MCQs and Answers

The application of the theory of comparative advantage explains that tariffs are inefficient for the world as a whole. They cause the production and consumption levels of the world as a whole to fall.

1. Effect on World Production:

Tariff causes the domestic relative price of imports in terms of exports (q) to exceed the foreign relative price (p). The fact q > p means that the marginal rate of transformation of exportables for importables (MRT_xm) is greater at home.

In other words, more exports must be sacrificed to produce one more importable at home than abroad. This further implies that the world can produce more of either of both goods if (a) the home country shifts its resources from producing importable; (b) the rest of the world does the opposite; and (c) international trade increases.

2. Effect on World Consumption:

Tariff causes the domestic relative price of imports in terms of exports to exceed the foreign relative price (i.e., q>p). This means that the marginal rate of substitution of exports (MRS_xm) of each domestic consumer exceeds marginal rate of substitution of exports for imports of each foreign consumer.

In other words, each domestic consumer is willing to sacrifice more of exports to obtain one more import than each foreign consumer would require to supply it. Thus, the consumers in both the countries can be made to increase their consumption levels by trading more.

The conclusion that tariffs are inefficient for the world as a whole does not mean that it is not beneficial to the imposing country.

The truth is that the tariff imposing country receives both favourable and unfavourable effects through the imposition of a tariff and it is also likely that the favourable effects outweigh the unfavourable effects.

But, the important implication of overall harmful effect of tariff on the world economy is that if a country gains from a tariff, it is at the expense of the rest of the world.

Kindleberger has discussed eight effects of tariff on the imposing country: (a) protective effect; (b) consumption effect; (c) revenue effect; (d) redistribution effect; (e) terms of trade effect; (f) income effect; (g) balance of payment effect; and (h) competitive effect.

In words of Kindleberger, a tariff “is likely to alter trade, price, output, consumption, and to reallocate resources, change factor proportions, redistribute income, change employment and alter the balance of payments.” All these effects of tariffs are discussed below:

1. Protective Effect:

A tariff has protective effect for the domestic industries. It tends to raise the domestic price of the imported commodity, reduce the domestic demand for that commodity and thereby stimulates its domestic produc­tion.

In Figure 2, DD and SS are the domestic demand and supply curves of the commodity in question. In the absence of trade, the equilibrium is at point E, the price is OP₃ and country’s production and consumption is P₃E. Under free trade conditions, becomes the supply curve which in­cludes both domestic and foreign supply.

Foreign supply is assumed to be perfectly elastic. Equilibrium is at point T and the price is OP. At this price, quantity OQ₂ is demanded, of which OQ₁ is produced at home and the rest Q₁Q₂ is im­ported.

Now the government imposes a tariff equal to the amount P P₂, thus shifting the supply curve to and raising the price to OP₂.

As a result, the quantity demanded falls from OQ₂ to 0Q_4, the quantity produced at home increases from OQ₂ to OQ₃ and the quantity imported reduces from Q₁Q₂ to Q₃Q₄. In this case, the protective effect (which is another name for production effect) is Q₁Q₃

2. Consumption Effect:

Imposition of tariff raises the price, and as a result, the demand for the commodity falls. Total outlay on consumption of the commodity is larger or smaller depending upon whether demand is inelastic or elastic.

In Figure 2, before the imposition of tariff, the consumers demand OQ₂ at price OP1. With the imposition of tariff (i.e., P,P₂), the price rises from OP, to OP₂ and the quantity demanded falls from OQ₂ to 0Q₄. thus, Q₄Q₂ is the consumption effect.

3. Revenue Effect:

Tariff brings revenue to the government. The revenue to the government is equal to the amount of the import duty multiplied by the quantity of imports. In Figure 2, the revenue effect is P₁P₂ x Q₃Q₄ = KLMN.

4. Redistribution Effect:

Redistribution Effect refers to the transfer of real income from the consumers to the producers as a result of tariff. The tariff-imposed price increase (from OP₁ to OP₂) results in the loss of consumer’s surplus equal to the amount P₁p₂LT. Of the total loss suffered by the consumers, P₁P₂ KR amount is transferred to the domestic producers.

This is the redistribution effect. KLMN amount is transferred to the government as tariff revenue.

The loss of consumer’s surplus represented by the triangles KRM and LNT is transferred neither to the producers nor to the government; do KRM + LNT represent the total net real loss to the economy as a result of tariff.

KRM is the net real loss suffered by the society due to inefficient use of the resources; increased output (i.e., Q₁Q₃) as a result of the tariff is possible by diverting factors of production from other sectors of the economy at higher cost (as represented by the rising supply curve). LNT is the net real loss due to the reduction in consumption (i.e., Q₄Q₂)

The above discussed effects of tariff (in Figure 2) can be summarises below:

1. Tariff imposed: P₁P₂.

2. Effect on price: from OP₁ to OP₂, i.e., P₁P₂.

3. Effect on imports: from Q₁ Q₂ to Q₃ Q₄

4. Protective effect: from OQ₁ to 0Q₃, i.e. Q₁Q₃.

5. Consumption effect: from OQ₂ to OQ₄ i.e., Q₄ Q₂.

6. Revenue effect: KLMN

7. Redistribution effect: P₁P₂KR

8. Real loss on production: KRM

9. Real loss on consumption: LNT

10. Total real cost of tariff: KRM + LNT

5. Terms of Trade Effect:

When a country imposes a tariff duty, its willingness to receive imports is reduced. For a given quantity of exports, the country now demands a larger quantity of imports because a part of these imports are to be surrendered to the customs authorities in the form of tariff payment.

Or, putting the same thing differently, the country is now willing to offer less of ex­ports in exchange for a given quantity of imports.

Thus, the tariff reduces the country’s offer of exports for imports. In diagrammatic terms, the tariff shifts the country’s offer curve to the left. This increases the country’s terms of trade or the rate at which exports are exchanged for imports.

The terms of trade is given by the slope of line OT. Country H is exporting OW wheat and importing OC cloth from country F. Now suppose the country H imposes a tariff on imports of cloth from country F.

As a result, the offer curve of country H will shift from OH to OH’. The new equilibrium is at point E’ and the new term of trade is given by the slope of line OT’. Now, the country H exports OW, of wheat in exchange for OC, of cloth from country F.

The change in the terms of trade (i.e., from OT to OT’), as a result of the imposition of tariff, is in favour of country H because it now offers less of its wheat in exchange for a certain quantity of country Fs cloth. The fall in imports from country F (i.e. CC,) is less than the fall in exports from country H (i.e., WW,).

6. Balance of Payments Effect:

Tariff has favourable effect on the balance of payments position of the imposing country. It reduces imports and increases the export surplus of the country. Thus, through tariffs, a deficit in the balance of payment can be corrected.

7. Income Effect:

As a result of tariff, the expenditure on imported goods is reduced. This will increase the export surplus of the country and thereby the income from foreign trade.

The money shifted from imports can now be spent on the domestically produced goods. If the country is at less than-full employment level, this will raise income and employment in the country.

8. Competitive Effect:

Tariff protects the domestic industry from foreign competition. Under this protec­tion an infant industry after a period of time, grows into an economically strong industry which can fully compete in the world market.

But, the sluggish and lazy industry may not like to face the competition and remain inefficient even under the protection cover provided through tariffs.

Various effects of the fixation of quota of an imported commodity are explained below:

1. Price Effect:

When the quota of an imported com­modity is fixed, its imports fall and price rises. The actual effect of quota on price will depend upon the elasticity of demand and supply. In Figure 6, DD and SS are demand and supply curves.

Under free trade, the price of the com­modity is 0P_1. At this price, the domestic demand for the commodity is QQ₂, but the domestic supply is OQ₁.

Thus, Q,Q, amount is imported. When import quota is imposed, the imports are reduced and fixed at Q₃Q₄ amount. As a result of reduction in imports from Q₁Q₂ to Q₃Q₄, the imports price rises from OP1 to OP₂ Thus P₁P₂ is the price effect.

2. Protective Effect:

Fixation of import quota leads to the reduction in imports and increase in import price. This increases the domestic production and gives the home producers protection against foreign competition. When Q₃0₄ import quota is fixed, domestic production increases from OQ₁ to 0Q₃. Thus, Q₁Q₃ is the protective effect of the import quota.

3. Consumption Effect:

When import price rises on account of the import quota, domestic consumption and hence the welfare declines. An import quota of Q₃Q₄ raises the price from OP₁ to OP₂ and reduces the domestic consumption form QQ₂ to 0Q₄. In this case, Q₄Q₂ decline in consumption is the consumption effect of the import quota.

4. Revenue Effect:

The revenue effect of import quota is uncertain. The fixation of import quota (Q₃Q₄) raises the import price (by P₁ P₂) and therefore yields revenue (P₁P₂ x 0₃0₄ = KLMN) which may go the government or may be divided among the domestic importers and foreign exporters.

The division of revenue among importers and exporters depends upon the market structures prevailing among these two groups:

(a) If the government auctions the import licenses, this revenue will be, like the tariff revenue, earned by the government,

(b) If the foreign supply is perfectly elastic (as is assumed in Figure 6), and if the government does not sell licenses, then the revenue will go to the importers,

(c) If the government does not sell license, but the exporters are able to raise delivered prices, then the revenue will be taken away by the exporters.

5. Redistributive Effect:

Import quota also has distributive effect by transferring real income from the consumers to the producers. The rise in price (from OP₁ to OP₂) as a result of import quota leads to the loss of consumer surplus as represented by P₁ P₂ LT.

Of this total consumer surplus, P1P₂ KR amount is the redistributive effect because it is earned by the producers as profit.

The loss of consumer surplus as represented by the areas KRM and LNT are considered the cost of the quota in terms of decreased productive efficiency and consumer satisfaction respectively.

6. Terms of Trade Effect:

Imposition of import quota generally results in a change in terms of trade in favour of the quota- fixing country.

The gain from the imposition of quota can be measured (in terms of wheat) as the quantity W1W₂ It is not certain how this gain will be distributed:

(a) If there is competitive bidding for import licenses, this gain will go the government,

(b) If the exporters in the foreign country and the home importers compete freely among themselves, this gain will go to the foreign exporters,

(c) If there is collision among the importers and exporters compete freely, the home importers will capture the gain,

(d) if there is collusion among both exporters and importers, the distribution of gain will depend upon the relative bargaining strength of the two parties.

7. Balance of Payment Effect:

Quotas restrict imports and thus help in correcting the adverse balance of payments. In this regard, quota is more effective than tariff because the former has direct impact on chacking imports.

8. Income Effect:

Quota is also superior to tariff in its impact on income and employment. Quota reduces imports without leakages. The money thus saved can be spent on domestically produced goods. This will increase income and employment in the country.

(i) As compared to tariffs, quotas are more precise in nature and more certain in effect.

(ii) Quotas are more popular and less resented by the trading nations than tariffs.

(iii) Quotas are preferred in the situations where domestic demand for the imported commodity is inelastic.

(iv) Quotas also have a strong case under the conditions of highly inelastic foreign supply.

(v) Quotas are administratively more flexible instruments of commercial policy than tariffs. Quotas can be more easily imposed and more easily removed. Tariffs, on the other hand, are relatively permanent measure and are more difficult to remove.

(vi) Quotas prove more useful in those situation where the domestic consumers and foreign exporters are needed to be checked effectively, i.e.,

(a) When the country is facing foreign exchange problem;

(b) When the country is passing through a period of economic distress and wants to check the outflow of domestic income by imports;

(c) When there is deflation abroad and the foreign exporters want to transmit this deflation to the importing country by stimulating exports.

Balance of payments should be distinguished from balance of trade. Balance of trade refers to the export and import of visible items, i.e., material goods. It is the difference between the value of visible exports and imports.

Visible items are those items which are recorded in the customs returns; for example, material goods exported and imported. If the value of visible exports is greater than that of visible imports, the balance of trade is favourable.

If the value of visible imports is greater than that of visible exports the balance of trade is unfavourable; if the value of visible exports is equal to that of visible imports, the balance of trade is in equilibrium. Balance of trade is also known as merchandise account of exports and imports.

Balance of payments, on the other hand, is a more comprehensive concept because it covers (a) visible items (i.e., balance of trade or merchandise account) and (b) invisible items.

Invisible items are those items which are not recorded in the customs returns; for example, services (such as transpiration, banking, insurance, etc.), capital flows, purchase and sale of gold, etc.

Thus, balance of payments is a broader term than balance of trade; balance of payments includes both visible as well as invisible items, whereas balance of trade includes only visible items.

According to the International Monetary Fund (IMF), the current account of the balance of payments includes the following items

1. Merchandise:

Exports and imports of goods form the visible account and have a dominant position in the current account of balance of payments. Exports constitute the credit side and import the debit side.

2. Travel:

Travel is an invisible item in the balance of payments. Travel may be for reasons of business, education, health, international conventions or pleasures. Expenditure by the foreign tourists in our country forms the credit item and the expenditure by our tourist’s abroad constitutes the debit item in our balance of payments.

3. Transpiration:

International transpiration of goods is another invisible transaction. It includes warehousing (while in transit) and other transit expenses. Use of domestic transpoart services by the foreigners is the credit item and the use of foreign transport services by domestic traders is the debit item.

4. Insurance:

Insurance premium and payments of claims is also an invisible transaction in a country’s balance of payments account. Insurance policies sold to foreigners are a credit item and the insurance policies purchased by domestic users from the foreigners are a debit item.

5. Investment Income:

Another invisible item in the current account of the balance of payment is the investment income which includes interest, rents, dividends and profits. Income received on capital invested abroad is the credit item and income paid on capital borrowed from abroad is the debit item.

6. Government Transactions:

Government transactions refer to the expenditure incurred by a government for the upkeep of its organisations abroad (e.g., payment of salaries to the ambassadors, high commissioners, etc.). Such amounts received by a government from abroad constitute the credit item and made to the foreign governments form the debit item.

7. Miscellaneous:

Miscellaneous invisible items include expenditure incurred on services like advertise­ment, commissions, film rental, patent fees, royalties, subscriptions to the periodicals, membership fees, etc. Such payments received by a country from abroad are a credit item and made by a country to foreign countries are a debit item.

8. Donations and gifts:

Donations, gifts, etc, received by a country from abroad are the credit item and sent to the foreign countries are the debit item in the balance of payments account. Donations and gifts are ‘unilateral transfers’ or ‘unrequited payments’ because nothing is given in return for them.