Jakob Steffen

Tariffs

–

Costs and Benefits

December 2005

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1. Introduction

Tariffs, quotas and other barriers are distorting trade around the world. In

2004/2005, the average import tariff rate in the EU was 4.2%, whereas it was about

3.7% in the USA. In developing countries, this rate was significantly higher: in India

it even reached 29.1%, for example1. And only recently Robert Portman, US trade

representative, and Peter Mandelson, EU trade commissioner, pleaded for maximum

tariff rates at 75% and 100%, respectively2. This essay’s aim is to examine and to

assess three of the arguments for and against protection (i.e., the imposition of trade

barriers). It will also focus on the import tariff (denoted by ‘tariff’ in the following

text) which is yet only a small part of the range of protectionism’s toolkit, including

import quotas, instruments restricting or encouraging exports, product standards,

domestic content requirements, etc. The evaluation of arguments will begin with the

most important one against trade distortions being the loss of welfare; also, the

exception to the rule when a tariff actually raises national welfare will be presented.

Finally, the text will move on to an interesting argument in favour of a tariff, the

developing government argument, and will close with a rather poor one, namely, the

income redistribution argument.

2. Evaluation of arguments

The main argument against trade barriers: loss of welfare

Provided the situation where a country is too small to influence the world price of

a commodity (the ‘small-country case’), all trade barriers and hence a tariff lead

unambiguously to a deadweight loss of welfare for the protectionist country and for

the world as a whole (though the ‘developing government’ argument describes the

single situation where a tariff eventually can make the world better off, see below).

‘Deadweight loss’ means a loss of welfare suffered by one particular party which is

not compensated by the gain of another; thus, it is a net loss for the country imposing

a tariff. As far as ‘welfare’ is concerned, this essay sticks to the traditionally applied

concepts of ‘consumer-‘ and ‘producer surplus’. In addition, this essay uses the

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usually assumed yardstick of the ‘one-pound-vote’ rule valuing equally each pound

lost or won by either consumers or producers to determine (national) welfare.

Under the further assumption that the analysed market is perfectly competitive,

the implementation of a tariff results in a loss of consumer surplus being represented

by areas a, b, c, and d in Figure 1A. Area a stands for the part of consumer surplus

merely changing hands between consumers and producers, whereas area c equals the

fraction of consumer surplus seized by the government in the form of the tariff’s

revenues. Areas b and d show the elements of the deadweight loss of national welfare:

area b represents the waste of resources used up by the increased domestic production

which is inefficient compared with foreign producers (known as the ‘production

effect’ of the tariff). Area d represents the part of consumption which has been made

up by imports whose price was below the consumer’s marginal willingness to pay and

which they are now made to forgo (the ‘consumption effect’ of the tariff). The total

national welfare loss may also be shown on the world market (area b+d in Figure 1B).

Overall, the argument aiming at the loss of national welfare is very convincing: a

tariff cannot possibly be justified if it results in a poorer nation (‘poor’ in terms of the

definition of welfare used here).

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However, a so called ‘nationally optimal’ or ‘optimal’ tariff (Bickerdike, 1906)3

may raise the welfare of a nation as a whole, too. To implement an optimal tariff, a

nation must be a monopsonist (i.e., it must dominate demand for a certain good). In

this situation, the large country is able to change the Terms of Trade (the number of

imported commodity units it gets for one exported unit) to its benefit by making

foreign exporters to cut their price by part of the tariff. The gain from that change

(amount of imports times the price-cut by foreign exporters, area e in Figure 2) may

outrank the still occurring deadweight loss of national welfare (again area b+d in

Figure 2). An optimal tariff, therefore, seems to be fairly attractive; nonetheless,

nations being large enough (like the United States) refrain from imposing it. The

reason for this reluctance lies in the very likely retaliation by the affected trade

partners; thus, it remains an only theoretically appealing concept. Furthermore, such a

tariff still makes the world worse off: foreign exporters receive no compensation for

their price-cut, and they face a deadweight loss of producer surplus (area f in Figure 2)

in addition to the self-inflicted deadweight loss of welfare in the protectionist country.

P

Q Q

A. Domestic market B. World market

Dw

Sw a

b d

c

S0 S1 D1 D0

Dd

Sd

b + d

c

D1-S1 D0-S0

P

Figure 1 Welfare loss from a tariff, small-country case, perfect competition

Sw: world supply curve Dw: demand curve for imports P: price Sd: domestic supply curve Dd: domestic demand curve Q: quantity D1-S1: imports with tariff D0-S0: imports with free trade Pa: price in autarky P0: free trade price P1: free trade price + tariff

P0

P1 Pa

Tariff

0 0

-Figure is not drawn to scale-

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Arguments in favour of a tariff: the developing government argument

The developing government argument as presented by Lindert and Pugel (1996)4

is a very strong argument in favour of a tariff. In countries with a quite weak

government in terms of administrational power, a tariff becomes the most important

source of public revenues. Firstly, it is easy to collect. Since there is only a certain

number of main ports, airports, and other border crossings, it is comparatively

effortless to levy customs duties there (instead of implementing an income-tax, for

example). Secondly, the amount of money collected by means of a tariff is quite

substantial: Many low-income countries receive between one-quarter and three-fifths

of their public revenues from tariffs4.

Q

World market

Dw

Sw b + d

D1-S1 D0-S0

P

Figure 2 Welfare loss and Terms of Trade gain from an ‘optimal tariff’

Pf e f

P0

Pd

0

Sw: world supply curve Dw: demand curve for imports P: price D0-S0: imports with free trade D1-S1: imports with tariff Q: quantity P0: free trade price Pd: price for domestic consumers Pf: price for foreign exporters

-Figure is not drawn to scale-

Tariff

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When spent wisely, the revenues from a tariff help an emerging country to

increase the supply of otherwise heavily restricted public goods like health care or

education and thereby enhance that country’s stage of economic development. In the

long run, the additional welfare resulting from the improved economic status

surpasses the initial costs of the tariff for the world as whole. This insight is one of the

reasons why, after a series of ‘trade rounds’ (of which the latest started in Doha,

December 2001), developing countries are allowed to be singularly protectionist.

Arguments in favour of a tariff: income redistribution

One of the most popular arguments in favour of a tariff concerns income

redistribution in order to iron out the sometimes vastly unjust allocation of the gains

and losses resulting from free trade. In particular, the supporters of this argument

often refer to the (real) wage rate in industrialised countries allegedly forced down by

competition from imports. Their main theoretical support comes from the famous

theorem devised by William F. Stolper and Paul A. Samuelson (1941)5 saying that a

rise in the relative price of a good leads to an increase in the real return of the factor

used relatively intensively in the production of that good. Hence, if a tariff is imposed

on relatively labour-intensive goods, the real wage rate ought to rise. Although the

logic of this first part of the argumentation is correct, its supporters fail to give a

reason why a tariff should be the best instrument to deal with the redistribution of the

results from free trade.

In fact, it is not. Instead, it is by far the worst tool to do so: a tariff always

downsizes the ‘income pie’ to be distributed6 (see the deadweight loss of national

welfare analysed above). The instruments of the modern welfare state (taxes and

transfer payments) are obviously far more efficient to solve the problem. Although

taxes are, strictly put, no better distortions than a tariff, they at least do not provoke

retaliation by other countries which leads inevitably to an even larger loss of welfare.

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3. Conclusion

The strongest case for a tariff (and only for this specific trade barrier) is the

developing government argument. If the receipts from a tariff are used to improve

public services in a poor country (a basic requirement for economic development), a

tariff actually makes not only that country, but also the world better off. As the utmost

possible contrast, the income redistribution argument shows the uselessness of a tariff

when implemented as an indirect means to cope with a specific problem: the

distortions it produces in areas which are not involved in the problem whatsoever

outrank its benefits easily.

Foreign retaliation will, moreover, certainly harm the export sector of the

protectionist country; thus, a tariff endangers more jobs and production than it

protects in the first place. In general, the probability of retaliation is a very strong

argument against trade barriers: one restriction of trade is bad enough, but if it

develops into a net of trade distortions, the loss of welfare for the world as a whole is

even more disastrous. Therefore, how is it possible that trade barriers are still so

common? Dunn and Ingram (1996)7 give a clear and uncomfortable answer: almost

always, the particular interests of groups losing from free trade are very well

organised, whereas the general interest of society gaining from free trade (yet with

every individual gaining only a little) is advocated fairly badly.

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References Main reference

Lindert, Peter H. and Pugel, Thomas A. (1996) International Economics, 10th Edition, Chicago & London: Irwin. Other references

Dunn, Robert M. and Ingram, James C. (1996) International Economics, 4th Edition, New York & Chichester (England): John Wiley & Sons.

Husted, S. and Melvin, M. (1998) International Economics, 4th Edition, New York & Harlow (England): Addison-Wesley.

Krugman, Paul R. and Obstfeld, M. (1997) International Economics, 4th Edition, New York & Harlow (England): Addison-Wesley. Endnotes 1 WTO Statistics database – Trade Profiles – Column “Applied 2004/2005”. [http://stat.wto.org/CountryProfile/WSDBCountryPFView.aspx?Language= E&Country=E25,IN,US] 2 “The Doha trade round - A stopped clock starts ticking again” in The Economist,

Vol. 377, No. 8448, 15 October 2005, pp. 78, 79. 3 Bickerdike, Charles F. (1906) “The Theory of Incipient Taxes”, Economic Journal,

Vol. 16, pp. 529-35. 4 Lindert, Peter H. and Pugel, Thomas A. (1996) International Economics, 10th

Edition, Chicago & London: Irwin, p. 167. 5 Stolper, William F. and Samuelson, Paul A. (1941) “Protection and Real Wages” in

Review of Economic Studies, Vol. 9, pp. 58-73. 6 Lindert, Peter H. and Pugel, Thomas A. (1996) International Economics, 10th

Edition, Chicago & London: Irwin, p. 168. 7 Dunn, Robert M. and Ingram, James C. (1996) International Economics, 4th Edition,

New York & Chichester (England): John Wiley & Sons, p. 173.