to phase
APPLICATION
Auctioning Import Quotas in
Australia and New Zealand
•
Table 8.3 also shows the value of bids for the
quota licenses.
These are estimates of rents.
•
If we take the ratio of the value of bids to the
value of imports covered by the quota, we obtain
an estimate of the tariff equivalent to the quota.
These are shown in the final column of table 8.3
•
Since there was no penalty from not following
APPLICATION
Auctioning Import Quotas in
Australia and New Zealand
APPLICATION
Auctioning Import Quotas in
Australia and New Zealand
•
The government therefore did not collect all the
winning bids as revenue.
•
For those that did buy their licenses, they could
be resold and some were at much higher prices.
•
This makes it appear that the government was not
Import Quotas
4.
“Voluntary” Export Restraint
The importing country can give authority for
implementing the quota to the exporting government.
This is often called a “voluntary” export restraint (VER) or a “voluntary” restraint agreement (VRA).
In the 1980s the U.S. used this type of arrangement to restrict imports of Japanese automobiles.
Import Quotas
•
With VERs, quota rents are earned by foreign
producers, making Home welfare:
Fall in consumer surplus -(a+b+c+d)
Rise in producer surplus +a
Net effect on Home welfare: -(b+c+d)
•
This is a higher net loss than with a tariff.
•
Why would an importing country do this?
It is typically political—the exporting country is less likely to retaliate since they gain the area c.
Import Quotas
•
Costs of Import Quotas in the U.S.
Table 8.4 presents some estimates of Home
deadweight losses and quota rents for some major U.S. quotas in the 1980’s.
In all cases except Dairy, the rents were earned by Foreign exporters.
Adding up the costs in the table, the total U.S.
deadweight loss due to these quotas ranged from $8– $12 billion annually.
Quota rents transferred another $7–$17 billion to foreigners.
Import Quotas
APPLICATION
China and the Multifibre Arrangement
• One of the principles of GATT was that countries should not use quotas to restrict imports.
• The MFA was a major exception to that which allowed the industrialized countries to restrict imports of textile and
apparel products from the developing countries.
• Organized under GATT, importing countries could join the MFA and arrange quotas bilaterally or unilaterally.
• Under the Uruguay round of WTO, developing countries were able to negotiate an end to this system of import quotas.
• Some developing countries and large producers in
APPLICATION
China and the Multifibre Arrangement
•
Growth in Exports from China
Immediately after January 1, 2005, exports of textiles and apparel from China grew rapidly.
In 2005, China’s textile and apparel imports to the U.S. rose by more than 40% compared to 2004.
Figure 7.12 (a) shows the change in the value of
exports of textiles and apparel from different countries. Note China.
The increases from China came at the expense of
APPLICATION
China and the Multifibre Arrangement
APPLICATION
China and the Multifibre Arrangement
•
Panel (b) of figure 7.12 shows the percentage
change in the prices of textiles and apparel
products from each country, depending on
whether the products were subject to the MFA
quota before January 1, 2005, or not.
•
China had the largest drop in the prices from 2004
to 2005.
•
Many other countries had a substantial fall in their
APPLICATION
China and the Multifibre Arrangement
APPLICATION
China and the Multifibre Arrangement
•
Welfare Cost of the MFA
Given the drop in prices in 2005, it is possible to estimate the welfare loss due to the MFA.
Using the price drops from figure 7.12, the welfare loss for the U.S. (b+c+d), is estimated at $6.5 to $16.2
billion in 2005 from the MFA.
Averaging out all losses and dividing among
APPLICATION
China and the Multifibre Arrangement
• Import Quality
Quotas are set on the quantity, not the quality of items imported.
Selling a higher value good for the same quantity will still meet the quota limit but will bring more money back home.
Incentive to export higher quality products.
Prices dropped the most for the lower- priced items.
An inexpensive T-shirt had a greater drop in price than a more expensively priced item.
U.S. demand shifted towards the lower-priced items imported from China: there was “quality downgrading” in the exports from China.
