ABC of the economics of tariffs and import quotas-I
SHAGHIL AHMED AND IFFAT ARA
ARTICLE (July 02 2007): Pakistan faces the important challenge of developing a comprehensive strategy for exports that can maximise long-run growth and per capita income without sacrificing the goal of poverty reduction and a more equitable distribution of wealth.
An understanding of and debate on trade policy issues - such as the sources of the disagreements among countries with regard to the liberalisation of agricultural trade that come up in World Trade Organisation (WTO) negotiations, the effects of tariff reductions and the effects of removal of textile quotas starting January 1, 2005 - would seem to be of central significance in meeting this challenge satisfactorily.
There are certainly experts in this area in Pakistan, including among policymakers. Nevertheless, there does seem to be some lack of a more widespread understanding of the basic economics of trade barriers like tariffs and quotas, among all the relevant parties that are engaged in debate. In particular, the discussion one sees in the press and in the electronic media, and even in some policy forums, could be better informed.
The objective of this article is to provide the basics on the economics of tariffs and quotas for the benefit of all those who wish to acquire a rudimentary, but analytical understanding of these issues. The idea is to encapsulate the gist of the analysis that would be found in a basic international economics textbook.
In doing so, we have tried to follow the famous scientist Albert Einstein's maxim that "everything should be made as simple as possible, but not simpler." Thus, while we will avoid equations, we will make use of diagrams (an age-old teaching tool in economics), which facilitate the exposition of the key arguments. But no prior knowledge of economic theory or economic concepts is required. Any concepts that are used will be introduced and developed as we go along.
At the same time it should also be emphasised that the real world of international trade and trade policy is much more complex than the simple world found in textbooks. Many - and often heroic - assumptions have to be made in the textbooks to understand the key building blocks. In particular, our analysis here will all be done in a static and partial equilibrium framework.
A static framework is one which does not take into account the dynamic feedbacks that can result in the future (eg the imposition of a tariff may be followed by retaliatory tariffs by other countries).
And partial equilibrium analysis, as opposed to general equilibrium, analyses the behaviour of a particular sector or portion of the economy separately, without modelling the feedback effects that changes in one sector may have on prices, outputs and other economic variables in other sectors.
Obviously, these are very simplistic notions, but the point is that the more subtle arguments and the finer points involved in the real world relationship cannot be understood without first understanding the simpler arguments which form the building blocks. It is the purpose here to apprise the reader of the key building blocks necessary for an analysis of the economic effects of tariffs and quotas.
The article deals with only a few issues and, in no way is it intended to be a substitute for a textbook or a course in international economics. Quite to the contrary, it is hoped that the interests of the readers will be sparke enough by the discussion here to spur them into acquiring a deeper an even more technical knowledge of trade policy issues.
This work is produced by the Social Policy and Development Centre (SPDC). It is part of a wider SPDC project on the elimination of textile quotas and Pakistan-EU (European Union) trade that is funded by the EU Commission under its Small Projects Facility (SPF) Programme for Pakistan.
It is difficult to grasp the case for free trade based on economic theory without understanding three key concepts - the law of comparative advantage, the notion of consumer surplus and the notion of producer surplus. The Law of Comparative Advantage, attributed to the 19th Century economist, David Ricardo, goes to the heart of the gains that countries will get from specialising in the production of some goods and trading with each other.
The concept is best illustrated through an example. Suppose there are two countries and they produce only two goods, wheat and cloth. By using one unit of labour, country A can produce either 6 bushels of wheat or 4 yards of cloth. Country B's technology is such that it can produce either 2 bushels of wheat or 2 yards of cloth with one unit of labour (Table 1).
TABLE 1
THE LAW OF COMPARATIVE ADVANTAGE:
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Production Possibilities
Production per unit of labour
Country A Country B
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Wheat (Bushels) 6 2
Cloth (Yard) 4 2
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This example has been deliberately rigged so that country A is more efficient at producing both goods - that is, it has what economists call "an absolute advantage" in the production of both goods. However, country B has a "comparative advantage" in the production of cloth because this is the good in which it has least absolute disadvantage - it is only half as efficient as country A at producing cloth compared to one-third as efficient in producing wheat.
Both countries can gain if country B specialises in the production of the good in which it has comparative advantage (cloth) and country A produces the good in which it has comparative advantage (wheat). If country B specialises in the production of cloth, it would be willing to trade 1 yard of cloth for 1 bushel of wheat without being worse off. But this would represent a gain for country A.
This is because if country A specialises in the production of wheat, it is willing to trade 1 bushel of wheat for 2/3 yard of cloth, but it is getting the more favourable terms of trade of 1 yard of cloth for 1 bushel of wheat. It should be clear that for any terms of trade in between 2/3 to 1 yard of cloth for 1 bushel of wheat, both economies would be better off by country A specialising in the production of wheat and country B specialising in the production of cloth and then trading with each other to get the good they do not produce.
This example illustrates the basic argument for the gains from trade and how these gains depend not on absolute advantage in production of goods but on comparative advantage, which is a concept of relative efficiency. This does not mean that a country has to live with or cannot change its comparative advantage. Countries should certainly aim to move up the value chain and produce goods with higher value added so that their per capita incomes can increase faster.
What the law of comparative advantage implies is that countries can only do so by increasing their competitiveness and being able to produce the high-value added items relatively more efficiently than others. In East Asia, for example, we can see how some countries are adjusting to the increased emergence of China by developing new areas of comparative advantage.
CONSUMER SURPLUS:
Another key concept in understanding the basics of trade policy issues is the idea of consumer surplus (CS). To grasp this concept, we must start with a demand curve. The demand curve for a product shows the quantities of the good that will be demanded at different prices. It is downward sloping, as shown in Figure 1.
When the price is high (say, Rs 900 per unit of the good), only those who value the good really highly will demand it and thus relatively less units will be demanded (say, 20 units as shown in the figure). As the price falls, some more consumers who place relatively lesser value on the good also are now able to afford it and find it worthwhile to buy it. Thus, the quantity demanded will increase.
For a given consumer, CS represents the difference between the amount the consumer is willing to pay to acquire the good and the amount she actually pays. The willingness to pay is represented by the vertical distance to the demand curve from the horizontal axis - the willingness to pay is what any point on the demand curve represents.
Thus, the willingness to pay for the 20th unit of the good is Rs 900; for the 40th unit, it is Rs 800; and for the 100th unit, it is Rs 500. If the good sells for Rs 500, say, the total willingness to pay for all of the consumers taken together is the area under the demand curve, which is equal to the sum of the shaded areas A and B, as shown in the figure.
What is the amount that the consumers actually pay for the good? At a price of Rs 500, 100 units of the goods will be bought so that the amount paid will be Rs 500 x 100 = Rs 50,000, which is represented by the area of the shaded rectangle B in the figure.
THE CS, THEN, IS GIVEN BY:
-- CS = Willingness to pay - amount actually paid
= (A+B) - B = A
Thus the CS represents the sum of the gains to all the consumers as a result of purchasing the good at a market price that is lower than the value they place on the good.
PRODUCER SURPLUS:
There is a similar concept of a Producer Surplus (PS), which is also crucial to gain a basic understanding of the effects of trade policy. To illustrate it, let's first consider the industry supply curve for a particular good. The industry supply curve is upward sloping, as shown in Figure 2. The cost of producing an extra unit of the good by the industry (the marginal cost) rises with the quantity produced.
Thus, producers in the industry need a higher price to produce more to cover their costs and that is why the supply curve slopes up. For a given producer, PS represents that difference between the amount received for producing the good and the minimum amount the producer would be willing to accept to produce it. Suppose the industry price is Rs 500 and 100 units of the goods are supplied, as shown by the supply curve in the figure.
What is the minimum amount that the producers would be willing to accept to produce 100 units of the good? This would be the area under the supply curve represented by the shaded area A. This is because any point on the supply curve represents the amount the producers would be willing to accept to produce a particular unit. For example, as shown, to produce the 33rd unit, producers would need Rs 300; to produce the 66th unit, they would need Rs 400; and to produce the 100th unit, they would need Rs 500.
The amount that the producers actually receive for producing 100 units is the price multiplied by the quantity supplied, or Rs 500x100 = Rs 50,000, which is represented in the figure by the areas of the rectangle which forms the sum of the shaded areas A and B.
THE PS IS, THEN, GIVEN BY:
-- PS = Amount received for producing - amount willing to accept to produce
= (A+B) - A=B
Thus, the PS represents the sum of the gains to all the producers as a result of selling the good at a price higher than the amount they would be willing to accept to produce it. In other words, PS could be thought of as producer's profit.
WORLD EQUILIBRIUM
THE POWER OF MARKETS:
Consider the world equilibrium for a single good in the absence of any trade restrictions, illustrated in Figure 3. The price would adjust to equate world demand to world supply and, as shown in the figure.
This happens at the price P = Pw. Now that we are talking about world prices, it should be noted that for our purposes it does not matter here so much whether they are expressed in Rs or US dollars or Euros, or some other currency since throughout our analysis we will be abstract from exchange rate issues and might as well treat the exchange rate as fixed.
The remarkable thing about the equilibrium market-clearing price in the absence of any distortions is that it maximises the sum of consumer surplus and producer surplus, shown by the shaded areas CS and PS in the figure. At a price higher than Pw, say P1 > Pw, there is excess supply.
If price was lower than this, more consumers would be willing to buy the good and there would be producers that are willing to produce it at that price. Thus, the price would fall in this case until the price Pw is reached again. On the other hand, at a price lower than Pw, say P2 < Pw, there is excess demand.
If price was higher than this, more producers would be willing to produce the good, and there would be consumers that are willing to buy it at that price. Thus, the price would rise in this case until the price Pw is reached again.
The above equilibrium is for the world, and it does not imply that demand will equal supply in each country. In the case of those goods in which a country has a comparative advantage in production over other countries, domestic supply will likely exceed domestic demand and the excess supply will be exported.
But the world market would still clear, with excess supply in countries with comparative advantage being matched by equal excess demand in other countries.
Similarly, in the case of goods in which a country does not have a comparative advantage it is likely that domestic demand will exceed domestic supply and the excess will be imported. Again, the world market will clear, with the excess demand in countries having a comparative disadvantage in production being matched by excess supply in other countries.
In sum, the key result here is that the world equilibrium market- determined price maximises the sum of consumer and producer surpluses. Moreover, countries specialise in the production of goods in which they have comparative advantage in, and they are likely to become a net exporter of these goods and a net importer of those goods in which they do not have a comparative advantage.
THE ECONOMICS OF TARIFFS:
A tariff is a tax on the imports of goods. It is one important element of trade policy for any country. There are two main types of tariffs - a specific tariff, which is a fixed tax for each unit of the good imported (eg $2 per barrel of imported oil), or an Ad valorem tariff, which is levied as a fraction of the imported value of a particular good (eg 20 percent of the value of all imported automobiles). Tariffs are imposed both for the purposes of adding to government revenue as well as to try and protect certain domestic sectors of the economy.
Generally, the revenue and protective effects of tariffs occur simultaneously. However, in some special cases only one of these effects occurs at a time. For example, a tariff that is imposed on an import when no domestic producer exists would be a pure revenue tariff; also, a tariff that is imposed is so high that it becomes prohibitive and no goods are imported would be a pure protective tariff. In such a case no government revenue is collected.
SITUATION WITHOUT TARIFFS:
In order to consider the effects of tariffs from the viewpoint of the importing country, let's first set up what the situation might look like without any tariffs. Suppose the world price (Pw) of a good is determined from the equality of world demand and world supply, as shown in Figure 3 (Note that we have expressed the price here in dollars, but given a fixed exchange rate, we could speak interchangeably about the rupee price which would just be a multiple of this).
Since we want to focus on a country importing the good, let's suppose that at this world equilibrium price, the country in question has excess demand for the good and is, therefore, a net importer of the good. Recall that other countries would have to have excess supply and be a net exporter for world equilibrium to hold.
The initial situation without any tariffs is shown in Figure 4. At the world price of $100, the domestic demand for the good in this particular country is 500 units. 100 units of this good are supplied by domestic producers, who are efficient at producing this good.
However, after 100 units have been produced domestically, it is more efficient to import additional units of the good at a cost of $100, since supply curve shows that domestic producers would demand a higher price to produce more than 100 units. Thus, 400 units of the good are imported from abroad.
EFFECTS OF IMPOSING A TARIFF:
Now consider the imposition of a $15 tariff on each unit of imports by the home country (This is 15 percent of the original price of $100). If the domestic price remained at $100, no one will be willing to export the good at the world price of $100. The price difference between the home market and the world market will have to rise to $15 for someone willing to ship the good to the home country from abroad, given the import tax of $15.
In other words, at the old world price of $100, there is now excess supply in the world market (since the demand for imports from the domestic country has fallen). The world price would have to drop and the domestic price inclusive of tariffs would have to rise until the price differential between the two markets was exactly equal to $15.
Suppose this happens at a new world price of Pw* = $95 and a domestic price inclusive of tariffs of PT = $110. At this new higher domestic price, domestic supply rises to 200 units from the previous 100 units, and domestic demand falls to 400 units from the previous 500 units. Therefore, 200 units are now imported, which is less than the previous imports of 400 units.
What are the welfare effects of the imposition of the $15 specific tariff? Let's start with what happens to a consumer surplus. Recall from Figure 1 that the consumer surplus is the area of the triangle that is formed by the vertical axis, the demand curve and the horizontal line at the price at which the good sells. With the domestic price rising from $100 to $110, it is easy to verify that the consumer surplus falls by the amount of the sum of the shaded areas A, B, C and D in Figure 4.
Now consider what happens to producer surplus. Again, recall from Figure 2, that this was the area of the triangle formed by the vertical axis, the supply curve and the horizontal line at the sale price of the good. With the price rising to $110 from $100, the producer surplus increases by the amount of the shaded area A, shown in Figure 4.
In addition to these effects, the government now has tariff revenue of the amount shown by the area of the rectangle which forms the sum of the shaded areas C and E. This is equal, of course, to the tax per unit ($15) multiplied by the quantity of imports (200 units), or $3,000.
THUS, THE NET WELFARE LOSS FROM THE IMPOSITION OF THE TARIFF IS GIVEN BY:
-- Net welfare loss = loss of consumer surplus - gain in producer surplus
-- rise in government revenue
= (A+B+C+D) - A - (C+E) = B+D-E
Domestic producers gain because the tariff increases the domestic price, allowing some domestic producers to compete with the more efficient foreign producers. Consumers lose because the price rises, causing them both to consume less and pay more per unit for the amount that they still consume. The government gains because it has revenue now that it did not have before.
Part of the loss of the consumers becomes the producers gain and washes out on net - this is the area A. Part of the loss of the consumers becomes the government's gain and also washes out on net - this is the area C. However, there are net efficiency losses amounting to the sum of the triangle areas B and D because of the distortions to the incentives to consume and produce caused by the imposition of the tariff.
It should be emphasised that the areas B and D represent net welfare losses that go to nobody. These net losses are caused by the distortion or wedge created by the tariff. Part of this net loss (the area D) is because consumption of the good falls from 500 to 400 units; and part of it (the area B) is because more costly domestic production to the tune of 100 units is being substituted for less costly foreign production.
Offsetting this is a net gain to the domestic economy, arising from the fact that the tariff causes the world price of the good to fall to $95 from $100, which is represented by the area E. If the domestic country is relatively small, as in the case of Pakistan, its decrease in import demand resulting from the higher tariff would be expected to have only a negligible downward effect on the world price and the area E would be very small. Most of the burden of the tariff would then be borne by domestic consumers, and the imposition of the tariff would represent a net welfare loss to the nation.
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