1. Studied the effects of tariffs in competitive markets:Consumer surplus falls, producer surplus increases, and government gets tariff revenue. But there is still a deadweight loss.
2. If tariffs create deadweight losses why are they used?
a. It is a relatively efficient way of raising revenue for developing countries.
b. Governments respond to lobbying by firms threatened by import competition.
c. A large economy could use a tariff to improve its terms of trade: A small tariff might increase welfare. However, this is a beggar thy neighbor tariff. A tariff by a large country creates a deadweight loss for the world as a whole.
3. Quotas are discouraged by GATT, but still used (MFA was an important exception). Quotas have effects similar to tariffs, except that they create quota rents, rather than revenue for the government. Depending upon how the quota rents are allocated, they may represent an extra deadweight loss.
A tariff on imports is the most commonly used trade policy tool. In this chapter, we have studied the effect of tariffs on consumers and producers in both importing and exporting countries. We have looked at several different cases. First, we assumed that the importing country is so small that it does not affect the world price of the imported good. In that case, the price faced by consumers and producers in the importing country will rise by the full amount of the tariff. With a rise in the consumer price, there is a drop in consumer surplus; and with a rise in the producer price, there is a gain in producer surplus. In addition, the government collects revenue from the tariff. When we add together all these effects—the drop in consumer surplus, gain in producer surplus, and government revenue collected—we still get a net loss for the importing country. We have referred to that loss as the deadweight loss resulting from the tariff.
The fact that a small importing country always has a net loss from a tariff explains why most economists oppose the use of tariffs. Still, this result leaves open the question of why tariffs are used. One reason that tariffs are used, despite their deadweight loss, is that they are an easy way for governments to raise revenue, especially in developing countries. A second reason is politics: the government might care more about protecting firms than avoiding losses for consumers. A third reason is that the small-country assumption may not hold in practice: countries may be large enough importers of a product so that a tariff will affect its world price. In this large-country case, the decrease in imports demanded due to the tariff causes foreign exporters to lower their prices. Of course, consumer and producer prices in the importing country still go up, since these prices include the tariff, but they rise by less than the full amount of the tariff. We have shown that if we add up the drop in consumer surplus, gain in producer surplus, and government revenue collected, it is possible for a small tariff to generate welfare gains for the importing country.
Still, any gain for the importer in this large-country case comes at the expense of the foreign exporters. For that reason, the use of a tariff in the large-country case is sometimes called a “beggar thy neighbor” policy. We have found that the drop in the exporter’s welfare due to the tariff is greater than the gain in the importer’s welfare. Therefore, the world loses overall because of the tariff. This is another reason that most economists oppose their use.
In addition to an import tariff, we have also studied import quotas, which restrict the quantity of imports into a country. The WTO has tried to limit the use of import quotas and has been somewhat successful. For example, the Multifibre Arrangement (MFA) was a complex system of quotas intended to restrict the import of textiles and apparel into many industrialized countries. It was supposed to end on January 1, 2005, but both the United States and the European Union then established new quotas against imports of textiles and apparel from China, which expired at the end of 2008. The United States continues to have a quota on imports of sugar, and up until very recently, the European Union had a quota and then a discriminatory tariff on imports of bananas (that “banana war” has now ended). These are some of the best-known import quotas, and there are other examples, too.
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Under perfect competition, the effect of applying an import quota is similar to the effect of applying an import tariff: they both lead to an increase in the domestic price in the importing country, with a loss for consumers and a gain for producers. One difference, however, is that under a tariff the government in the importing country collects revenue, whereas under a quota, whoever is able to bring in the import earns the difference between the domestic and world prices, called “quota rents.” For example, if firms in the importing country have the licenses to bring in imports, then they earn the quota rents. Alternatively, if resources are wasted by firms trying to capture these rents, then there is an additional deadweight loss. It is more common, however, for the foreign exporters to earn the quota rents, as occurs under a “voluntary” export restraint, administered by the foreign government. A fourth possibility is that the government in the importing country auctions the quota licenses, in which case it earns the equivalent of the quota rents as auction revenue; this case is identical to the tariff in its welfare outcome.