Study Unit 2 - gimmenotes

Study Unit 2 - gimmenotes

STUDY UNIT 5 Ms. K Amusa HOW TO USE THESE SLIDES? While working through these slides: Keep your study guide and textbook open next to you. Ask questions if there is anything you do not understand. These slides do not cover the entire chapter, only some of the important points. Make sure you also study the other parts as stipulated by your study guide. Remember to make notes! FOLLOW US IN YOUR TEXTBOOK

11th ed. pg. 211-224 247-266 10th ed. pg. 239-252 279-300 Arguments for protection Nontariff barriers Tariffs THIS STUDY UNIT COVERS:

TARIFFS A tariff is defined as a tax rate levied on imported goods as they cross national borders. There are three types of tariffs: 1. Ad-valorem- levied as a percentage of the value of the commodity. 2. Specific tariff- levied as a fixed amount of the value of the commodity. 3. Compound tariff- a combination of an ad valorem and specific tariff. ECONOMIC IMPACT OF A TARIFF. In discussing the impact of a tariff, distinction has to be made between a large and small country. A large country is one that can affect the world

price of the commodity and therefore influence its terms of trade A small country is one that cannot influence the world price of the commodity and as such cannot impact upon its terms of trade. When discussing the economic impact of a tariff make sure your discussion comprises of price, consumption, production, revenue and terms of trade effects. EFFECT OF A TARIFF ON A SMALL COUNTRY Domestic price of the imported commodity increases by the full amount of the tariff.

Consumers pay more because of the higher price Consumers will consume less of the imported commodity as they will switch to consuming less desirable domestic substitutes. This constitutes a loss in consumer welfare Producers experience an increase in production of the import competing commodity. There is loss in production efficiency as resources are reallocated from more efficient production to less.

Government receives revenue from the tariff. There is redistribution of real income from consumers to government and producers. PARTIAL EQUILIBRIUM EFFECT OF A TARIFF Figure 8.1 on pg.214 (follow animations in the textbook) Nation 2: demand and supply of commodity X PX($) SX At the free trade price of PX=$1, Nation 2

consumes 70X E Of which 10X is produced locally and 60X is imported 1 DX 60X Imported 10 70

X PARTIAL EQUILIBRIUM EFFECT OF A TARIFF Figure 8.1 on pg.214 (follow animations in the textbook) Nation 2: demand and supply of commodity X PX($) SX With 100% import tariff on X, PX rises to $2 for Nation 2 E

Now Nation 2 consume 50X of which 20X is locally produced and 30X is imported 2 30X Imported 1 DX 10 20 50

70 X PARTIAL EQUILIBRIUM EFFECT OF A TARIFF Figure 8.1 on pg.214 (follow animations in the textbook) Nation 2: demand and supply of commodity X Trade effect PX($) SX E Consumption

effect Production effect 2 $30 = Revenue Effect 1 10X X 10 DX

-20X 20 50 70 X ECONOMIC IMPACT OF A TARIFF ON A LARGE COUNTRY. The domestic price of the imported commodity increases but not by the full amount of the tariff.

Consumption of the imported commodity declines as consumers switch to less desirable domestic substitutes. Due to the big share in global demand for the commodity a large country has, the fall in their consumption forces the exporting nation to reduce its export price. Therefore the tariff burden is shared by consumers in the large country and the exporting nation Since the import price is now less, the terms of trade of the large nation improves. NB: Only a large country can improve its terms of trade (tot) by imposing a tariff. For a large country imposing a tariff, the trade volume decline but the tot improves,

whether the overall welfare of the nation increases or decreases depends on the net effect of the two forces. For a small country imposing a tariff, trade volume falls, representing a decline in welfare, the tot remain unchanged. Therefore the nation experiences an overall decline in welfare. OPTIMUM TARIFF This is the tariff rate that maximizes the difference between loss in trade volume and gains in terms of trade. For a small country, because it can't

influence world prices, it can't influence its tot either. See the illustration on page 42 of the study guide on optimum tariff and welfare. EFFECTIVE RATE OF PROTECTION (ERP) One of the reasons for imposing a tariff is to protect domestic producers So the question is how effective is the tariff? Nominal tariff is defined as the tariff imposed on the value of a final good. Nominal tariff does not tell us anything about the protection given to domestic producers. It is only for the consumers. Effective rate of protection measures the degree

of protection given to domestic production activities. ERP takes into account the tariff on both the final good and the imported inputs used to produce it. If the final good is taxed but the raw material used in producing it is not, the ERP will be high. If the raw materials are taxed but the final good is not then the ERP will be low. Meaning the domestic producers are taxed rather than protected. When the tariff on the final good exceeds that on the imported input, the ERP exceeds the nominal rate imposed on the good. When the tariff rate on the imported input

exceeds that on the final good, the ERP is less than the nominal rate imposed on the good. If the nominal tariff on the final good = the nominal tariff on the imported input, ERP=the nominal tariff rate imposed on the good. DO THE FOLLOWING TRUE OR FALSE QUESTIONS 1. The revenue from an ad valorem tariff changes as the value of imports changes. 2. Only a large importing country can improve its terms of trade by levying a tariff.

3. In times of inflation, a specific tariff costs importers less then an ad valorem tariff, provided the physical quantities imported remain unchanged. Kafayat do you have any specific questions on tariffs that you would like to include here? No NON TARIFF BARRIERS The non tariff barriers include: Import quotas Voluntary export restraint

International cartels Export subsidies local content requirement Border tax adjustments IMPORT QUOTAS Are direct quantitative restrictions on the amount of a commodity that can be imported Because quotas restrict imports, they cause an increase in the domestic price of the imported commodity just like a quota. The there is no limit to the difference between the domestic and world prices with a quota. Domestic consumption of the imported good

falls as consumers switch to less desirable substitutes DO THE FOLLOWING QUESTIONS 1. 2. Name and describe the main forms of nontariff barriers. Compare the partial equilibrium effect of an export subsidy to the effects of an import quota. ARGUMENTS FOR PROTECTION The

argument for protection include Infant industry argument Scientific tariff argument Strategic trade policy Optimum tariff argument NB: when discussing the arguments for protection make sure to explain each argument and also include any shortcomings/ criticisms the arguments may have. INFANT INDUSTRY ARGUMENT Due to lack of know how an industry might not set up or even when it has set up, it might not be able to compete with established foreign

industries. Therefore, an industry should be protected when it is in its infancy to enable it to attain a level of economies of scale to make it competitive with foreign industries. The protection must be temporary. The return from the grown industry must be sufficient to offset high prices paid by consumers during its infancy stage. The argument can however be abused Some industries remain protected even though they are not efficient or competitive

The argument is more applicable to developing nations than developed Production subsidy might be a better approach as it does not cost the consumers in terms of high prices paid during infancy. It is difficult to determine which industry can be regarded as an infant industry. SCIENTIFIC TARIFF ARGUMENT This is the rate that will equalize wage rates across countries. It is to enable domestic producers to meet foreign competition It is meant to offset the competitive advantage

of low wages in foreign countries This argument however does not take into account productivity differentials. There is not much that is scientific about the argument. The argument also takes wages to be the only component of production costs. STRATEGIC TRADE POLICY Argument that government needs to protect some large oligopolistic industries This is done to increase their market share at the expense of foreign competitors

To increase the global share of domestic firms. Strategic trade policy requires large capital, but as output increases marginal costs fall. There is lack of information to help government make its decision. There is also a loss of production efficiency. Read more from the text book OPTIMUM TARIFF This is the tariff that maximized the difference between loss in trade volume and improvement in tot.

The optimum tariff for a large country is positive The optimum tariff for a small country is zero. Only a large country can improve its tot by imposing a tariff. When a large country imposes a tariff, it forces the exporting nation to lower its price. this leads to an improvement in the large countrys tot and a worsening of the small countrys tot. ARGUMENTS AGAINST PROTECTION: Output declines with protection Production efficiency falls

Consumers pay more Consumers choices decline under protection. Local production of domestic substitute increases. Production

efficiency falls as resources are drawn from more efficient industries. No revenue accrues to government. The revenue goes to the license holders. Government only receives revenue if it auctions the import licenses. A rise in demand causes the domestic price of

the imported good to increase under a quota but the domestic price remains the same under a tariff. QUOTAS VS. MONOPOLISTS If a quota is imposed on an imported input, this raises the cost of production of the final good with no possibility of a rebate. While with a tariff, a rebate is given. A domestic monopolist can cause more harm to the economy under a quota than under a tariff. VOLUNTARY VS. AGREEMENTS Voluntary export restraint

International commodity agreements Here Are importing nation induces the exporting nation to voluntarily reduce its exports by threatening higher trade restrictions. VERs restrict supply thus increasing prices in the importing nation. So

the effects are similar to that of a quota. agreements between producing nations to stabilize commodity prices. INTERNATIONAL CARTELS Group of countries/ governments of countries with same industries agree to reduce /restrict trade in a commodity. Most famous is OPEC

Cartels restrict output thus raising prices. Cartels are harmful to the economy, much like a monopoly. In the long run cartels cannot be sustained as a supplier can deviate Local content requirement Export subsidies A Are portion of

the final good must be produced domestically. payments by government to a firm for each unit of the product shipped abroad DO THE FOLLOWING TRUE OR FALSE QUESTIONS 1. The infant industry argument only applies to

industries which can eventually acquire a comparative cost advantage 2. An argument for tariffs on certain goods is that they help to reduce the pricing power of local monopolies over domestic consumers. 3. Strategic trade policy may justify protection in some highly competitive markets where local producers need time to acquire a comparative cost advantage. Kafayat do you have any specific questions on protection that you would like to include here? No

END OF STUDY UNIT 5

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