International Trade: Tariffs - Research Paper Example

?INTERNATIONAL TRADE -TARIFFS Introduction A tax imposed on goods crossing the national border of a country is called customs duty. A schedule of such taxes on goods and services are called tariff. The existence of customs duty or tariffs can be found for hundreds of years. In those days main purpose of the tariff was to generate extra income for the government from traders. Tariff was levied from ports, markets, streets or even bridges. Tariff extracted on imports at the boundaries of the country has existed from the 17th century (Organization for Economic Co-operation and Development, pp-336). Such tariffs levied on the import of good are called the import tariff. Another kind of tariff which is not very common is called the export tariff. It is levied on exported products. Ghana imposed a tax on the export of cocoa. The OPEC (Organization of the Oil Producing Countries) once imposed export tax on oil to generate revenue and also artificially create a scarcity of oil in the international markets to increase the price of the product. A more important purpose of tariffs is to produce revenue for the government. A revenue tariff may be on export or import, depending on the trade policy of the government. But in modern times when international trade has a huge impact on the economy of a country, the most important role of tariffs is for protection purpose. Different Types of Tariffs Tariffs can be classified into three categories – the specific tariff, the ad valorem tariff and the compound tariff. Each kind of tariff has their own pros and cons we shall discuss them briefly. Specific tariff is fixed amount of money taxed on each unit of the imported goods. The advantage of this kind of tariff is that it can be very easily calculated on the standard goods that are regularly imported. However the degree of protection that this kind of tariff offers varies inversely with the price of the good in the international market. If the price of good is say $1000, a tariff of $250 will seem rather high and discourage domestic consumers from buying that product. However the $250 tariff would not affect the domestic consumers if the price of the good rises to $5000. Therefore if the price of the imported good rises the tariff loses its protective purpose. In such cases the domestic industry has to supply the domestic market with less expensive good to win back the consumers. But in times of depression the prices of goods in the world market falls. In such a situation the domestic markets are better protected by the specific tariff. Specific tariffs help the domestic industries against the foreign producers who reduce their prices as the extra price the domestic consumer has to pay for foreign good. Ad valorem tariff is a tax levied as a fixed percentage of the value of the imported good. Ad valorem tariff is more proportionate and progressive than specific tariff. For a slight improvement in the product which is reflected in its price a higher price needs to be paid. For example if Ad valorem tariff rate for a country is 10% then tariff for $200 iPod will be $20. For a slightly higher version of an iPod worth $220 the tariff will proportionately higher at $22. Furthermore, ad valorem rate of tariff ensures that there is a constant protection for the domestic industries through periods of fluctuating price. However ad valorem tariffs generate revenue for the government that is proportional to the value of imports. Therefore the government revenue may also fluctuate with price fluctuation. Another difficulty of imposing ad valorem tariff is the problem of evaluation. The evaluation of the value of the good poses a difficulty for the customs appraisers. The difficulty increases due to constant fluctuation of prices of goods in the world market. (Helpman and Krugman). Sometimes compound tariff rates are also preferred by the countries. This kind of tariff consists of a specific component and an ad valorem component. The specific tariff is used to negate the disadvantage of cost faced by the domestic producers of finished goods due to the protection enjoyed by the domestic producers of raw materials. The ad valorem component of the tariff shields the producers of the final goods. Effect of Tariff: Small Country and Large Country To demonstrate the effect of tariff on the economy of a country we will have to a few key concepts like consumers surplus, producer’s surplus and how welfare depends on these two. Consumer’s surplus is defined as the difference between the highest price the consumer is willing to pay for the product and the price he actually pays. The difference is the extra utility that he gets and therefore is called a surplus. The market demand curve denotes all combinations of prices and quantities that the consumers are willing. The consumer however ends up paying the equilibrium price and demanding the equilibrium quantity. This gives us the difference between the two gives us the consumer surplus of a product. D S’ P* E S D’ q* In the corresponding diagram DD’ is the demand curve. The equilibrium price and quantity is p* and q*. So the Consumer surplus in this case is the triangle D p*E. Producer’s surplus is the difference between the minimum price that a producer desires and the actual price that he gets. Since the market supply curve gives all combinations of this desired price and quantity. The seller however sells only the equilibrium quantity at the equilibrium price. In this way we get the difference between the two which is the producer’s surplus. In the above diagram, SS’ is the supply curve. So we have S p* E as the producer’s surplus. Together producer’s surplus and consumer surplus gives the welfare of a country. Small Country Case A small country is a price taker in the world market. An imposition of tariff by a small country cannot affect the terms of trade of the world economy. A P* PT B C D PO E F G H I When the economy was closed the domestic consumers and producers faced the price P*. The producers surplus was E+B and the consumers surplus was A. So the welfare of the country was A+E+B. But after the country was opened it faced the international price PO. The consumers were better off as their surplus increased to A+B+C+D+E+F+G+H+I. But the producer’s surplus decreased. The domestic producers of the country would start losing income and employment opportunity. As a result the government may decide to impose a tariff on the import of the product. This would increase the price to PT. This would have number of effect on the economy. Firstly the consumer’s surplus would decrease by the amount E+F+G+H+I to become only A+B+C+D. Of the loss in consumer’s surplus, G+H would be received by the government as tariff revenue. Therefore the country retains the surplus. It has been only converted to public surplus from the private surplus. This is called the revenue effect. The tariff will generate higher income for the domestic producers. Therefore the producer’s surplus would increase by E amount. This is called the redistributive effect of tariff, as consumer’s surplus has been converted to producer’s surplus. But the amount F is lost by the country for employing resources that are not the most efficient for the production of the good. F accounts for the ill-managed resources and is called the protective effect. Again an increase in tariff leads to a fall in consumption due to high priced goods. Therefore it is lost and is called the consumption effect. Together F+I are called the deadweight loss. This is a real loss to the society and is not redistributed to any sector. As long as the country remains a price taker and cannot affect the terms of trade, this deadweight loss will have to be incurred. (Samuelson, 446) Large Country Case A large country is a large consumer of the good. So an increase in the tariff or a drop in the quantity demanded can affect the global price and supply of the good. In case of an increase in price of the good in large country the quantity demanded will fall. Therefore the international supply curve is not elastic like a small country. st+f P* PT sf PO A B C D In case of a tariff, the domestic suppliers will reduce their prices to keep supplying their goods. In this way the burden of tax is shared by the foreign suppliers. Initially the price of the good was at p* when the country is closed. But as the country opens up to the foreign market the price falls to PO. The domestic manufacturers then get a less price. Therefore they lose income and employment. If the government now decides to impose a tariff and the supply curve shifts upward. The foreign supply curve shifts upward. Therefore the new equilibrium price is PT. At this price the loss in consumer surplus is A+B+C+D. But A is accrued to the producers as Redistribution Effect. B is the protection effect and D is the consumption effect. Therefore B+D are the deadweight loss incurred by the economy. But the revenue effect in case of a large country is higher than that of the small country. It is now C+F. Here C is converted from the consumer surplus and it already belonged to the economy. But F is the tariff revenue that previously belonged to the foreign producers and is now the government is earning it. This is called the terms of trade effect. So a large country can impose tariff if the revenue generated from F is higher or equal than the deadweight loss from B+D. Otherwise it should refrain from protective policies (Carbaugh, 221-229) Conclusion Tariff rate can therefore improve the welfare for a large country though for a small country there are no advantages. However it helps the domestic industries of the small country and is sometimes necessary for the creation of employment. For a large country the optimum tariff rate can actually increase the welfare of the country. The purpose of protective tariff is more economic than financial. The government of a country uses this tariff to shield its domestic industry from the high competition of the world market. In the global market the supply of any good is elastic at a very low price. It means that a very low price the market has the capacity of supplying almost infinite quantity of that good. So it becomes necessary for the government to impose a tariff on the import. This protective policy is mostly adopted by the developing countries. The developed countries rely more on open trade for their development. BIBLIOGRAPHY 1. Carbaugh, Robert. International Economics, Connecticut, Cengage Learning, 2008. Pg 121-129 2. Helpman, Elhanan and Paul Krugman. Trade Policy and Market Structure, Massachusetts, MIT Press, 1992. 3. Organization for Economic Co-operation and Development, Liberalizing Fisheries Markets: Scope and Effects. Paris, OECD Publishing, 2003. Pp-338 4. Samuelson, Paul A. Economics, Noida, Tata-Mcgraw Hill Education, 1980. Pg 446-449 Read More