Chapter 7 - Import Tariffs and Quotas Under Perfect Competition

Introduction

On September 11, 2009, President Barack Obama announced a 35% tariff on Chinese tire imports; it expired on September 27, 2012.
This illustrates a trade policy, which is a government action to influence international trade amounts.
Trade policies, including import tariffs, import quotas, and export subsidies, arise because trade gains are uneven, and industries/labor unions seek government intervention to limit losses or maximize gains.

Tariffs and Quotas in Perfect Competition

This chapter focuses on the effects of tariffs and quotas in a perfectly competitive industry.
It establishes the international context for trade policy.
It examines the use of tariffs, the most common trade policy.
It explores import quotas, which limit the quantity of a good imported from a foreign country.

A Brief History of the World Trade Organization

After World War II, Allied countries discussed high trade barriers and unstable exchange rates.
In 1947, the General Agreement on Tariffs and Trade (GATT) was established to reduce trade barriers between nations.
GATT main provisions:
1. Nations must extend the same tariffs to all WTO trading partners.
2. Tariffs can be imposed in response to unfair trade practices like dumping.
  - Dumping is selling export goods at a price lower than at home or below production and shipping costs.
3. Countries should not limit the quantity of goods and services they import.
4. Countries should declare export subsidies.
  - Article XVI addresses export subsidies, requiring countries to notify each other and discuss eliminating them.
5. Countries can temporarily raise tariffs for certain products under Article XIX, the safeguard provision or escape clause.
6. Regional trade agreements are permitted under Article XXIV of GATT.
  - GATT recognizes free-trade areas (removing trade barriers between members) and customs unions (free-trade areas with identical tariffs).

Key Provisions of the GATT

Article I: General Most-Favored-Nation (MFN) Treatment
Article VI: Anti-Dumping and Countervailing Duties
Article XI: General Elimination of Quantitative Restrictions
Article XVI: Subsidies
Article XIX: Emergency Action on Imports of Particular Products
Article XXIV: Territorial Application—Frontier Traffic—Customs Unions and Free-Trade Areas

Consumer and Producer Surplus

Consumer Surplus: Satisfaction of consumers above what they pay. Area below demand curve and above price.
Producer Surplus: Return to fixed factors of production. Area above the supply curve and below the price.
Supplier with marginal costs of $P0$ sells for $P1$ . The difference is the producer surplus.

Gains from Trade for a Small Country

No Trade: Home demand is D, supply is S; equilibrium at point A, price at $PA$ , producing $Q0$ .
Free Trade: World price is $PW$ , quantity demanded increases to $D1$ , quantity supplied falls to $S1$ . Home imports are $D1 – S_1$ .
Consumer surplus increases by area $(b + d)$ , producer surplus falls by area $b$ .
Gains from trade are measured by area $d$ . Rise in consumer surplus: $(b + d)$ . Fall in producer surplus: $-b$ . Net effect on Home welfare: $+d$ .

Home Import Demand Curve

With Home demand D and supply S, the no-trade equilibrium is at point A, with price $PA$ and import quantity $Q0$ .
Import demand at this price is zero, as shown by point A' in panel (b).
At a lower world price of $PW$ , import demand is $M1 = D1 – S1$ , as shown by point B.
The import demand curve shows the relationship between the world price and the quantity of imports demanded by Home consumers.

Tariff for a Small Country

Applying a tariff of $t$ dollars increases the import price from $PW$ to $PW + t$ . The domestic price also rises to $P_W + t$ .
This price rise increases Home supply from $S1$ to $S2$ and decreases Home demand from $D1$ to $D2$ .
Imports fall from $M1$ to $M2$ .

Effect of Tariff on Welfare

The tariff increases the price from $PW$ to $PW + t$ .
Consumer surplus falls by $(a + b + c + d)$ .
Producer surplus rises by area $a$ , and government revenue increases by area $c$ .
Net loss in welfare (deadweight loss) is $(b + d)$ .
Fall in consumer surplus: $-(a + b + c + d)$ . Rise in producer surplus: $+a$ . Rise in government revenue: $+c$ . Net effect on Home welfare: $-(b + d)$ .

Interpretation of Deadweight Loss

Triangle $b$ equals the increase in marginal costs for the extra units produced and can be interpreted as the production loss (or the efficiency loss) due to producing at marginal cost above the world price.
Triangle $d$ represents the drop in consumer surplus for those individuals no longer able to consume units between $D1$ and $D2$ because of the higher price (consumption loss).

Why Are Tariffs Applied?

Developing countries implement tariffs because they lack other government revenue sources; tariffs are "easy to collect."
Producers (and workers) benefit more directly and are concentrated on specific firms and states than the costs to consumers, which are spread nationwide.

Foreign Export Supply

With Foreign demand of $D^$ and Foreign supply of $S^$ , the no-trade equilibrium in Foreign is at point $A^$ , with the price of $P_A^$ .
At this price, the Foreign market is in equilibrium and Foreign exports are zero—point $A^$ in panel (a) and point $A^\prime$ in panel (b), respectively.
When the world price, $PW$ , is higher than Foreign’s no-trade price, the quantity supplied by Foreign, $S^1$ , exceeds the quantity demanded by Foreign, $D^1$ , and Foreign exports $X^1 = S^1 – D^*1$ .
Home import demand of $M$ , the world equilibrium is at point $B^*$ , with the price $P_W$ .

Effect of Import Tariffs for a Large Country

The tariff shifts up the export supply curve from $X^$ to $X^ + t$ .
The Home price increases from $PW$ to $P^* + t$ , and the Foreign price falls from $PW$ to $P^*$ .
The deadweight loss at Home is the area of triangle $(b + d)$ , and Home also has a terms-of-trade gain of area $e$ .
Foreign loses the area $(e + f)$ , so the net loss in world welfare is the triangle $(b + d + f)$ . Area $e$ measures terms-of-trade gain for the importer.
Fall in consumer surplus: $-(a + b + c + d)$ . Rise in producer surplus: $+a$ . Rise in government revenue: $+(c + e)$ . Net effect on Home welfare: $e – (b + d)$ .

Optimal Tariff for a Large Importing Country

For a large importing country, a tariff initially increases the importer’s welfare because the terms-of-trade gain exceeds the deadweight loss.
Welfare continues to rise until the tariff is at its optimal level (point C). After that, welfare falls. If the tariff is too large (greater than at B'), then welfare will fall below the free-trade level. For a prohibitive tariff, with no imports at all, the importer’s welfare will be at the no-trade level, at point A.
Optimal Tariff Formula: $Optimal\ tariff = \frac{1}{E^*_X}$
- $E^*_X$ is the elasticity of Foreign export supply.

Import Quotas

On January 1, 2005, China was poised to become the world’s largest exporter of textiles and apparel. On that date, the Multifibre Arrangement (MFA) was abolished.
Besides the MFA, there are many other examples of import quotas.
For example, since 1993 Europe had a quota on the imports of bananas that allowed for a greater number of bananas to enter from its former colonies in Africa than from Latin America.
Another example is the quota on U.S. imports of sugar, which is still in place despite calls for its removal.

Import Quota in a Small Country

Under free trade, the Foreign export supply curve is horizontal at the world price $PW$ , and the free-trade equilibrium is at point B with imports of $M1$ .
Applying an import quota of $M2 < M1$ leads to the vertical export supply curve $X$ —with the equilibrium at point C. The quota increases the import price from $PW$ to $P2$ .
There would be the same impact on price and quantities if instead of the quota, a tariff of $t = P2 - PW$ had been used.
The quota and tariff differ in terms of area c, which would be collected as government revenue under a tariff.
Under the quota, this area equals the difference between the domestic price $P2$ and the world price $PW$ , times the quantity of imports $M_2$ .

Quota Rents

The difference between the world price $PW$ and the higher Home price $P2$ is the rent associated with the quota; area $c$ represents total quota rents.

Four Ways to Allocate Quota Rents

Giving the Quota to Home Firms
- Quota licenses are given to Home firms: With home firms earning the rents $c$ , the net effect of the quota on Home welfare is:
  - Fall in consumer surplus: $-(a + b + c + d)$
  - Rise in producer surplus: $+ a$
  - Quota rents earned at Home $+ c$
  - Net effect on Home welfare: $-(b + d)$
Rent Seeking
- Inefficient activities done to obtain quota licenses are called rent-seeking.
  - Fall in consumer surplus: $-(a + b + c + d)$
  - Rise in producer surplus: $+ a$
  - Net effect on Home welfare: $-(b + c + d)$
Auctioning the Quota
- The government auctions off quota licenses, collecting revenue equal to the rents (area $c$ ).
  - Fall in consumer surplus: $-(a + b + c + d)$
  - Rise in producer surplus: $+ a$
  - Auction revenue earned at Home $+ c$
  - Net effect on Home welfare: $-(b + d)$
“Voluntary” Export Restraint
- The importing country gives authority for implementing the quota to the exporting country’s government.
- Quota rents are earned by foreign producers.
  - Fall in consumer surplus: $-(a + b + c + d)$
  - Rise in producer surplus: $+ a$
  - Net effect on Home welfare: $-(b + c + d)$

China and the Multifibre Arrangement

One of the founding principles of GATT was that countries should not use quotas to restrict imports.
The Multifibre Arrangement (MFA), organized under the auspices of the GATT in 1974, was a major exception to that principle and allowed the industrial countries to restrict imports of textile and apparel products from the developing countries.
Importing countries could join the MFA and arrange quotas bilaterally (i.e., after negotiating with exporters) or unilaterally (on their own).
The MFA expired on January 1, 2005.
The welfare loss for the United States due to the MFA is the area (b + c + d) in Figure 7-11.

China and the Multifibre Arrangement: Growth in Exports from China

The biggest potential supplier of textile and apparel products was China. Immediately, exports of textiles and apparel from China grew rapidly.

China and the Multifibre Arrangement: Import Quality

The prices of textile and apparel products dropped the most (in percentage terms) for the lower-priced items.
An inexpensive T-shirt coming from China and priced at $1 had a price drop of more than 38% (more than 38¢), whereas a more expensive item priced at $10 experienced a price drop of less than 38% (less than $3.80).
As a result, U.S. demand shifted toward the lower-priced items imported from China: there was “quality downgrading” in the exports from China.