Question

Consider a situation where the Terms of Trade Effects Tariff Model holds for a country that imports Commodity A. Initially, the country has trade without tariffs on Commodity A. It then changes its policy and imposes a tariff on Commodity A, while continuing to allow trade in A. Answer the following assuming there is no foreign retaliation.

(a) What happens to Total Surplus for the country? Why?

(b) What happens to Total Surplus for foreign exporting countries of Commodity A that have the tariff imposed on them? Why?

(c) What happens to Total Surplus for the world? Why?

Answer 1

(a) The import tariff is initially set at 10%. Note that the tariff is applied to the CIF price, not to the full import parity price. The tariff represents part of the gap between the world price (in black) and the domestic price (in green), the other part being port-to-destination marketing costs.

We can set a new tariff rate of 20% by typing “20” or “0.20” in cell C19. The impact of this change is shown in the “after” column of the table marked in yellow and in the dashed lines on the graph. The new domestic price is 7% higher than in the base scenario. The higher price causes consumption to contract and production to expand, though the increased production would typically take at least one year to occur because of the planting cycle. As a result, imports decline by 23%. Although the tariff rate is doubled, the tariff revenue increases by only 55%. This is because higher tariff reduces the volume of imports, which partially offsets the higher rate. The import parity price (which includes the tariff) rises, thus increasing the domestic price by 7%.

(b) The change in producer surplus is about US$ 13 million. This represents the benefits to farmers of the higher price of the commodity. On the other hand, the negative consumer surplus indicates that consumers lose US$ 10 million. The net loss to farmers and consumers is US$ 3 million, but the government gains US$ 2.5 million in tariff revenue. The net impact of the higher import tariff on the economy is a loss of US$ 700 thousand.
If the tariff is raised from 20% to 30%, the tariff revenue increases to US$ 6.1 million, but the net cost to the economy rises by a factor of three. If the tariff is raised to 40%, the tariff revenue falls to US$ 2.15 million, but the overall cost to the economy increases to US$ 5.2 million. This illustrates two patterns with tariff rate changes:

• Tariff revenue rises at low rates, but eventually it reduces imports so much that tariff revenue begins to decline.
• As the tariff rate is increased, the net effect on the economy is initially small but rises proportionately faster than the tariff rate. When the tariff rate rises by a factor of four (from 10% to 40%), the net loss to the economy increases by a factor of seven (from US$ 700 thousand to US$ 5.2 million).

(c) If the tariff is increased above 60%, it becomes prohibitive, meaning that it chokes off all imports. The country becomes self-sufficient in the commodity, though the net cost to the economy is more than US$ 13 million. Farmers have gained about US$ 54 million, but this is offset by US$ 63 million in losses to consumers in the form of higher prices. In addition, tariff revenue, which was US3.6 million when the tariff was 10%, disappears with prohibitive tariffs. A further increase in tariffs has no effect on the economy because imports are no longer profitable.