8 - Import tariffs and quotas under perfect competition
Trade policy is government action meant to influence the amount of international trade, e.g.
import tariffs (taxes), quotas (quantity limits), and export subsidies.
World Trade Organisation
At the end of WW2 allied countries met in Bretton Woods and established the International
Monetary Fund and the World Bank (1944). In 1947 the General Agreement on Tariffs and Trade
was established, committed to reducing barriers to international trade.
Under the GATT countries hold periodic ‘rounds’ to lower trade restrictions, and it provides some
key provisions:
-Most favoured nation clause, stating every country belonging to the WTO must be treated
equally: Lowering tariffs to one country means doing the same to all.
-Tariffs may be imposed in response to unfair practices such as dumping, selling exports below
the price charged at home/below costs.
-Quotas are forbidden.
-Declare subsidies and discuss eliminating them.
-Safeguard provision/escape clause allowing for temporary tariff raise for certain products when
the import causes or threatens serious injury to domestic producers.
-Regional trade agreements are permitted, such as free-trade areas, or custom unions (EU) whose
countries adopt identical tariffs with the rest of the world on top of being a free-trade area.
Gains from trade
Earlier we used a production possibilities frontier and indifference curves to
demonstrate these gains, now we do it using Home and Foreign supply and
demand curves combined with consumer and producer surplus.
With demand D and facing price P1, all consumers that bought the product
except for the last one valued it above P1: They obtain a surplus over the
purchase price, as their willingness to pay (demand curve) exceeds the actual
price. Someone willing to pay P2 has a P2 - P1 surplus.
The same goes for the producer’s side: Supply curve shows the firm’s marginal
cost at each level of production. At the last unit supplied at S1, the price exactly
equals the costs. For all earlier units the firm had marginal costs below the price,
adding together to a producer surplus. Producer surplus is not profit: It’s the
return to fixed factors of production, as only variable costs are reflected in the
marginal costs.
Combining these two graphs shows us the no-trade equilibrium at
autarky price P’a, where the total surplus is consumer + producer,
making the total Home welfare a + b + c.
Suppose we open to free-trade, and being a small country it is
unable to influence the world price and acts as a price taker. This
given price Pw is below Pa, increasing Home demand from Q0 to D1,
while the lower price will decrease supply to S1, meaning imports of
M1 are traded.
The new Consumer surplus is a + b + d, whereas the producer
surplus has decreased to c. Total welfare is then a + b + c + d,
making the net effect an increase of d. D is a measure of the gains
from trade, also measured as 0.5 * (Pa - Pw) * M1, which is the
increase in consumption.
The import demand curve shows the relationship between world
price and quantity of imports demanded, and can be derived by
tracing certain points. Starting with the no-trade equilibrium A, we
know there is no import demanded. At Pw the demand and Home
supply differ, meaning the difference is imported: We can thus find
M1 imports. Then we trace a line between these two points.
,Import tariffs for a small country
Now that we’ve got the supply and demand curves we can see what happens when we impose a
tariff. Being a small country, we can’t influence world price meaning the Home price of the good
will increase thanks to the tariff:
Home consumers will pay the
tariff as an extra for the product.
Looking at the free-trade
equilibrium on the right we see
the Foreign export supply is
horizontal since Home’s a price-
taker. Where X intersects M is
the free-trade equilibrium.
Shown in the Home market, we
see Home’s supply at this price
is S1 and demand D1, meaning
the difference has to be
imported: D1 - S1 = M1.
The import tariff of t dollars shifts up X by exactly this, similar to a sales tax would. The new
intersection (higher world price) reduces demand and increases the amount Home’s suppliers are
willing to supply, since they actually receive the price + tariff, whereas foreign exporters receive
the “net-of-tariff”. So the amount of imports demanded falls from M1 to M2.
As firms increase the produced quantity though, the marginal cost of production rises: This is why
Home will supply up to the point where their marginal costs equal the import price Pw + t.
The tariff makes the consumer
surplus fall by abcd, the area
underneath the demand curve
by which consumption falls.
The producer surplus increases
by a, the area to the left of the
supply curve by which
production increases.
Government revenue increases
with the tariff times the amount
of imports: So the area c.
Net effect on Home welfare =
-abcd + a + c = -bd. The net welfare loss is deadweight loss because it is not offset anywhere
else in the economy. a and c is taken from consumers and given to respectively producers and
government.
The triangle b, the increase in Home supply thanks to the tariff, has the height of the increase in
marginal costs. Instead of Pw it is now produced at a marginal cost of Pw + t. The fact that this
marginal cost exceeds world price means it’s produced inefficiently: Import would be cheaper.
The area b is the increase in marginal costs and the production loss or efficiency loss.
Triangle d is the price increase’s effect on Home demand, decreasing it from D1 to D2. Those
consumers that no longer consume at the new price lose their consumer surplus: Consumption
loss.
Despite always leading to welfare loss for small countries they’re still often used since they’re
easier to collect than most taxes, and because of politics. Countries are only allowed to impose
them under the GATT because of the safeguard clause: If an import causes substantial injury or
threatens to do so for a US industry a tariff may be applied.
,To measure the DWL of a tariff we need to estimate the area bd. The base of this triangle is the
change in imports ∆M=M1-M2, and the height is ∆P = t. This makes the DWL = 1/2* ∆M * t.
Measuring the DWL relative to imports Pw * M and
also using the percentage of the price the tariff is
t/Pw, and lastly the percentage change in imports
∆M/M gives us the deadweight loss relative to the
value of imports:
If the tariff is 30% and imports decrease by 30%
the DWL is 4.5% of the import value:
Steel and tire tariffs in the US
President Bush imposed tariffs of this volume during his tenure, which exporting countries
brought before the WTO’s formal dispute settlement procedure. The WTO concluded in 2003 that
the US hadn’t sufficiently proven its steel industry had been harmed enough to justify safeguard
tariffs, making the tariffs unlawful by GATT agreement.
The increased competition faced by US steel firms was at least partially caused by an
appreciating dollar, which made imports more competitive. Since this applied to all imports, not
just steel, it didn’t justify tariffs on steel.
The WTO ruling entitled the EU to retaliate against the US, the threat of which led Bush to
suspend the tariffs after 19 months in 2003, avoiding a tariff war.
Obama imposed tariffs on Chinese tires in 2009, making it a discriminatory tariff since it’s on a
specific country. This violates the ‘most favoured nation’ principle, but the US negotiated Section
421 as a condition for China entering the WTO: A China-specific safeguard allowing the US to
impose tariffs after significant material injury, lower
requirements than the usual safeguard clause.
China retaliated with its own tariffs.
Deadweight loss of a discriminatory tariff
Suppose China can sell any amount of tires at Pw. US
supply is S, all other countries except China is X. So all
supply except China is S + X. Under free trade this makes
the price Pw and US supply S1, from all countries except
China S1+X1, and demand D1.
When we apply a tariff of t against only China, the price of
tires rises to Pw + t and US supply rises to S2. Supply from
the US and other countries than China is S2+X2 now. China
exports the difference between demand and supply. It used
to supply D1 - S1 - X1, now D2 - S2 - X2.
Because the price has risen to Pw + t everyone except China
sells more since supply increased, but demand actually
decreased so China sells a lot less.
When we calculate what effect this has on US welfare a difference with non-discriminatory tariffs
arises. With a tariff on only China, not just US companies but all companies except Chinese ones
get to keep the higher price. Only Chinese exporters receive net-of-tariff price excluding t.
Since there’s no tariff revenue for the government on imports from third countries, only C is
collected as government revenue in stead of e+c. e therefore becomes part of DWL for the US.
So with regular tariffs DWL would be b + d, now it is b + e + d. Exporters sell for a higher price,
and not all of this accrues to the US government, making them lose out.
In the Obama example, other countries such as Mexico were able to sell more tires to the US at
higher prices. Chinese imports decreased and were simply replaced.
Import tariffs for a large country
For large countries able to influence the world price the welfare can actually be improved for the
importing country in some cases. The Foreign supply curve is now no longer horizontal but
downward sloping. We derive it on the graph on the next page in much the same way that we did
, with Foreign export supply last time. Taking the
Foreign market’s S and D, we see that at Pa* at the
no-trade equilibrium supply equals demand. So
drawing this in panel b, as Pa* the exports are 0. At
the world price above the autarky-price, Foreign’s
supply exceeds demand meaning it will import the
difference S - D = X, which equals imports.
Drawing a line between these 2 gives us the
Foreign export supply curve X.
We see that the Home import demand curve starts
at Pa wheres Foreign’s export supply curve starts
at Pa*: Foreign’s price in autarky is lower, meaning it
has a comparative advantage in producing this
good, causing it to become an exporter.
X intersects import demand M at the world
equilibrium price at point B*. When a tariff of t
dollars is applied by Home, the Foreign export
supply curve shifts up by exactly that amount: From
X* to X* + t, since the cost Foreign producers
exporting face is t higher than before shifts the
curve.
The new equilibrium is point C, where Foreign
exporters receive the net-of-tariff price C*. This price P* is the new world price. So the tariff has
increased the price received by Home’s producers to P*+t, but decreased the price received by
Foreign exporters to p*. So the price Home consumers pay for their imports rises by less than the
tariff because Foreign exporters absorb part of the tariff by lowering their price from Pw to P*.
So the tariff drives a wedge between what Home pays and Foreign receives, the difference
between them being received by Home’s government.
Terms of trade for a country is the ratio of export to import prices, an improvement in which
means a country either pays less for its imports or receives more for exports. To measure Home’s
terms of trade we use the price P*, the net-of-tariff price received by Foreign firms. Since this has
fallen from Pw to P* Home’s terms of trade have improved.
Whether Home’s welfare improved too depends on the effect on consumers. Consumer prices
increased from Pw to P* + t, making consumers worse off. The drop in consumer surplus is the
area between these prices to the left of demand abcd.
The extra price received by Home firms increases their producer surplus by a.
The government revenue increases with ce. This makes the net welfare effect:
-abcd + a + e + c = -bd + e.
The triangle bd is the deadweight loss due to the tariff, just as it was for a small country.
The difference is the area e offsetting this DWL: If e exceeds the production and consumption loss
the net welfare improves. e is a rectangle whose height is the price fall to Foreign exporters and
width the quantity of imports M2. Price drop * import quantity = terms of trade gain.
If the drop in price times imports exceeds the DWL from production and consumption loss Home
gains from a tariff.
Foreign however always loses, by the area ef in panel b in the graph above.
This loss occurs due to selling less goods: e is the terms-of-trade gain for
Home, equalling the terms-of-trade loss for Foreign. Then added to this is a
DWL of f to Foreign. Therefore the combined welfare loss in Foreign always
exceeds the gain in Home, explaining why tariffs imposed by large countries
are also known as ‘beggar thy neighbour’ tariffs.
In the world economy as a whole, the terms of trade gain is offset by a loss, e
Foreign cancelling out e Home. This leaves the DWL for the world b+d+f, the
red triangle with a height of the tariff and width of the import decrease.
