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Welcome to Econ 414 International Economics

Study Guide

Week Seven

Chapter 6

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• Tax on imported goods• Why?

– Revenue for Government

– Protect domestic suppliers of similar goods from foreign completion• Protect jobs

What is a tariff?

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What are the types of tariff?

1. Specific tariffs Tax per unit

• specific tariff is regressive. Why?– A specific tariff of $1,000 on each

imported auto• a high percentage of the value of less

expensive cars• a low percentage of the value of high-

priced cars

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Under specific tariff, what type of cars will be imported less? Expensive cars?

Cheap cars?• Cheap cars

– A specific tariff encourages domestic producers to produce less expensive goods.

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2. Ad valorem tariffs– Taxes = fraction of the value of the imported

goods• A 5% tariff on an international price of $10,000

means that customs officials collect the fixed sum of _________.

– Importers have an incentive to under-voice the price of the imported good.

– Ad valorem tariffs are more difficult for a country to administer than specific tariffs.

What are the types of tariff?

$500

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3. Compound tariffs

– a combination of an ad valorem and a specific tariff

– Common on agricultural products whose prices tend to fluctuate.

What are the types of tariff?

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1. Free alongside (FAS) price• The price of the imported good in the exporting

nation before loading the good for shipment to the importing country

2. Free on Board (FOB) price• FAS + the cost of loading the good in the

means of transportation

What are different methods of valuing imports?

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3. Cost, Insurance, and Freight (CIF) price• FOB + all inter-country

transportation costs up to the importing country’s port of entry.

What are different methods of valuing imports?

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What is consumer surplus (CS)?

D

P1

P

Q

Consumer Surplus

Price

Quantity

The difference between the highest price consumers would be willing to pay (Price on demand curve) and the market price.

Graphically, it is equal Graphically, it is equal to the area under the to the area under the demand curve and demand curve and above the priceabove the price

The higher the CS the ___________ the consumers

Better off

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What is producer surplus (PS)?

E

P2

Producer Surplus

S

Quantity of Cloth

Price of Cloth

Q

P

The difference between the market price and lowest price producers will sell a good (price on the supply curve).

Graphically, it is Graphically, it is equal to the area equal to the area under the price and under the price and above the supply above the supply curvecurveThe higher the PS the ___________ the producers

Better off

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The combined effect

S

D

E

Price

Quantity

P1

Q

P

P2

Consumer Surplus

Producer Surplus

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How does a free trade affect consumer surplus and producer surplus?

Price

Quantity

Price

Quantity

D

Exports

Imports

D

E

US

India

a

b

c

d

SS

10

4

a’

b’

c’

d’

8

E’

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CS ↑ by b+ d, PS ↓ by b CS↓ by b’, PS ↑ by b’ + d’

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What are the economic effects of tariffs?

1. Case of small importing nation Note: A small nation can import as much as it

likes at the same international price.

– World Prices = €8.– Domestic government imposes a specific

tariff on imported good in the amount of €2/unit

– Domestic Price = 8 + 2 = €10

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What are the economic effects of tariffs in a small importing

nation?

S

D

E

Price

Quantity

20

2

a b c d

35 401510

8

10

Tariff = 2

-a+b+c+d: loss in CS = €75- a: added to PS= €25- b: cost of resources transferred from their best use to the production of 5 more units of the good= €5- c: government revenue = €40-d: loss to consumers = €5- a + c: redistributed effect- b+d: dead-weight loss

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2. Case of large importing nation• Note: A large nation can influence the international

price.

– World Prices = €8.– Domestic government imposes a specific tariff

on imported good in the amount of €2 .– World supplier reduces the price to €7– Domestic Price after tariff= 7+ 2 = €9

What are the economic effects of tariffs

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What are the economic effects of tariffs

in a large importing nation?

S

D

E

Price

Quantity

20

2

a b c d

35 401510

8

9

Tariff = 2

-a+b+c+d: loss in CS = €37.5- a: added to PS= €12.5- b: efficiency loss= €2.5- c+ f: government revenue = €40-d: loss to consumers = €2.5- a + c: redistributed effect- b+d: dead-weight loss-f: loss in exporter’s revenue

7f

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The Effective Rate of Protection

• Effective Rate of ProtectionERP = (Tf – aTc)/(1-a)

which,

Tf = tariff rate on imported final product

Tc = tariff rate on the imported components

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The Effective Rate of Protection

• Example: Consider two DVD players; one produced in the U.S. and one produced in a foreign country. Both DVD players sell for $100 in the U.S. with half of that price represents the cost of components purchased from a third country. An ad valorem tariff of 20% imposed by the U.S. raises the value added from $50 to $70. Thus, the effective rate of protection is (70-50)/50 = 40%.

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Arguments for Tariffs

• Infant Government Argument– Developing countries use tariffs as a way to generate revenue.

• National Defense Argument– Certain industries need to be protected from foreign competition

to ensure an adequate output of the industry in the case of conflict.

– Two problems arise with this argument:• It is hard to identify the industries that are essential for national

defense.

• A tariff is a costly means of protection. Instead, a domestic production subsidy should be used to encourage domestic production of the good.

– The next slide depicts the effects of a domestic production industry.

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• Infant Industries– From World War II until the 1970s many developing countries

attempted to accelerate their development by limiting imports of manufactured goods to foster a manufacturing sector serving the domestic market.

– The most important economic argument for protecting manufacturing industries is the infant industry argument.

• Senile Industry Protection– Many developed countries protect industries that are old.

• For example, the apparel industry in most developed countries experience this type of protection.

Arguments for Tariffs

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Arguments for Tariffs

S

D

E

Price of Cloth

Quantity of Cloth

P1

P

P2

a b c

Q

d

G

F

Q4 Q2Q3Q1

Pw

Pt

Tariff = T

Figure 6-6: The Effects of a Domestic Production Subsidy

S’

Subsidy

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• Tariffs, Trade and Jobs– The imposition of a tariff in a particular industry produces more

jobs in that particular industry but fewer jobs in other industries.• The overall level of employment is unchanged in the short-run

whereas in the long-run it may decrease.

• An economy with a lot of tariffs will usually grow more slowly than a more open economy.

Arguments for Tariffs