Macroeconomics

UV2703 Rev. July 24, 2009

This technical note was prepared by Associate Professor Peter Debaere Copyright  2007 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 7/09.

THE EFFECTS OF TARIFFS AND QUOTAS

Tariffs and quotas are the most prominent tools of protection. Any global firm is bound to encounter them as impediments to its exports or as hurdles for its imports. As Japanese car manufacturers in the United States showed in the early 1980s, multinationals sometimes set up affiliates abroad to circumvent import restrictions. But even those firms that do not venture into foreign markets should know about tariffs and quotas, because they will affect the size of the domestic market and the price that can be charged. In this note, the welfare effects of tariffs and quotas on consumers, producers, and the government are outlined. At the same time, a brief overview of protectionism in recent years and a short discussion of why protectionism occurs are given. Tools of Protection

Policymakers have many ways to shield a local industry. A common way is through tariffs and quotas. Tariffs are taxes on imported products that are paid at a country’s border. Quotas amount to quantitative restrictions on imports. Tariff protection gradually declined after World War II, due to the trade liberalizations that started under the umbrella of the General Agreement of Tariffs and Trade (GATT). Recent estimates by the World Bank (world development indicators) put the average tariff in manufacturing for high-income OECD (Organisation for Economic Co-operation and Development) countries at 3.3% and at 11% for developing countries. Agricultural trade liberalizations have only been on the agenda very recently. This, in part, explains why they are much higher: 10.6% for the same high-income countries and 16.3% for developing countries.

There are many other ways to protect an industry. One can, for example, impose high

quality and safety standards on foreign products. So long as domestic producers have to meet the same standards, those standards technically do not amount to protection. There is room, however, for some discussion. A country can tailor the standards to the product descriptions at home, and thus give the home producers an unfair advantage. It becomes even less clear when cultural/societal preferences are involved. Just think of the ongoing debate between the United States and the European Union over genetic engineering, or more generally, the debate about the oftentimes much stricter standards for antibiotics in the European Union versus the United

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States. To what extent do these measures constitute a safety issue or rather a way to protect an industry? Similarly, foreigners have often found it hard to break into Japanese markets and have sometimes blamed the differential treatment of their products by retailers. And finally, there is red tape: all kinds of procedures that may delay exporter access to a country’s market. Trade Liberalizations and Protection under the WTO

In 2007, about 151 member countries were part of the World Trade Organization (WTO), the international organization that followed the GATT. The WTO has a broader charter than the GATT. In addition to tariff liberalizations in manufacturing, the WTO also has liberalizations in agriculture on its agenda as well as issues related to foreign direct investment (FDI), intellectual property rights, and so on. The WTO is primarily a rules-oriented organization that aims to guarantee equal treatment for all countries. Its guiding principle is that of the most favored nation (MFN): All trading partners of a country should be treated in the same way as that country’s most favored trading partner. There are, however, important exceptions to the MFN principle. An ever-growing class of legal exceptions to MFN is formed by preferential trade agreements. There are currently more than 200 preferential trade agreements in force. In these, a restricted group of countries only reduces tariffs among themselves, but not necessarily with outside countries. The best-known preferential trade agreements are the North American Free Trade Agreement (NAFTA), the European Union (EU), and Mercosur.1 Another category of exceptions is for developing countries that benefit under the general system of preferences (GSP). This system gives zero-tariff entry to markets in developed countries without requiring reciprocity. In part because of this nonreciprocity, tariffs in developing countries tend to be higher.

As WTO members, countries’ trade policies are bound by the rules of the WTO and the

many rounds of trade negotiations. Therefore, countries in principle cannot unilaterally increase their tariffs. Because of this, the most popular protectionist tool in recent years has become the antidumping tariff for both developed and developing countries. The WTO allows countries to temporarily raise tariffs unilaterally against a country that is suspected of, for example, selling its products on international markets at prices that are lower than its production costs. There is a growing consensus that these tariffs are typically used for protectionist purposes and have very little to do with dumping. The recent antidumping tariffs in the United States against shrimp from China, Thailand, Vietnam, and a few other countries, illustrate this once more.

The Doha round is the latest round of trade liberalizations. It is the first time that

agricultural trade liberalization has been the main focus. But a division between developed and emerging economies offers little prospect of success. The United States, Europe, and Japan do not want to reduce their support for agriculture enough. The emerging economies led by India and Brazil do not guarantee the rich countries enough access to their markets in return.

1 Regional Free Trade Agreement among Argentina, Brazil, Paraguay and Uruguay.

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Tariffs

Figure 1 illustrates how a tariff works. Take a small country that in most industries has no way of influencing the world price. The upward- and downward-sloping curves are the domestic supply and demand for a particular good (say, sugar). The lowest horizontal line indicates the world supply of sugar at Pw. At this price, the rest of the world would be willing to supply any quantity of the good. Because we have assumed our country is small and cannot affect the world price, the line is flat or perfectly price-elastic. At Pw, there is excess demand. Domestic consumers want to buy more, Q4, than domestic producers supply, Q1. Therefore, sugar gets imported. Imports will amount exactly to the excess demand at Pw, or the distance between the intersections of the Pw line and, respectively, the domestic supply curve and domestic demand curve, Q4 − Q1. The intersection of the domestic supply and demand curve marks the autarky price that prevails if the country does not trade. Because we are looking at an import good, the autarky price is higher than the world price. In other words, the rest of the world is more efficient at producing the good.

Figure 1. How tariffs work.

Now imagine what happens when the country imposes a tariff, t. The price consumers

have to pay increases to Pd = Pw + t. The world price by assumption does not change. At this higher domestic price, consumers want to consume less of the goods and domestic producers will produce more. Consequently, imports will shrink to Q3 − Q2.

To get a sense of how this tariff affects the welfare in the small country, we look at

consumer and producer surplus. Table 1 summarizes the analysis.

Pd

Pw

Price

b c dt a

Q1 Q2 Q3 Q4

Domestic demand

Domestic supply

Quantity

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Table 1. Change in welfare with tariff and quota. Welfare Change With Tariff With Quota Consumer surplus −a – b – c − d −a – b – c − d Producer surplus + a + a Tariff revenue + c Net welfare −b − d −b – c − d

Consumer surplus, we remember, is the difference between how much consumers are

willing to pay for the good and the price that they actually pay. It is the area under the demand curve above the market price. When we compare consumer surplus before and after the tariff is imposed, we see that consumers lose the entire trapezoid area, marked by the letters a, b, c, and d. Tariffs are not a good thing for consumers: They have to pay a higher price and subsequently consume less. Producer surplus tells us how much more producers get for their good than the cost that they incur to put it on the market. It is the area under the price, above the supply curve. Here, clearly, when we compare producer surplus at Pd with that at Pw, producers are benefiting from the higher domestic price after the tariff, t. The small trapezoid named a delineates their entire gain. Note that to fully assess the welfare implications, we also have to include the area, c, which is the tariff revenue that the government collects. Adding tariff revenue and consumer and producer surplus together, we see that the country loses on net. It loses b and d, often called dead-weight loss triangles as less efficient producers, that with free trade should not be in business produce—and as consumers pay a higher price and consume less than they could under free trade. Equivalence of Tariff and Quota

The analysis of a quota is very similar to that of a tariff: We just start with quantities, instead of prices. As before, under free trade our country imports Q4 − Q1 when there are no trade restrictions in place. To protect the sugar industry, policy-makers now decide to restrict the quantity of imports to Q3 − Q2.

Now what should happen? Since Q3 − Q2 is smaller than Q4 − Q1 at the world price Pw,

there is excess demand for sugar. Consequently, the price will rise until Pd, when excess demand exactly matches the amount of imports allowed under the quota Q3 − Q2. In other words, as far as the effects on the domestic consumer and producers go, imposing a tariff, t, is equivalent to restricting imports to Q3 − Q2.

Note that the equivalence between tariffs and quotas implies that we can calculate for any

quota a corresponding tariff. This has proven to be a huge advantage in trade negotiations. Tariffs and tariff equivalents are easily comparable across countries, whereas quotas are not. There is, however, an important difference between a quota and a tariff in terms of welfare. With a quota, the government does not get the tariff revenue, c. (See Table 1.)

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Why Is There Protectionism?

The welfare analysis is very clear for both a quota and a tariff. A small country stands to lose when it implements protectionism. Then why is there protectionism? Ours is a simple model, so it may well be that it does not capture all relevant elements.

For example, we have assumed that a country is small. If our country is not small, the

world supply will not be flat. Instead, it will be upward-sloping. In this case, a tariff will lead to a drop in the Pw, because there is now less demand on the world markets. With this drop, the domestic price after the tariff will be lower than in the small country case and consumers will lose less (producers gain less). On net, the large country can even be better off with the tariff than without it if the tariff revenue offsets the smaller dead-weight losses. (Convince yourself that this is possible.) Although this may be a concern, it certainly is not an issue for many small countries that are price-takers in most markets.

To understand protectionism, it helps instead to look at the distribution of who loses and

who gains from the tariff or the quota. Producers gain, and consumers lose. The losses for consumers are so large primarily because there are so many of them. The loss for each individual consumer is limited: for sugar, maybe a few dollars a year per consumer. For the producers, it is an entirely different ball game. There are typically only a restricted number of producers, so each individual producer stands to gain a great deal from the higher domestic price after protection. Mancur Olson was one of the first economists to point out the asymmetry between producers’ and consumers’ interests. The small number of producers and their concentrated interests make it much easier for producers than consumers to mount collective action and to lobby. Consumers are hence more often less-successful lobbyists. Tariffs persist at the expense of consumers’ welfare.

The government, of course, will also benefit from tariffs. Because the government has

many alternative ways to raise taxes such as direct and indirect taxes, tariff revenues typically are not a big consideration in developed countries. But for developing countries, things are different; they may not have a system in place to successfully raise income or excise taxes. Additional tariff revenue may be a nonnegligible factor in their stand on protection. Exercises

1. Consider the following domestic supply, Q = 1 + 2P, and demand, Q = 10 − P, for a small open economy. Verify that under free trade with a world price of 2, the country will import 3. With a tariff of 1, the country will not import at all.

2. For the government, a tariff and a quota have different effects. With a tariff, the government gets tariff revenue; with a quota, it does not. But there are ways to recover the lost tariff revenue. The government could, for example, auction a limited number of

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export licenses. Argue why potential exporters of sugar to our country would be willing to pay exactly the price, t, to be able to sell one unit of sugar in our country.

3. A voluntary export restraint (VAR) is a particular type of quota. With a VAR, a country voluntarily decides to restrict its exports to, for example Q3 − Q2. Japan did this in the early 1980s for its car exports. By restricting the exports themselves, Japan wanted to avoid future U.S. tariffs on Japanese car imports. The U.S. car industry was in a slump at the time. Argue why, from the Japanese perspective, a VAR was a smart move that was more advantageous for Japan than, say, having to face a U.S. tariff that would restrict Japanese exports to the same level, Q3 − Q2.

This document is authorized for use only by Hameeda Lamb in Business & Economic Policy Graduate Online Fall 2018-2019 at Northwood University, 2018.