Chapter 8
Analysis of a Tariff
Overview
This chapter starts the analysis of government policies that limit imports, by examining the tariff
—a government tax on imports.
Early in the chapter, the first in a series of boxes on Global Governance introduces the World
Trade Organization (WTO), created in 1995, which subsumed the General Agreement on Tariffs
and Trade (GATT), formed in 1947. The major principles of the WTO include trade
liberalization, nondiscrimination, and no unfair encouragement of exports. Eight completed
rounds of multilateral trade negotiations have been successful in lowering tariffs imposed on
most nonagricultural imports into industrialized countries. The box also notes the different path
that developing countries have taken to their tariff reductions.
In addition to beginning the examination of the role and activities of the WTO, the chapter has
two major purposes. First, the analysis shows the effects of a tariff when the importing country is
small, so that its import policies have no effect on world prices. Second, the analysis of a large
importing country—one whose policies can affect world prices—shows that a large country can
use a tariff to lower the price that it pays foreigners for its imports. Furthermore, the box “They
Tax Exports, Too” shows that analysis of an export duty parallels that of an import tariff.
We begin by examining the effects of an import tariff imposed by a small country (contrasted
with free trade), using supply and demand within the importing country. Since foreign exporters
do not change the price that they charge for the product, the domestic price of the imported
product rises by the amount of the tariff. Domestic producers competing with these imports can
also raise their domestic prices as the domestic price of imports rises. Domestic producers gain
when the government imposes a tariff on competing imports. They get a higher price for their
products, they produce and sell a larger quantity (a movement along the domestic supply curve),
and they receive more producer surplus. (The effects of the entire tariff system on domestic
producers can be more complicated than this, because other tariffs can raise the costs of materials
and components. The box on “The Effective Rate of Protection” discusses this more complete
analysis, focusing on the effects of the tariff system on value added per unit of domestic
production.)
Domestic consumers of the product are also affected by the imposition of the tariff. They must
pay a higher price (for both imported and domestically produced products), they reduce the
quantity that they buy and consume (a movement along the domestic demand curve), and they
suffer a loss of consumer surplus.
The government also collects tariff revenue, equal to the tariff rate per unit imported times the
quantity that is imported with the tariff in place (less than the free-trade import quantity).
We thus have two domestic winners (domestic producers and the national government) and one
domestic loser (domestic consumers) because of the imposition of a tariff. We can evaluate the
net effect on the whole country, if we have some way of comparing winners and losers. As we
did beginning in Chapter 2, we can, for instance, use the one-dollar, one-vote metric. Part of
what consumers lose is matched by the gain to domestic producers, and another part is matched
by the revenue gain to the government. But there is an additional amount that consumers lose
and that is not a gain to the other groups. This is the net national loss from a tariff (for a small
country). In the national market graph this loss is two triangles; equivalently, in the
import-export graph this loss is one triangle.
If we look at the national market graph, we can see why these are deadweight losses. The
consumption effect of the tariff is the loss of consumer surplus for those consumers who are
squeezed out of the market because the tariff “artificially” raises the domestic price, even though
foreigners remain willing to sell products to the importing country at the lower world price. The
production effect of the tariff is the loss from using high-cost domestic production to replace
lower-cost imports (available to the country at the unchanged world price). The high production
cost is shown by the height of the domestic supply curve, for each of the extra units produced
because of the tariff.
The analysis is affected in important ways if the importing country is a large country, one that
has monopsony power in world markets. A large country can gain from the terms-of-trade effect
when it imposes a tariff. The tariff reduces the amount that the country wants to import, so
foreign exporters lower their price (a movement along the foreign supply-of-exports curve). We
analyze the large country case using the international market (imports and exports), and we show
the tariff as driving a wedge between import demand and export supply, so the price to the
import buyers exceeds the price received by foreign exporters by the amount of the tariff. For the
large importing country, the imposition of the tariff causes a triangle of national loss (comparable
to the one shown for the small country) but also a rectangle of national gain because the price
paid to foreign exporters is lowered, for the units that the country continues to import.
The net effect on the importing country depends on which of these two is larger. For a suitably
small tariff, the rectangle is larger, so the importing country has a net gain from imposing a tariff.
A prohibitive tariff would cause a net national loss, because the rectangle would disappear. It is
possible to determine the country’snationally optimal tariff—the tariff rate that makes the net
gain to the importing country as large as possible. The optimal tariff rate is inversely related to
the price elasticity of foreign supply of the country’s imports.
We conclude by pointing out that the optimal tariff causes a net loss to the whole world. The loss
to the foreign exporting country is larger than the net gain to the importing country. And a
country trying to impose an optimal tariff risks retaliation by the foreign countries hurt by the
country’s tariff.
Tips
This chapter is crucial to understanding the effects of government policies toward trade. We
recommend a strategy of “stereo” coverage. Every key point should be expressed in written
words as well as in diagrams, in lecture as well as in the textbook.
A requirement for clear understanding throughout Chapters 8-15 is that students know how to
interpret the height of the demand curve as marginal benefits and the height of the supply curve
as marginal costs, leading them to measures of consumer surplus and producer surplus. If
students have not mastered these concepts in other courses, they must be taken through this
material in Chapter 2. Even a course that wants to go quickly to government policies toward
trade, skipping the details of trade theory, should start with Chapter 2.
In the textbook, we choose to show the optimal tariff (in Figure 8.6) using only
demand-for-imports and supply-of-exports in the international market. In class session you may
also want to show the analysis in the equivalent way, using the national market (as for the small
tariff in Figure 8.4). The national market can be used to show the full range of effects when a
large country imposes an optimal tariff: increase in domestic producer surplus; decrease in
domestic consumer surplus; government tariff revenue, with some of it paid by domestic
consumers and some effectively paid by foreign exporters, compared with the free-trade price;
and the net effect on national well-being as the difference between the rectangle of gain from the
lower price paid to foreign exporters and the two triangles of loss.
We present the analysis of a tariff in this chapter for both the small country and the large country,
and we present the analysis of an import quota and a voluntary export restraint (VER) in the next
chapter. In your class presentation you might consider a different way of organizing this material,
in which you present the small country analysis of the tariff, the quota, and the VER as a
package, and then turn to looking at the large country analysis of the tariff and the quota. This
alternative approach is designed to emphasize the fundamental similarities of the analyses of
these different government policies, as well as the specific ways in which they are different.
Students generally find it easier to grasp the small country analyses, so it can be useful to do all
three policies for this easier case before turning to the large country analyses.
For those who want to present a more technical analysis of the optimal tariff, the first section of
Appendix D presents the basic mathematics. The third section of Appendix D shows how to use
offer curves and trade indifference curves to determine the optimal tariff.
We have found that many students have a stronginterest in the WTO, because they have heard
about it in the news. The chapter introduces the WTO early, to draw on this student interest. The
placement of the introduction of the WTO is helpful to instructors who like to begin their
discussion of trade policy with the WTO. Other instructors may choose to defer examination of
the WTO until after the graphical analysis of government policies toward imports in completed.
This can be done, for instance, by merging the information in the WTO box in this chapter with
the WTO material in Chapter 9, for a discussion of a full range of WTO activities, including the
nearly dormant Doha Round of trade negotiations and the WTO dispute settlement process (both
covered in Chapter 9).