Tarrifs

A tarrif is a tax levied on imports. It is synonymous with import duties or custom duties. Tarrifs are used for two different purposes for revenue and for protection. Revenue tarrifs are meant to provide the state with revenue. Revenue duties are levied on luxury consumer goods. Protection Tarrifs are meant “to maintain and encourage those branches of home industry protected by the duties.

Effects of Tarrifs on the Terms of Trade under General Equilibrium:

The terms of trade effect of a tarrif is that a country imposing a tarrif improves its terms of trade. It can get its imports more cheaply because the foreign importer is forced to pay more part of the duty of the whole of it. But the extent to which the terms of trade of the tarrif imposing country improve depends upon the reciprocal demand of the two countries. Suppose there are two countries Germany and England which produce linen and cloth respectively. If the offer curve of England is more elastic, the terms of trade will be favourable to it than to Germany.

Here OE and OG are the offer curves of England and, Germany respectively. The terms of trade under free trade are given by point A on the ray OT whereby England is exporting OC cloth and importing OL of linen from Germany. Suppose a tarrif is imposed by England on Germany’s linen. It shifts the offer curve of England from OE` to OE<sub>1</sub> and England offer less cloth for Germany’s Lenin. This changes the terms of trade from OT to OT` in favour of England. Now England exports OC₁ of cloth in exchange for OL₁ of Lenin from Germany. It now exports CC₁ less of cloth than before and imports LL₁ less of linen. Since the quantity of imports reduced by England is less than its exports to Germany (LL₁ <>1) the terms of trade have moved in favour of England with the imposition of tarrif. However since England improves its terms of trade at the expense of Germany. Germany is likely to retaliate and in the end both countries will lose.

(a) Terms of trade effects without retaliation: The imposition of a tarrif by a country when the other country does not retaliate has two effects, first the tarrif imposing country improves its terms of trade. It gets its imports more cheaply because the foreign exporter is forced to pay some part of the duty or the whole of it. Second the tarrif tends to reduce the volume of trade.

Suppose there are two countries England and Germany which produce cloth and Lenin respectively. OE is the offer curve of England and OG of Germany. The terms of trade between the two countries under free trade are given by point A on the ray OT whereby England is exporting OC cloth and importing OL of Lenin from Germany. Suppose an import duty is imposed by England on Germany’s Lenin. It shifts the offer curve of England from OE to OE₁ and intersects the offer curve of Germany OG at point B. this changes the terms of trade of England to the left from OT to TO₁. This is an improvement for England. Now England exports OC₁ of cloth in exchange for OL₁ linen form Germany. Out of C₁B (=OL₁) of Lenin which England imports, DB is collected as import duty buy the government. Thus the imposition of a tarrif by England has led to (a) an improvement in the terms of trade of England. It now exports CC₁ less of cloth than before and imports LL₁ of linen. Since the quantity of imports reduced by England is les than the reduction in exports to Germany LL₁ <>1, the terms of trade have improved for England and (b) reduction in the total volume of trade between two countries OC₁ + OL₁ <>Germany is perfectly elastic.

Under free trade the offer curves OG and OE intersect at point T indicating that CC cloth of England is exchanged for OL linen of Germany. With the imposition of tarrif by England, its offer curve OE shifts to the left as OE` and intersects the offer curve OG at T`. But the terms of trade of England and the volume of trade falls by an equal amount in the two countries, CC` cloth of England = LL` linen of Germany.

On the other hand, if the offer curve of Germany is inelastic, the terms of trade will move in favour of tarrif imposing country England.

Under free trade the terms of trade of the two countries are depicted by the OT line and they exchange OC of cloth for OL of linen. Between A and B the offer curve of Germany OG is highly inelastic. With the imposition of a tarrif the offer curve of England OE₁ crosses OG at point B so that the new terms of trade line is OT₁. This shows an improvement in the terms of trade of England because its exports fall very substantially by CC₁ of cloth, while the imports of linen which she exchanges actually increase by LL­₁ amount.

(b) Terms of trade effect with retaliation: The normal situation in international trade is not one of improving its terms of trade by one country by imposing a tarrif, while the other country sustains the loss without any counter action. Infact if England improves its terms of trade by imposing a tarrif, Germany will in turn impose a retaliatory tarrif. The effect of such counter action on the part of the each country is shown in figure 5 below.

FIG 18

The free trade offer curves of England and Germany are OE and OG which intersect at point A, with terms of trade settled at OT line. When England imposes a tarrif on Germany’s Lenin, its offer curve shifts to the left as OE₁. The new terms of trade point is B which shows improvement in the welfare of England. Now Germany retaliates by imposing an import duty on England’s cloth so that its offer curve shifts to the position of OG₁. The new terms of trade are set at point D which is much lower than point B before retaliation. Now there is substantial reduction in the volume of trade in both countries due to retaliation. If the two countries continue to retaliate by imposing retaliatory tarrifs, the trading point will move successively form D to F to E which will leave the terms of trade unchanged at point E on the OT line. Consequently, the effects of the retaliatory tarrifs are to reduce the volume of trade between the two countries to bring the terms of trade at the free trade level. This is shown in the figure with the volume of trade successively falling from (OC₁ + OL₁) to (OC₂ + OL₂) to (OC₃ + OL₃) and the terms of trade at point E reverting back to the free trade line OT. Thus the imposition of tarrifs to improve the terms of trade, followed by retaliation leads to loss for both countries.