CHAPTER
8
Trade
Restrictions:
Tariffs
LEARNING
GOALS:
After reading this chapter, you should be able
to:
Describe the effect of a tariff on
consumers and producers
Identify the costs and benefits of a
tariff on a small and a large nation
Describe an optimum tariff and
retaliation
Understand the meaning and
importance of tariff structure
Introductio
n
• Free trade maximizes global output and benefits all nations, yet most countries implement some restrictions
known as trade or commercial policies. These trade restrictions, often justified by claims of national welfare,
typically serve the interests of specific groups within the nation that stand to gain from them.
• Historically, tariffs have been the most significant form of trade restriction. A tariff is a tax levied on commodities
crossing national borders, with import tariffs (on foreign goods) being more prevalent and significant than export
tariffs (on domestic goods). While export tariffs are banned by the U.S. Constitution, many developing countries
implement them on traditional exports, like cocoa and coffee, to secure better prices and increase revenue.
• Industrialized nations generally use import tariffs and other trade restrictions to protect certain industries,
particularly labor-intensive ones, while they rely on income taxes for revenue generation. In contrast, developing
nations tend to depend on export tariffs for easier revenue collection.
Partial Equilibrium Analysis of a
Tariff
The partial equilibrium analysis of a tariff is most
appropriate when a small nation imposes a tariff on imports
competing with the output of a small domestic industry.
Then the tariff will affect neither world prices (because the
nation is small) nor the rest of the economy (because the
industry is small).
Partial Equilibrium Effects of a Tariff
The partial equilibrium effects of a
tariff can be analyzed in Nation 2,
where DX is the demand curve and SX
is the supply curve for commodity X.
In equilibrium without trade, the
curves intersect at point E, with a
demand and supply of 30X at a price
of PX = $3. With free trade at a world
price of PX = $1, Nation 2 consumes
70X, producing 10X domestically and
importing 60X. The horizontal dashed
line SF indicates the infinitely elastic
free trade foreign supply curve for
commodity X to Nation 2.
FIGURE 8.1. Partial Equilibrium Effects of a Tariff.
DX and SX represent Nation 2’s demand and supply curves of commodity X. At the free
trade price of PX = $1, Nation 2 consumes 70X (AB), of which 10X (AC) is produced
domestically and 60X (CB) is imported. With a 100 percent import tariff on commodity X,
PX rises to $2 for individuals in Nation 2. At PX= $2, Nation 2 consumes 50X (GH), of
which 20X (GJ) is produced domestically and 30X (JH) is imported. Thus, the consumption
effect of the tariff is (–) 20X (BN); the production effect is 10X (CM); the trade effect
equals (–) 30X (BN + CM); and the revenue effect is $30 (MJHN).
Effect of a Tariff on Consumer and Producer
Surplus
The imposition of a 100 percent tariff by Nation 2 raises the price of
commodity X from PX = $1 to PX = $2, resulting in a reduction in
consumer surplus and an increase in producer surplus. The loss of
consumer surplus, shown as the shaded area AGHB in Figure 8.2,
amounts to $60. Prior to the tariff, consumers in Nation 2 consumed
70X at PX = $1, where each consumer is willing to pay a higher
price for earlier units, as indicated by the demand curve DX.
Consumer surplus is defined as the difference between what
consumers are willing to pay for each unit and what they actually
pay. For instance, consumers would pay LE = $3 for the 30th unit
but only pay $1, receiving a surplus of $2. For the 50th unit, they
would pay ZH = $2 and receive a surplus of $1. The 70th unit has
no surplus since the willingness to pay equates to the price. The
total consumer surplus before the tariff for 70X at PX = $1 is ARB =
$122.50, reflecting a willingness to pay of $192.50 compared to the
actual payment of $70.
Costs and Benefits of a Tariff
The concepts of consumer and producer surplus can be applied to
evaluate the costs and benefits of a tariff, as shown in Figure 8.3. When
Nation 2 imposes a 100 percent import tariff, the price of commodity X
rises from PX = $1 to PX = $2, resulting in consumption falling from 70X
to 50X and production increasing from 10X to 20X. Imports decrease from
60X to 30X, and the government collects $30 in tariff revenue. Consumer
surplus declines by $60, while producer surplus increases by $15.
In Figure 8.3, the reduction in consumer surplus is composed of $30 in
tariff revenue, $15 redistributed to domestic producers, and $15
representing protection cost or deadweight loss. The protection cost
includes a production component of $5 due to inefficient resource
transfer from exportable commodity Y to importable commodity X, and a
consumption component of $10 from distorted consumption patterns
resulting from the higher price.
Overall, the tariff redistributes income from consumers to producers and
from abundant factors to scarce factors, causing inefficiencies associated
with the protection cost or deadweight loss. The cost per domestic job
saved can be calculated by dividing the loss of consumer surplus by the
number of jobs preserved due to the tariff. The effects of tariffs in small
nations are simpler to analyze than those in large nations, which require
more complex considerations discussed in the advanced appendix.
The Theory of Tariff Structure
So far, we have discussed the nominal tariff on imports of a final
commodity. We now extend the partial equilibrium analysis of the
previous section to define, measure, and examine the importance of the
rate of effective protection. This is a relatively new concept developed
only since the 1960s but widely used today.
The Rate of Effective
Protection
Nations often import raw materials duty-free or impose lower tariffs on
inputs compared to the final products to encourage domestic
processing and employment. For instance, a country may allow wool to
be imported without tariffs while imposing tariffs on cloth to boost
domestic cloth production and jobs.
In such cases, the effective protection rate, based on the domestic
value added during processing, will exceed the nominal tariff rate that
applies to the final commodity. Domestic value added is calculated as
the price of the final good minus the cost of imported inputs. The
nominal tariff rate indicates how much prices of final commodities rise,
while the effective tariff rate shows the actual protection provided to
domestic producers.
For example, if $80 worth of imported wool is used to produce suits
priced at $100, a 10 percent nominal tariff on suits leads to a price of
$110 to consumers. This essentially consists of $80 for imported wool,
$20 for domestic value added, and $10 for the tariff. Thus, the nominal
tariff rate is 10 percent ($10/$100), but the effective rate is 50 percent
($10/$20) based on domestic value added. Consequently, the $10 tariff
offers a more substantial protection level to producers compared to
what the nominal rate suggests, thereby incentivizing domestic suit
production over imports. Whenever inputs are imported duty-free or at
a lower tariff, the effective protection rate will exceed the nominal tariff
rate.
Generalization and Evaluation of the Theory of
Effective
From analyzing Equation (8-1), several key Protection
conclusions can be drawn regarding the relationship between the effective
protection rate (g) and the nominal tariff rate (t) on final commodities:
1. If the input tariff (ai) is zero, then g equals t.
2. For fixed values of ai and ti, an increase in t results in a larger g.
3. For fixed t and ti values, larger ai values lead to a greater g.
4. The relationship between g and t depends on whether ti is smaller, equal to, or larger than t.
5. If the product of ai and ti exceeds t, g becomes negative.
Tariffs on imported inputs act as a tax on domestic producers, increasing their costs and reducing effective protection for
them, which can lead to lower domestic production even when nominal tariffs on the final commodity are positive. The
nominal tariff rate may not accurately reflect the protection level for domestic producers.
Many industrial nations employ a "cascading" tariff structure, imposing low or zero tariffs on raw materials while increasing
tariffs as the degree of processing rises. This can make the effective protection rate significantly higher than what the
nominal tariff suggests. Additionally, the effective protection concept must be used carefully due to its partial equilibrium
nature; it assumes that tariffs do not affect international prices and that inputs are used in fixed proportions, which is often
not the case. Despite these limitations, the effective protection rate provides a better measure of actual protection granted
to domestic producers than nominal rates. The formula can also be adapted to account for multiple imported inputs with
different nominal tariffs, as detailed in the appendix.
General Equilibrium Analysis of a Tariff in a
Small Country
In this section, we use general equilibrium analysis to study the
effects of a tariff on production, consumption, trade, and welfare
when the nation is too small to affect world prices by its trading. In
the next section, we relax this assumption and deal with the more
realistic and complex case where the nation is large enough to
affect world prices by its trading.
General Equilibrium Effects of a Tariff in a
Small
When a very small nation imposes Country
a tariff, it does not impact world market prices.
However, the domestic price of the imported commodity rises by the full amount of the
tariff for individual producers and consumers within that nation. For instance, if the
international price of commodity X is $1 and a 100 percent ad valorem tariff is imposed,
domestic producers can compete as long as their selling price does not exceed $2.
Consumers will pay $2 per unit, regardless of whether the commodity is imported or
domestically produced, assuming both are identical.Despite individual producers and
consumers facing a higher price due to the tariff, the price of commodity X remains $1
for the nation as a whole because the nation collects the tariff revenue. This distinction
between individual prices (including the tariff) and the national price (which reflects the
world price) is crucial for analysis. It is also assumed that the government uses the tariff
revenue to subsidize public services or reduce internal taxes, thereby decreasing the
need for other forms of tax collection to fund essential services.
Illustration of the Effects of a Tariff in a Small
Country
In the context of general equilibrium effects of a tariff, consider
Nation 2, a capital-abundant country that produces commodity Y
ratio of 𝑃𝑋/𝑃𝑌=1P X /P Y =1, Nation 2 produces at point B,
and imports commodity X. Under free trade, with the world price
exchanging 60Y for 60X and consuming at point E on
indifference curve III.
X, the domestic price ratio rises to 𝑃𝑋/𝑃𝑌=2P X /P Y =2, while
When a 100 percent ad valorem tariff is imposed on commodity
the world price remains at 1. Consequently, domestic producers
move to point F on the production frontier, increasing the
production of commodity X and reducing Y. After the tariff, the
nation exports 30Y for 30X, with 15X consumed domestically
and 15X collected as tariff revenue.
The new consumption point H, determined by intersecting the
dashed lines (reflecting the respective price levels), is on
indifference curve II, indicating a lower utility compared to point
E on curve III. Thus, with the imposition of the tariff, Nation 2
experiences reduced specialization and gains from trade.
𝑃𝑋/𝑃𝑌=4P X/P Y=4, and the nation would revert to its autarky
If a 300 percent tariff is imposed, domestic prices rise to
point A, indicating a prohibitive tariff scenario. This rate is the
minimum necessary to restrict imports entirely, maintaining
production and consumption levels at A under such high tariffs.
The Stolper–Samuelson
Theorem
The Stolper–Samuelson theorem postulates that an increase in the relative
price of a commodity (for example, as a result of a tariff) raises the return
or earnings of the factor used intensively in the production of the
commodity. Thus, the real return to the nation’s scarce factor of
production will rise with the imposition of a tariff
General Equilibrium Analysis of a Tariff in a
Large Country
In this section, we extend our general equilibrium analysis of the
production, consumption, trade, and welfare effects of a tariff to
the case of a nation large enough to affect international prices
by its trading.
General Equilibrium Effects of a Tariff in a
Large Country
To analyze the general equilibrium effects of a tariff in a large nation, offer curves are utilized.
When a nation imposes a tariff, its offer curve shifts toward the axis of the importable commodity
by the amount of the tariff, as importers require more of the import commodity to offset the tariff.
The curvature of the trade partner's offer curve reflects the nation's large size. As a result,
imposing a tariff reduces the volume of trade but improves the nation's terms of trade. While the
reduced trade volume typically harms welfare, the improved terms of trade can enhance it. The
overall impact on the nation's welfare depends on the balance between these opposing effects. In
contrast, a small country imposing a tariff sees a decline in trade volume with unchanged terms of
trade, leading to an inevitable decrease in welfare.
Illustration of the Effects of a Tariff in a Large
Country
The imposition of a 100 percent ad valorem tariff on imports of
commodity X by Nation 2 causes its offer curve to rotate to offer
curve 2², positioning it twice as far from the Y-axis at every point
compared to offer curve 2. Prior to the tariff, the equilibrium point E
𝑃𝑋/𝑃𝑌=𝑃𝑊=1P X /P Y =P W =1. Post-tariff, the new equilibrium
was established at an exchange of 60Y for 60X with a price ratio of
price of 𝑃𝑋/𝑃𝑌=𝑃𝑊2=0.8P X /P Y =P W2 =0.8, thereby
point E² results in an exchange of 40Y for 50X at a reduced world
deteriorating Nation 1's terms of trade from 1 to 0.8, while Nation 2's
terms of trade improve from 1 to 1.25.
The volume of trade declines, but Nation 2's welfare could potentially
increase, decrease, or remain unchanged due to these opposing
effects. This contrasts with a small nation scenario, where the tariff
leads to a straightforward reduction in volume from 60Y for 60X to
30Y for 30X with no change in price ratio, resulting in decreased
welfare for Nation 2.
For the large nation, at equilibrium E², out of 50X imported, 25X is
Consequently, individual prices for commodity X rise to 𝑃𝐷=1.6P D
collected as tariff revenue while the remainder serves consumers.
=1.6, indicating a significant price increase for domestic consumers.
wages increase. However, in instances where 𝑃𝑋/𝑃𝑌P X /P Y drops
The Stolper–Samuelson theorem holds in this context, suggesting that
for consumers after the tariff, the Metzler paradox applies,
contradicting the theorem's implications. Additionally, the Stolper–
Samuelson theorem generally addresses long-run conditions, while
short-run scenarios with factor immobility yield different income
effects, as elaborated in the appendix with the specific-factors model.
The Optimum Tariff
In this section, we examine how a large nation can increase its
welfare over the free trade position by imposing a so-called
optimum tariff. However, since the gains of the nation come at
the expense of other nations, the latter are likely to retaliate, and
in the end all nations usually lose.
The Meaning of the Concept of Optimum Tariff
and
When aRetaliation
large nation imposes a tariff, its trade volume declines, but its terms of trade
improve. The decrease in trade volume generally lowers the nation's welfare, whereas the
enhanced terms of trade can increase it. The optimum tariff is the rate that maximizes net
benefits, balancing the positive effects of improved terms of trade against the negative
impacts of reduced trade volume. As the tariff rises from the free trade position to the
optimum level, welfare increases, but beyond that point, welfare declines, ultimately
reverting toward the autarky point with a prohibitive tariff.
The improvement in the imposing nation's terms of trade results in a deterioration of the
trade partner's terms of trade, leading to a decline in the partner's welfare. This often
prompts the partner to retaliate with an optimum tariff of its own, reducing trade volume
even further. A cycle of retaliation may ensue, diminishing the gains from trade for all
involved nations. Even if retaliation does not occur, the tariff-imposing nation’s gains are
outweighed by the trade partner's losses, resulting in a net decrease in global welfare
compared to a free trade scenario, underscoring that free trade maximizes overall well-
being.
Illustration of the Optimum Tariff and
Retaliation
The figure illustrates that with the optimum tariff, Nation 2’s offer
curve rotates to 2, leading to a new equilibrium point E, where Nation
𝑃𝑋/𝑃𝑌=𝑃𝑊∗=0.625P X /P Y =P W∗ =0.625. Consequently, Nation
2 exchanges 25Y for 40X, establishing a world market price ratio of
1’s terms of trade decrease from 𝑃𝑋/𝑃𝑌=𝑃𝑊=1P X /P Y =P W =1
to 𝑃𝑋/𝑃𝑌=𝑃𝑊∗=0.625P X /P Y =P W∗ =0.625, while Nation 2’s
terms of trade improve to 𝑃𝑌/𝑃𝑋=1/𝑃𝑊∗=1.6P Y /P X =1/P W∗
=1.6.
The welfare improvement for Nation 2 from enhanced terms of trade
surpasses the welfare reduction due to decreased trade volume,
achieving the highest welfare possible with the tariff, exceeding that
of free trade.However, Nation 1 experiences worsened terms of trade
and reduced trade volume, leading to a likely retaliation in the form of
its own optimum tariff, represented by offer curve 1. This adjustment
moves equilibrium to point E*, resulting in higher terms of trade for
Nation 1 and lower for Nation 2, but with significantly reduced trade
volume.
The potential for further retaliation exists, pushing both nations
toward the autarky position, ultimately negating all gains from trade.
It is noted that the optimum import tariff is equivalent to an optimum
export tariff, and importantly, a small nation's optimum tariff is zero,
as any tariff would only decrease trade volume without affecting
terms of trade. Recent research by Broda, Limao, and Weinstein
(2008) supports that nations tend to impose higher tariffs on goods
with lower export elasticity.
thank
you!