Chapter 8Analysis of a Tariff

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Analysis of a TariffA tariff is a tax on importing a good or service into a country. Types of tariffs:• Specific tariff is stipulated as a money amount per

unit of import, such as dollars per ton of steel bars, or dollars per eight-cylinder two-door sports car.

• Ad valorem tariff is a percentage of the estimated market value of the imported good when it reaches the importing country.

• Compound tariff is a combination of specific and ad valorem tariffs.

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A Preview of Conclusions• A tariff almost always lowers world well-being.• A tariff usually lowers the well-being of each nation, including the nation imposing the tariff.• The exception is the “nationally optimal” tariff. When

a nation can affect the prices at which it trades with foreigners, it can gain from its own tariff. (The world as a whole loses, however.)

• A tariff absolutely helps those groups tied closely to the production of import substitutes, even when the tariff is bad for the nation as a whole

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The Effect of a Tariff on Domestic Producers

The U.S. Market for Bicycles with Free Trade:

Domestic producer surplus is area CBADomestic consumer surplus is area FEC

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The Effect of a Tariff on Domestic Producers

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The Effect of a Tariff on Domestic Consumers

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The Tariff as Government Revenue

• As long as the tariff is not so high as to prohibit all imports, it also brings revenue to the country’s government– Revenue equals the unit amount of the tariff times

the volume of imports with the tariff (area c in the diagram)

• This revenue could be used to pay for extra government spending, matched by an equal cut in some other tax, or serve as extra income

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The Net National Loss From a Tariff

• One-dollar, one-vote metric: Every dollar of gain or loss is just as important as every other dollar of gain or loss, regardless of who the gainers or losers are.

• Consumption effect of the tariff shows the loss to the consumers in the importing nation based on the reduction in their total consumption (area d in the diagram).

• Production effect of the tariff is the amount by which the cost of drawing domestic resources away from other uses exceeds the savings from not paying foreigners to buy extra units (area b in the diagram).

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Small Importing Country: Net National Loss from a Tariff

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The Effective Rate of Protection

The effective rate of protection of an individual country is defined as the percentage by which the entire set of a nation’s trade barriers raises the industry’s value added per unit of output.Effective rate of protection (ERP) = where v = value added under free trade and v’ = value added under tariffs.

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Illustrative Calculation of ERP

𝐸𝑅𝑃𝑏𝑖𝑐𝑦𝑐𝑙𝑒𝑠=99−8080

=23.8%

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Export Tax, Small Country

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Large Country and the Terms of Trade

• Monopsony power: a nation has a large enough share of the world market for one of its imports that changes in the country’s import buying can noticeably affect the world price of the product.

• If the country’s demand for imports increases, it terms of trade deteriorate. If its import demand decreases, its terms of trade improve.

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The Terms-of-Trade Effect of a Tariff Imposed by a Large Country

• The large country will import less because the tariff increases the domestic price, so foreign firms export less and produce less

• By removing demand pressure on foreign production, the marginal cost at the smaller level of foreign production is lower

• With lower marginal cost and weak demand, foreign firms will compete and lower their export price

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A Large Country Imposes a Small Tariff

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The Nationally Optimal Tariff

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The Nationally Optimal Tariff• A nationally optimal tariff is the tariff that

creates the largest net gain [area e −area (b + d)] for the country imposing it, assuming the rest of the world is passive.

• The optimal tariff rate, as a fraction of the price paid to foreigners, equals the reciprocal of the price elasticity of foreign supply of home country’s imports.

• Danger: Rest of world is worse off. Risk of retaliation by foreign country governments.