Solution 8

Import Tariffs and Quotas under Perfect Competition

8

1. The following questions refer to Side Bar: Key Provisions of the GATT. a. If the United States applies a tariff to a particular product (e. g. , steel) imported from one country, what is the implication for its steel tariffs applied to all other countries according to the “most-favored-nation” principle? Answer: The MFN principle levels the playing field among countries with regard to any “advantage, favour, privilege or immunity granted by any contracting party to any product. . . ” Thus, if the United States removed a tariff on steel imports from a particular country, it would necessarily have to remove it for the other GATT countries. Thus MFN treatment would prevent the application of a steel tariff to certain countries whereas others had lower or no tariffs. Conversely, a uniform tariff on steel imports from all countries alike would not violate the MFN principle. b. Is Article XXIV an exception to most-favored-nation treatment? Explain why or why not. Answer: Article XXIV allows for the creation of customs unions and free-trade areas. By definition, these contradict the MFN principle: Trade barriers are lowered within the area or union without a corresponding decrease in barriers to outside countries. c. Under the GATT articles, instead of a tariff, can a country impose a quota (quantitative restriction) on the number of goods imported? What has been one exception to this rule in practice? Answer: Article XI expressly prohibits the application of quantitative restrictions by any GATT country to any product. The MFA was a notable exception in practice; it allowed Canada, the United States, and Europe to restrict the amount of textiles and apparel products that were imported from garment-producing countries.

S-69

S-70

Solutions

■

Chapter 8

Import Tariffs and Quotas under Perfect Competition

2. Consider a small country applying a tariff, t, to imports of a good like that represented in Figure 8-5. a. Suppose that the country decides to reduce its tariff to t!. Redraw the graphs for the Home and import markets and illustrate this change. What happens to the quantity of goods produced at Home and their price? What happens to the quantity of imports? Answer: The reduction of the tariff, and corresponding decrease in domestic price in the small country, leads to a reduction in domestic production (to S3) and an increase in domestic quantity demanded (to D3). The result is an increase in imports (to M3). See the following figure. Price

Price

S

PW + t

X*+ t

PW +

t! PW

X* M

D S1 S3 S2

D2 D3 D1

(a) Domestic market

Quantity

M2

M3

M1

Imports

(b) Import market

b. Are there gains or losses to domestic consumer surplus due to the reduction in tariff? Are there gains or losses to domestic producer surplus due to the reduction in tariff? How is government revenue affected by the policy change? Illustrate these on your graphs. Answer: Consumer surplus increases because consumers now buy a greater quantity of products at a lower price. Domestic producer surplus, on the other hand, decreases because producers sell a smaller quantity of products at a lower price. Government revenue changes from the rectangle S2D2P WP W " t to the rectangle S3D3P WP W " t!. Notice that the area of the rectangle does not necessarily decrease when the tariff is lowered because, although the tax per import is less, the amount of imports has increased. c. What is the overall gain or loss in welfare due to the policy change? Answer: The overall welfare gain from the reduction in the tariff is illustrated by the decrease in total deadweight loss. On our graphs this is the reduction in the size of the striped triangles; after the reduction in the tariff, total deadweight loss is represented by the smaller shaded triangles. 3. Consider a large country applying a tariff, t, to imports of a good like that represented in Figure 8-7. a. How does the export supply curve in panel (b) compare with that in the smallcountry case? Explain why these are different. Answer: The export supply curve is upward-sloping in the large-country case (it was horizontal in the small-country case). In the small-country case, a horizontal export supply curve means that the supply of exports from the rest of the world is infinitely elastic. This corresponds to the price taking assumption in perfect competition. In contrast, an upward-sloping export supply curve means that the price of exports from the rest of the world responds when the large country changes its import demand. For instance, if the large-country importer applies a

Solutions

■

Chapter 8

Import Tariffs and Quotas under Perfect Competition

tariff that decreases its demand for imports, the price charged by foreign exporters falls. b. Explain how the tariff affects the price paid by consumers in the importing country, and the price received by producers in the exporting country. Use graphs to illustrate how the prices are affected if (i) the export supply curve is very elastic (flat), or (ii) the export supply curve is inelastic (steep). Answer: Refer to Figure 8-5: In the small-country case (flat export supply curve), a tariff increases the amount that consumers pay by exactly the amount of the tariff and foreign exporters are paid the original world price, P *; the difference is collected by the domestic government as tax revenue. Refer to Figure 8-7:With an upward-sloping export supply curve (in the large-country case) foreign exporters reduce their price due to a tariff; that is, foreign exporters receive less than they did prior to the tariff. Domestic consumers pay more than before, but by less than the full amount of the tariff. Again, the difference between what consumers pay and what Foreign exporters receive is the amount of the tariff, t, collected by the domestic government. In the large-country case, the incidence of the tariff is shared by domestic consumers and foreign producers. Moreover, a steeper foreign export supply curve implies that foreign exporters absorb more of the price increase due to the tariff. 4. Consider a large country applying a tariff, t, to imports of a good like that represented in Figure 8-7. How does the size of the terms-of-trade gain compare with the size of the deadweight loss when (i) the tariff is very small, and (ii) the tariff is very large? Use graphs to illustrate your answer. Answer: Refer to panel (b) of Figure 8-7: As the size of the tariff increases, the export supply curve shifts upward by more, M2 decreases by more (relative to M1), and the size of the triangle with area b " d increases relative to rectangle e. That is, consumer deadweight losses get larger relative to terms-of-trade gains due to the tariff. We can interpret this as meaning that for small tariffs the welfare gains from termsof-trade improvements outweigh consumer deadweight losses, but the opposite is true for tariffs that are sufficiently large. 5. Consider the following scenarios: a. If the foreign export supply is perfectly elastic, what is the optimal tariff Home should apply to increase welfare? Explain. Answer: This is the small-country case. Because the incidence of the tariff is shouldered completely by consumers and there is no terms-of-trade gain to applying a tariff, the optimal tariff is zero. b. If the foreign export supply is less than perfectly elastic, what is the formula for the optimal tariff Home should apply to increase welfare? Answer: This is the large-country case. The optimal tariff is determined as: 1 , where E X* is the Foreign export supply elasticity. t # $$ E X* c. What happens to Home welfare if it applies a tariff higher than the optimal tariff? Answer: Refer to Figure 8-8: For a tariff higher than the optimal tariff, welfare declines because deadweight losses increasingly outweigh terms-of-trade gains. For a sufficiently high tariff, welfare can go as low as the autarky level. 6. Rank the following in ascending order of Home welfare and justify your answers. If two items are equivalent, indicate this accordingly. a. Tariff of t in a small country corresponding to the quantity of imports M.

S-71

S-72

Solutions

■

Chapter 8

Import Tariffs and Quotas under Perfect Competition

b. Tariff of t in a large country corresponding to the same quantity of imports M. c. Tariff of t! in a large country corresponding to the quantity of imports M! % M. Answer: a & c & b. For the same quantity of imports, M, Home welfare is greater in the large-country case relative to the small-country case because (assuming an optimal tariff) the terms-of-trade gain partially offsets the deadweight losses due to the tariff; thus, a & b. A larger quantity of imports implies that t! & t. Therefore, in the large-country case with optimal tariff t, the welfare associated with a tariff of t! is somewhere in between the small-country case and the large-country case; thus, a & c & b. 7. Rank the following in ascending order of Home welfare and justify your answers. If two items are equivalent, indicate this accordingly. a. Tariff of t in a small country corresponding to the quantity of imports M. b. Quota with the same imports M in a small country, with quota licenses distributed to Home firms and no rent seeking. c. Quota of M in a small country with quota licenses auctioned to Home firms. d. Quota of M in a small country with the quota given to the exporting firms. e. Quota of M in a small country with quota licenses distributed to rent-seeking Home firms. Answer: d # e & a # b # c. A tariff t corresponding to imports M, and a quota on M units of import corresponding to tariff t are equivalent in terms of welfare so long as proceeds from quota rents remain in the Home country and are not squandered by rent-seeking activities: a # b # c. When quota rents are either given away to Foreign firms or are squandered completely by Home firms seeking access to rents, Home welfare diminishes by an equal amount (the amount of the quota rents): d # e & a # b # c. 8. Why did President George W. Bush suspend the U. S. tariffs on steel seventeen months ahead of schedule? Answer: The threat of a tariff war from the European Union, Brazil, China, Japan, South Korea, New Zealand, Norway, and Switzerland in response to the U. S. steel tariff led President Bush to suspend the import tax earlier than the initial three-year schedule. 9. What provision of U. S. trade law was used by President Barack Obama to apply a tariff on tires imported from China? Does this provision make it easier or harder to apply a tariff than Section 201? Answer: President Obama used Section 421 to apply the tariff on imports of tires from China. Section 421, which is a China-specific safeguard provision, is easier to apply because it requires a lower level of injury to a U. S. industry. To apply safeguard tariffs under section 421 the U. S. International Trade Commission (ITC) need only find that rising imports from China are a “significant cause of material injury, or threat of material injury, to the domestic industry. ” To impose a tariff under Section 201, the U. S. ITC must find that increased imports are the most important cause of material injury. 10. No U. S. tire producers joined in the request for the tariff on tires in 2009. Rather, the petition for a tariff on tires imported from China was brought by the United Steelworkers of American, the union who represents workers in the tire industry. Why did major tire manufactures operating in the United States, like Goodyear, Michelin, Cooper, and Bridgestone, not support the tariff? Answer: Tire manufactures operating in the United States did not support the tariff because many of them already manufacture tires in China. Of the ten manufactures operating in the United States, seven also produce tires in China, so a tariff on tires imported from China would make it more costly for them to produce in China.

Solutions

■

Chapter 8

Import Tariffs and Quotas under Perfect Competition

11. Suppose Home is a small country. Use the graphs below to answer the questions. Price

Price

18

S

9 8

X *+ t

6

X*

4

D 2

4

5

6

8

M 2

Quantity

(a) Home market

6

Import

(b) Import market

a. Calculate Home consumer surplus and producer surplus in the absence of trade. Answer: Total surplus in the absence of trade is 35. Consumer surplus without tariff:

CS #

1 $$ 2

Producer surplus without tariff:

PS #

! 5 ! (18 ' 9)

CS # 22. 5

1 $$ 2

! 5 ! (9 ' 4)

PS # 12. 5

b. Now suppose that Home engages in trade and faces the world price, P * # $6. Determine the consumer and producer surplus under free trade. Does Home benefit from trade? Explain. Answer: Home is better off with trade because total surplus increases by 15 (i. e. , total surplus under trade is 50). Consumer surplus under free trade:

CS #

1 $$ 2

Producer surplus under free trade:

PS #

! 8 ! (18 ' 6)

CS # 48

1 $$ 2

! 2 ! (6 ' 4)

PS # 2

c. Concerned about the welfare of the local producers, the Home government imposes a tariff in the amount of $2 (i. e. , t # $2). Determine the net effect of the tariff on the Home economy. Answer: The net effect on Home welfare is '8. Consumer surplus with tariff:

CS #

1 $$ 2

Producer surplus with tariff:

PS #

! 6 ! (18 ' 8)

CS # 30

1 $$ 2

PS # 8

Government with tariff: Government # (6 ' 4) ! (8 ' 6) Government # 4 Fall in consumer surplus:

'18

Rise in producer surplus:

"6

Rise in government revenue:

"4

Net effect on Home welfare:

'8

! 4 ! (8 ' 4)

S-73

S-74

Solutions

■

Chapter 8

Import Tariffs and Quotas under Perfect Competition

12. Refer to the graphs in problem 11. Suppose that instead of a tariff, Home applies an import quota limiting the amount foreign can sell to 2 units. a. Determine the net effect of import quota on the Home economy if the quota licenses are allocated to local producers. Answer: An import quota of 2 units has the same net effect on Home welfare as an equivalent tariff of $2 when the quota licenses are allocated to local producers as long as the firms do not participate in rent-seeking activities. Price

X

Price S

18

9 8 6

X*

4

M

D 2

4

5

6

8

2

Quantity

(a) Home market

6

Import

(b) Import market

Fall in consumer surplus:

'18

Rise in producer surplus:

"6

Quota rents earned at Home:

"4

Net effect on Home welfare:

'8

b. Calculate the net effect of the import quota on Home’s welfare if the quota rents are earned by foreign exporters. Answer: Fall in consumer surplus:

'18

Rise in producer surplus:

"6

Net effect on Home welfare:

'12

c. How do your answers to parts (a) and (b) compare with part (c) of problem 11? Answer: With an import quota of 2 units the net effect on Home welfare is equivalent to that of a tariff of $2 (i. e. , the net effect on Home welfare is '8) when the quota licenses are allocated to local producers. If the quota rents are earned by foreign exporters, Home welfare falls further so that the net effect is '12. 13. Consider a small country applying a tariff, t, such as in Figure 8-5. Instead of a tariff on all units imported, however, we will suppose that the tariff applies only to imports in excess of some quota amount M! (which is less than the total imports). This is called a “tariff-rate quota” (TRQ) and is commonly used on agricultural goods. a. Redraw Figure 8-5, introducing the quota amount M!. Remember that the tariff applies only to imports in excess of this amount. With this in mind, what is the rectangle of tariff revenue collected? What is the rectangle of quota rents? Explain briefly what quota rents mean in this scenario. Answer: Refer to the following figure: For the small-country tariff case, tariff revenue equals the tariff per import multiplied by the amount of imports. In panel (b), this is represented by the rectangle a " b. With the TRQ, only M!M2

Solutions

■

Chapter 8

Import Tariffs and Quotas under Perfect Competition

imports are subject to the tariff. Therefore the government collects t ! M!M2 # b. Because the new domestic price is P * " t, someone has the ability to buy (or produce) abroad for P * and sell domestically for P * " t. This differential is called quota rents and can be represented by the amount of the quota multiplied by the difference between domestic and world price: t ! M! # a. Price

Price

S

X* + t

P* + t a

b

P*

X* M D S1 S2

D2

D1

Quantity

(a) Domestic market

M!

M2

M1

Imports

(b) Import market

b. How does the use of a TRQ, rather than a tariff at the same rate, affect Home welfare? How does the TRQ, as compared with a tariff at the same rate, affect Foreign welfare? Does it depend on who gets the quota rents? Answer: If the quota rents stay at Home and are not squandered by rent seekers (that is, they are collected by the government through auction or given to Home firms), then Home’s welfare is the same as under a tariff. However, if quota rents are given to the foreign country, then Home’s welfare is less than under a tariff. By analogous reasoning, if quota rents stay at Home, then Foreign’s welfare is unchanged, whereas if quota rents are sent abroad, then Foreign’s welfare is higher. c. Based on your answer to part (b), why do you think TRQs are used quite often? Answer: Given that the Foreign country’s welfare decreases with the addition of a tariff on its exports to Home (i. e. , it sells fewer goods to Home at the same price or less than before), Home can make the situation more politically palatable to Foreign by implementing a TRQ and giving away the quota rents to foreign firms. 14. Consider the following hypothetical information pertaining to a country’s imports, consumption, and production of T-shirts following the removal of the MFA quota:

World price ($/shirt) Domestic price ($/shirt) Domestic consumption (million shirts/year) Domestic production (million shirts/year) Imports (million shirts/year) MFA, multifibre arrangement.

With MFA

Without MFA (Free Trade)

$2.00 $2.50 100 75 25

$2.00 $2.00 125 50 75

S-75

S-76

Solutions

■

Chapter 8

Import Tariffs and Quotas under Perfect Competition

a. Graph the effects of the quota removal on domestic consumption and production. Answer: With the quota removal, domestic consumption increases from 100 units to 125 units, whereas production decreases from 75 units to 50 units. Price

Price

X

S

2.50 2.00

a

b

c

b+d

d D

50

75

M

125 Quantity

100

(a) Home market

25

75

Import

(b) Import market

b. Determine the gain in consumer surplus from the removal of the quota. Answer: Consumers gain by the areas a " b " c " d with the removal of the quota. c. Determine the loss in producer surplus from the removal of the quota. Answer: Producers lose by the area a with the removal of the quota. d. Calculate the quota rents that were earned under the quota. Answer: The quota rents are 12. 5[# (2. 50 ' 2. 00)(100 ' 75)]. e. Determine how much the country has gained from removal of the quota? Answer: The gain to the country from the removal of the quota is 12. 5 " 6. 25 " 6. 25 # 25.

area b #

1 $$ 2

! (75 ' 50) ! (2. 50 ' 2. 00)

area b # 6. 25 area d #

1 $$ 2

! (125 ' 100) ! (2. 50 ' 2. 00)

area d # 6. 25 15. Suppose that a producer in China is constrained by the MFA to sell a certain number of shirts, regardless of the type of shirt. For a T-shirt selling for $2. 00 under free trade, the MFA quota leads to an increase in price to $2. 50. For a dress shirt selling for $10. 00, the MFA will also lead to an increase in price.

With MFA Domestic price of t-shirt ($/shirt) Domestic price of dress shirt ($/shirt) MFA, multifibre arrangement.

$2.50 $?

Without MFA (Free Trade) $2.00 $10.00

Solutions

■

Chapter 8

Import Tariffs and Quotas under Perfect Competition

a. Suppose that the MFA leads to an increase in the price of dress shirts from $10 to $11. Will the producer be willing to export both T-shirts and dress shirts? (Remember that only a fixed number of shirts can be exported, but of any type. ) Explain why or why not. Answer: The MFA is tantamount to an increase in rents on each of the imports falling under the quota amount. Because Chinese shirt producers receive these rents in the form of higher prices, they will only export the product which has the greatest price increase. As such, they will export only dress shirts. b. For the producer to be willing to sell both T-shirts and dress shirts, what must be the price of dress shirts under the MFA? Answer: The producer will sell both types of shirts if the price increase of dress shirts is also $0. 50; the price of dress shirts under the MFA is $10. 50. c. Based on your answer to part (b) calculate the price of dress shirts relative to T-shirts before and after the MFA. What has happened to the relative price due to the MFA? Answer: The relative price of dress shirts before the MFA is $10 / $2 # 5. The relative price of dress shirts under the MFA is $10. 50 / $2. 50 # 4. 2. The relative price of dress shirts has declined. d. Based on your answer to part (c), what will happen to the relative demand in the United States for dress shirts versus T-shirts from this producer, due to the MFA? Answer: Relative demand for dress shirts will increase. e. Thinking now of the total export bundle of this producer, does the MFA lead to quality upgrading or downgrading? How about the removal of the MFA? Answer: The MFA causes quality upgrading. Demand for dress shirts increases relative to T-shirts, causing the relative amount of dress shirts in the Chinese exporter’s bundle to increase. Removing the MFA would drive up the relative price of dress shirts with converse effects on the average quality of the exporter’s bundle.

S-77