Basic Tariff Analysis
A tariff, the simplest of trade policies, is a tax levied when a good is imported. Specific
tariffs are levied as a fixed charge for each unit of goods imported (for example, $3 per
barrel of oil). Ad valorem tariffs are taxes that are levied as a fraction of the value of the
imported goods (for example, a 25 percent U.S. tariff on imported trucks—see the following
box). In either case, the effect of the tariff is to raise the cost of shipping goods to a
country.
Part Two
9
International Trade Policy
Tariffs are the oldest form of trade policy and have traditionally been used as a
source of government income. Until the introduction of the income tax, for instance,
the U.S. government raised most of its revenue from tariffs. Their true purpose, however,
has usually been twofold: both to provide revenue and to protect particular
domestic sectors. In the early 19th century, for example, the United Kingdom used tariffs
(the famous Corn Laws) to protect its agriculture from import competition. In the
late 19th century, both Germany and the United States protected their new industrial
sectors by imposing tariffs on imports of manufactured goods. The importance of
tariffs has declined in modern times because modern governments usually prefer to
protect domestic industries through a variety of nontariff barriers, such as import
quotas (limitations on the quantity of imports) and export restraints (limitations on
the quantity of exports—usually imposed by the exporting country at the importing
country’s request). Nonetheless, an understanding of the effects of a tariff remains vital
for understanding other trade policies.
In developing the theory of trade in Chapters 3 through 8, we adopted a general equilibrium
perspective. That is, we were keenly aware that events in one part of the economy
have repercussions elsewhere. However, in many (though not all) cases, trade policies
toward one sector can be reasonably well understood without going into detail about those
policies’ repercussions on the rest of the economy. For the most part, then, trade policy
can be examined in a partial equilibrium framework. When the effects on the economy as
a whole become crucial, we will refer back to general equilibrium analysis.
Supply, Demand, and Trade in a Single Industry
Let’s suppose there are two countries, Home and Foreign, both of which consume and produce
wheat, which can be costlessly transported between the countries. In each country,
wheat is a simple competitive industry in which the supply and demand curves are functions
of the market price. Normally, Home supply and demand will depend on the price in terms
of Home currency, and Foreign supply and demand will depend on the price in terms of
Foreign currency. However, we assume that the exchange rate between the currencies is not
affected by whatever trade policy is undertaken in this market. Thus we quote prices in both
markets in terms of Home currency.
Trade will arise in such a market if prices are different in the absence of trade.
Suppose that in the absence of trade, the price of wheat is higher in Home than it is in
Foreign. Now let’s allow foreign trade. Since the price of wheat in Home exceeds the
price in Foreign, shippers begin to move wheat from Foreign to Home. The export of
wheat raises its price in Foreign and lowers its price in Home until the difference in
prices has been eliminated.
To determine the world price and the quantity traded, it is helpful to define two new
curves: the Home import demand curve and the Foreign export supply curve, which are
derived from the underlying domestic supply and demand curves. Home import demand is
the excess of what Home consumers demand over what Home producers supply; Foreign
export supply is the excess of what Foreign producers supply over what Foreign consumers
demand.
Figure 9-1 shows how the Home import demand curve is derived. At the price , Home
consumers demand , while Home producers supply only . As a result, Home import
demand is . If we raise the price to , Home consumers demand only , while
Home producers raise the amount they supply to , so import demand falls to .
These price-quantity combinations are plotted as points 1 and 2 in the right-hand panel of
Figure 9-1. The import demand curve MD is downward sloping because as price increases,
the quantity of imports demanded declines. At PA, Home supply and demand are equal in
S2 D2 – S2
D1–S1 P2 D2
D1 S1
P1
CHAPTER 9 The Instruments of Trade Policy 193
194 PART TWO International Trade Policy
the absence of trade, so the Home import demand curve intercepts the price axis at
.
Figure 9-2 shows how the Foreign export supply curve XS is derived. At Foreign
producers supply , while Foreign consumers demand only , so the amount of the
total supply available for export is . At Foreign producers raise the quantity
they supply to and Foreign consumers lower the amount they demand to , so the
quantity of the total supply available to export rises to . Because the supply
of goods available for export rises as the price rises, the Foreign export supply curve is
S*2– D*2
S*2 D*2
S*1– D*1 P2
S*1 D*1
P1
PA (import demand = zero at PA)
Price, P
Quantity, Q
PA
P1
P 2
S1 S2 D 2 D1
Price, P
D MD
S
Quantity, Q D 2 – S 2 D1 – S1
A
1
2
Figure 9-1
Deriving Home’s Import Demand Curve
As the price of the good increases, Home consumers demand less, while Home producers
supply more, so that the demand for imports declines.
Price, P
Quantity, Q
P1
P2
D*2 D*1 S*1 S*2
Price, P XS
D*
S*
Quantity, Q S*1 – D*1 S*2 – D*2
PA*
Figure 9-2
Deriving Foreign’s Export Supply Curve
As the price of the good rises, Foreign producers supply more while Foreign consumers
demand less, so that the supply available for export rises.
CHAPTER 9 The Instruments of Trade Policy 195
upward sloping. At , supply and demand would be equal in the absence of trade, so the
Foreign export supply curve intersects the price axis at .
World equilibrium occurs when Home import demand equals Foreign export supply
(Figure 9-3). At the price where the two curves cross, world supply equals world
demand. At the equilibrium point 1 in Figure 9-3,
By adding and subtracting from both sides, this equation can be rearranged to say that
or, in other words,
Effects of a Tariff
From the point of view of someone shipping goods, a tariff is just like a cost of transportation.
If Home imposes a tax of $2 on every bushel of wheat imported, shippers will be unwilling
to move the wheat unless the price difference between the two markets is at least $2.
Figure 9-4 illustrates the effects of a specific tariff of t per unit of wheat (shown as t in
the figure). In the absence of a tariff, the price of wheat would be equalized at in both
Home and Foreign, as seen at point 1 in the middle panel, which illustrates the world market.
With the tariff in place, however, shippers are not willing to move wheat from Foreign
to Home unless the Home price exceeds the Foreign price by at least t. If no wheat is being
shipped, however, there will be an excess demand for wheat in Home and an excess supply
in Foreign. Thus the price in Home will rise and that in Foreign will fall until the price
difference is t.
Introducing a tariff, then, drives a wedge between the prices in the two markets. The
tariff raises the price in Home to and lowers the price in Foreign to . In
Home, producers supply more at the higher price, while consumers demand less, so that
fewer imports are demanded (as you can see in the move from point 1 to point 2 on the
MD curve). In Foreign, the lower price leads to reduced supply and increased demand, and
thus a smaller export supply (as seen in the move from point 1 to point 3 on the XS curve).
Thus the volume of wheat traded declines from QW, the free trade volume, to QT, the
PT * PT = PT - t
PW
World demand = World supply.
Home demand + Foreign demand = Home supply + Foreign supply
Home demand - Home supply = Foreign supply - Foreign demand.
PW
PA * 1export supply = zero at PA * 2
PA
*
Price, P
Quantity, Q
PW
PA
PA
* MD
XS
QW
1
Figure 9-3
World Equilibrium
The equilibrium world price is where
Home import demand (MD curve)
equals Foreign export supply
(XS curve).
196 PART TWO International Trade Policy
volume with a tariff. At the trade volume , Home import demand equals Foreign export
supply when .
The increase in the price in Home, from to , is less than the amount of the tariff,
because part of the tariff is reflected in a decline in Foreign’s export price and thus is not
passed on to Home consumers. This is the normal result of a tariff and of any trade policy
that limits imports. The size of this effect on the exporters’ price, however, is often very
small in practice. When a small country imposes a tariff, its share of the world market for
the goods it imports is usually minor to begin with, so that its import reduction has very
little effect on the world (foreign export) price.
The effects of a tariff in the “small country” case where a country cannot affect
foreign export prices are illustrated in Figure 9-5. In this case, a tariff raises the price of
the imported good in the country imposing the tariff by the full amount of the tariff, from
to . Production of the imported good rises from to , while consumption of
the good falls from to . As a result of the tariff, then, imports fall in the country
imposing the tariff.
Measuring the Amount of Protection
A tariff on an imported good raises the price received by domestic producers of that good.
This effect is often the tariff’s principal objective—to protect domestic producers from the
low prices that would result from import competition. In analyzing trade policy in practice, it
is important to ask how much protection a tariff or other trade policy actually provides. The
answer is usually expressed as a percentage of the price that would prevail under free trade.
An import quota on sugar could, for example, raise the price received by U.S. sugar producers
by 35 percent.
Measuring protection would seem to be straightforward in the case of a tariff: If the
tariff is an ad valorem tax proportional to the value of the imports, the tariff rate itself
should measure the amount of protection; if the tariff is specific, dividing the tariff by the
price net of the tariff gives us the ad valorem equivalent.
D1 D2
PW PW + t S1 S2
PW PT
PT - PT * = t
QT
Home market World market Foreign market
Price, P
PW
Quantity, Q
D
S
PT
Price, P
QT Quantity, Q
D*
S*
Price, P
QW Quantity, Q
MD
XS
PT*
2
1
3
t
Figure 9-4
Effects of a Tariff
A tariff raises the price in Home while lowering the price in Foreign. The volume traded thus declines.
CHAPTER 9 The Instruments of Trade Policy 197
Price, P
Quantity, Q
PW + t
D
S
S1 S2 D2 D1
Imports after tariff
Imports before tariff
PW
Figure 9-5
A Tariff in a Small Country
When a country is small, a tariff it
imposes cannot lower the foreign
price of the good it imports. As a
result, the price of the import rises
from to and the quantity
of imports demanded falls
from D1 - S1 to D2 - S2.
PW PW + t
However, there are two problems with trying to calculate the rate of protection this
simply. First, if the small country assumption is not a good approximation, part of the
effect of a tariff will be to lower foreign export prices rather than to raise domestic prices.
This effect of trade policies on foreign export prices is sometimes significant.
The second problem is that tariffs may have very different effects on different stages of
production of a good. A simple example illustrates this point.
Suppose that an automobile sells on the world market for $8,000 and that the parts out
of which that automobile is made sell for $6,000. Let’s compare two countries: one that
wants to develop an auto assembly industry and one that already has an assembly industry
and wants to develop a parts industry.
To encourage a domestic auto industry, the first country places a 25 percent tariff
on imported autos, allowing domestic assemblers to charge $10,000 instead of $8,000. In
this case it would be wrong to say that the assemblers receive only 25 percent protection.
Before the tariff, domestic assembly would take place only if it could be done for $2,000
(the difference between the $8,000 price of a completed automobile and the $6,000 cost of
parts) or less; now it will take place even if it costs as much as $4,000 (the difference
between the $10,000 price and the cost of parts). That is, the 25 percent tariff rate provides
assemblers with an effective rate of protection of 100 percent.
Now suppose that the second country, to encourage domestic production of parts,
imposes a 10 percent tariff on imported parts, raising the cost of parts of domestic
assemblers from $6,000 to $6,600. Even though there is no change in the tariff on
assembled automobiles, this policy makes it less advantageous to assemble domestically.
Before the tariff it would have been worth assembling a car locally if it could be
done for ; after the tariff, local assembly takes place only
if it can be done for . The tariff on parts, then, while providing
positive protection to parts manufacturers, provides negative effective protection to
assembly at the rate of
Reasoning similar to that seen in this example has led economists to make elaborate
calculations to measure the degree of effective protection actually provided to particular
-30 percent 1-600/2,0002.
$1,400 1$8,000 - $6,6002
$2,000 1$8,000 - $6,0002
industries by tariffs and other trade policies. Trade policies aimed at promoting economic
development, for example (Chapter 11), often lead to rates of effective protection much
higher than the tariff rates themselves.
A tariff, the simplest of trade policies, is a tax levied when a good is imported. Specific
tariffs are levied as a fixed charge for each unit of goods imported (for example, $3 per
barrel of oil). Ad valorem tariffs are taxes that are levied as a fraction of the value of the
imported goods (for example, a 25 percent U.S. tariff on imported trucks—see the following
box). In either case, the effect of the tariff is to raise the cost of shipping goods to a
country.
Part Two
9
International Trade Policy
Tariffs are the oldest form of trade policy and have traditionally been used as a
source of government income. Until the introduction of the income tax, for instance,
the U.S. government raised most of its revenue from tariffs. Their true purpose, however,
has usually been twofold: both to provide revenue and to protect particular
domestic sectors. In the early 19th century, for example, the United Kingdom used tariffs
(the famous Corn Laws) to protect its agriculture from import competition. In the
late 19th century, both Germany and the United States protected their new industrial
sectors by imposing tariffs on imports of manufactured goods. The importance of
tariffs has declined in modern times because modern governments usually prefer to
protect domestic industries through a variety of nontariff barriers, such as import
quotas (limitations on the quantity of imports) and export restraints (limitations on
the quantity of exports—usually imposed by the exporting country at the importing
country’s request). Nonetheless, an understanding of the effects of a tariff remains vital
for understanding other trade policies.
In developing the theory of trade in Chapters 3 through 8, we adopted a general equilibrium
perspective. That is, we were keenly aware that events in one part of the economy
have repercussions elsewhere. However, in many (though not all) cases, trade policies
toward one sector can be reasonably well understood without going into detail about those
policies’ repercussions on the rest of the economy. For the most part, then, trade policy
can be examined in a partial equilibrium framework. When the effects on the economy as
a whole become crucial, we will refer back to general equilibrium analysis.
Supply, Demand, and Trade in a Single Industry
Let’s suppose there are two countries, Home and Foreign, both of which consume and produce
wheat, which can be costlessly transported between the countries. In each country,
wheat is a simple competitive industry in which the supply and demand curves are functions
of the market price. Normally, Home supply and demand will depend on the price in terms
of Home currency, and Foreign supply and demand will depend on the price in terms of
Foreign currency. However, we assume that the exchange rate between the currencies is not
affected by whatever trade policy is undertaken in this market. Thus we quote prices in both
markets in terms of Home currency.
Trade will arise in such a market if prices are different in the absence of trade.
Suppose that in the absence of trade, the price of wheat is higher in Home than it is in
Foreign. Now let’s allow foreign trade. Since the price of wheat in Home exceeds the
price in Foreign, shippers begin to move wheat from Foreign to Home. The export of
wheat raises its price in Foreign and lowers its price in Home until the difference in
prices has been eliminated.
To determine the world price and the quantity traded, it is helpful to define two new
curves: the Home import demand curve and the Foreign export supply curve, which are
derived from the underlying domestic supply and demand curves. Home import demand is
the excess of what Home consumers demand over what Home producers supply; Foreign
export supply is the excess of what Foreign producers supply over what Foreign consumers
demand.
Figure 9-1 shows how the Home import demand curve is derived. At the price , Home
consumers demand , while Home producers supply only . As a result, Home import
demand is . If we raise the price to , Home consumers demand only , while
Home producers raise the amount they supply to , so import demand falls to .
These price-quantity combinations are plotted as points 1 and 2 in the right-hand panel of
Figure 9-1. The import demand curve MD is downward sloping because as price increases,
the quantity of imports demanded declines. At PA, Home supply and demand are equal in
S2 D2 – S2
D1–S1 P2 D2
D1 S1
P1
CHAPTER 9 The Instruments of Trade Policy 193
194 PART TWO International Trade Policy
the absence of trade, so the Home import demand curve intercepts the price axis at
.
Figure 9-2 shows how the Foreign export supply curve XS is derived. At Foreign
producers supply , while Foreign consumers demand only , so the amount of the
total supply available for export is . At Foreign producers raise the quantity
they supply to and Foreign consumers lower the amount they demand to , so the
quantity of the total supply available to export rises to . Because the supply
of goods available for export rises as the price rises, the Foreign export supply curve is
S*2– D*2
S*2 D*2
S*1– D*1 P2
S*1 D*1
P1
PA (import demand = zero at PA)
Price, P
Quantity, Q
PA
P1
P 2
S1 S2 D 2 D1
Price, P
D MD
S
Quantity, Q D 2 – S 2 D1 – S1
A
1
2
Figure 9-1
Deriving Home’s Import Demand Curve
As the price of the good increases, Home consumers demand less, while Home producers
supply more, so that the demand for imports declines.
Price, P
Quantity, Q
P1
P2
D*2 D*1 S*1 S*2
Price, P XS
D*
S*
Quantity, Q S*1 – D*1 S*2 – D*2
PA*
Figure 9-2
Deriving Foreign’s Export Supply Curve
As the price of the good rises, Foreign producers supply more while Foreign consumers
demand less, so that the supply available for export rises.
CHAPTER 9 The Instruments of Trade Policy 195
upward sloping. At , supply and demand would be equal in the absence of trade, so the
Foreign export supply curve intersects the price axis at .
World equilibrium occurs when Home import demand equals Foreign export supply
(Figure 9-3). At the price where the two curves cross, world supply equals world
demand. At the equilibrium point 1 in Figure 9-3,
By adding and subtracting from both sides, this equation can be rearranged to say that
or, in other words,
Effects of a Tariff
From the point of view of someone shipping goods, a tariff is just like a cost of transportation.
If Home imposes a tax of $2 on every bushel of wheat imported, shippers will be unwilling
to move the wheat unless the price difference between the two markets is at least $2.
Figure 9-4 illustrates the effects of a specific tariff of t per unit of wheat (shown as t in
the figure). In the absence of a tariff, the price of wheat would be equalized at in both
Home and Foreign, as seen at point 1 in the middle panel, which illustrates the world market.
With the tariff in place, however, shippers are not willing to move wheat from Foreign
to Home unless the Home price exceeds the Foreign price by at least t. If no wheat is being
shipped, however, there will be an excess demand for wheat in Home and an excess supply
in Foreign. Thus the price in Home will rise and that in Foreign will fall until the price
difference is t.
Introducing a tariff, then, drives a wedge between the prices in the two markets. The
tariff raises the price in Home to and lowers the price in Foreign to . In
Home, producers supply more at the higher price, while consumers demand less, so that
fewer imports are demanded (as you can see in the move from point 1 to point 2 on the
MD curve). In Foreign, the lower price leads to reduced supply and increased demand, and
thus a smaller export supply (as seen in the move from point 1 to point 3 on the XS curve).
Thus the volume of wheat traded declines from QW, the free trade volume, to QT, the
PT * PT = PT - t
PW
World demand = World supply.
Home demand + Foreign demand = Home supply + Foreign supply
Home demand - Home supply = Foreign supply - Foreign demand.
PW
PA * 1export supply = zero at PA * 2
PA
*
Price, P
Quantity, Q
PW
PA
PA
* MD
XS
QW
1
Figure 9-3
World Equilibrium
The equilibrium world price is where
Home import demand (MD curve)
equals Foreign export supply
(XS curve).
196 PART TWO International Trade Policy
volume with a tariff. At the trade volume , Home import demand equals Foreign export
supply when .
The increase in the price in Home, from to , is less than the amount of the tariff,
because part of the tariff is reflected in a decline in Foreign’s export price and thus is not
passed on to Home consumers. This is the normal result of a tariff and of any trade policy
that limits imports. The size of this effect on the exporters’ price, however, is often very
small in practice. When a small country imposes a tariff, its share of the world market for
the goods it imports is usually minor to begin with, so that its import reduction has very
little effect on the world (foreign export) price.
The effects of a tariff in the “small country” case where a country cannot affect
foreign export prices are illustrated in Figure 9-5. In this case, a tariff raises the price of
the imported good in the country imposing the tariff by the full amount of the tariff, from
to . Production of the imported good rises from to , while consumption of
the good falls from to . As a result of the tariff, then, imports fall in the country
imposing the tariff.
Measuring the Amount of Protection
A tariff on an imported good raises the price received by domestic producers of that good.
This effect is often the tariff’s principal objective—to protect domestic producers from the
low prices that would result from import competition. In analyzing trade policy in practice, it
is important to ask how much protection a tariff or other trade policy actually provides. The
answer is usually expressed as a percentage of the price that would prevail under free trade.
An import quota on sugar could, for example, raise the price received by U.S. sugar producers
by 35 percent.
Measuring protection would seem to be straightforward in the case of a tariff: If the
tariff is an ad valorem tax proportional to the value of the imports, the tariff rate itself
should measure the amount of protection; if the tariff is specific, dividing the tariff by the
price net of the tariff gives us the ad valorem equivalent.
D1 D2
PW PW + t S1 S2
PW PT
PT - PT * = t
QT
Home market World market Foreign market
Price, P
PW
Quantity, Q
D
S
PT
Price, P
QT Quantity, Q
D*
S*
Price, P
QW Quantity, Q
MD
XS
PT*
2
1
3
t
Figure 9-4
Effects of a Tariff
A tariff raises the price in Home while lowering the price in Foreign. The volume traded thus declines.
CHAPTER 9 The Instruments of Trade Policy 197
Price, P
Quantity, Q
PW + t
D
S
S1 S2 D2 D1
Imports after tariff
Imports before tariff
PW
Figure 9-5
A Tariff in a Small Country
When a country is small, a tariff it
imposes cannot lower the foreign
price of the good it imports. As a
result, the price of the import rises
from to and the quantity
of imports demanded falls
from D1 - S1 to D2 - S2.
PW PW + t
However, there are two problems with trying to calculate the rate of protection this
simply. First, if the small country assumption is not a good approximation, part of the
effect of a tariff will be to lower foreign export prices rather than to raise domestic prices.
This effect of trade policies on foreign export prices is sometimes significant.
The second problem is that tariffs may have very different effects on different stages of
production of a good. A simple example illustrates this point.
Suppose that an automobile sells on the world market for $8,000 and that the parts out
of which that automobile is made sell for $6,000. Let’s compare two countries: one that
wants to develop an auto assembly industry and one that already has an assembly industry
and wants to develop a parts industry.
To encourage a domestic auto industry, the first country places a 25 percent tariff
on imported autos, allowing domestic assemblers to charge $10,000 instead of $8,000. In
this case it would be wrong to say that the assemblers receive only 25 percent protection.
Before the tariff, domestic assembly would take place only if it could be done for $2,000
(the difference between the $8,000 price of a completed automobile and the $6,000 cost of
parts) or less; now it will take place even if it costs as much as $4,000 (the difference
between the $10,000 price and the cost of parts). That is, the 25 percent tariff rate provides
assemblers with an effective rate of protection of 100 percent.
Now suppose that the second country, to encourage domestic production of parts,
imposes a 10 percent tariff on imported parts, raising the cost of parts of domestic
assemblers from $6,000 to $6,600. Even though there is no change in the tariff on
assembled automobiles, this policy makes it less advantageous to assemble domestically.
Before the tariff it would have been worth assembling a car locally if it could be
done for ; after the tariff, local assembly takes place only
if it can be done for . The tariff on parts, then, while providing
positive protection to parts manufacturers, provides negative effective protection to
assembly at the rate of
Reasoning similar to that seen in this example has led economists to make elaborate
calculations to measure the degree of effective protection actually provided to particular
-30 percent 1-600/2,0002.
$1,400 1$8,000 - $6,6002
$2,000 1$8,000 - $6,0002
industries by tariffs and other trade policies. Trade policies aimed at promoting economic
development, for example (Chapter 11), often lead to rates of effective protection much
higher than the tariff rates themselves.
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