4.3 - Tariffs
Common types of trade protection
Although free trade offers advantages such as increased efficiency and consumer choice, many governments limit international trade to safeguard domestic industries.
Main forms of trade protection:
- Tariffs - Taxes applied to imported goods.
- Quotas - Limits on the quantity of specific goods that can be imported.
- Subsidies - Financial support given to domestic producers.
- Administrative barriers - Regulations or standards that make importing more difficult or costly.
Definition and features of tariffs
A tariff acts as a barrier to trade by increasing the cost of imported products. Governments often use tariffs to generate revenue or encourage domestic production. A tariff is a tax levied on goods entering a country, designed to reduce import volumes and support local industries.
Types of tariffs:
- Specific tariffs - A fixed charge per unit of the imported good.
- Ad valorem tariffs - A percentage of the good's value.
For example, a government might apply a tariff on foreign cars to make them costlier than locally made vehicles, boosting demand for domestic manufacturers.
Analysis of tariffs in a small country
In a small country that cannot influence global prices, introducing a tariff alters the domestic market by raising prices and adjusting supply and demand.
How tariffs affect the market:
- Free trade scenario - The domestic price matches the world price (Pw).
- Post-tariff scenario - The tariff (t) increases the domestic price to P' = Pw + t.
- Domestic production rises.
- Domestic consumption falls.
- Import quantities decrease.
Welfare effects of tariffs
Tariffs redistribute economic benefits within a country but often result in an overall loss of efficiency. They affect different groups unevenly, creating gains for some while imposing costs on others.
Impacts on welfare:
- Consumer surplus - Reduces.
- Producer surplus - Increases.
- Government revenue - Grows from the tariff collections.
- Net welfare loss - Arises from two inefficiencies:
- Production inefficiency - Resources are diverted to domestic production at a higher cost than the world price.
- Consumption inefficiency - Consumers miss out on goods they would value more than the world price but cannot afford at the tariff-inflated price.
Calculations related to tariffs
Various calculations help quantify the impact of tariffs on markets, including revenues, expenditures, and government income. These are based on the adjusted domestic price (P') after the tariff.
Total revenues for domestic producers
Where:
- P' = Domestic price after tariff
- Domestic production = Quantity produced locally post-tariff
Total expenditures by domestic consumers
Where:
- P' = Domestic price after tariff
- Domestic consumption = Quantity consumed locally post-tariff
Import expenditures
Where:
- Pw = World price
- Quantity imported = Volume of imports after tariff
Tariff revenues
Where:
- Tariff rate = Amount or percentage of the tariff
- Quantity imported = Volume of imports after tariff
Worked example - Calculating tariff revenues and producer revenues
In a small country, the world price (Pw) of a good is £15 per unit. A tariff of £5 per unit is imposed, raising the domestic price (P') to £20 per unit. Domestic production increases to 700 units, domestic consumption decreases to 1100 units, and imports fall to 400 units. Calculate the total revenues for domestic producers, total expenditures by domestic consumers, import expenditures, and tariff revenues.
Step 1: Identify the values
- P' = £20 per unit
- Domestic production = 700 units
- Domestic consumption = 1100 units
- Quantity imported = 400 units
- Pw = £15 per unit
- Tariff rate = £5 per unit
Step 2: Calculate total revenues for domestic producers
Step 3: Calculate total expenditures by domestic consumers
Step 4: Calculate import expenditures