Chapter 4

Tariffs

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 Free Trade
• Free-trade argument posits that open markets foster most efficient use of world
resources

• It improves global welfare and benefits each participating country

• Policies often meet resistance among companies and workers who face losses
in income and jobs because of import competition

• Policymakers torn between global efficiency and needs of voting public

• The benefits of free trade take time and are spread widely, the costs are
immediate and impact specific groups

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 Free Trade
• When creating international trade policy, a government
must choose its position between autarky (a closed
market) and free trade (an open market).
• If a government protects its producers from
foreign competition, it moves closer to
isolationism or autarky.
• if a government does not restrict trade, it adopts
a free-trade policy.

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 Tariffs

• A tax levied on a product when it crosses

national boundaries
• There is two type of tariff:
✓Import tariff
✓Export tariff

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 Tariffs
• Import tariff
• Tax levied on an imported product
• Most common; collected before shipment can be unloaded in domestic port
• For example:-
• If Malaysia imports tea from China.
• Malaysian government imposes an import tariff of 10% on imported tea
commodities. (To protect local product of tea)

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 Tariffs
• Export tariff
• Tax imposed on an exported product
• Less common; illegal under U.S. Constitution
• Commonly used by developing nations
• For example:-
Indonesia has imposed export tariffs on crude palm oil that can range from
3% to 7.5%, depending on the global price of palm oil.

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 Why Are Tariffs Imposed?

Protective tariff • Protects domestic producers from foreign competition

• Facilitates increase in output of import-competing
producers

Revenue tariff • Generates tax revenues by placing tariffs on either

imports or exports
• Many developing nations rely on tariffs as major
source of income

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 Table 4.1 Taxes on International Trade as a
Percentage of Government Revenues, 2018:
Selected Countries
Developing Countries Percentage Advanced Countries Percentage
Benin 41.2 Australia 3.3
Bahamas 34.8 New Zealand 2.8
Botswana 31.7 Canada 1.7
Bangladesh 24.6 United States 1.5
Gambia 23.5 Japan 1.4
Central African Republic 23.0 Mexico 1.2
Fiji 18.7 Switzerland 0.9
India 11.3 Norway 0.2

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 4-2
Types of Tariffs

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 Specific Tariff (1 of 2)
• Fixed amount of money per physical unit of imported product

• For example:

❑ $100 per computer, regardless of the computer’s price

• Relatively easy to apply and administer

• Particularly to standardized commodities and staple products

• i.e rice and wheat

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 Specific Tariff (2 of 2)
• A main disadvantage of a specific tariff

• Degree of protection varies inversely with changes in import prices

• For example:$1,000 charged for each imported automobile

• For an auto priced at $20,000, the tariff represents 5% of the car's
price (1,000/20,000).
• For an auto priced at $25,000, the tariff represents 4% of the car's
price (1,000/25,000).
• Advantage of a specific tariff

• Provides domestic producers increased protection during recession

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 Ad Valorem Tariff (1 of 2)
• Ad valorem (of value) tariff is expressed as a fixed percentage of the value of
the imported product.
• Suppose that an ad valorem duty of 2.5 percent is levied on imported automobiles.
• If $100,000 worth of autos are imported, the government collects $2,500 in tariff revenue
($100,000 x 2.5% = $2,500).
• This $2,500 is collected whether five $20,000 Toyotas are imported or ten $10,000
Nissans are imported.
• Primarily used with manufactured goods because can be applied to products
with range of grade variations

• Maintains constant degree of protection for domestic producers through the

business cycle
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 Ad Valorem Tariff (2 of 2)

• Customs valuation

• Determining value of imported product; is complex, subject to disagreement

• US: Free-on-board valuation (FOB)

• Tariff applied to product’s value as it leaves exporting country

• Europe: Cost-insurance-freight valuation (CIF)

• Tariffs levied as percentage of imported commodity’s total value upon arrival

at final destination

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 Compound Tariff

• Compound duties combine two types of tariffs:

• a specific duty (a fixed fee per unit)

• an ad valorem duty (a percentage of the item’s value)

• They are commonly used on manufactured products that contain imported raw
materials which also have tariffs.

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 Compound Tariff

• Applied to manufactured products composed of raw materials that are subject

to tariffs

• Specific portion of the duty neutralizes the cost disadvantage of domestic

manufactures that results from tariff protection granted to domestic suppliers
of raw material

• Ad valorem portion of the duty grants protection to the finished-goods

industry

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 Malaysia
• Harmonized Commodity Description & Coding System, commonly known
as HS Codes and ASEAN Harmonized Tariff Nomenclature (AHTN) were
created for international use by the Custom Department to classify
commodities when they are being declared at the custom frontiers by exporters
and importers.
• AHTN is used for trade transaction between Malaysia and the other ASEAN
countries
• HS Code applies for trade with non-ASEAN countries.
• For reference of HS and AHTN Codes, you may search from Search Tariff
function at JKDM HS -Explorer Website [Link]://[Link]

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 Table 4.3 Average Import Tariff Rates for
Selected Countries, All Products, 2018
Country Percentage Country Percentage
Bahamas 26.8 Japan 3.7
Bermuda 19.9 Mexico 3.4
Brazil 13.4 Austria 2.5
Cambodia 12.4 Germany 2.4
Cuba 9.9 Denmark 2.4
India 8.9 Canada 2.0
China 8.5 Hong Kong 0.0
Dominican Republic 6.3 World average 5.2
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 4-3
Effective Rate of Protection

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 Tariff Rates

Nominal tariff rate Effective tariff rate

• Rate published in country’s tariff • Includes nominal tariff on finished

schedule good and any tariff applied to
imported inputs
• Applies to value of finished product

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 Effective Tariff Rate
1. Zero Tariff on Finished Desktops vs. Tariffs on Components:
• If imported desktops have no tariff, Dell isn’t directly protected by tariffs.
• But if components used to make desktops (like memory chips or hard
drives) have tariffs, this adds to Dell’s production costs.

2. Higher Tariff on Finished Desktops, Lower on Components:

• The U.S. government might apply a lower tariff on desktop components
and a higher tariff on imported finished desktops.
• This allows Dell to import cheaper components for desktop assembly,
lowering its overall costs.
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Robert J. Carbaugh, International Economics, Eighteenth Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted
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 Effective Rate of Protection
• Measures the percentage increase in domestic production activities (value
added, VA) per unit of output by applying tariffs on both the finished goods and
imported inputs.
• Dell's value added (VA) increases from $100 to $150.
• Percentage increase in VA (Value Added):

• The tariff effectively allows Dell’s assembly costs to rise by 50% from what they
would be under free trade.
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 Effective Tariff Rate (1 of 3)

• Effective tariff rate (e) is calculated as:

( n − ab)
e= =
(1 − a )
where
e = effective rate of protection
n = nominal tariff rate on final product
a = ratio of value of the imported input to value of finished product
b = nominal tariff rate on imported input
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 Effective Tariff Rate (2 of 3)
Assume that imported inputs are also subject to a tariff (5%):

What is effective rate of protection????

n = 10%
a = 80%
b = 5%

* 30% increase in VA (value added) in domestic production activities

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 Effective Tariff Rate (3 of 3)

• If tariff on finished product is less than tariff on imported input

• Effective rate of protection is less than nominal tariff (ERP < nominal tariff,
may even be negative)
• Tariff protects domestic suppliers of raw materials more than domestic
manufacturers
• If tariff on finished product exceeds tariff on imported input
• Effective tariff exceeds nominal tariff (ERP > nominal tariff )

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 4-4
Tariff Escalation

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 What Is Tariff Escalation?

• Processed goods have higher import tariffs

• Raw materials often imported at zero or low tariff rates

• Nominal and effective protection increases at each production stage

For example:

• Logs may be imported tariff free while processed goods such as

plywood, veneers, and furniture face higher import tariffs.

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 Table 4.5 Tariff Escalations in Advanced and
Developing Countries, 2012
Agricultural Products Industrial Products
Country Primary Products Processed Products Primary Products Processed Products
Bangladesh 17.5 23.0 9.1 15.4
Uganda 17.5 20.3 4.2 11.7
Argentina 5.7 11.5 2.9 9.5
Brazil 6.5 12.1 4.2 10.7
Russia 6.9 9.2 5.3 9.5
United States 1.0 2.8 1.3 2.8
Japan 4.5 10.9 0.5 1.9
World 12.0 15.1 5.6 7.7

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 4-5
Outsourcing and Offshore-Assembly Provision

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 Outsourcing

• Competitive strategy for producers

• Each production stage in country where it incurs least cost

• Example

• Electronic components made in the U.S. are shipped to another country with
low labor costs for assembly into TV sets; assembled sets returned to U.S.
for further processing or packaging & distribution

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 Self-Learning

Offshore-Assembly Provision (OAP)

• Provides favorable treatment to products assembled abroad from U.S.-made

components

• Incentivizes foreign manufacturers to purchase components from U.S. sources

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 4-6
Tariff Avoidance and Tariff Evasion

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 Self-Learning
Tariff Avoidance and Tariff Evasion
• Tariff avoidance

• Legal use of tariff system to company’s advantage to reduce the amount of

tariff payable by legal means

• Tariff evasion

• Evading tariffs by illegal means such as smuggling imported goods into a

country

• Ford strips its wagons to avoid high tariff

Ex: Ford strips its wagons to avoid high tariff
Ex: Smuggled steel evades U.S. tariffs

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 4-7
Postponing Import Tariffs

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 Self-Learning
Bonded Warehouse

• Under U.S. tariff law, dutiable imports can be brought into U.S. and temporarily
left in a bonded warehouse, duty free (up to 5 years)

• Owners of warehouses must be bonded to ensure they will satisfy all customs
duty obligations

• Bonding company guarantees payment of custom duties if importing company

unable to do so

• When goods removed from warehouse, firm must pay duty on value at time of
removal

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 Self-Learning
Foreign-Trade Zone (FTZ)
• Area in U.S. where businesses operate without paying duties on imported
products or materials as long as they remain in area and do not enter U.S.
marketplace

• In an FTZ, can do just about anything to merchandise – repair, repackage,

assemble

• FTZ program treats a product manufactured in FTZ as if it were imported, not

made in U.S.

• Customs duties are due when goods are transferred from FTZ for U.S.
consumption
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 4-8
Tariff Effects: An Overview

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 Self-Learning
Tariff Effects

• As taxes on imports, tariffs make items more expensive for consumers,

reducing demand
• Buyers pay more for U.S.-made goods than they would for imported goods
under free trade
• Job loss in retail and transportation sectors that import foreign-made goods
• Job loss in any domestic industry that suffers retaliatory tariffs
• Additional costs of imported inputs passed on to consumers through goods
and services that use such inputs in production process

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 4-9
Tariff Welfare Effects: Consumer Surplus and
Producer Surplus

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 Consumer Surplus and Producer Surplus

Consumer Surplus

• Difference between what buyers are

willing and able to pay and the
amount they actually pay

• Inverse relationship between change

in market price and CS

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 Producer Surplus
Producer Surplus
• Difference between what producers
are willing and able to receive and
the amount they actually receive

• Direct relationship between change

in price and PS

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 4-10
Tariff Welfare Effects: Small-Nation Model

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 Small Nations

• Small nations import very small portion of world market supply and are unable
to impact market price
• Price takers, face constant world prices for imported products
• Tariff effects
• Raises home price of imported good by full amount of duty

• Results in higher domestic production and increases PS

• Lowers domestic consumption and decreases CS

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Figure 4.2 Tariff Trade and Welfare Effects:
Small-Nation Model
Before the tariff was levied
• consumer surplus equaled areas a + b + c + d + e + f + g.

With the tariff

• consumer surplus falls to areas e + f + g
• overall loss in consumer surplus equal to areas a +b + c + d

A small nation tariff effects on nation’s welfare

• Consumer surplus falls = a+b+c+d
• Additional tax revenues = c
• Benefits domestic producers = a
• Wastes resources = (b + d)

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 Small-Nation Tariff Effects (1 of 2)

• Introduction of the tariff raises the home price of

imports by the full amount of the duty; increase
falls entirely on the domestic consumer

• Revenue effect (c)

• Government’s collections of duty

• Redistributive effect (a)

• Transfer of consumer surplus to domestic

producers
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 Small-Nation Tariff Effects (2 of 2)
• Protective effect (b)

• Loss to domestic economy from wasted

resources used to produce at increasing unit
costs

• Consumption effect (d)

• Decrease in consumption resulting from tariff’s

artificially increasing price

• Deadweight loss (b+d)

• Protective effect and consumption combined

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 4-11
Tariff Welfare Effects: Large-Nation Model

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 Large Nations

• Tariffs may increase national welfare when imposed by importing nation large
enough that changes in its quantity of imports influence world price

• If U.S. imposes tariff on automobile imports

• Prices increase for American consumers, quantity demanded decreases

• Effect shared between U.S. consumers, who pay higher price, and Japanese
firms, which receive lower price than under free trade

• Terms of trade improve for U.S. at Japan’s expense

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Figure 4.3 Tariff Trade and Welfare Effects:
Large-Nation Model

▪ If e > (b + d)
National welfare is increased

▪ If e = (b + d)
National welfare remains constant

▪ If e < (b + d)
National welfare is diminished

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 Large-Nation Tariff Effects (1 of 2)
• Redistributive effect (a)

• From domestic consumers to domestic

producers

• Deadweight loss (b+d)

• Consumption effect (b)

• Protective effect (d)

• Revenue effect (c+e)

• Domestic revenue effect (c)

• Terms-of-trade effect (e)

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 The Optimal Tariff and Retaliation
• Optimal tariff

• Maximizes positive difference between

gain of improving terms of trade (e) and
loss in economic efficiency from the
protective effect (b) and consumption
effect (d)

• Only beneficial to importing nation

• Beggar-thy-neighbor policy

• Could invite retaliation

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 4-13
How a Tariff Burdens Exporters

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 How a Tariff Burdens Exporters

• Effects of import tariffs on exporters

• Higher production costs from imported inputs and reduction in CS

• Can result in higher prices and, depending on elasticity of demand, reduce overseas sales

• Raise cost of living

• International repercussions lead to reduction in domestic exports

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 4-15
Arguments for Trade Restrictions

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Free-Trade Argument

• If each nation produces what it does best and permits trade, in long term, there
will be lower prices and higher levels of output, income, and consumption

• Tariffs and other trade barriers are viewed as tools that prevent the economy
from undergoing adjustment, resulting in economic stagnation

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Job Protection Argument

• Job gains less visible than job losses

• Trade restrictions result in job gains for few industries

• Job losses are spread out

• Saved jobs costs more than worker’s salary

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Protection against Cheap Foreign Labor

• Low wages abroad makes it hard for U.S. firms to compete with firms using
cheap foreign labor

• Fails to recognize links among efficiency, wages, and production costs

• Low wages do not guarantee low costs

• Low-wage nations have competitive advantage only in goods requiring greater

labor and few other factor inputs

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 Self-Learning
Table 4.8 Hourly Compensation Costs for Production Workers in
Manufacturing as Percent of U.S. Dollars Costs in the United
States
Country 1997 2016 1997 2016
Germany $28.86 $43.18 125 111
Austria 24.88 39.54 108 101
United States 23.04 39.03 100 100
Japan 22.00 26.46 96 68
Portugal 6.44 10.96 28 28
Mexico 2.62 3.91 11 10
Philippines 1.24 2.06 5 5

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Table 4.9 Productivity, Wages and Unit Labor Costs Relative to
the United States: Total Manufacturing (U.S. = 1.0)
Labor Productivity Wages Relative to Unit Labor Cost Relative
Country Relative to United States United States* to United States
Hong Kong (2008) 0.21 0.44 2.09
Mauritius (2007) 0.06 0.12 2.00
South Africa (2008) 0.14 0.27 1.93
European Union (2009) 0.46 0.84 1.83
United Kingdom (2009) 0.50 0.84 1.68 U.S. More Competitive
Singapore (2008) 0.40 0.61 1.53 U.S. Less Competitive
Japan (2008) 0.67 0.72 1.07
Mexico (2009) 0.18 0.17 0.94
South Korea (2006) 0.71 0.61 0.86
Poland (2006) 0.26 0.20 0.77
China (2008) 0.12 0.08 0.67

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Fairness in Trade: A Level Playing Field
• Domestic producers say import restrictions need to offset foreign advantages,
to create level playing field

• Rationale for restrictions is that foreign governments play by different rules,

giving foreign firms unfair competitive advantage

• Trade benefits domestic economy even if foreign nations impose trade

restrictions

• Fair-trade argument overlooks potential impact of trade restrictions on global

trade

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Maintenance of the Domestic Standard of
Living
• Advocates of trade barriers often contend tariffs are useful in maintaining high
level of income and employment in home nation

• However, one nation imposes a tariff that improves its income and
employment at the expense of its trading partner’s living standard (beggar-
thy-neighbor policy)

• May spark retaliatory tariffs, resulting in lower level of welfare for all nations

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Equalization of Production Costs
• Scientific tariff to eliminate unfair competition from abroad
• Problems
• Different costs across business
• Higher domestic prices
• Benefit efficient domestic companies
• Domestic consumer subsidizing inefficient production

• Approximates prohibitive tariff

• Contradicts comparative advantage & eliminates basis/gains for/from trade

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 Self-Learning
Infant-Industry Argument
• Trading nations temporarily shield newly developing industries from foreign
competition
• If protective tariff imposed, difficult to remove
• Special-interest groups convince policy makers that further protection is
justified
• Difficult to determine which industries will realize comparative advantage in
long run
• Not valid for mature, industrialized nations
• Alternative is providing domestic industry subsidy
Robert J. Carbaugh, International Economics, Eighteenth Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part. 63
 4-16
The Political Economy of Protectionism

Robert J. Carbaugh, International Economics, Eighteenth Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part. 64
 Self-Learning
Protectionism (1 of 2)

• Bias in the political system favors protectionism

• Protection-biased sector
• Import competing producers
• Labor unions in protected industry
• Suppliers of producers in protected industry
• Established firms in aging industry that could lose comparative advantage
• Free-trade-biased sector
• Exporting producers, their workers, and their suppliers
Robert J. Carbaugh, International Economics, Eighteenth Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part. 65
 Self-Learning
Protectionism (2 of 2)
• Though protectionism provides benefits to domestic producers, society as
whole pays costs
• Loss of consumer surplus because of higher prices
• Resulting deadweight losses
• Lost economies of scale as further opportunities are lost
• Loss of incentive for technological development provided by import
competition
• The higher the costs of protection, the less likely a government is to shield an
industry from import competition
Robert J. Carbaugh, International Economics, Eighteenth Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part. 66
 Self-Learning
Supply of Protectionism
• Supply of protectionism increases, depending on:

• Political importance of import-competing industry

• Whether domestic firms and workers face large costs of adjusting to rising
import competition

• Public sympathy for a group of domestic businesses or workers

Robert J. Carbaugh, International Economics, Eighteenth Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted
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 Self-Learning
Demand for Protectionism
• Rises with:

• Intensification of domestic industry’s comparative disadvantage

• Higher levels of import penetration

• Concentration of domestic production

• Degree of export dependence

Robert J. Carbaugh, International Economics, Eighteenth Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part. 68