Trade Policy Concerns: Tariff

Lecture 3
How to use Consumer and Producer
Surplus concepts for understanding
Welfare Effects of Trade?
 Consumer Surplus: Concept-Geometry
• Consumer surplus – additional benefit obtained by
the buyer of a good
Price, P • difference between the maximum that the buyer
is willing to pay and the actual price
• area below demand and above price

• At Price P1, CS = a
• At Price P2, CS = a + b
a • If price falls, the consumers
are motivated to demand more
and CS increases.
P 1
• If import tariff t is increased,
t b the price for the consumers
P 2
increases from P2 to P1,
resulting loss of CS.
• If price increases from P2 to P1
due to the tariff increase, total
D loss in CS is b.

Q 1 Q 2 Quantity, Q
 Producer Surplus: Concept-Geometry
• Producer Surplus – additional benefit obtained by
the seller of a good
• difference between the minimum that the seller is
Price, P willing to accept and the actual price
• area above supply and below price
S
• At Price P1, PS = c
• At Price P2, PS = c + d
P 2
• If import tariff t is imposed,
t d the price increase from P1 to
P 1
P2 motivates producers to
c produce more and there is
gain of PS.
• If price increases from P1 to
P2 by tariff increase, gain in
PS is d.

Q 1 Q 2
Quantity, Q
How do we distinguish Small and Large
Countries in International Trade?
 Small Country: What it means?
A: Normal Scenario B: Supply Shock

S S

P* E P* E

D D

C: Demand Shock • Suppose the demand and supply conditions

represent world wheat market.
So, Small
S • A: Initially P* denotes the equilibrium
Country is a
price.
Price-Taker
• B: Suppose there is a crop failure in India
and it decides not to export wheat.
P* E However, since India is a small player,
world supply will not be greatly affected
and world price will remain almost
unchanged at P*.
D • C: Similarly, if demand increases in
Jamaica, the D and S curves will not shift.
 Large Country: What it means?
A: Normal Scenario B: Supply Shock
S’ S
S

P1
P* E P* E

D D

C: Demand Shock • Suppose the demand and supply

conditions represent world petroleum
So, Large
S market.
Country is a
• A: Initially P* denotes the equilibrium
Price-Maker
price.
• B: Suppose OPEC decides to cut
P* E production of petroleum. Then global
P1 supply will shrink to S’ and world price
will increase to P1.
• C: Similarly, if there is recession in
D the US and EU, demand will shift to D’
D’
and world price will fall to P1.
 Large Country: Hypothetical Scenario
• World Price of the import product, pulses = $100
• India domestic price = $120

• Tariff = 10%

• World Price for Indian consumers, after tariff = $110

• World import = 10000000 units

• India imports = 400000 units
• India reduce import of 20000 units

• All exporters would sense an oversupply in the world market, they’ll go for price discount

• New world price = $95

WS
• Tariff = 10%

• Indian consumers pay an import price of = 104.5 A

Pw B

P’w
WD
W’D
 Welfare Effect of Tariff in
Small / Large Country

• Px / Pm = Terms of Trade

• If TOT improves, then welfare of a country is improving:

• Say, Px = 114
• PM = 100

• (Px / Pm)pre-tariff = 114/100 – Small Country

• (Px / Pm)post-tariff = 114/100 – Small Country

• (Px / Pm)pre-tariff = 114/100 – Large Country

• (Px / Pm)post-tariff = 114/95 – Large Country
 Which Factors may Increase / Reduce
Export Price?
Px = Export Price

• Price Rise
• Demand more than Supply
• Monopoly of exporter – Raw material control, Technology
product
• Supply shock – input price rise

• Price Reduction
• Newer entrants in other country
• Sunset phase
• Economies of scale – cost reduction
• Poor quality
• Subsidy by government
How to Interpret the TOT Change
Scenarios?
Px / Pm Rises Px / Pm Falls
Share in World Quality gains EOS, Subsidy
Market Rises
Share in World Raw material Poor quality
Market Falls cost rising
 Effects of an Import Tariff

Home
Home market
market World
World market
market Foreign
Foreign market
market

Price, P Price, P Price, P

S S*
XS

PT
2
1
PW
t P *
T

MD
D*
D

Quantity, Q QT QW Quantity, Q Quantity, Q

 Effect of Tariff
• The terms of trade is the relative price of the exportable good
expressed in units of the importable good.
• A small country is a country that cannot affect its terms of trade
no matter how much it trades with the rest of the world.
• Assume that two large countries trade with each other.
• Suppose Home imposes a tariff of $t (say, $2) on every bushel of
wheat imported.
• Then shippers will be unwilling to move the wheat unless the price
difference between the two markets is at least $2.
• In the absence of tariff, the world price of wheat (Pw) would be
equalized in both countries.
• With the tariff in place, the price of wheat rises to PT at Home and
falls to P*T (= PT – t) at Foreign until the price difference is $t.
 The Effects..
• In Home: producers supply more and consumers demand less due
to the higher price, so that fewer imports are demanded.
• In Foreign: producers supply less and consumers demand more
due to the lower price, so that fewer exports are supplied.
• Thus, the volume of wheat traded declines due to the imposition
of the tariff.
• The increase in the domestic Home price is less than the tariff,
because part of the tariff is reflected in a decline in Foreign’ s
export price.
• If Home is a small country and imposes a tariff, the foreign
export prices are unaffected and the domestic price at Home
(the importing country) rises by the full amount of the tariff.
How will Tariff Imposition work out
for a Small Nation?
 Tariff Welfare Effects – Small Nation
• In the pre-Trade scenario, the Consider the automobile market.
domestic market is represented
by Sd and Dd curves.
Pre-Trade
• Domestic market equilibrium is
reached at E (US $ 9,500 and
50 units).
• U.S. consumer surplus is area in
red.
• U.S. producer surplus is area in
green.
• The world price is Sd+w, which
signifies that home is less
efficient in production of autos.
• Now suppose the country
adopts the policy of Free Trade
and the tariff is reduced to
zero.
 Tariff Welfare Effects – Small Nation
• Free-Trade equilibrium is
reached at F, where home
demands 80 units Free-Trade
(intersection of Dd and
Sd+w), produces 20 units
(intersection of Dd and Sd)
and imports 60 units.
• Consumer surplus then is
represented by areas a, b,
c, d, e, f and g.
• Producer surplus however
decreases by areas a and e.
• The overall increase in
welfare is b, c, d and f. J
• Since the producers are
hurt, they might lobby to
the government for
subsidy, tax relief and
similar policies.

So, free trade is the best policy for small countries

 Tariff Welfare Effects – Small Nation
• Now suppose, the Tariff Intervention
country goes for a
$1000 Tariff on imports.
• The resulting
developments are noted
in the diagram.
• c = revenue effect = lost
consumer surplus, now
government revenue.
• a = redistributive effect
= shift from consumer to
producer surplus
• b + d = deadweight loss
= benefits lost to all
parties
• b = protective effect
• d = consumption effect

• b happens because resources which are less adaptable to auto production

are also being diverted for that purpose.
• d happens because consumption falls owing to import-augmented price
increase.
India Increased Duty on Solar Cells
 Global Evidence
• Automobile Tariff in ASEAN and emergence as part of Auto-GVCs
• India’s Tariff Policy in pre-91 days
• India’s Tariff policy in technology-intensive products in recent
period
https://blogs.worldbank
.org/psd/how-do-
import-tariffs-cars-
affect-
competitiveness-case-
india-and-pakistan
How will Tariff Imposition work out
for a Large Nation?
 Tariff Welfare Effects – Large Nation
Pre-Trade
• Here foreign supply
price is not a fixed
constant, but
depends on price.
• Before Trade:
• E is the equilibrium
point where Sd
intersects with Dd.
• US consumer
surplus is area in
red
• US producer
surplus is area in
green.
 Tariff Welfare Effects – Large Nation
• With Free Trade: Free-Trade
• F is the equilibrium point
where world price Sd + w
intersects with Dd.
• Consumer surplus increases
substantially, and is denoted
by the red region.
• Producer surplus decreases
and is denoted by the green
region.
• The overall increase in
welfare is b, c, d and the
triangle above.
J
• Total demand = 110 units
• Domestic production = 30
units
• Imports = 80 units
 What’s different with Large Countries?
Effect of increases in US Tariffs on the world prices of imported goods
Product Tariff (or equivalent) Increase in US Price Decrease in World Price
Ball bearings 11.0 10.2 0.8
Chemicals 9.0 6.5 2.5
Jewelry 9.0 5.4 3.6
Orange juice 30.0 21.7 8.3
Glassware 11.0 7.3 3.7
Luggage 16.5 11.0 5.5
Resins 12.0 5.4 6.6
Footwear 20.0 16.1 3.9
Lumber 6.5 4.1 2.4

Suppose US • When a country imposes tariff, the price of the product in the import
impose tariff on market increase, as a result of which demand falls.
Indian exports • Hence exporting countries try to reduce their price so as to partially nullify
the effect of tariff.
• TOTUS = PX / PM
• With the imposition of tariff, Indian players will reduce PM, as a result of
which USA TOT increase.
• Suppose USA’s export price is 100. A 10 percent tariff increase is imposed.
However price is reduced to 98, and the post-tariff price would be 107.8,
not 110. So, consumer surplus suffers but not to the fullest extent of tariff.
 Tariff Welfare Effects – Large Nation
• Now suppose a specific duty of
$ 1000 is imposed on imports. Tariff Intervention
• However, the foreign suppliers
reduce their supply price by $
200.
• So, home consumers pay only $
800 extra.
• CS falls by a + b + c + d.
• c + e = revenue effect =
consumer surplus now
government revenue.
• a = redistributive effect =
shift from consumer to
producer surplus
• b + d = deadweight loss =
benefits lost to all parties
• b = protective effect
• d = consumption effect
 Tariff Welfare Effects – Large Nation
• Revenue Effect:
Optimum tariff, where e > (b + d) would be maximum
• In this case there are two
separate portions:
• c = domestic revenue
effect = tariff revenue
borne by the domestic
consumers – goes to
government
• e = terms-of-trade
effect = redistribution of
income from foreign nation
because of reduction in
import price
• area e > (b + d) leads to
Greater domestic welfare
• area e < (b + d) leads to
Lower domestic welfare

What happens
in US then?

Failure: ‘Beggar-Thy-Neighbour’ Policy

 Welfare Consequences
• Total welfare = CL + PG + GR
• Total welfare = - (a + b + c + d) + a + c + e
• Total welfare = e – b – d

• Say,

• TOT = PX / PM
• TOT Initial = PX (114) / PM (100)
• TOT Post Tariff = PX (114) / PM (98)
Can there be any difference in Welfare
Consequence on US Tariff?

• Raw material
• Final product
 Global Evidence
• US Tariff on Iron and Steel products in 2018 on all partner
countries – improvement in welfare?
• US-China Tariff War in 2018 – are the Trade Effects permanent?
• Demand for protection in sunrise segments – higher tariff on solar
photovoltaic cells (HS 854143) across countries and trade effects
• US-Canada Tariff war in Aluminium in 2017 (76 in general and
761699 in particular) – are the Trade Effects permanent?
How Tariff Imposition can be analyzed
through Offer Curve?
 Representing International Equilibrium with
Offer Curves
Home’s Offer Curve

Home’s imports, DF - QF
C
• Total Export = Total Import
B T 2 • (QC – DC ) X PC = (DF - QF) X PF
• (DF - QF) = (QC – DC ) X (PC / PF)
• δ(DF - QF)/ δ (QC – DC ) = (PC / PF)
• As (PC / PF) rises, QC rises and QF
falls.
• DF rises, and DC may rise or fall.
A
T 1 • However, (DF - QF) and (QC – DC )
both normally rise if income
effects are not too strong.

O Home’s
exports, QC - DC
 Representing International Equilibrium with
Offer Curves
Home’s Desired Trade at a Given Relative Price

Home’s imports, DF - QF
T2

Desired
T1
imports
of food

PC / PF

O Desired Home’s
exports exports, QC - DC
of cloth
 Representing International Equilibrium with
Offer Curves
Home’s Offer Curve

Home’s imports, DF - QF
C
T 3 • How will exports rise with
improvement in TOT?
T 2
• Increasing rate?
• Decreasing rate?
• Any lesson from the PPF?

T 1

O Home’s
exports, QC - DC
 Deriving Offer Curve with PPF:
The Autarky
T0 = PC / PF
Production Consumption Trade

Autarky C1, F1 C1, F1 0

F1

O C1
 Trade Scenario
T1 = PC / PF
Production Consumption Trade

T0 = PC / PF Autarky C1, F1 C1, F1 0

Free Trade C2, F2 C ”, F ” C2 – C ”,

F “ – F2
C1
C0
F ”

F1
DF - QF

F2

C”
O C1 C2
QC - DC
Export for indefinite period?
T1 = PC / PF
T2 = PC / PF
Production Consumption Trade
T0 = PC / PF
Autarky C1, F1 C1, F1 0

Free Trade C2, F2 C ”, F ” C2 – C ”,

F “ – F2
Continuation C3, F3 ? ?
of Trade
F1

F2

F3

O C1 C2 C3
 Representing International Equilibrium with
Offer Curves
C2

Home’s imports, DF - QF
C1

B T 2

A
T 1

O Home’s
exports, QC - DC
 Representing International Equilibrium with
Offer Curves
Foreign country’s Offer Curve

Foreign’s exports, Q*F – D*F

T1

O Foreign’s imports, D*C – Q*c

 Trade Equilibrium in Terms of Offer Curve:
Period Zero

Home’s imports of food, DF – QF • Let foreign

Foreign’s exports of food, Q *F – D *F
country’s offer
M curve be OF
• Home country’s
F offer curve be OM
E
Y • E is the initial
equilibrium point

O
X Home’s exports of cloth, QC – DC
Foreign’s imports of cloth, D *C – Q *C
Small Country Tariff Case through
Offer Curve
 Effect of Tariff on the Terms of Trade: Period 1A

Home imports of food, DF - QF Slope = (P * /P * )1

C F • Initial equilibrium
Foreign exports of food, Q *F – D *F
point is 1.
M 1
T 1 • Suppose home
imposes a tariff on
F imports. Then the
M 2
1 offer curve shifts to
OM2.
• A small country
always faces a
straight line offer
curve
• If home is a small
country, TOT remains
at OT1.
2 • The new equilibrium
point is 2.

O
Home exports of cloth, QC - DC
Foreign imports of cloth, D *C - Q *C
 Effect of Tariff on the Terms of Trade: Period 1A

Home imports of food, DF - QF Slope = (P * /P * )1

C F • Initial equilibrium
Foreign exports of food, Q *F – D *F
point is 1.
M 1
T 1 • Suppose home
T 1
imposes a tariff on
F imports. Then the
M 2
1 offer curve shifts to
OM2.
• A small country
always faces a
T 2
straight line offer
curve
• If home is a small
country, TOT remains
at OT1.
2 • The new equilibrium
point is 2.

3
O
Home exports of cloth, QC - DC
Foreign imports of cloth, D *C - Q *C
 A Hypothetical Example
• Say, Home country is Cambodia – LDC.
• Pre-Tariff: X = 100, M = 150
• Cambodia increases tariff from 2% to 11%.
• Post-Tariff: Consumers are paying a higher price.
• Suppose, China is exporting to Cambodia.
• China’s exports fall from 150 to 110 units.
• As China’s export revenue comes down, their capability for
imports are expected to come down as well.
• Fall in China’s imports means in a two-country world
Cambodia’s export potential is coming down too.
Large Country Tariff Case through
Offer Curve
 Effect of Tariff on the Terms of Trade: Period 1B

Home imports of food, DF - QF • Initial equilibrium

Slope = (P *
C /P * )1
F point is 1.
Foreign exports of food, Q *F – D *F
• Suppose home
M 1
T 1
Slope = (P * /P * )2 imposes a tariff on
C F
imports. Then the
T 2
offer curve shifts
M 2 F
1 to OM2.
• If home is a small
3 country, TOT
remains at OT1.
The new
equilibrium point is
2.
• If home is a large
country, it’s TOT
2
improves to OT2
and the new
equilibrium is 3.

O
Home exports of cloth, QC - DC
Foreign imports of cloth, D *C - Q *C
 GSP Benefit Withdrawal as an example of
increased Tariff Barriers: Trade Effects?
 Effect of ‘Beggar-Thy-Neighbour’ Policy on Trade:
Period 2A

Home imports of food, DF - QF Slope = (P * /P * )1

C F
Foreign exports of food, Q *F – D *F • Now if the
M1 T1 foreign country
Slope = (P *
C /P * )2
F also imposes a
T2 tariff, it’s offer
M2 F1
curve will come
1 down to OF2, and
M3 the new
3
equilibrium point
will be at 4.
• TOT will improve
4 for Foreign
F2
country and
worsen for home.
2 • As a result,
global trade
flows will suffer.

O Home exports of cloth, QC - DC

Foreign imports of cloth, D *C - Q *C
 Effect of ‘Beggar-Thy-Neighbour’ Policy on Trade:
Period 2B

Home imports of food, DF - QF Slope = (P * /P * )1

C F
Foreign exports of food, Q *F – D *F
M1
Slope = (P *
C /P * )2
F
T1 • The world is
T2 suffering from
M2 F1 an adverse trade
1 equilibrium at 4.
M3 • If the Trade
3 War goes on,
equilibrium will
be reached as 5.
4 • What if one
F2 country is small?

F3

O Home exports of cloth, QC - DC

5 Foreign imports of cloth, D *C - Q *C
 Effect of ‘Beggar-Thy-Neighbour’ Policy on Trade:
Period 2C

Home imports of food, DF - QF Slope = (P * /P * )1

C F
Foreign exports of food, Q *F – D *F
M1
Slope = (P *
C /P * )2
F
T1 • The world is
T2 suffering from
M2 F1 an adverse trade
1 equilibrium at 4.
M3 • If the Trade
3 War goes on,
equilibrium will
be reached as 5.
4 • What happens if
F2 home country is
retaliating back?
2

F3

O Home exports of cloth, QC - DC

5 Foreign imports of cloth, D *C - Q *C
 Retaliations and Beyond ..

Collateral
Damage?
 Effect of Tariff Reforms

Slope = (P *
C /P * )1
F
Home imports of food, DF - QF
Foreign exports of food, Q *F – D *F M2 T 1

6 • Initial equilibrium
M1 F2 point is 1.
• Suppose home
reduces tariff on
F1 imports. Then the
1 offer curve shifts
to OM2.
• Suppose foreign
country also
reduces tariff on
imports. Then the
offer curve shifts
to OF2.
• The new
equilibrium point
is 6.

O
Home exports of cloth, QC - DC
Foreign imports of cloth, D *C - Q *C
 Welfare effect of Tariff: Summary
Policy \ Small Country
Country Group
No Trade Worse off, as inputs are
utilized both by the
comparatively efficient and
inefficient industry,
efficiency loss
Free Trade Better off, welfare increases
as production of the relatively
inefficient sector declines and
vice versa
Imposition of Worsens welfare as tariff
Tariff increases the price for the
domestic consumers and users
of imported inputs, without
any decline in world price
Large Country
Worse off, as inputs are
utilized both by the
comparatively efficient and
inefficient industry,
efficiency loss
Better off, welfare
increases as production of
the relatively inefficient
sector declines and vice
versa
Ambiguous, welfare worsens
as consumer surplus
declines, but TOT improves
as world price declines. The
overall gain depends on the
relative strength of the two
effects.