Ch. 5: Import Tariffs and Quotas

Unit 3 (Feenstra and Taylor, Chapter 8) studies the instruments of trade policy under perfect competition. The gains from trade are unevenly spread, and industries, labour unions and other groups often ask governments to limit their losses from international trade. What governments do is trade policy: measures taken by governments to affect the domestic prices (and quantities) of tradable goods and, if possible, also their world prices. This chapter covers the institutional background (GATT and WTO), the welfare tools (consumer and producer surplus), import tariffs in a small and a large country, the optimal tariff, import quotas and the allocation of quota rents, other instruments (local content requirements, administrative policies, dumping and antidumping), and the arguments for intervention.

Trade policy in practice: recent US examples

• G.W. Bush (2001 to 2009): the 2002 US steel tariffs cost the United States nearly 200,000 jobs in steel-consuming industries, far more than total employment in steel production at the time.
• Obama: in September 2009 announced a 35% tariff on imports of tyres from China.
• Trump (2017 to 2021): withdrawal from the Paris Agreement and the Trans-Pacific Partnership, renegotiation of NAFTA (replaced by the USMCA in 2020), new tariffs on about $200 billion (later about $380 billion) of Chinese and other imports, and threats of punitive tariffs on EU, Japanese and Korean cars, steel and electronics. The 2018 to 2019 tariffs amounted to about $80 billion of new taxes, one of the largest tax increases in US history.
• Biden kept most of these tariffs and in May 2024 added tariffs on a further $18 billion of Chinese goods (semiconductors, electric vehicles), a tax increase of $3.6 billion.
• The US Tax Foundation estimated that the Trump and Biden tariffs reduce long-run GDP by 0.2%, the capital stock by 0.1% and employment by 142,000 full-time equivalent jobs. The additional tariffs proposed in the 2024 campaign would raise taxes by another $524 billion a year and reduce GDP by at least 0.8%, the capital stock by 0.7% and employment by 684,000 jobs, before counting retaliation or a global trade war. Academic and government studies find that these tariffs raised prices and reduced output and employment: a net negative effect on the US economy.

Instruments of trade policy

To study their effects the analysis distinguishes:

• Small open economies (SOEs): countries that cannot affect their terms of trade (world prices) through their policies.
• Large open economies (LOEs): countries whose policies can affect world prices and thus their terms of trade (a strategic effect).

From GATT to WTO

After the Second World War the Allied countries discussed trade issues such as high trade barriers and volatile exchange rates. In 1947 the General Agreement on Tariffs and Trade (GATT) was created to reduce, and possibly eliminate, barriers to international trade. Since 1995 the GATT has been continued within the World Trade Organization (WTO).

Keystone principles of GATT/WTO:

1. A country must apply uniform trade barriers, at the same rate, to all WTO trading partners (the most-favoured-nation (MFN) principle, Article I). If the United States levies a tariff on steel from one member, it must apply the same tariff to steel from all members.
2. Trade restrictions can be justified as countervailing measures against unfair trade practices such as dumping (Article VI).
3. Dumping is selling an exported good in another country at a price lower than the price charged at home, or lower than its average cost of production (plus transport costs).
4. Countries may not unilaterally impose import or export quotas, that is restrict the quantity of trade (Article XI, general elimination of quantitative restrictions). The Multifibre Arrangement for textiles was a major exception until 2005.
5. Countries must notify their partners of export subsidies granted to specific firms and sectors; Article XVI requires members to inform each other of the level of export subsidies and to examine the possibility of abolishing them.
6. Countries may temporarily raise tariffs on certain products when domestic producers are hurt by import competition: Article XIX, the safeguard provision or escape clause.
7. Regional trade agreements are allowed under Article XXIV, even though they give members lower tariffs than non-members and are therefore an exception to MFN.

Forms of regional integration, from weakest to strongest:

RCEP (Regional Comprehensive Economic Partnership, signed 15 November 2020) is the most recent and the world's largest regional trade agreement: the ASEAN countries plus Australia, China, Japan, New Zealand and South Korea. It covers about 2.2 billion people, 30% of global GDP and 30% of world consumption. India took part in the negotiations but withdrew, fearing that lower tariffs would hurt many of its sectors; it retains the option to join.

Welfare tools: consumer and producer surplus

Trade policy is evaluated by its effect on the national welfare (real income) of the country that uses it and on the welfare of its trading partners (rest of the world, ROW). Two tools are used:

The gains from free trade for a small importing country

With Home demand D and supply S, the no-trade equilibrium is at point A with price P A and quantity Q 0. With free trade the world price P W is lower (Home imports this good). Quantity demanded rises to D 1 > Q 0 and quantity supplied falls to S 1 < Q 0; Home imports D 1 minus S 1.

Area b is a transfer from producers to consumers; area d, the triangle between demand and supply below P A, is the net gain from trade.

Import tariff in a small country

A small country faces a horizontal Foreign export supply curve at P W. A tariff of t per unit raises the Home price by the full amount of the tariff, to P W + t. In panel (a) (Home market), quantity supplied rises from S 1 to S 2 and quantity demanded falls from D 1 to D 2. In panel (b) (import market), imports fall from M 1 = D 1 minus S 1 to M 2 = D 2 minus S 2, and the equilibrium moves from point B to point C.

The triangle (b + d) is the deadweight loss (DWL): a loss not offset by a gain elsewhere in the economy. It has two parts:

• Triangle b, the production loss (efficiency loss): the extra units S 1 to S 2 are produced at a marginal cost above the world price; b is the increase in marginal cost for those units.
• Triangle d, the consumption loss: the drop in consumer surplus of consumers who no longer buy the units between D 2 and D 1 because of the higher price.

In the import market (panel b) the DWL is the single triangle (b + d) under the import demand curve between M 2 and M 1. Welfare in the rest of the world does not change: the small country cannot affect world prices.

Why do so many countries use tariffs if a small country always loses? First, a developing country may have few other sources of tax revenue, and tariffs are easy to collect at the border. Second, politics: the benefits to producers and their workers are concentrated on specific firms and sectors, while the costs to consumers are spread thinly over the whole country, so producers lobby more effectively.

Mock exam check. A small country levies a tariff of 10 euros per unit under perfect competition: the domestic price rises by the full 10 euros and the price received by foreign producers is unchanged. And since the net effect is minus DWL < 0, any combination of changes must satisfy CS change + PS change + tariff revenue < 0. Of the options CS = minus 60, PS = 80, TR = 20 (net +40), CS = minus 70, PS = 50, TR = 20 (net 0), CS = minus 70, PS = 50, TR = 10 (net minus 10) and CS = minus 80, PS = 70, TR = 20 (net +10), only the third is possible.

Worked example: small country (textbook problem 8)

The figure shows Home supply S rising from 4 (P = 4 + Q) and a downward sloping demand curve that passes through the points (5, 9), (6, 8) and (8, 6). Autarky: demand equals supply at Q = 5, P = 9. With free trade at P* = 6, demand is 8 and supply 2, so imports are 6.

• No trade: PS = 0.5 × (9 minus 4) × 5 = 12.5. CS is the triangle under demand above 9; with the demand intercept of 18 as labelled in the figure it is 0.5 × (18 minus 9) × 5 = 22.5. (The labelled intercept does not lie on the straight line through the other points, so the level of CS depends on how the figure is read; the changes below only use the marked points.)
• Free trade at P* = 6: CS rises by the trapezoid between 6 and 9: 0.5 × (5 + 8) × 3 = 19.5. PS falls by 0.5 × (5 + 2) × 3 = 10.5 (PS becomes 0.5 × 2 × 2 = 2). Net gain from trade = 19.5 minus 10.5 = 9 (the triangle 0.5 × 3 × 6). Home benefits from trade.
• Tariff: the import market panel shows the tariff raising the Home price from 6 to 8 (t = 2). Demand falls to 6, supply rises to 4, imports fall to 2.

The problem text mentions a tariff of $3. At a price of 6 + 3 = 9, demand and supply are both 5, so imports are zero: a tariff of 3 is prohibitive and Home loses all its gains from trade (minus 9), with no tariff revenue.

Problem 9 (quota of 2 units). A quota of 2 units raises the Home price to 8, exactly like the tariff of 2. If the quota licences go to local producers (Home firms earn the quota rent of (8 minus 6) × 2 = 4), the net effect is minus 4, the same as the tariff. If the quota rents are earned by Foreign exporters, the net loss is 4 + 4 = minus 8.

Import tariff in a large country

Foreign export supply. In Foreign, with demand D* and supply S*, the no-trade equilibrium is at A* with price P A*; Foreign exports are zero there. At a world price P W above P A*, Foreign supply S* 1 exceeds Foreign demand D* 1 and Foreign exports X* 1 = S* 1 minus D* 1. Joining the points A* and B* gives the upward sloping export supply curve X*. For a small importer this curve is horizontal (the importer is too small to move the price); a large importer faces the upward sloping curve. With Home import demand M, free-trade equilibrium is at B* with price P W.

Effect of the tariff. The tariff shifts the export supply curve up by t, from X* to X* + t. The Home price rises from P W to P* + t, but the price received by Foreign exporters falls from P W to P*. Consumers and producers at Home face a higher price, but by less than the full tariff, because part of the tariff is paid by Foreign exporters.

Area e = (P W minus P*) × M 2 is the terms-of-trade gain: the part of the tariff revenue paid by foreign exporters through a lower price. If e exceeds the deadweight loss (b + d), the tariff raises Home welfare. Foreign loses e plus its own deadweight loss f, so the world as a whole loses (b + d + f). The large country's gain comes at the expense of its trading partners, which invites retaliation and tariff wars.

Numerical example. Home import demand M = 60 minus 5P, Foreign export supply X* = 5P minus 20. Free trade: 60 minus 5P = 5P minus 20 gives P W = 8 and M = 20. A tariff t = 2: 60 minus 5(P* + 2) = 5P* minus 20 gives P* = 7, Home price 9, M = 15. Terms-of-trade gain e = (8 minus 7) × 15 = 15. Home DWL (b + d) = 0.5 × (9 minus 8) × (20 minus 15) = 2.5. Net Home gain = 15 minus 2.5 = +12.5. Foreign loses e + f = 15 + 0.5 × 1 × 5 = 17.5; world loss = 2.5 + 2.5 = 5. Half the tariff is borne by Home consumers (price up 1) and half by Foreign exporters (price down 1), because the two curves have equal slopes.

The optimal tariff

For a large importing country, a small tariff initially raises welfare because the terms-of-trade gain exceeds the deadweight loss (the DWL grows with the square of the tariff, the terms-of-trade gain roughly in proportion). Welfare keeps rising up to the optimal tariff (point C in the textbook figure), the tariff that maximises the importer's welfare. Beyond it welfare falls; a very large tariff lowers welfare below the free-trade level (point B), and a prohibitive tariff (no imports) brings the importer back to its no-trade welfare (point A).

Import quotas

Examples: the Multifibre Arrangement (MFA), a worldwide system of textile and apparel quotas that was abolished on 1 January 2005, when China was poised to become the largest exporter; the EU banana quota (from 1993) that let in more bananas from former colonies in Africa than from Latin America; and the US sugar quota, still in place.

Quota in a small country. Under free trade the export supply curve is horizontal at P W and imports are M 1. A quota M 2 < M 1 makes the export supply curve vertical at M 2; the Home price rises to P 2 where import demand equals M 2. For every quota there is an equivalent import tariff, t = P 2 minus P W, that gives the same Home price and imports. The effects on CS (minus (a + b + c + d)) and PS (+ a) are the same. The difference is area c:

Rent seeking: if licences are allocated in proportion to past production, Home firms may overproduce just to get next year's licences; or they may bribe or lobby. Such inefficient activities use up resources equal to the value of the rents. VERs were used by the United States in the 1980s to restrict Japanese car imports; the quota rents went to Japanese producers, which raised their prices and profits.

Ranking by Home welfare (small country, same imports M): quota with rent seeking = quota given to foreign exporters (VER), lowest at minus (b + c + d), below tariff = quota to Home firms without rent seeking = auctioned quota, all at minus (b + d).

Tariff-rate quota (TRQ): a tariff applied only to imports above a quota amount M'. Imports up to M' pay no tariff, so the rectangle of tariff revenue is only t times the imports above M', and the quota holders earn rents of t × M' on the tariff-free units. The Home welfare effect is the same as a tariff if the rents go to Home firms and worse if foreign firms earn them; Foreign is better off than under a full tariff if its exporters get the rents. TRQs are common in agriculture because they combine protection with a guaranteed quota for favoured suppliers.

Worked example: removal of the MFA quota (textbook problem 11)

• Gain in consumer surplus from removing the quota: 0.5 × (100 + 125) × 0.50 = $56.25 million.
• Loss in producer surplus: 0.5 × (75 + 50) × 0.50 = $31.25 million.
• Quota rents under the MFA: (2.50 minus 2.00) × 25 = $12.5 million.
• Net gain from removal: 56.25 minus 31.25 = $25 million if the quota rents went to foreign exporters (as under the MFA, where exporting countries administered the quotas). If the rents had been earned at home, the gain would be 25 minus 12.5 = $12.5 million (the two deadweight triangles, 0.5 × 0.5 × 25 each).

Quotas that limit the number of units regardless of type also lead to quality upgrading: exporters shift to higher value products (for example dress shirts instead of T-shirts), because the quota raises the price of cheap units proportionally more.

Other instruments

Local content requirements: policies requiring foreign producers to use domestically made products or services (or, for example, to prefer qualified nationals in hiring) in order to operate in the market. They benefit domestic producers of import-competing inputs, but consumers face higher prices.

Administrative policies: bureaucratic rules designed to make it difficult for imports to enter, such as pre-shipment costs, customs fees and service charges, or conformity with specific technical standards. They hurt consumers by denying access to possibly superior foreign products.

Dumping: selling goods in a foreign market below their average cost of production, or below their fair market value (the home price). Dumping lets firms unload excess production abroad. Some dumping may be predatory: firms use profits from their home market to subsidise low prices abroad, allegedly to drive local competitors out and later raise prices. Antidumping policies (countervailing duties) are designed to punish dumping firms and protect domestic producers from unfair competition.

Arguments for government intervention

Political arguments protect the interests of certain groups (normally producers), often at the expense of others (normally consumers): protecting jobs; protecting industries important for national security; retaliating against unfair foreign competition; protecting consumers from dangerous products; protecting the human rights of individuals in exporting countries.

Economic arguments aim to raise the overall wealth of the nation, generate government revenue or protect particular (infant or traditional) industries:

• Infant industry argument: an industry should be protected until it has developed and become internationally competitive. The WTO accepts it as a justification for temporary trade restrictions. Problems: it is hard to judge when an industry has grown up, and critics argue that an industry with real potential should be able to raise funds from private investors without government support. In the textbook figure, today the world price P W is below the firm's average cost AC, so it makes losses; a tariff t with P W + t = AC lets it survive. Producing today lowers the average cost through learning, so that in the future it can produce S 3 at the world price without protection and earn producer surplus e. The tariff is justified only if the future gain e outweighs today's deadweight loss.
• Strategic trade policy: where there are important first-mover advantages, governments can help domestic firms attain them, or help firms overcome barriers to entry in industries where foreign firms have an initial advantage (through tariffs or export subsidies; see the Boeing and Airbus game in the next chapter).

Key points

1. Governments use laws and regulations called trade policies to affect trade flows; the import tariff, a tax at the border, is the most common.
2. The rules for trade policies are set out in the GATT (since 1995 the WTO).
3. A small importing country faces a fixed world price, so its domestic price rises by the full tariff.
4. A tariff by a small country always causes a net welfare loss, the deadweight loss.
5. In a large country the fall in import demand lowers the foreign exporters' price; domestic prices rise by less than the tariff.
6. A large country's tariff can raise its welfare through a terms-of-trade gain.
7. The optimal tariff maximises the importer's welfare; it is zero for a small country and positive for a large one.
8. The optimal tariff depends inversely on the foreign export supply elasticity.
9. Import quotas raise the domestic price and domestic production and create quota rents for those allowed to import.
10. With perfect competition quotas resemble tariffs, but welfare effects depend on who earns the quota rents; an auction is the case most similar to a tariff.