Chapter 6: The Theory of

Tariffs and Quotas

Dr. Jennings Byrd
ECO 4451 – Economics of Globalization
Learning Objectives
• Draw a supply and demand diagram and use it to illustrate consumer
and producer surplus.
• Draw a graph that shows the effects of tariffs and quotas on prices,
output, and consumption.
• Explain in words and with a diagram the effects of tariffs and quotas
on resource allocation and income distribution.
• Differentiate effective from nominal rates of protection.
• List and discuss at least three dynamic costs of protection.
Introduction: Tariffs and Quotas
• This chapter and the next chapter provide an
introduction to the theory and policy of tariffs and
quotas
• This analysis is called commercial policy
• The inefficiency and expense of tariffs and quotas to
protect industries and jobs are apparent once direct
costs are measured
Analysis of a Tariff
• There are numerous barriers to trade, some are obvious
(transparent), others are not (non-transparent)
• Quotas: direct limit on imports: regulate the quantity of
imports
• Tariffs: indirect limit on imports: impose a tax on imports
Analysis of a Tariff
• Tariffs and quotas encourage
• Consumers to switch to relatively cheaper domestic goods or to
drop out of the market
• Domestic producers to increase their output as demand switches
from foreign to domestic goods
• This chapter is a partial equilibrium analysis of the effects of
tariffs and quotas: Considers only their impact on the
industry on which they are imposed, rather than their
economy-wide effects
Consumer and Producer Surplus
There are two key concepts in the analysis of the impact of
tariffs
• Consumer surplus: value received by consumers in excess of
the price they pay (can be measured only if the demand curve is
known)
• Producer surplus: value received by producers in excess of the
minimum price at which they are willing to produce (can be
measured only if the supply curve is known)
Consumer and Producer Surplus
Price What is consumer and producer
Sdomestic surplus?
50

Consumer surplus:

½[(50 – 25)*200] = $2,500

25
Producer surplus:

½[(25 – 5)*200] = $2,000

Ddomestic
5 Total surplus: CS + PS =
200 Quantity
2,500 + 2,000 = $4,500
Prices, Output, and Consumption
Assume:
1. There is only one price for a good (world price P w)
• At the world price, the exporting country has the comparative
advantage.
2. Foreign producers are willing to supply us with all of the
units of the good we want at that price
Domestic Supply and Demand for an Imported Good
Price
Sdomestic
50

25

15 Pw

Ddomestic
5
100 200 350 Quantity

Imports = 250
Consumer/Producer Surplus Questions
Price
Sdomestic
50

25

15 Pw

Ddomestic
5
100 200 350 Quantity

1. Find the domestic equilibrium price, quantity, consumer/producer surplus.

2. If the country imports at the world price, what is the volume of imports, and
the new consumer/producer surplus?
Answers
Question 1: find domestic price, quantity and consumer/producer surplus.

• Domestic equilibrium price and quantity are $25 and 200.

• Consumer surplus is ½[(50 – 25)*200] = $2,500
• Producer surplus is ½[(25 – 5)*200] = $2,000

Question 2: trade is allowed at the world price. Find the volume of imports,
consumer and producer surplus.

• After trade is allowed at the world price, the amount imported is 250 units.
• The new consumer surplus is ½[(50 – 15)*350] = $6,125
• The new producer surplus is ½[(15 – 5)*100] = $500
Prices, Output, and Consumption
• Now assume: Government imposes a tariff of amount “t.”
Importers will still be able to buy the good from foreign
producers for Pw, but they will have to pay the import tax of
“t.”
• The tax is subsequently tacked onto the price to domestic
consumers: price to them is
Pw+ t = Pt
• The consumption of the imported good subsequently decreases
The Effects of a Tariff
Results:
Price
Sdomestic
50 1) Imports fall
2) Consumer surplus falls
3) Producer surplus rises
4) Government gains
tariff revenue
25 5) Societal welfare falls
20 Pw + t = Pt
15
Pw

Ddomestic
5
100 200 350 Quantity
175 300

imports
Prices, Output, and Consumption
In Summary,
• tariffs cause the domestic price to rise by the amount of the tariff,
• domestic consumption falls,
• domestic production rises,
• imports fall.
• On a positive note, tariff revenue is collected.
• On a negative note, countries may retaliate with their own tariffs
Resource Allocation and Income Distribution
• Tariffs have more subtle effects than just a rise in prices
and a fall in imports.
• Inputs in domestic production: increase domestic production
requiring additional resources of land, labor, and capital to be
reallocated from their prior uses into the industry receiving
protection under the tariff.
• when the price changes, consumer and producer surplus do too
Resource Allocation and Income Distribution
• Deadweight loss - destruction of value that is not compensated by a
gain somewhere else : area d is this type of loss.
• Efficiency loss - another deadweight loss which occurs on the
production side: area b is this type of loss
• One the following graph:
Gains to producers: a + g
Gains to government: c
Losses to consumers: a + b + c + d
Welfare loss: b + d
The Effects of a Tariff

Efficiency loss due to

overproduction

DWL due to under-

consumption
Economic Effects of the Tariff
Tariff Example
Price
Sdomestic
35

25

20
15 Pw

Ddomestic
5

75 90 100 120 150 Quantity

1. Calculate the volume of imports with the tariff.
2. What is the amount of tariff revenue collected?
3. What is the amount of deadweight/efficiency loss?
4. Who is better/worse off as a result of the tariff?
Answers
Price
$900 Sdomestic
35
$37.50
$150

$75
25

20
15 Pw 30

Ddomestic
5

75 90 100 120 150 Quantity

$675
A Comparison of Tariff Rates
• The Doha Development Agenda of the World Trade
Organization (WTO) is focused on the trade problems of
developing countries
• At issue for many developing countries are the levels of
tariffs and other industrial country barriers that block
access to agriculture, clothing, and textile markets.
• However, developed nations often have highest tariffs in
agriculture, textiles, and other labor-intensive products –
the very products developing nations would like to export
Comparison of Tariff Rates
• Industrial countries, the World Bank, and the WTO have argued a
major problem facing developing countries is the relatively high
level of protection among themselves

• High tariffs limit the countries’ ability to sell into each other’s
markets—and consequently their ability to follow their comparative
advantage.

• If you want to view tariff rates go here:

http://www.wto.org/english/tratop_e/tariffs_e/tariff_data_e.htm
Average Applied Tariff Rates (weighted), 1988-2017

35

30

25

20

15

10

0
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

High income Low & middle income Low income Upper middle income

Source: World Bank, World Development Indicators

US Historical Tariff Rates (1790 – 2013)
Tariff of Abominations (1828)
60

50
Morrill and War Tariffs (1861-1864)

40
Tariff Rates (Percent)

Smoot-Hawley Tariff (1930)

30

20

10

0
1790 1802 1814 1826 1838 1850 1862 1874 1886 1898 1910 1922 1934 1946 1958 1970 1982 1994 2006
Other Potential Costs
• A tariff may have effects that are less predictable and
harder to quantify
• Retaliation by other countries: adds to the net loss of a tariff by hurting
export markets of other industries; can escalate rapidly
• Innovation: tariffs reduce competitive pressures on domestic firms and
thus their incentives to innovate and improve the quality of existing
products
• Rent seeking: any activity that uses resources in order to capture more
income without actually producing a good
(e.g., firms hire lobbyists to maintain tariff protection)
- Political systems that do not easily provide tariffs are more likely to avoid rent seeking
The Large Country Case
• Economists distinguish between small and large countries in
analysing tariffs
• Large country: one that imports enough of a particular product so that
if it imposes a tariff, the exporting country will reduce its price of the
good in order to keep its share of the large country's market
• In theory, large countries can improve their national welfare by
imposing a tariff as long as their trading partners do not retaliate
• Additional tariff revenue collected must be greater than the
deadweight and efficiency losses.
Tariffs in the Large Country Case
Export Tariffs

P Consumer Surplus (Gain)

Exports
Exports Sdomestic ACDB

F G
Producer Surplus (Loss)
A C E
Pw AGHB
B I D H
Pw – t
Government (Tariff)
PD Revenue
EFHD

Deadweight Losses
CED & FGH
Ddomestic
Q1 Q3 QD Q4 Q2 Q
Effective versus Nominal Rates of Protection
• The amount of protection given to any one product depends not only
on the tariff rate but also on tariffs on the inputs used to produce the
good
• Nominal rate of protection: tariff rate levied on a given product
• Effective rate of protection: nominal rate + tariffs on intermediate
inputs
• Value added: price of a good minus the costs of intermediate
goods used to produce it (the contributions of labor and capital at a
given stage of production)
Effective versus Nominal Rates of Protection
• In sum, effective rate of protection:
(VA* - VA) / VA
VA = amount of domestic value added under free trade;
VA* = domestic value added after taking into account all
tariffs (on both final goods and intermediate inputs)
Nominal and Effective Rates of Protection

Negative effective rates of protection can happen.

Consider that China has placed tariffs on U.S. cars and steel.

If the tariff rate on imported steel is sufficiently high, then China could have a negative
effective rate of protection, which is the opposite of what the US wanted.
Questions
Suppose that United States car makers import $1,000,000 of steel and parts in order to
make 100 cars selling for $15,000 each. The imports have no tariff or quota
restrictions.

1. What is the value added by car makers in the United States?

2. If a tariff of 20 percent is placed on imports of cars, the effective rate of protection

is?

3. If a tariff of 20 percent is placed on imports of cars, and another tariff of 25 percent

is placed on imports of steel and parts, then the effective rate of protection on cars
made in the United States is?
Answers
1. Imported steel and parts per car = $1,000,000 / 100 = $10,000.
Domestic value added = Price of car – value of import inputs
$5,000 = $15,000 - $10,000

2. With a 20% tariff on imports, prices rise to $18,000 for all cars: ($15,000 +
0.2*15,000 = $18,000)
The effective rate of protection is: (VA* - VA) / VA
Answers cont.
3. With a 20% tariff on imports, and a 25% tariff on prices rise to $18,000 for all
cars like before, but now the value of imported inputs rises to $12,500:
$10,000 + 0.25*10,000 = $12,500

Now, the price of the good minus the value of imported inputs results in a
domestic value added of $18,000 - $12,500 = $5,500.

The effective rate of protection is: (VA* - VA) / VA

Analysis of Quotas
• Quota: A quantitative restriction that specifies a limit on the
quantity of imports
• Differences between quotas and tariffs
• Tariff limits imports by imposing a tax on them
• Unlike tariffs, quotas do not generate tariff revenue for the
government
• Most economists favor tariffs for this reason in trade protection
does take place.
• Similarities between quotas and tariffs
• Both lead to a reduction in imports, a fall in total domestic
consumption, and an increase in domestic production
Types of Quotas
1) Most transparent type of quota:
• an outright limitation on the quantity of imports
e.g., a limit on the quantity of imports from country X, or a limit on
the quantity of imports from the rest of the world as a whole

Examples from the U.S. include a textile quota on China in 2012 and
ongoing sugar quotas
Quota Bulletin from U.S. Customs
Types of Quotas
2) Import licensing requirement:

• forcing importers to obtain government licenses for their imports;

• government regulates the number of licenses available

• This creates a shortage of licenses, thus restricting the volume of

imports.
Types of Quotas
3) Voluntary export restraint (VER) (or voluntary restraint
agreement, VRA)
• the exporting country “voluntarily” agrees to limit its exports for
a period
• VERs have similar effects as quotas
• However, VERs are more popular:
1) do not require domestic legislative action
2) allow politicians to provide protection for domestic industry
and to appear as proponents of free trade
Types of Quotas: VERs
• The use of VERs increased with the decline in tariffs that results
from the global trade rounds; however, recent international
negotiations have restricted the use of VERs
• Japanese VER on cars
• 1981 VER was set at 1.68 million cars
• 1984 the cap was raised to 1.85 million
• 1985 the cap was raised to 2.30 million
• 1994 the program was terminated
• The most shocking result: the price, on average, for a Japanese car increased
by $1,200 due to the VER.
The Effect on the Profits of Foreign Producers
• The main difference between tariffs and quotas is that
there is no government revenue from quotas.
• In place of tariff revenue, there are greater profits for
foreign producers, called quota rents.
• This flows back to the foreign country and doesn’t allow
any additional welfare redistribution effects through tariff
revenue.
Analysis of a Quota
Quota rents: Increased profits accruing to foreign producers from the use of
quotas; take the place of tariff revenue

Imports Excess Demand

Analysis of a Quota: Small Country Case
Price charged

• In the case of a tariff, the government earned revenue from imports; in the case
of a quota, foreign producers receive extra profits (c)
The Effect on the Profits of Foreign Producers
• Two circumstances that can limit quota rents
• If there is a large number of foreign producers, competition may
limit their ability to increase prices
• The government can extract the extra profits from foreign
producers through an auction for import licenses
• For a foreign firm to go this route and capture a profit:

PQ – PW > PA
Auction Pricing
• Suppose the world price is $10 and a quota binds imports to
30.
• With the quota, domestic firms raise prices to capture the
remaining market. The price after the quota is now $15.
• If the domestic government attempts to capture some of the
quota rents then the auction price (P A) can not be greater than
PQ – PW

• If PA > $5 then foreign firms do not find it advantageous to

export their goods.
The Effect on the Profits of Foreign Producers
• Second important difference between tariffs and quotas:
• Over time, as demand for the good increases and quota
remains fixed: an increase in consumer demand, increases the
price paid by consumers, increases in producer surplus
garnered by domestic firms.

• In contrast, an increase in consumer demand for an item that

has an import tariff increases the quantity of imports and
leaves the price intact
Changes in Demand and Quotas
Quota = 30
New domestic quantity = 130
Price Domestic suppliers provide 120
Sdomestic
$35

$30
$28
$25
$20
Pw = $15 D1

D0
$5

75 90 100 120 130 150 225 Quantity

Changes in Demand and Tariffs

Price
Sdomestic
$35

$30

$25

Tariff ($5) $20

Pw = $15 D1

D0
$5

75 90 100 120 130 200 225 Quantity

Hidden Forms of Protection
• Any trade barrier that reduces imports without imposing a tax
has effects similar to those of a quota
• Tariffs: impose a tax
• Non-tariff barriers (NTBs): quotas and non-tariff
measures
Hidden Forms of Protection
Non-tariff measures are hidden, non-transparent forms of protection,
such as:
• excessively complicated customs procedures
• environmental and consumer health and safety precautions
• technical standards
• government procurement rules
• limits imposed by state trading companies
• Embargoes
• VERs
Intellectual Property Rights and Trade
• Intellectual property (intellectual property rights) are usually
divided into:
– Copyrights and related rights for literary and artistic work,
– Industrial property rights for trademarks,
– Patents,
– Industrial designs,
– Geographical indications
– Layout of integrated circuits
Intellectual Property Rights and Trade
• There are rules for respecting intellectual property
rights as they relate to trade

• These rules were negotiated during the Uruguay

Round (1986-1994) with the Trade Related Aspects
Intellectual Property Rights (TRIPS) agreement
The Uruguay Round