An Introduction to

International Economics
Chapter 5: Trade Restrictions: Tariffs

Dominick Salvatore
John Wiley & Sons, Inc.

Dale R. DeBoer 5-1

University of Colorado, Colorado
Springs
 Movements away from free trade

• While it is generally accepted that free trade

best enhances societal welfare, complete free
trade is seldom practiced.
• This situation generates two questions
– Why is complete free trade seldom practiced?
– What are the effects of deviating from free trade?
• This chapter considers the second question by
considering the effects of employing one
common tool of deviating from free trade – the
tariff.
Dale R. DeBoer 5-2
University of Colorado, Colorado
Springs
 Types of tariffs

• Import vs. export tariffs

– An import tariff is a tax (or duty) on imported
goods or services.
• This is the most common form of tariff.
– An export tariff is a tax on exported goods or
services.
• This is rarely seen in developed countries but is
occasionally practiced in developing countries to
generate government revenue.

Dale R. DeBoer 5-3

University of Colorado, Colorado
Springs
 Types of tariffs

• Import vs. export tariffs

• Ad valorem tariff
– A fixed percentage tax on the traded commodity.

Dale R. DeBoer 5-4

University of Colorado, Colorado
Springs
 Types of tariffs

• Import vs. export tariffs

• Ad valorem tariff
• Specific tariff
– A fixed sum tax per unit of a traded commodity.

Dale R. DeBoer 5-5

University of Colorado, Colorado
Springs
 Types of tariffs

• Import vs. export tariffs

• Ad valorem tariff
• Specific tariff
• A compound tariff
– A combination of an ad valorem and specific tariff.

Dale R. DeBoer 5-6

University of Colorado, Colorado
Springs
 Types of tariffs

• Import vs. export tariffs

• Ad valorem tariff
• Specific tariff
• A compound tariff

Dale R. DeBoer 5-7

University of Colorado, Colorado
Springs
 Small vs. large

• The implications of interfering with trade differ

depending on the nature of the country.
– The key distinction is between whether the
country is “small” or “large.”

Dale R. DeBoer 5-8

University of Colorado, Colorado
Springs
 Small vs. large

• The implications of interfering with trade differ

depending on the nature of the country.
• A “small” country is one where changes in its
domestic market do not alter the international
price of the commodity.
– In the case of tariff, this means that the imposition
of a tariff does not alter the international price.
– In other words, the country acts as a “price-taker”
in the international market.

Dale R. DeBoer 5-9

University of Colorado, Colorado
Springs
 Small vs. large

• The implications of interfering with trade differ

depending on the nature of the country.
• A “small” country is one where changes in its
domestic market do not alter the international
price of the commodity.
• A “large” country is one where changes in its
domestic market do alter the international
price of the commodity.
– In the case of a tariff, this means that the
imposition of a tariff does alter the international
price.
Dale R. DeBoer 5 - 10
University of Colorado, Colorado
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 Effects of a tariff: small country

• The effects of a tariff are 120

easily seen in a market 110

100 Supply
supply and demand
90
diagram. 80
• In this market, the 70

autarky equilibrium 60

occurs a price of $50 50

40
and quantity of 50.
30

20

10
Demand
0
0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 11
University of Colorado, Colorado
Springs
 Effects of a tariff: small country

• In this market, if the 120

international price is 110

100 Supply
$20, the country will be
90
an importer of the item. 80
• Domestic production 70

will fall from 50 to 20. 60

50
• Domestic consumption
40
will rise from 50 to 80. 30
International
• These changes 20 price

generate imports of 60 10
Demand
0
units. 0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 12
University of Colorado, Colorado
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 Effects of a tariff: small country

• If a 50% ad valorem 120

tariff is placed on 110

100 Supply
imports, the domestic
90
price rises from $20 (the 80
international price) to 70
the tariff price of $30. 60

• Domestic production 50

40
increases from 20 to 30. Tariff
30 price
• Domestic consumption 20

falls from 80 to 70. 10

Demand

• Imports fall to 40. 0

0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 13
University of Colorado, Colorado
Springs
 Effects of a tariff: small country

• The final effect is that 120

the government will 110

100 Supply
begin collecting tariff
90
revenue in this market. 80
– The amount of the 70
revenue is $10 x 40 = 60
$400 per unit of time. 50

40
Tariff
30 price
20

10
Demand
0
0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 14
University of Colorado, Colorado
Springs
 Welfare effects: small country

• To show the welfare changes from the tariff

the concepts of consumer and producer
surplus must be considered.
• Consumer surplus is the difference between
what consumers are willing to pay for a
specific amount of a commodity and what
they actually pay for it.
– Graphically, consumer surplus is the area under
the demand curve and above the price paid on
every unit purchased.

Dale R. DeBoer 5 - 15
University of Colorado, Colorado
Springs
 Welfare effects: small country

• Consumer surplus is the difference between what

consumers are willing to pay for a specific amount
of a commodity and what they actually pay for it.
• Producer surplus is the extra payment
received by producers above what needed to
have been paid to cause them to produce the
commodity.
– Graphically, producer surplus is the area below
the price received and above the supply curve on
every unit sold.

Dale R. DeBoer 5 - 16
University of Colorado, Colorado
Springs
 Welfare effects: small country

• Consumer surplus at 120

autarky is given by the 110

indicated region. 100 Supply

• When the nation moves 90

to free trade this 80

70
surplus increases.
60
• The imposition of a 50
tariff reduces this 40
surplus by the 30
Tariff
price
difference between the 20
international and the 10
Demand
tariff price. 0
0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 17
University of Colorado, Colorado
Springs
 Welfare effects: small country

• Producer surplus at 120

autarky is given by the 110

100 Supply
shaded region.
90
• Opening the economy 80

to free trade reduces 70

the surplus to the 60

smaller shaded region. 50

40
• Imposing a tariff 30
Tariff
price
increases the producer 20

surplus. 10
Demand
0
0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 18
University of Colorado, Colorado
Springs
 Welfare effects: small country

• The losses and gains 120

from the imposition of a 110

100 Supply
tariff exist in the shaded
90
region. 80
• The entire region is lost 70

consumer surplus. 60

50
– The dollar value of this
40
region is ($10 x 70) + (½ Tariff
30
x $10 x 10) or $750. price
20

10
Demand
0
0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 19
University of Colorado, Colorado
Springs
 Welfare effects: small country

• The entire region is lost 120

consumer surplus. 110

100 Supply
• Of this, the portion 90
above the supply curve 80

is gained by producers. 70

– The dollar value of this 60

region is ($10 x 20) + (½ 50

x $10 x 10) or $250. 40

Tariff
30 price
20

10
Demand
0
0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 20
University of Colorado, Colorado
Springs
 Welfare effects: small country

• The entire region is lost 120

consumer surplus. 110

• Of this, the portion above 100 Supply

the supply curve is gained 90

by producers. 80

70
• The rectangular area is 60
gained by the 50
government as tariff 40
revenue. 30
Tariff
price
– The dollar value of this 20
region is $10 x 40 or 10
Demand
$400. 0
0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 21
University of Colorado, Colorado
Springs
 Welfare effects: small country

• This leaves a net 120

welfare loss to society 110

of the two triangular 100 Supply

shaded regions. 90

• These regions are 80

70
known as the
60
deadweight loss of a
50
tariff. 40
– These have a dollar value 30
Tariff
price
of $750 - $250 (gained by
20
producers) - $400
10
(gained by the Demand
government) or $100. 0
0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 22
University of Colorado, Colorado
Springs
 Effects of a tariff: large country

• The effects of a tariff on 120

a large country differ 110

100 Supply
from that in a small
90
country because the 80
imposition of a tariff 70
results in a fall in import 60

demand that lowers the 50

international price. 40
30
– This is known is as the International
20 price
terms of trade effect.
10
Demand
0
0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 23
University of Colorado, Colorado
Springs
 Effects of a tariff: large country

• In this case, the 50% 120

tariff results in a drop of 110

100
the international price Supply
90
from $20 to $15. 80
– This takes the tariff price 70
to $22.50 per unit. 60

• The effects of this 50

change are more clearly 40

30
seen through a 20
International
price
narrowing of focus in 10
the graph. 0
Demand

0 10 20 30 40 50 60 70 80 90 100 110 120

Dale R. DeBoer 5 - 24
University of Colorado, Colorado
Springs
 Effects of a tariff: large country

• With the tariff and 40

improvement in the
terms of trade,
30
production rises from
20 to 22.5 units.
• Consumption falls from 20

80 to 77.5 units.
• Imports fall from 60 to 10
55 units.

0
10 20 30 40 50 60 70 80 90

Dale R. DeBoer 5 - 25
University of Colorado, Colorado
Springs
 Welfare effects: large country

40
• Consumer surplus
declines by the shaded
region. 30

– This has a dollar value of

($2.50 x 77.5) + (½ x
$2.50 x 2.5) = $196.875 20

10

0
10 20 30 40 50 60 70 80 90

Dale R. DeBoer 5 - 26
University of Colorado, Colorado
Springs
 Welfare effects: large country

40
• Consumer surplus
declines by the shaded
region. 30

• Producer surplus
increases by the shaded
20
region offsetting part of
the consumer loss.
– This has a dollar value of 10

($2.50 x 20) + (½ x $2.50

x 2.5) = $53.125
0
10 20 30 40 50 60 70 80 90

Dale R. DeBoer 5 - 27
University of Colorado, Colorado
Springs
 Welfare effects: large country

40
• Consumer surplus
declines by the shaded
region. 30

• Producer surplus
increases by the shaded
20
region offsetting part of
the consumer loss.
• Government revenue 10

increases by $10 x 75 or
$750.
0
10 20 30 40 50 60 70 80 90

Dale R. DeBoer 5 - 28
University of Colorado, Colorado
Springs
 Welfare effects: large country

40
• The net effect is a
welfare gain.
– Consumer surplus falls 30
by $196.875
– Producer surplus rises
by $53.125 20

– Government revenue
increases by $750
10
– This generates a net gain
of $500 for this case.
0
10 20 30 40 50 60 70 80 90

Dale R. DeBoer 5 - 29
University of Colorado, Colorado
Springs
 Welfare effects: large country

40
• This result arises as the
improvement in the
terms of trade more 30

than offsets the

potential deadweight
loss of the tariff. 20

– Welfare lost
– Welfare gained 10

0
10 20 30 40 50 60 70 80 90

Dale R. DeBoer 5 - 30
University of Colorado, Colorado
Springs
 Optimum tariff

• The previous example demonstrates that it is

possible for the imposition of a tariff in a large
county to improve societal welfare.
• An optimal tariff is the tariff rate that
maximizes the benefit resulting from the
imposition of a tariff.
– The gain comes from the improvement in the
terms of trade.
• Positive welfare gains are always possible
from tariff imposition in large countries.
Dale R. DeBoer 5 - 31
University of Colorado, Colorado
Springs
 A concern about the optimal tariff

• By itself, the existence of an optimum tariff

appears to be a strong argument for
interfering with free trade.
• It is important to note that the positive welfare
gains exist only if no retaliation in other
markets occurs following the imposition of a
tariff.
– History does not support the no retaliation
assumption.

Dale R. DeBoer 5 - 32
University of Colorado, Colorado
Springs
 Nominal tariffs vs. effective
protection

• The nominal tariff is the percentage increase

in the price of the final commodity.
– A 50% ad valorem tariff raises the price of the
commodity by 50% generating a 50% nominal
tariff.

Dale R. DeBoer 5 - 33
University of Colorado, Colorado
Springs
 Nominal tariffs vs. effective
protection

• The nominal tariff is the percentage increase in

the price of the final commodity.
• The effective rate of protection is calculated
on the increase in domestic value added
offered by tariff protection.
– The effective rate of protection offers a better
measure of the protection offered producers as it
takes into account the cost to producers of tariffs
on input markets.

Dale R. DeBoer 5 - 34
University of Colorado, Colorado
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 Examples of effective protection

• Suppose a product sells $12,000

for $10,000 but has
$10,000
input costs of $5,000
per unit. $8,000 Value
– In this case, its value Added
added is $5,000. $6,000

• The imposition of a 10%

$4,000
ad valorem tariff raises Input
the sales price from $2,000 Cost
$10,000 to $11,000.
$0
Free Trade

Dale R. DeBoer 5 - 35
University of Colorado, Colorado
Springs
 Examples of effective protection

• The imposition of a 10% $12,000

ad valorem tariff raises Gain
$10,000
the sales price from
$10,000 to $11,000. $8,000 Value
Value
Added
• This raises the value Added
$6,000
added from $5,000 to
$6,000 and offers an $4,000
effective rate of Input Input
protection of 20%. $2,000 Cost Cost

– $1,000 (gain in value

$0
added) ÷ $5,000 (original
Free Trade 10% Tariff
value added) = 20%
Dale R. DeBoer 5 - 36
University of Colorado, Colorado
Springs
 Examples of effective protection

• Using the starting point, $12,000

assume that a 20% ad
$10,000
valorem tariff is placed
on the inputs. $8,000 Value
• This raises the input Added
$6,000
cost from $5,000 to
$6,000. $4,000
Input
$2,000 Cost

$0
Free Trade

Dale R. DeBoer 5 - 37
University of Colorado, Colorado
Springs
 Examples of effective protection

• Using the same example, $12,000

assume that a 20% ad
valorem tariff is placed on the $10,000
inputs. Value
$8,000 Value
• This raises the input cost from Added
Added
$5,000 to $6,000. $6,000 Loss
• This decreases the value
added from $5,000 to $4,000 $4,000
Input
and offers an effective rate Input
Cost
$2,000 Cost
of protection of - 20%.
– - $1,000 (loss in value added)
$0
÷ $5,000 (original value added)
Free Trade 10% Input
= - 20%
Tariff

Dale R. DeBoer 5 - 38
University of Colorado, Colorado
Springs
 Examples of effective protection

• As a final example, $12,000

consider the effective
$10,000
rate of protection
offered by combing the $8,000 Value
previous two policies – Added
a 20% tariff on the $6,000
inputs and a 10% tariff
$4,000
on the final output.
Input
$2,000 Cost

$0
Free Trade

Dale R. DeBoer 5 - 39
University of Colorado, Colorado
Springs
 Examples of effective protection

• This increases both $12,000

input cost and final Gain
$10,000
price by $1,000 and Value
leaves an effective rate $8,000 Value Added
of protection of zero. Added
$6,000
• As is seen, the effective Loss

level of protection may $4,000

Input
differ greatly from the Input
Cost
$2,000 Cost
rate of the nominal
tariff. $0
Free Trade 10% Input
Tariff

Dale R. DeBoer 5 - 40
University of Colorado, Colorado
Springs