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WMU ECON 2010 - Trade Policy - Tariffs

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1Trade Policy - TariffsTrade Policy Tools• The government often uses “policy instruments” to “interfere” with free trade.• When this occurs, we have “managed trade”Types of Trade Policy ToolsTariffsNon-tariff barriers:QuotasVER’sSubsidiesLicensing Agreements2Tariffs• There are two types of tariffs that we can consider:1) Specific Tariff – fixed monetary amount per unit2) Ad valorem – constant % of unit’s valueWhy might a specific tariff be used instead of an ad valorem tariff?Tariff Legislation• Types of Tariff Legislations1) Preferential DutiesA tariff rate is applied according to its geographical source – a country is given preferential treatment 2) Generalized System of Preferences (GSP)When a DC permits duty-free entry of selected products from a LDC –the same product from a DC does face the tariff.3)Most favored nation (MFN)Any country that trades with (for example) the US will get the lowest tariff given by the US to any country for that goodMFN• Somewhat misleading since most countries do have MFN status.• MFN indicates that a country is not being discriminated against in regard to tariff ratesExample Suppose that US-India bilateral trade agreementUS lowers tariff on cloth from India; India lowers tariff on computersfrom USCountries with MFN status will now receive the lower tariff on cloth they export to the US.3How “closed” is a country?• Tariffs are a means to “protect” a country from foreign goods – reducing trade – the country becomes more “closed” to trade.How closed is a country? Can we tell from tariff rates?We can look at tariff rates in several ways.1) Non-weighted Average Tariff Rates2) Weighted Tariff RatesWhich one is a better indication of the level of protection?3) Effective Rate of ProtectionModeling Tariffs• How do we model tariffs?• Specific tariffs are per unit price increases that raise the world priceFocus: What happens to domestic production and consumptionafter the tariff is imposed?What is government revenue (GR) from the tariff?National Welfare is now CS+PS+GRTariff Example• We first consider a “small country” that wishes to impose a tariff on an imported good.• A “small country” is a country that cannot affect the world price – it is a “price taker”4DQPS$8150100 190PW$5Suppose now a20% tariff is imposed.$6PW+ TariffThe new import price rises to $6. Importsfall from 90 to 40.120160abcdefghijWhat happens to CS,PSand GR?DQPSPW$5$6PW+ TariffabcdefghijCS is reduced by (e+f+g+h+i)PS increases byeGR is (g+h)So, CS+PS+GR is-(f+i) after the tariff150100 190160120Deadweight Loss from Tariff• For a small country, the deadweight loss from the tariff is the lost consumer surplus that is not gained by increases in PS or GR• This is welfare that is “lost”Thus, the optimal tariff (tariff that maximizes national welfare) fora small country, is 0!!For a small country, tariffs are always welfare reducing!!!Protection may help an industry, but hurts the country as a whole!5Large Country Tariff• Do tariffs always reduce welfare in a “large country”?• “Large country”- a country that can affect the world price (e.g. the US is a large country)Can a tariff in a large country actually increase national welfare?Ex. Suppose that the US puts a tariff on imported carsThere now exists a wedge between what we pay and what foreignproducers receiveThe response by foreign firms may be to drop the price to keep fromlosing too many exportsDQSPW$5$6PW+ TariffabcdefghijPkmIn response to the large country’s tariff, foreign producers drop their price to $4.50$4.50150100 190160120What happens to CS?PS? GR? Foreign Welfare?DQSPW$5$6PW+ TariffabcdefghijPkm$4.50160120CS falls by(e+f+g+h+i)PS increases by eGR increases by (g+h+k+m)So, national welfare changeIs (k+m)-(f+i)6Large Country Tariff• Now, national welfare is not necessarily negative. The deadweight loss of the tariff may be outweighed by the increase in GR.• Area (k+m) is the amount by which foreign producers “pay” for the tariff by lowering the price to save importsThe larger the area (k+m), the greater the likelihood that the US gains from the tariff – the size of (k+m) comes from the reactionby foreign firms to the tariff.Note: So government would like to maximize (k+m)- (f+i)Optimal Tariff for Large Country• Note that if the country sets too high of a tariff, the foreign reaction may be greater, increasing (k+m), but that also increases (g+h)• Too low of a tariff, (k+m) small but so is (g+h)The “optimal tariff” is equal to:1/(eΠ-1)Where eΠis the foreign price elasticity of


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