International Economics 6th Edition

James Gerber Solutions Manual

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34 Gerber • International Economics, Sixth Edition

Chapter 6
The Theory of Tariffs and Quotas

◼ Outline
Introduction: Tariffs and Quotas
Analysis of a Tariff
Consumer and Producer Surplus
Prices, Output, and Consumption
Resource Allocation and Income Distribution
Case Study: A Comparison of Tariff Rates
Other Potential Costs
The Large Country Case
Effective versus Nominal Rates of Protection
Case Study: The Uruguay and Doha Rounds

Analysis of Quotas
Types of Quotas
The Effect on the Profits of Foreign Producers
Hidden Forms of Protection
Case Study: Intellectual Property Rights and Trade

◼ What Students Should Know after Reading Chapter 6

Chapter 6 introduces students to tariffs, quotas, and non-tariff measures. Tariffs are addressed first, using
the tools of consumer and producer surplus in a simple partial equilibrium setting to show the effects of
tariffs on resource allocation and income distribution. Deadweight losses from tariffs are identified, and
a distinction is drawn between consumption losses and efficiency losses. Other potential costs of tariffs,
including retaliation, lack of incentives for innovation, and rent seeking are addressed. The chapter
illustrates the possibility for large countries to potentially gain from tariffs and explains the difference

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 Chapter 6 The Theory of Tariffs and Quotas 35

between nominal and effective rates of protection. A case study compares tariffs for high-income and
low-income countries within the framework of the Doha negotiations.
Quotas are introduced and are explicitly contrasted with tariffs, both in terms of their transparency and
in terms of their revenue effects and deadweight losses. Quotas, import licenses, and voluntary export
restraints are all presented.

©2014 Pearson Education, Inc.

36 Gerber • International Economics, Sixth Edition

The last part of the chapter addresses other non-tariff measures. Examples and the problem of interpreting
whether a measure is protectionist or serves the public interest are identified. A case study on intellectual
property rights describes both the benefits and the potential costs of enforcement through TRIPs.
Subthemes to develop could include the lack of overall coordination of trade protection and problems of
transparency. Transparency is addressed in terms of the mechanisms of protection, but it can be extended
to non-tariff barriers to trade. When is a health law motivated by market failure and when is it protection?
The fact that individual trade laws are based on special interests and assembled piecemeal over time means
that they often don’t have the intended effects. Barriers in one sector sometimes undermine the goals of
barriers in another sector, and it is often difficult to separate protectionist measures from measures that are
implemented for entirely different reasons.
Note that the WTO’s Web site has extensive tariff data and information on other forms of import protection.
See http://www.wto.org, click on Resources, then Trade and Tariff Data. The trade profiles section for
individual countries also provides information on bound and applied rates, as well as the share of trade
subject to non-tariff measures.

◼ Assignment Ideas
1. Have students research trade barriers that are important to a specific industry. These could be
assigned by country or at a multilateral level. Students could be asked to create a briefing for use in
lobbying U.S. governmental officials prior to multilateral trade talks. If this industry wants to
increase its exports, which international trade barriers will it want to have reduced? Are the barriers
largely tariffs, quotas, or non-tariff measures?

2. Have students research the trade policies and trade barriers of a particular country. A number of
questions can be used to guide the assignment. (See the WTO site, mentioned above.)
• How high are tariffs? Are there quotas or quota-like measures? In what sectors?
• Are there other non-tariff measures that the United States finds objectionable? Are there currently
discussions to resolve these issues?

Resources for these assignments include:

i. World Trade Organization (www.wto.org).
ii. Country Commercial Guides, published by the International Trade Administration of the
Department of Commerce (http://www.stat-usa.gov/mrd.nsf). The Office of the United States
Trade Representative (USTR) also publishes short trade profiles. See www.ustr.gov/countries-
regions/countries-z.
iii. National Trade Estimate Report on Foreign Trade Barriers, also published by the Office of the
United States Trade Representative (http://www.ustr.gov/about-us/press-office/reports-and-
publications/2012).

3. Suppose a domestically produced motor bicycle sells at a world price of $5,000 under unrestricted
trade. The domestic producer uses $3,000 worth of imported inputs, (VA*). The $2,000 difference
between the world price of the final motor bicycle and the cost of the imported components represents
domestic value added (VA). Domestic value-added includes the payments made to domestic labor
and capital inputs. Under restricted trade, domestic value-added cannot exceed $2,000, or the price of
the domestically produced motor bicycle will exceed that of imported ones and the domestic ones
will not sell. Suppose a 10 percent ad valorem (on the value) tariff is imposed on the imported motor
bicycle.
i. What is the domestic price of the imported motor bicycle?

©2014 Pearson Education, Inc.

 Chapter 6 The Theory of Tariffs and Quotas 37

ii. What is the possible price of the domestically produced motor bicycle?
iii. What is the domestic value-added of the imported motor bicycle (VA*)?
iv. What is the effective rate of protection (ERP)?
v. Is this an effective rate of protection? Why or why not?
vi. What price do domestic producers pay on the imported components that they use as inputs?
vii. What is the amount of the new domestic value-added after the tariff? (Note: the new value-added
is the difference between the tariffed price of imported motor bicycles and the tariffed price of
imported inputs used in domestic production.)
viii. What is the value of the new ERP?
ix. Suppose that the government decided to tax the imported inputs by the same rate (10 percent) as
the finished imported good. What is the ERP under this condition?

Answers:
i. $5000(1 + 0.10) = $5500.
ii. Between $5000 and $5500. It is likely to be $5500 for two reasons: (1) the tariff effectively
reduces the supply curve, thereby raising the price level, and (2) because the tariff is intended to
help domestic producers, who they will charge higher prices unless demand decreases
substantially.
iii. It is $5500 – $3000 = $2500.
iv. Applying the formula in the text, we have:

ERP = (VA* − VA)/VA = ($2500 − $2000)/$2000 = 25%

Hence, a 10 percent nominal tariff rate resulted in a 25 percent ERP!
v. Yes, it is! As long as there is no tariff on the imported inputs, the ERP and the nominal tariff rate
would always be higher than the nominal tariff rate (25 percent  10 percent).
Note that the relationship between the nominal tariff and the ERP depends on: (1) the share of
imported inputs in the production process, and (2) the presence or absence of tariffs on imported
inputs.
Suppose now that the 10 percent tariff on finished motor bicycles is accompanied by a 5 percent
tariff on imported components used in the domestic production of motor bicycles.
Answer the following three questions based on this proposition.
vi. $3000(1 + 0.05) = $3150.
vii. VA* = $5000(1 + 0.10) – $3000(1 + 0.05) = $5500 – $3150 = $2350.
viii. Applying the formula:

ERP = (VA* − VA)/VA = ($2350 − $2000)/$2000 = 17.5%

ix. New VA* = $5000(1 + 0.10) – $3000(1 + 0.10) = $5500 – $3300 = $2200. Thus:

ERP = ($2200 − $2000)/$2000 = 10%

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38 Gerber • International Economics, Sixth Edition

◼ Answers to End-of-Chapter Questions

1. Graph the supply and demand of a good that is both produced domestically and imported. Assume
that the country is not large enough to affect the world price. Illustrate the effects of a tariff on
imports. Discuss the following:
a. Income distribution effects
b. Resource allocation effects
c. Domestic production and consumption effects
d. Government revenue effects
e. Price of the good effects

Answers:
See Figure 6.3 in the text.
a. The income distribution effects are a loss in consumer surplus, some of which is destroyed, but
other parts of which are transferred to producers and the government.
b. The resource allocation effects include a production inefficiency from the expansion of relatively
higher cost domestic production. The consumption side also experiences a reduction in efficiency
due to squeezing consumers, who value the good more than it costs to buy it, out of the market.
c. Domestic production rises, consumption falls.
d. Government revenue rises by the amount of the tariff times the number of units imported.
e. The price rises by the amount of the tariff.

2. Suppose the world price for a good is 40 and the domestic demand-and-supply curves are given by
the following equations:
Demand: P = 80 – 2Q
Supply: P = 5 + 3Q
a. How much is consumed?
b. How much is produced at home?
c. What are the values of consumer and producer surplus?
d. If a tariff of 10 percent is imposed, by how much do consumption and
domestic production change?
e. What is the change in consumer and producer surplus?
f. How much revenue does the government earn from the tariff?
g. What is the net national cost of the tariff?

Answers:
a. Using the demand curve to determine consumption, 40 = 80 – 2Q, or Q = 20.
b. Using the supply curve to determine production, 40 = 5 + 3Q, or Q = 11.67.
c. Consumer surplus is given by 20  (80 – 40)  1/2 = 400; producer surplus
is 11.67  (40 – 5)  1/2 = 204.17.
d. A 10 percent tariff raises prices by 4, from 40 to 44. Consumption moves along
the demand curve: 44 = 80 – 2Q, or Q = 18. Production moves up the supply
curve: 44 = 5 + 3Q, or Q = 13.

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 Chapter 6 The Theory of Tariffs and Quotas 39

e. The new value for consumer surplus is 18  (80 – 44)  1/2, or 324; hence it has fallen by 76.
Producer surplus is 13  (44 – 5)  1/2 = 253.5; hence it has grown by 49.33.
f. Tariff revenue is 5  4 = 20.
g. The net national cost of the tariff is the combination of the efficiency loss and the consumption
deadweight loss. It is equal to the lost consumer surplus minus the transfer to producers and the
government, or 76 − 49.33 − 20 = 6.67.

3. Under what conditions may a tariff actually make a country better off?

Answer: It is possible for a large country to improve national welfare by levying a tariff. The
conditions that must hold are that the country is large enough to affect the world
price when it imposes a tariff, and other nations must not retaliate. It is possible under
these circumstances to design a tariff that raises national welfare by causing the price
of imports to fall. As long as the gains from the cheaper imports are greater than the
production and consumption side losses, the national welfare improves.

4. In addition to the production and consumption side deadweight losses, what are some of the other
potential costs of tariffs?

Answer: Other potential costs of tariffs include the threat of retaliation and the potential loss of
exports markets, the stifling of the incentive to innovate, and the encouragement of rent
seeking.

5. The Uruguay Round of the GATT began a process of phasing out the use of voluntary export
restraints. Why did they come into widespread use in the 1980s? For example, given that VERs
are a form of quotas, and that they create quota rents and a larger reduction in national welfare than
tariffs, why did nations use them instead of tariffs?

Answer: Voluntary export restraints avoid the obligations nations share under the rules of the
GATT to not raise tariffs. They do not require legislative action to implement.
Furthermore, VERs permitted politicians to claim they supported free trade while
at the same time offering protection to special interests.

6. The GATT strongly favors tariffs as a protective measure over quotas or other nontariff measures. It
encourages new members to convert quotas to their tariff equivalents. One of the main reasons tariffs
are preferred is because they are more transparent, particularly by comparison to nontariff measures.
Explain the idea of transparency, and how nontariff measures may be nontransparent.

Answer: Transparency refers to the ability of everyone to easily discover and understand the rules.
Tariffs are transparent because they usually are not associated with special circumstances
known only to a select few. Non-tariff barriers like an outright quota may or may not be
transparent. Quotas may vary according to the country trying to export; they may also be
implemented in the form of import licenses that involve large amounts of red tape and
unknown availability. Nontariff measures such as health and safety codes, product
standards, or testing requirements can be even less well defined and pose an even greater
uncertainty for firms trying to enter the market.

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40 Gerber • International Economics, Sixth Edition

7. Suppose that bicycles are made in the United States out of a combination of domestic and
foreign parts.
a. If a bike sells for $500 but requires $300 of imported parts, what is the domestic value added?
b. If a 20 percent tariff is levied on bikes of the same quality and with the same features, how do
the price and the domestic value added change? (Assume the United States cannot cause the
world price to change.)
c. What is the effective rate of protection?
d. If in addition to the 20 percent tariff on the final good, a 20 percent tariff on imported parts is
also levied, what is the effective rate of protection for U.S. bike manufacturers?

Answers:
a. Value added is $500 – $300 = $200.
b. The domestic price rises by 20 percent to $600; the value added is $600 – $300 = $300,
hence it has risen $100.
c. The effective rate of protection is (300 – 200)/200 = 0.5 = 50 percent.
d. The cost of inputs rises from $300 to $360, so value added is $600 – $360 = $240.
The effective rate of protection is now (240 – 200)/200 = 0.2 = 20 percent.

©2014 Pearson Education, Inc.