This document provides an overview of tariffs as an instrument of trade policy. It discusses: 1. The objectives of understanding tariffs and their effects on trade patterns, welfare, and income distribution. 2. How tariffs work as a tax on imports, affecting supply and demand in domestic and world markets. Tariffs can create costs through deadweight loss. 3. Tools for analyzing the effects of tariffs, including partial equilibrium models and concepts of consumer surplus, producer surplus, and total surplus to measure costs and benefits. Tariffs typically reduce total welfare.

1. Learning Unit 10
Instruments of Trade Policy
Part 1: Tariff
ECON452
International Economics

2. Objectives
1. Distinguish various instruments of trade policies (tariffs, quotas,
export subsidies, VERs).
2. Understand the effects of tariffs and subsidies on trade patterns
and the welfare of trading nations and on the distribution of
income within countries.
3. Evaluate the costs and benefits of tariffs and winners and losers of
tariff policies
4. Articulate arguments for free trade that go beyond the conventional
gains from trade.
5. Evaluate national welfare arguments against free trade.

3. Introduction
• Governments attempt to interfere the international trade for various reasons.
However, any interference of international trade will
– affect the relative supply and demand in the world market.
– affect the world relative prices.
– cause terms of trade effect to all the countries.
– affect national welfare.
• Many reasons for government interventions on international trade are invalid,
and the government may not achieve the intended objectives, but the country
will suffer from unintended consequences of government interventions.

4. Trade Policy and Instruments
Trade (Commercial) policies: Regulations governing a nation’s international trade.
Trade restrictions are broadly categorized into two:
• Tariff: Tax (duty) levied on the traded commodity
• Non-Tariff Barriers (NTBs): All other government instruments to restrict or
control the international trade flows. NTBs include
– (a) Import Quota, (b) Voluntary Export Restraint (VER), (c) Export Subsidies, and (d) Export
Credit Subsidies which directly affect imports of foreign goods and services form other
countries or export of domestic goods and services to other countries
– (e) Local Content Requirement, (f) Government Procurement, (g) Bureaucratic regulations, and
(h) Subsidies which indirectly affect imports of foreign goods and services by imposing
disadvantages on foreign-made goods and services over domestic goods and services

5. Types of Tariffs
• Import tariff: a duty on the imported commodity.
• Export tariff: a duty on the exported commodity.
• A specific tariff is levied as a fixed charge for each unit of imported goods.
– Similar to excise taxes, but only imposed on specific imported goods.
– For example, $3 per barrel of oil.
• An ad valorem tariff is levied as a fraction of the value of imported goods.
– Similar to sales taxes, but only imposed on specific imported goods.
– For example, 25% tariff on the value of imported trucks.

6. Models to Analyze Effects of Tariffs
• Partial Equilibrium Model: Focus on one market at time and find equilibrium
through demand and supply in each market.
– Example: Examine effects of tariffs on steel import by looking only at steel
markets
• Two Cases of Analysis:
– Small country case: When the importing country is small relative to the world
market, its action cannot affect the world price of goods that the country
imports.
– Large country case: When the importing country is large relative to the world
market, its action will affect the world price of goods that the country
imports.

7. Measuring Costs and Benefits of Tariffs
• Because a tariff affects a relative price of goods, it has a distributional
effect among factor owners.
• Generally speaking, a tariff raises the price of a good in the importing
country, so it hurts consumers and benefits producers there.
• In addition, the government gains tariff revenue.
• How to measure these costs and benefits and compare them?
• Use the concepts of consumer surplus and producer surplus

8. Consumer and Producer Surplus
• Consumer surplus measures the amount that consumers gain from
purchases by computing the difference in the price actually paid from
the maximum price they would be willing to pay for each unit
consumed.
• Producer surplus measures the amount that producers gain from
sales by computing the difference in the price received from the
minimum price at which they would be willing to sell.

9. Consumer Surplus - Diagram
• Consumer surplus (CS) is equal to an area
below the demand curve, but above the
market price line.
– At P2, CS = a
– At P1, CS = a + b.
• As the price increases, the consumer surplus
decreases.
• For a straight-line demand, it is an area of
triangle:
– At P2, CS = (1/2) x (P0 – P2) x D2
P0

10. Producer Surplus - Diagram
• Producer surplus (PS) is equal to an area
above the supply curve, but below the
market price line.
– At P1, PS = c.
– At P2, CS = c + d.
• As the price increases, the producer surplus
increases.
• For a straight-line supply, it is an area of
triangle:
– At P1, PS = (1/2) x (P1 – P0) x S1
P0

11. Total Surplus (Total Welfare)
• Total surplus (Total Welfare) measures the
total amount that an economy gains.
• In an economy with only consumers and
producers, the total surplus is equal to the
sum of consumer surplus and producer
surplus.
• TS = CS + PS
• When a market reaches equilibrium, the
economy achieves efficient allocation of
resources and its total surplus is maximum.

12. Deadweight Loss
• Deadweight loss: the decrease in total
surplus that results from an inefficient
underproduction or overproduction.
– Any deviation from equilibrium leads to
inefficiency in market and in economy.
• When the market produces and consume less
than its equilibrium, the total surplus
decreases and the deadweight loss is created.
– Example: When an economy under-
produces at Q1, the total surplus decreases
to CS + PS and creates a deadweight loss
(DWL).

13. Sources of Deadweight Loss
• Overproduction or underproduction may occur when the government imposes
– Taxes on goods and services
– quota
– price ceiling and price floor
• Tariff acts like excise taxes, raising price and causing under-consumption by the
importing country and under-production by the exporting country.
– In general, the tariffs results in the deadweight loss of the world economy.

14. Autarky, Free Trade, and Tariff
• We examine an equilibrium of domestic market under
– Autarky
– Free Trade
– Tariff
• Compare total welfares in three cases to measure
– Gains from free trade (Difference between the autarky and free trade)
– Costs of tariffs (Difference between free trade and tariff)

15. Equilibrium under Autarky
• Without trade, the domestic
equilibrium occurs where the
domestic demand and domestic
supply intersect.
• A country produces QA units at
price of PA, which consumers
pay.

16. Equilibrium under Free Trade
• When the world price (PW) is less than domestic price
(PA), the country will import the goods at PW.
• At the lower price, the domestic consumers consume
more and the domestic firms produce less.
– At PW, domestic producers will produce QP units.
– At PW, domestic consumers will consume QC units.
– A difference between QP and QC (QP – QC) is imported
from other countries.
• Free trade benefits domestic consumers and hurts
domestic firms competing with the imports.
– Consumers are able to purchase at lower price.
– Produces must sell at lower price.

17. Basic Tariff Analysis
• A tariff acts like a sales tax, making foreign producers to charge domestic
consumers at a domestic price (PT) equal to the foreign price (PT*) plus the
amount of the tariff (t):
PT = PT
* + t
• Foreign producers, collecting tax (tariff) from domestic consumers, pay tariffs to
the government.
• Because foreign producers are selling to domestic consumers at PT, domestic
producers as price taker also sell to domestic consumers at PT.
• Even though foreign producers sell to domestic consumers at PT, foreign
consumers are still purchasing at PT* from foreign producers.

18. Effects of Tariff – Small Country Case
• A small country cannot affect the world price (foreign
export price).
• domestic price must increase by t (an amount of tariff).
PT = PW + t
• A tariff makes the price rise in the domestic market
from PW to PT.
• Consumers reduce their purchase and consumption
from D1 to D2.
• Producers increase their production and sales from S1
to S2.
• Imports decrease from D1-S1 to D2-S2.
PT =

19. Total Surplus under Autarky
• Under the autarky (in absent of trade) a
country reaches its equilibrium at EA, with
equilibrium price of PA and equilibrium
quantity of QA.
• Domestic price of the good is PA.
• Domestic producers produce QA units of
the goods and domestic consumers
consume QA units of the goods.
• CS = (1/2) x (PD - PA) x QA
• PS = (1/2) x (PA – PS) x QA
• TS = CS + PS
PD
PS
PA
QA
EA

20. Total Surplus under Free Trade
• Under free trade, the country can import foreign
goods at PW, which is lower than the domestic
equilibrium price under the autarky (PA)
• Domestic price of the good is PW.
• Domestic producers produce QS units of the
goods at PW and domestic consumers consume
QD units of the goods at PW.
• The country imports QD – QS units of the goods
from the foreign country.
• CS = (1/2) x (PD - PW) x QD
• PS = (1/2) x (PW – PS) x QS
• TS = CS + PS
PD
PS
PW
QS QD
PA

21. Welfare Effects of Free Trade
• Domestic consumers benefit from free trade because they can purchase at
lower price (PW) than under autarky (PA) and their consumer surplus
increases.
• Domestic producers hurt from free trade because they must sell at lower
price (PW) than under autarky (PA) and their producer surplus decreases.
• Because the gains for consumers outweigh the losses for producers, the
country as whole gains from free trade.
• TS under free trade > TS under autarky

22. Total Surplus with Tariff – Small Country
Case
• The government of the country imposes tariff by an
amount of t per unit of imports of goods.
• Domestic price increases by t (an amount of tariff).
PT = PW + t
• Domestic producers produce QS
T units of the goods at PT
and domestic consumers consume QD
T units of the
goods at PT.
• The country imports QD
T – QS
T units of the goods from
the foreign country.
• CS = (1/2) x (PD - PT) x QD
T
• PS = (1/2) x (PT – PS) x QS
T
• Tariff revenue by the government = TR = t x (QD
T – QS
T)
• TS = CS + PS + TR
PD
PS
QS QDQS
T QD
T

23. Welfare Effects of Tariff – Small Country
Case
• Compare the total welfare under tariff with the total welfare under free trade to
measure welfare effects of tariff to an economy.
• Domestic producers benefit from tariff because they can sell at higher price (PT)
than under free trade (PW) and their producer surplus increases.
• Domestic consumers hurt from tariff because they must pay a higher price (PT)
than under free trade (PW) and their consumer surplus decreases.
• Tariff brings tax revenues (TR) to the government by t x (QCT - QPT)
• Now, total surplus of the country is sum of consumer surplus (CS), producer
surplus (PS) and government tariff revenue (TR).
– Although the government does not gain by itself, any tariff revenues must be
redistributed to either consumers or producers or both, its tariff revenue is a
part of total welfare of the country.

24. Welfare Effects of Tariff – Small Country
Case
• Although the tariff increases producer surplus of domestic producers and bring
revenue to the government, the loss for consumers outweigh the gains for
producers and the government, the country as whole loses from tariff.
TS under tariff < TS under free trade
• Tariff creates deadweight loss (DWL) as compared with free trade.
– The loss of total surplus due to the tariff is equal to the deadweight loss.
– DWL = t x (QS
T – QS) + t x (QD – QD
T) = t x (QD – QS) – t x (QD
T – QS
T)
= t x (Imports under free trade – Imports under tariffs)
– Deadweight loss depends on an amount of tariff (t) and how much the tariff
reduces the imports.

25. Consequence of Tariff
• The partial equilibrium analysis only measures a direct effect of tariff to the
domestic economy. Both domestic or foreign producers will react to the tariff
over time and create additional costs to the country.
• However, the tariff also affects foreign countries by reducing their exports to the
country – lowering welfare of other countries.
– Tariffs can lead trading partners to retaliate with their own tariffs, thus
hurting exporters in the country that first adopted the tariff.
• Facing tariff, foreign and domestic producers may react to increase their profits.
– Tariffs may induce foreign producers to engage in wasteful activities to avoid
paying tariffs.
– Tariffs may induce domestic producers to engage in wasteful activities to
continue tariffs and reduce incentives for domestic producers to lower costs
to be competitive in the world market.

26. Measuring Effects of Tariffs - Large Country
Case
• The equilibrium under autarky is same as the small country case.
• Three steps to find the world equilibrium of market of goods
1. From the demand and supply of goods in domestic market, derive an excess
demand for goods, representing the quantity of goods imported (import
demand curve).
2. From the demand and supply of goods in foreign market, derive an excess
supply of goods, representing the quantity of goods exported (export supply
curve).
3. The world equilibrium is where the excess demand is equal to the excess
supply (Home’s imports = Foreign’s exports).
• Assume that Home country imports the goods from Foreign country

27. Domestic Import Demand Curve
• Import demand curve
shows a relationship
between the price of
goods and the quantity
of goods imported,
which is an excess
demand for the goods
in domestic market.

28. Foreign Export Supply Curve
• Export supply curve
shows a relationship
between the price of
goods and the quantity
of goods exported,
which is an excess
supply of the goods in
domestic market.

29. Home, Foreign, and World Market
• The equilibrium in the world market is where the domestic import demand equals the foreign
export supply.
• The equilibrium world relative price (Pw) is between the equilibrium relative price in Foreign
(PA) and the equilibrium relative price in Home (PA*) under autarky.
Shortage
Surplus
Export
=
Import

30. Welfare Effects of Free Trade – Large
Country Case
• Because the gains for consumers outweigh the losses for producers, the country
as whole gains from free trade.
– Domestic consumers benefit from free trade because they can purchase at
lower price (PW) than under autarky (PA) and their consumer surplus
increases.
– Domestic producers hurt from free trade because they must sell at lower
price (PW) than under autarky (PA) and their producer surplus decreases.
• Because the gains for producers outweigh the losses for consumers, the foreign
country as whole gains from free trade.
– Foreign consumers hurt from free trade because they must pay a higher
price (PW) than under autarky (PA*) and their consumer surplus decreases.
– Foreign producers benefit from free trade because they can sell at a higher
price (PW) than under autarky (PA
*) and their producer surplus increases.

31. Analysis of Tariff – Large Country Case
• The government imposes a tariff on imports form foreign country by t (an
amount of tariff).
• Foreign producers will charge domestic consumers at a domestic price (PT) equal
to the foreign price (PT*) plus the amount of the tariff (t).
– Foreign producers, collecting tax (tariff) from domestic consumers, pay tariffs
to the government.
• The foreign export supply curve will shift up by t.
– Note: this is similar to analyzing an effect of excise tax in domestic market.

32. Equilibrium under Tariff – Large Country
Case
• A new equilibrium in
the world market is
achieved at Point 2
where the domestic
import demand curve
intersects the new
foreign export supply
curve reflecting tariff.
XST
t

33. Domestic and Foreign Prices under Tariff –
Large Country Case
• Domestic price rises
to PT, while Foreign
price falls to PT*.
• A large country can
affect the foreign
price.
• A difference
between domestic
price and foreign
price is t.
PT = PT* + t

34. Effects of Tariff – Large Country Case
• Direct Effects of Tariff on Domestic Country:
– Effect on Price: increase by PT - PW
– Effect on Consumption: reduction of consumption
– Effect on Production: expansion of domestic production
– Effect on Trade: decline of import from QW to QT
• Direct Effects of Tariff on Foreign Country:
– Effect on Price: decrease by PW - PT*
– Effect on Consumption: increase of consumption
– Effect on Production: decline of production (for export)
– Effect on Trade: decline of export from QW to QT

35. Total Surplus under Tariff – Large Country
Case
• The government of the country imposes tariff by an
amount of t per unit of imports of goods form the
foreign country.
• Domestic producers produce QS
T units of the goods at
PT and domestic consumers consume QD
T units of the
goods at PT.
• The country imports QD
T – QS
T units of the goods from
the foreign country.
• CS = (1/2) x (PD - PT) x QD
T
• PS = (1/2) x (PT – PS) x QS
T
• Tariff revenue by the government = TR = t x (QD
T – QS
T)
• TS = CS + PS + TR
PD
PS
QS QDQS
T QD
T
PW
PT
PT*

36. Welfare Effects of Tariff – Large Country
Case
• Compare the total welfare under tariff with the total welfare under free trade to
measure welfare effects of tariff to an economy.
• Domestic producers benefit from tariff because they can sell at higher price (PT)
than under free trade (PW) and their producer surplus increases.
• Domestic consumers hurt from tariff because they must pay a higher price (PT)
than under free trade (PW) and their consumer surplus decreases.
• Tariff brings tax revenues (TR) to the government by t x (QD
T - QS
T)
• Tariff creates deadweight loss (DWL) as compared with free trade:
– DWL = (PT – PW) x (QS
T – QS) + (PT – PW) x (QD – QD
T)
= (PT – PW) x (Imports under free trade – Imports under tariffs)

37. Welfare Effects of Tariff – Comparison with
Small Country Case
• Compared with the small country case,
– its price will not rise by full tariff (PT – PW < t), so its adverse effect to
consumers is less, and its beneficial effect to producers is also less.
– The importing country reduces its import, but not so much as the small
country case because the domestic price increases less in large country than
small country.
– It will have less DWL because its price will not rise by full tariff (PT – PW < t)
and its import decreases less in large country.
– It will have greater tariff revenues, because the import decreases less in large
(impose tariff on more imports in large country with the same tariff per unit).

38. Welfare Effects of Tariff – Large Country
Case
• Total surplus under tariff may be less than, equal to, or
greater than total surplus under free trade.
– It depends on loss of efficiency caused by tariff and gains of
tariff revenue (TR).
– A part of tariff revenues are extracted from foreign country
(by lowering their producer’s surplus).
• Efficiency loss: the deadweight loss caused by the tariff
because the tariff distorts price to consume and produce.
• Terms of trade gain: gains from tariff which lowers foreign
export prices (causing its terms of trade to improve).
• If the terms of trade gain (from foreign country) is greater
than own efficiency loss created by tariff, then the country
will gain from the tariff at the cost of foreign countries.

39. Optimal Tariff
• Optimal tariff: the level of tariff that maximizes own total surplus.
– By choosing t (an amount of tariff), a large country may increase total welfare.
– It depends on elasticities of demand and supply in the domestic country and
foreign country.
– Tariff will always lower the total surplus of foreign country.
• Since small country cannot affect the world price, its tariff always lowers the total
surplus of the small country.

40. Measuring the Amount of Protection
• The effective rate of protection measures how much protection a tariff (or other
trade policy) provides.
– It represents the change in value that firms in an industry add to the production process
when trade policy changes, which depends on the change in prices the trade policy causes.
• Effective rates of protection often differ from tariff rates because tariffs affect
industries/markets other than the protected industry/market, causing indirect
effects on the prices and value added for the protected industry/market.

41. Measuring the Amount of Protection -
Example
• Automobiles sell in world markets for $8,000, and they are made from parts worth
$6,000.
– The value added of the production process is
$2,000 = $8,000 – $6,000.
• If a country puts a 25% tariff on imported autos so that home auto assembly firms can
charge up to $10,000 instead of $8,000.
– The value added increases to $4,000.
– The effective rate of protection for home auto assembly firms is the change in
value added:
($4,000 – $2,000)/$2,000 = 100%
– In this case, the effective rate of protection (100%) is greater than the tariff rate (25%).

42. Disclaimer
Please do not copy, modify, or distribute
this presentation
without author’s consent.
This presentation was created and owned
by
Dr. Ryoichi Sakano
North Carolina A&T State University
Disclaimer
Please do not copy, modify, or distribute
this presentation
without author’s consent.
This presentation was created and owned
by
Dr. Ryoichi Sakano
North Carolina A&T State University