Costs and Benefits of a Tariff

Costs and Benefits of a Tariff
A tariff raises the price of a good in the importing country and lowers it in the exporting country.
As a result of these price changes, consumers lose in the importing country and gain in the exporting
country. Producers gain in the importing country and lose in the exporting country. In
addition, the government imposing the tariff gains revenue. To compare these costs and benefits,
it is necessary to quantify them. The method for measuring costs and benefits of a tariff depends
on two concepts common to much microeconomic analysis: consumer and producer surplus.
Consumer and Producer Surplus
Consumer surplus measures the amount a consumer gains from a purchase by computing
the difference between the price he actually pays and the price he would have been willing
to pay. If, for example, a consumer would have been willing to pay $8 for a bushel of
wheat but the price is only $3, the consumer surplus gained by the purchase is $5.
Consumer surplus can be derived from the market demand curve (Figure 9-6). For
example, suppose that the maximum price at which consumers will buy 10 units of a good is
$10. Then the 10th unit of the good purchased must be worth $10 to consumers. If it were
worth less, they would not purchase it; if it were worth more, they would have been willing to
purchase it even if the price were higher. Now suppose that in order to get consumers to buy
11 units, the price must be cut to $9. Then the 11th unit must be worth only $9 to consumers.
198 PART TWO International Trade Policy
Price, P
Quantity, Q
D
$12
$10
$9
8 9 10 11
Figure 9-6
Deriving Consumer Surplus from
the Demand Curve
Consumer surplus on each unit
sold is the difference between the
actual price and what consumers
would have been willing to pay.
1The effective rate of protection for a sector is formally defined as , where is value added in
the sector at world prices and is value added in the presence of trade policies. In terms of our example, let
be the world price of an assembled automobile, the world price of its components, the ad valorem tariff rate
on imported autos, and the ad valorem tariff rate on components. You can check that if the tariffs don’t affect
world prices, they provide assemblers with an effective protection rate of
VT - VW
VW
= tA + PC a
tA - tC
PA - PC
b.
tC
PC tA
VT PA
VW 1VT - VW2/VW
CHAPTER 9 The Instruments of Trade Policy 199
Suppose that the price is $9. Then consumers are willing to purchase only the 11th
unit of the good and thus receive no consumer surplus from their purchase of that unit.
They would have been willing to pay $10 for the 10th unit, however, and thus receive
$1 in consumer surplus from that unit. They would also have been willing to pay
$12 for the 9th unit; in that case, they would have received $3 of consumer surplus on
that unit, and so on.
Generalizing from this example, if P is the price of a good and Q the quantity demanded
at that price, then consumer surplus is calculated by subtracting P times Q from the area
under the demand curve up to Q (Figure 9-7). If the price is , the quantity demanded is
and the consumer surplus is measured by the areas labeled a plus b. If the price rises to
, the quantity demanded falls to and consumer surplus falls by b to equal just a.
Producer surplus is an analogous concept. A producer willing to sell a good for $2 but
receiving a price of $5 gains a producer surplus of $3. The same procedure used to derive
consumer surplus from the demand curve can be used to derive producer surplus from the
supply curve. If P is the price and Q the quantity supplied at that price, then producer
surplus is P times Q minus the area under the supply curve up to Q (Figure 9-8). If the
price is , the quantity supplied will be , and producer surplus is measured by area c. If
the price rises to , the quantity supplied rises to , and producer surplus rises to equal c
plus the additional area d.
Some of the difficulties related to the concepts of consumer and producer surplus are
technical issues of calculation that we can safely disregard. More important is the question
of whether the direct gains to producers and consumers in a given market accurately
measure the social gains. Additional benefits and costs not captured by consumer and
producer surplus are at the core of the case for trade policy activism discussed in
Chapter 10. For now, however, we will focus on costs and benefits as measured by consumer
and producer surplus.
Measuring the Costs and Benefits
Figure 9-9 illustrates the costs and benefits of a tariff for the importing country. The tariff
raises the domestic price from to but lowers the foreign export price from to PT * PW PT PW
P2 S2
P1 S1
P2 D2
D1
P1
Price, P
Quantity, Q
D
D1
P1
P2
D2
a
b
Figure 9-7
Geometry of Consumer Surplus
Consumer surplus is equal to the
area under the demand curve and
above the price.
200 PART TWO International Trade Policy
(refer back to Figure 9-4). Domestic production rises from to while domestic consumption
falls from to . The costs and benefits to different groups can be expressed
as sums of the areas of five regions, labeled a, b, c, d, e.
Consider first the gain to domestic producers. They receive a higher price and therefore
have higher producer surplus. As we saw in Figure 9-8, producer surplus is equal to the
area below the price but above the supply curve. Before the tariff, producer surplus was
equal to the area below but above the supply curve; with the price rising to , this surplus
rises by the area labeled a. That is, producers gain from the tariff.
Domestic consumers also face a higher price, which makes them worse off. As we saw
in Figure 9-7, consumer surplus is equal to the area above the price but below the demand
PW PT
D1 D2
S1 S2
Price, P
Quantity, Q
S
S2
P2
P1
S1
d
c
Figure 9-8
Geometry of Producer Surplus
Producer surplus is equal to the
area above the supply curve and
below the price.
a
Price, P
Quantity, Q
D
S
S1 S2 D2 D1
PW
= consumer loss (a + b + c + d)
= government revenue gain (c + e)
PT
= producer gain (a)
b
c
d
e
PT*
QT
Figure 9-9
Costs and Benefits of a Tariff for
the Importing Country
The costs and benefits to different
groups can be represented as
sums of the five areas a, b, c, d,
and e.
CHAPTER 9 The Instruments of Trade Policy 201
curve. Since the price consumers face rises from to , the consumer surplus falls by
the area indicated by So consumers are hurt by the tariff.
There is a third player here as well: the government. The government gains by collecting
tariff revenue. This is equal to the tariff rate t times the volume of imports
. Since , the government’s revenue is equal to the sum of
the two areas c and e.
Since these gains and losses accrue to different people, the overall cost-benefit
evaluation of a tariff depends on how much we value a dollar’s worth of benefit to each
group. If, for example, the producer gain accrues mostly to wealthy owners of resources,
while consumers are poorer than average, the tariff will be viewed differently than if the
good is a luxury bought by the affluent but produced by low-wage workers. Further
ambiguity is introduced by the role of the government: Will it use its revenue to finance
vitally needed public services or waste that revenue on $1,000 toilet seats? Despite these
problems, it is common for analysts of trade policy to attempt to compute the net effect
of a tariff on national welfare by assuming that at the margin, a dollar’s worth of gain or
loss to each group is of the same social worth.
Let’s look, then, at the net effect of a tariff on welfare. The net cost of a tariff is
(9-1)
or, replacing these concepts by the areas in Figure 9-9,
(9-2)
That is, there are two “triangles” whose area measures loss to the nation as a whole and a
“rectangle” whose area measures an offsetting gain. A useful way to interpret these gains
and losses is the following: The triangles represent the efficiency loss that arises because a
tariff distorts incentives to consume and produce, while the rectangle represents the terms
of trade gain that arise because a tariff lowers foreign export prices.
The gain depends on the ability of the tariff-imposing country to drive down foreign
export prices. If the country cannot affect world prices (the “small country” case
1a + b + c + d2 - a - 1c + e2 = b + d - e.
Consumer loss - producer gain - government revenue,
t = PT - PT * QT = D2 - S2
a + b + c + d.
PW PT
Price, P
Quantity, Q
D
S
PW
PT
b d
e
Imports
= efficiency loss (b + d)
= terms of trade gain (e)
PT*
Figure 9-10
Net Welfare Effects of a Tariff
The colored triangles represent
efficiency losses, while the
rectangle represents a terms
of trade gain.
202 PART TWO International Trade Policy
Tariffs for the Long Haul
We just saw how a tariff can be used to increase
producer surplus at the expense of a loss in consumer
surplus. There are also many other indirect
costs of tariffs: They can lead trading partners to
retaliate with their own tariffs (thus hurting
exporting producers in the country that first imposed
the tariff); they can also be fiendishly hard
to remove later on even after economic conditions
have completely changed, because they help to
politically organize the small group of producers
that is protected from foreign competition. (We
will discuss this further in Chapter 10.) Finally,
large tariffs can induce producers to behave in
creative—though ultimately wasteful—ways in
order to avoid them.
In the case of the tariff known as the “Chicken
Tax,” the tariff lasted for so long (47 years, and
counting) that it ended up hurting the same
producers that had intensively lobbied to maintain
the tariff in the first place!* This tariff got its name
because it was a retaliation by U.S. President
Lyndon Johnson’s administration against a tariff
on U.S. chicken exports imposed by Western
Europe in the early 1960s. The U.S. retaliation,
focusing on Germany (one of the main political
forces behind the original chicken tariff), imposed
a 25 percent tariff on imports of light commercial
truck vehicles. At the time, Volkswagen was a big
producer of such vehicles and exported many of
them to the United States. As time went by, many
illustrated in Figure 9-5), region e, which represents the terms of trade gain, disappears,
and it is clear that the tariff reduces welfare. A tariff distorts the incentives of
both producers and consumers by inducing them to act as if imports were more expensive
than they actually are. The cost of an additional unit of consumption to the economy
is the price of an additional unit of imports, yet because the tariff raises the
domestic price above the world price, consumers reduce their consumption to the point
at which that marginal unit yields them welfare equal to the tariff-inclusive domestic
price. This means that the value of an additional unit of production to the economy is
the price of the unit of imports it saves, yet domestic producers expand production to
the point at which the marginal cost is equal to the tariff-inclusive price. Thus the
economy produces at home additional units of the good that it could purchase more
cheaply abroad.
The net welfare effects of a tariff are summarized in Figure 9-10. The negative effects
consist of the two triangles b and d. The first triangle is the production distortion loss
resulting from the fact that the tariff leads domestic producers to produce too much of this
good. The second triangle is the domestic consumption distortion loss resulting from the
fact that a tariff leads consumers to consume too little of the good. Against these losses
must be set the terms of trade gain measured by the rectangle e, which results from the
decline in the foreign export price caused by a tariff. In the important case of a small country
that cannot significantly affect foreign prices, this last effect drops out; thus the costs of
a tariff unambiguously exceed its benefits.