International Commercial Policy: The Tariff Issue

Introduction to Trade Barriers

Free trade, according to various economic models, leads to the most efficient use of global
resources and maximizes world output. It allows participating nations to consume beyond
their isolated production
capabilities. However, free trade policies face resistance from industries and workers who
experience
income and job losses due to import competition. Policymakers often grapple with the conflict
between the long-term benefits of free trade and the immediate concerns of the public
regarding employment and
income.

While the advantages of free trade are widespread and gradual, the costs are immediate and
concentrated on specific groups. Research indicates that well-educated individuals and those
in well-educated countries tend to favor free trade. Conversely, workers in import-competing
industries are generally against it.
Interestingly, even well-educated workers in poorer nations may oppose free trade, potentially
hindering its expansion.

This chapter focuses on barriers to free trade, with a particular emphasis on tariffs.

Objectives of This Chapter

Explain the different types of trade barriers (e.g., tariffs, quotas, domestic content
requirements). Identify the motives behind imposing trade barriers.
Analyze the welfare implications of trade barriers for trading nations and the world
economy.

The Tariff Concept

A tariff is a tax or duty imposed on a product as it crosses national borders. The most
common type is an import tariff, levied on imported goods. A less common type is an export
tariff, imposed on exported goods, often used by developing nations to generate revenue
or influence global prices.

Why Tariffs?

Governments impose tariffs for two primary reasons:

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1. Protection: A protective tariff aims to shield domestic producers of import-competing
goods from foreign competition. It doesn't necessarily aim to prohibit imports but rather
to disadvantage foreign producers in the domestic market.

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 2. Revenue: A revenue tariff is imposed to generate tax revenue for the government.
These can be applied to either imports or exports and are more common in
developing nations.

Types of Tariffs

Tariff s can be categorized as specifi c , advalorem, or compound:

Specific Tariff: A fixed monetary amount charged per physical unit of the
imported product. Example: A duty of $1000 per imported computer,
regardless of its price.
Ad Valorem Tariff: A tax expressed as a fixed percentage of the value of the
imported product. Example: A 300% duty on the price of an imported
automobile.
Compound Tariff: A combination of both specific andad valorem tariffs.
Example: A duty of $200 plus 5% of the value of an imported television.

Merits and Demerits of Tariff Types

Specific Tariff:
Merits: Easy to administer, especially for standardized goods where value is hard to
determine.
Demerits: The degree of protection varies inversely with import prices. It offers less
protection when import prices rise and more protection when import prices fall
(during recessions).
Ad Valorem Tariff:
Merits: Appropriate for manufactured goods with varying grades and prices.
Maintains a
constant degree of protection during price fluctuations as the duty collected is
proportional to the product's value. Increasingly common due to global inflation
and the rise of manufactured goods trade.

Demerits: Administrative complexities in customs valuation (determining the value

of imported goods). Valuation methods (e.g., FOB vs. CIF) can differ, impacting the
final duty.

Compound Duties:
Merits: Used for manufactured goods that incorporate raw materials subject to tariffs.
The
specific portion can offset cost disadvantages for domestic manufacturers due to
tariffs on raw materials, while the advalorem portion protects the finished goods
industry.
Example: A compound duty on woven fabrics might include a specific amount per
kilogram to compensate fortariffs on cotton and an advalorem percentage to
protect the fabric

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 manufacturers.

Effective Rate of Protection

The nominal tariff rate is the published rate on a final product. However, it may not accurately
reflect the actual protection provided to domestic producers. The effectivetariff rate indicates
the total increase in domestic productive activities (value added) that a tariff structure
makes possible, compared to free-trade

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conditions. It shows how much more expensive domestic production can be and still remain

competitive. The effectivetariff rate is calculated using the following formula:

Where:

e = the effective rate of protection

n = the nominal tariff rate on the final product
a = the ratio of the value of the imported input to the value of the final product
(value added as a fraction of final product value)

b = the nominal tariff rate on the imported input

Example Calculation:

Assume:

Nominal tariff rate on final product (n) = 10% (or 0.10)

Value of imported components is 80% of the final product's value ( a
= 0.80 ) Imported components enter duty-free ( b = 0 )

Using the formula:

This means the effective rate of protection is 50%. Domestic producers can be 50% more
costly in their assembly activities and still be competitive, compared to free trade.

Key Consequences of Effective Rate Calculation:

The effective protection rate increases as the value added by domestic producers declines
(i.e., as the ratio of imported input value to final product value increases).
A tariff on raw material imports used in production reduces the level of effective
protection.

Tariff Escalation

Tariff escalation refers to tariff structures where nominal and effective protection rates
increase at each stage of production, from raw materials to intermediate goods to finished
products. Industrialized nations often have low tariffs on primary commodities and higher
tariffs on processed goods.

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 Impact on Developing Nations: Tariff escalation can discourage industrialization and
diversification in developing countries by making it difficult for them to compete in
processing and manufacturing sectors. Low tariffs on raw materials encourage exports
of primary commodities, while hightariffs on finished goods act as significant barriers to
entry for manufactured exports.

Welfare Effects ofTariffs

To analyze the impact of tariffs on national welfare, we use the concepts of consumer
surplus and producer surplus.

Consumer Surplus: The difference between the maximum price consumers are willing
to pay for a good and the price they actually pay. Represented graphically as the area
under the demand curve and above the market price.
Producer Surplus: The difference between the revenue producers receive and the
minimum amount necessary for production. Represented graphically as the area above
the supply curve and below the market price.

A. Welfare Effects ofTariffs: Small-Nation Model

A small nation is one that is too small to influence world prices through its trade policies. It is a
price taker.

Before Trade: The nation operates at its domestic equilibrium (price Pd, quantity Qd).
With Free Trade: The world price (Pw ) is lower than the domestic price. Consumers benefit
from
lower prices, and imports fill the gap between domestic demand and supply at Pw.
Consumer surplus increases, and producer surplus decreases.
With an Import Tariff: The world price plus the tariff (Pw + t) becomes the new domestic
price.
Domestic consumption falls.
Domestic production
increases. Imports
decrease.
Consumer surplus falls.
Producer surplus increases.
The government collectstariff revenue.

Welfare Decomposition of a Tariff in a Small Nation:

1. Revenue Effect: The tax revenue collected by the government from imports. This is a
transfer from consumers to the government, not a net welfare loss for the nation.

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2. Redistributive Effect: The transfer of consumer surplus to domestic producers. This is also
a transfer within the nation, not a net welfare loss.

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 3. Protective Effect: The loss to the domestic economy due to inefficient domestic production
substituting for more efficient foreign production. This represents a real welfare loss
(deadweight loss).
4. Consumption Effect: The loss to consumers due to reduced consumption caused by the
higher tariff- inclusive price. This also represents a real welfare loss (deadweight loss).

Conclusion for Small Nations: Imposing an import tariff always reduces the national welfare
of a small nation because the deadweight losses (protective and consumption effects)
outweigh any benefits.

B. Tariff Welfare Effects: Large-Nation Model

A large nation is an importer large enough to influence world prices through its trade policies.

With Free Trade: The world price is determined by the interaction of global supply and
demand. The large nation imports at this price, leading to lower domestic prices,
increased consumption, and
reduced domestic production compared to autarky.
With an Import Tariff:
The domestic price increases, but not by the full amount of the tariff, as the world
price is also pushed down due to reduced import demand.
The tariff burden is shared between domestic consumers (higher price) and
foreign producers (lower export price).
The terms of trade improve for the large nation, as it pays less for imports.

Welfare Decomposition of a Tariff in a Large Nation:

Redistributive Effect: Transfer from domestic consumers to domestic producers (similar

to the small nation case).
Deadweight Loss: Comprises the protective effect (inefficient domestic
production) and the consumption effect (reduced consumption).
Revenue Effect: This is more complex in the large-nation case. It includes:
Domestic Revenue Effect: Tariff revenue collected by the government from
domestic consumers.
Terms of Trade Effect: The gain to the nation from paying a lower world price for
imports due to the tariff. This is a gain from foreign producers to the tariff-levying
nation.

Conclusion for Large Nations: A large nation can potentially improve its national welfare by
imposing an import tariff if the gain from improved terms of trade (area e) is greater than the
deadweight loss (areas b + d).

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Optimum Tariff

The optimum tariff is the tariff rate that maximizes a large nation's economic welfare. It is the
rate where the gains from improving terms of trade are balanced against the losses from
reduced import volume and deadweight loss.

Arguments for Trade Restriction

Despite the economic case for free trade, most nations employ trade restrictions. Arguments
for protection include:

1. Job Protection Argument: Claims that tariffs protect domestic jobs from competition
by cheap foreign goods.
Critique: This argument overlooks the dual nature of trade; restricting imports
can reduce export demand and lead to job losses in export industries.
2. Protection Against Cheap Foreign Labor: Argues fortariffs to equalize production
costs when foreign laboris significantly cheaper.
Critique: Fails to consider labor productivity. Higher productivity can offset higher
wages. Also, low-wage countries often specialize in labor-intensive goods where
labor costs are a large
component of total costs.
3. Infant Industry Argument: Proposes temporary protection for new domestic industries
until they can compete with established foreign fi rms.
Qualifications: Protection can be difficult to remove once granted. Identifying which
industries will succeed is challenging. Subsidies might be a better alternative.
4. Maintenance of Domestic Standard of Living: Suggeststariffs can boost domestic
spending, stimulating economic activity and employment.
Critique: This is a beggar-thy-neighbor policy; one nation's gain comes at the
expense of another, potentially leading to retaliation.
5. Equalization of Production Costs (Scientific Tariff): Aims to offset specific cost
advantages (e.g., lower wages, subsidies) of foreign producers.
Critique: Such tariffs can be prohibitive, eliminating trade and its benefits, and
contradict the principle of comparative advantage.

Non-Economic Arguments for Protection

National Security: Protecting industries deemed vital for defense during

international crises. Cultural and Sociological Considerations: Restricting imports
of socially undesirable goods.
Non-Tariff Trade Barriers

6.6 Non-Tariff Trade Barriers (NTBs)

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Non-tariff trade barriers (NTBs) are policies other than tariffs that restrict international
trade. They have become more prominent as tariffs have been reduced through
international
negotiations. NTBs vary in their impact, from minor restrictions like labeling
requirements to
signifcant trade pattern infuencers like import quotas, voluntary export restraints,
subsidies, and domestic content requirements. These measures are typically
implemented to reduce imports
and beneft domestic producers.

6.6.1 Import Quota

An import quota is a quantitative restriction on the amount of a good that can be

imported into a country within a specifc period. This limit is generally set below the level
that would exist under free trade.
Global Quota:
This type of quota allows a specifed quantity of a good to be imported annually, without
specifying the source country or the importer.
Problems: Global quotas can lead to a rush to import early in the year, potentially
disadvantaging importers from distant locations or those with weaker trade connections.

Selective Quota: This is a quota allocated to specifc countries. For example, a country
might set a global quota for a product but specify how much can be imported from each
individual exporting nation. This allows customs ofcials to monitor imports from each
source more effectively.
Comparison to Tariffs: Import quotas are often considered more restrictive than tariffs
because they can lead to domestic monopolies and higher prices. Unlike tariffs, which
allow unlimited imports at a certain price, quotas impose a hard limit, giving domestic
producers more power to raise prices once the quota is flled.
6.6.2 Trade and Welfare Effects of Import Quota

An import quota, like a tariff, has signifcant effects on an economy's welfare.

Example: Consider the U.S. importing cheese from the European Union.
Free Trade: The price is $2.50 per unit. The U.S. produces 1 unit, consumes 8 units,
and imports 7 units.
With a Quota:
The U.S. imposes a quota limiting cheese imports to 3 units. The total supply curve
shifts upward.
The equilibrium price rises to $5.00 per unit. U.S. production increases to 3 units.

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 U.S. consumption decreases to 6 units.

Imports are now restricted to the quota limit of 3 units.

Welfare Effects:
Consumer Surplus:
Falls by an amount represented by areas a + b + c + d.
Area 'a': Redistributive effect (transfer of surplus to domestic producers).
Area 'b': Protective effect (deadweight loss due to less efcient domestic production).
Area 'd': Consumption effect (deadweight loss due to reduced consumption).

Revenue Effect (Area 'c'):

This represents the additional revenue generated because consumers pay a higher price
for the imported units due to the scarcity created by the quota. This revenue can accrue
to:
U.S. importers as proftif they can buy at the world price and sell at the higher domestic
price.
Foreign exporters if they can raise their price to the domestic market price. The U.S.
government if import licenses are auctioned.

The overall welfare loss to the importing nation includes the protective effect (b), the
consumption effect (d), and any portion of the revenue effect (c) captured by foreign
exporters.

6.7 Subsidies

Subsidies are fnancial assistance provided by governments to domestic producers to

improve their trade position. They can take various forms, including cash payments, tax
concessions, insurance, and low-interest loans. There are two main types:
Domestic Subsidy: Granted to producers of import-competing industries. Export
Subsidy: Granted to producers selling goods overseas.

Subsidies increase the price received by the producer (purchaser price +

subsidy),enabling them to supply more at each consumer price.

6.7.1 Trade and Welfare Effects of Domestic Subsidy

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A domestic production subsidy for import-competing industries aims to lower production
costs for domestic frms.

Example: The U.S. government grants a $25 per ton subsidy for steel production.
Free Trade: World price is $400 per ton. U.S. consumes 14 million tons, produces 2
million tons, and imports 12 million tons.
With Subsidy:
The supply curve shifts downward (or effectively, the net price received by producers

increases).
Domestic production rises from 2 to 7 million tons. Imports fall from 12 to 7 million
tons.
The price paid by consumers remains at $400 per ton.
The net price received by domestic steelmakers is $425 ($400 consumer price + $25
subsidy).

Welfare Effects:
Government Cost:
The total cost to the government is the subsidy amount multiplied by the subsidized
output: $25/ton * 7 million tons = $175 million (represented by areas a + b).
Area 'a': Producer surplus gained by domestic producers.
Area 'b': Protective effect (deadweight loss from using less efcient domestic
production).

Consumer Surplus: Remains unchanged because consumers continue to pay the world
price. Deadweight Loss: The protective effect (b) is the deadweight loss.

Domestic subsidies result in a smaller welfare loss than equivalent tariffs or quotas
because consumers are not harmed by higher prices. However, the cost of the
subsidy must befnanced through taxes.

6.7.2 Trade and Welfare Effects of Export Subsidy

Export subsidies are designed to increase a nation's exports by lowering the price for
foreign buyers.

Example: The Japanese government grants a $50 subsidy per television set to its
exporters.
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 Free Trade: Japan exports 1 million TV sets to the U.S. at $100 per unit. With Export
Subsidy:
The Japanese export supply curve shifts downward. The export price falls to $75 per
unit.
The quantity exported may increase, depending on the elasticity of U.S. demand.

Welfare Effects:
Terms of Trade Effect: Worsened for the exporting country (Japan) because its export
prices have fallen.
Export Revenue Effect: May increase if the increase in export volume due to the lower
price more than offsets the price decrease.
Costs to the Exporting Nation:
Consumers in the exporting nation may face higher domestic prices or less availability
of the good.
The cost offnancing the subsidy through taxes.

6.8 Dumping and Anti-Dumping Strategies

Dumping is a form of international price discrimination where a frm sells an identical

product in
a foreign market at a lower price than in its domestic market, or sells below its cost of
production.

Forms of Dumping:
Sporadic Dumping (Distress Dumping): Occurs when a frm sells excess inventory in
foreign markets at lower prices due to unforeseen changes in demand or supply.
Predatory Dumping: A frm temporarily lowers prices in a foreign market to drive out
competitors, intending to raise prices once a monopoly position is achieved. This is
theoretically possible but empirically unproven.
Persistent Dumping: A frm consistently sells products in foreign markets at lower
prices than in its domestic market to maximize economic profts.

Anti-Dumping Regulations:

Governments may impose penalty duties (anti-dumping duties) on products found to be

dumped if these imports cause or threaten material injury to domestic industries.
Determination: Involves determining if the foreign merchandise is being sold at "less
than fair value" (LTFV) and if LTFV imports are injuring domestic industry.
Calculating Dumping Margin:
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The difference between the foreign market value and the U.S. price.
Price-Based Defnition: Dumping occurs when the U.S. price is lower than the home
market price.
Cost-Based Defnition: Used when the price-based defnition is not applicable. The
foreign market value is constructed based on manufacturing costs, general expenses (at
least
10% of manufacturing cost), and proft (at least 7% of manufacturing cost plus general
expenses).

If dumping is found, importers must pay a special tariff equal to the dumping margin.

6.9 Domestic Content Requirements

Domestic content requirements stipulate the minimum percentage of a product's total

value that must be produced domestically for it to be sold in the home country. These
requirements aim to limit foreign sourcing (outsourcing) and encourage the use of
domestic inputs.
Effect: Increases demand for domestic inputs, potentially raising their prices.
Manufacturers may face higher production costs and lose competitiveness.
Example (Automobiles): A domestic content requirement might force automakers to
establish production facilities in countries with higher resource prices (e.g., higher
wages), leading to increased production costs and prices for consumers. This shifts
welfare from

consumers to domestic resource owners.

6.10 Economic Sanctions

Economic sanctions are government-mandated limitations on customary trade or

fnancial relations between nations. They are used for foreign policy objectives, such
as protecting the domestic economy, preventing nuclear proliferation, combating
terrorism, preserving national security, and protecting human rights.
Goal: To impair the economic capabilities of a target nation, forcing it to comply with
the imposing nation's objectives.
Types:
Trade Sanctions: Boycotts on exports from the imposing nation or quotas on imports
from the target nation.
Financial Sanctions: Limitations on ofciallending or aid, or freezing offnancial assets.

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 Effects on Target Nation:
Forces the nation to operate inside its production possibilities curve (PPC). Can lead
to an inward shift of the PPC, reducing overall production capacity.
Can cause economic inefciencies, reduced growth rates, and decreased investment.

Factors Infuencing the Success of Sanctions:

The number of nations imposing sanctions.
The degree of economic and political ties between the target and imposing nations.
The extent of political opposition within the target nation. Cultural factors in the
target nation.

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