Effects of Tariffication: Tariffs and Quotas
under Monopolistic Competition
Jan G. Jørgensen∗and Philipp J.H. Schröder†
February 2003
Abstract
Recent rounds of GATT and later WTO have advocated
widespread tariffication, meaning that existing non-tariff barriers be
converted into import equivalent tariffs. From an economic point of
view, the effects of such tariffication are not entirely clear. The paper presents a trade model with monopolistic competition to examine the welfare effects of tariffication. The ranking of pre- and posttariffication welfare depends crucially on the nature of the initial trade
barrier and the tariff tool applied. Tariffication using a specific (an ad
valorem) tariff results in the same (a reduced) welfare level compared
to an initial sold quota, whereas welfare is increased (the same) compared to an initial shared quota.
Key Words: Trade policy, tariffication, specific tariff, ad valorem tariff, quota, tariff rate quotas, VER. JEL: F02, F12, F13
1
Introduction
In the past ten years tariffication – the conversion of non-tariff barriers such
as quotas and voluntary export restraints (VERs) into import equivalent
tariffs – has been promoted and implemented on a global scale. Yet, the
welfare effects of such policies have not been fully understood. The present
paper addresses this issue for the case where industries feature monopolistic
∗
Department of Economics, University of Southern Denmark, Denmark.
DIW Berlin, Germany. Corresponding author: Philipp J.H. Schröder, DIW Berlin,
German Institute for Economic Research, Department of International Economics,
Königin-Luise-Straße 5, 14195 Berlin, Germany, Tel.: +49 30 89789-692, Fax:+49 30
89789-108, E-mail: [email protected].
†
1
competition. In particular the paper finds that, in terms of consumers’ utility,
tariffication using a specific tariff is preferable to an ad valorem tariff, even
though an ad valorem tariff generates more tariff revenue and all revenues
are reallocated to the population. The initial trade regime – in particular,
if and how rents accrue (sold versus shared quota) – in combination with
the tariffication tool applied determines whether consumer welfare de- or
increases under the process of tariffication.
Different trade policy instruments have different impacts on the involved
countries’ welfare and different visibilities, with a tariff being a clear and
straightforward policy rule, while policies such as quotas or VERs are hard
to quantify and hence blur the picture of the true level of protectionism (see
Anderson (1988)). Because of this, GATT, and now its successor the WTO,
have initiated major breakthroughs in tackling protectionism by – among
other things – promoting widespread tariffication:
‘Members shall not maintain, resort to, or revert to any measures
of the kind which have been required to be converted into ordinary
customs duties, . . . ’ (Final Act of the Uruguay Round, 1994)1
The importance and impact of tariffication in the recent GATT (WTO)
rounds has been discussed among others by Ingco (1996) and Nguyen et
al. (1993) (see also OECD (1996) and WTO (1998, chapter 3)). Further,
Lawrence (1989) provides an assessment of the significance of tariffication
for US trade policy. The widespread tariffication trend can also be detected
in the tariff levels of the major trading nations. Even though tariffs are
generally falling, table 1 shows that, for example, for the sector of food,
beverages and tobacco, the mid 1990s see a rise in the average tariff level.
The reason is tariffication.
Table 1: Average external tariff levels1 (percent)
USA2
Japan
EU15
Food, beverages and tobacco
1988 1993 1996
7.6
8.2 15.9
15.6 17.5 18.9
27.4 27.1 32.5
For all products
1988 1993 1996
4.4
4.7
5.2
4.2
3.6
3.4
8.2
8.4
7.7
Note: 1. Average tariff levels are estimated using production weights based on the
destination countries’ composition of value added. 2. 1989 values instead of 1988.
Source: OECD (1996), tables 1 and 2; OECD (1999) table 7.1; authors’ calculation.
1
Article 4, Agreement on Agriculture. The footnote to this article explains: ‘These
measures include quantitative import restrictions, variable import levies, minimum import prices, discretionary import licensing, non-tariff measures maintained through statetrading enterprises, voluntary export restraints, . . . ’.
2
The issue of tariff-quota equivalence – the underpinning of tariffication –
has received considerable attention in economics, see for example Bhagwati
(1965). It is well known that bilateral tariff-quota conversions are welfare
neutral for perfectly competitive markets if the quota rent accrues to domestic residents. A country may, however, benefit from a tariff if it can
extract rents that under the quota regime accrued to foreign residents. For
imperfectly competitive markets, however, tariff-quota equivalence becomes
a more complex issue, see for example Helpman and Krugman (1989).
Despite of the substantial literature on tariff-quota equivalence, or rather
the lack thereof, few models exist that explicitly study the case of tariffication, and to the best of our knowledge there is no formal approach that
addresses the issue of tariffication for industries that feature monopolistic
competition. There are, however, a number of contributions that relate to
the present work. Kowalczyk and Skeath (1994) have shown that in a setting
where a country faces a foreign monopolist, ad valorem tariffs are welfare superior to specific tariffs. This result is opposed to our finding and driven by
the fact that the ad valorem tariff is superior in terms of revenue extraction.
On the other hand, in line with our result, Das and Donnenfeld (1987) show
that for a country facing a foreign monopolist that has a quality choice, the
specific tariff may generate the higher welfare. In a dynamic two-country
game of setting optimal tariffs with retaliation, Lockwood and Wong (2000)
show that the move from specific tariffs to ad valorem tariffs improves welfare
in at least one country. Their model and in particular the mechanism driving
it is very different from the present approach; again, what drives their result
is the superiority of ad valorem tariffs in terms of revenue generation. As to
the effects of tariffication Kaempfer and Marks (1994) present a model where
the profitability of an exporting monopolist is affected by tariffication. They
show that global efficiency – in the sense of purchasing from the lowest cost
producer – may be reduced by the switch from a quota to a tariff. Again
their setting is not one of monopolistic competition and increasing returns,
rather, and contrary to the present model, producers vary as to their cost
efficiency. Yet, all the above contributions (as well as Helpman and Krugman (1989) when addressing non-equivalence of ad valorem tariffs, specific
tariffs and quotas) deal with situations of monopoly or oligopoly but not with
symmetric situations of monopolistic competition – the topic of the present
paper.
The contributions most closely related to the present paper are those
of Gros (1987) and Collie and Su (1998). Both deal with trade policies in
monopolistic competition settings. Gros (1987) builds a two-country single
industry model based on Krugman (1980). His central results concern welfare
effects of retaliation in tariff wars. However, Gros (1987) focusses primarily
3
on ad valorem tariffs and does not address the welfare issues of tariffication.
Collie and Su (1998) use the framework of Romer (1994) and find – in line
with the present paper – that a VER (with rents realised by the foreign
industry) might be welfare superior to an ad valorem tariff. In addition to
being situated in a different framework, the present paper goes beyond the
results in Collie and Su (1998) by including the case of specific tariffs as well
as distinguishing how the quantitative trade restriction is administered, i.e.
whether or not the rents of the initial quantitative trade restriction accrue
(sold versus shared quota).
To examine tariffication for industries that feature monopolistic competition we use a Krugman (1980) type model. We model two symmetric
countries, with two industries, one of which is internationally traded. The
paper is novel both in terms of treating tariffication explicitly and in terms
of distinguishing the tariffication tools (specific versus ad valorem tariffs) as
well as the nature of the initial quantitative import restriction (sold versus
shared quotas). All policy tools are applied bilaterally and are compared
according to the same exogenously given and binding import restriction.2
The differentiation into sold and shared quotas (e.g the classification of
the initial quantitative import restriction regime) that is proposed in this
paper is motivated as follows. Under a sold quota well defined property
rights exists and rents accrue either to the home or the foreign country,
i.e. the government or industry (home or foreign) has a clear property right
to the quota and can control export volumes such that the quota rent can
actually be realised. This case would occur in a situation of auctioned or
sold import quotas or a VER that the foreign country administers via selling
export licenses. Under a shared quota, on the other hand, property rights
to the quota are not well defined, i.e. no one owns the quota and access
is uncontrolled. Hence, the shared quota suffers from the ‘tragedy of the
commons’, i.e. firms, by engaging in export activity, capture part of the
overall quota from other exporting firms. Such a situation might typically
occur under a VER if entry into the export activity cannot be controlled or
under a regime of tariff rate quotas with very low within-quota tariffs and
prohibitively high outquota tariffs. In the latter case all potential exporters
can take a share of total export sales until the quota is filled, after this no
further exports take place. With free entry and exit, such a tariff rate quota
system will not generate any rents or tariff revenue (e.g. the within-quota
tariff is zero).
From the formal model the following results are derived. First, it is found
2
It should be noted that this paper does not deal with the emergence or rationale of
the initial quantitative import restriction but with its conversion into a tariff.
4
that there is a significant difference in the welfare impact between specific
and ad valorem tariffication. Even with complete reallocation of all tariff
revenues, a specific tariff generates more consumer utility than an ad valorem
tariff. This result is driven by the larger number of variants in the traded
sector in the case of a specific tariff. The specific tariff allows for more firms to
exist, because industry profitability is higher. Or put differently, as a revenue
extractor, the ad valorem tariff is more efficient than the specific tariff. This
is what drives the usual result of ad valorem tariffs being welfare superior
to specific tariffs in models featuring monopoly or oligopoly market power
(see Helpman and Krugman, 1989, chapter 4). However, under monopolistic
competition, it turns out that this superior ability of the ad valorem tariff
to extract revenue reduces industry profits, therefore, the number of firms
is reduced, and this corresponds to lower welfare. Second, we establish that
the change in consumers’ welfare under the process of tariffication depends
crucially on the initial trade regime. If the import restriction is initially
given by a shared quota (sold quota), then under the process of tariffication,
welfare will be increased (remain unchanged) in case of a specific tariff and
remain unchanged (be reduced) under an ad valorem tariff. In any case free
trade dominates any initial quota situation as well as the post-tariffication
situations in terms of consumer utility.
Section two introduces the formal model. In section three we analyse the
impact of the initial sold quota, shared quota and subsequent tariffication
on quantities, prices and the number of variants. Section four presents the
welfare results of the analysis. Section five concludes the paper.
2
The Model
We develop a setting of Chamberlinian monopolistic competition. The specific starting point for our model are its applications to international trade
developed by Krugman (1980 and 1981).
Assumptions of the model
It is assumed that the world consists of two symmetric countries, each with
two industries. In both countries market conditions are characterised by
monopolistic competition, increasing returns to scale in production and differentiated goods. Each industry has a large number of potential variants
which enter symmetrically into demand. For convenience we assume that
the first industry is a non-traded industry and that the other industry is a
pure export industry, i.e. the second industry in the home country exports
5
its entire output to the foreign country and vise versa. All our results can
be extended to the case of actual intra-industry trade, however, what is decisive for our results to occur is some degree of market segmentation, i.e. the
assumption that products within each industry are closer substitutes than
products from home and abroad.
The model adopts the utility function of Krugman (1981). However, for
each industry we apply the functional form utilised in Krugman (1980). As
the two countries are completely identical, we only show the specification for
one of the countries throughout the analysis. All the individuals in the two
countries are assumed to have the same utility function,
U = ln
N
X
θ
ci + ln
i=1
N̂
X
ĉθj
(1)
j=1
where 0 < θ < 1 and ci is consumption of the ith variant of the foreign
export industry and ĉj is consumption of the jth variant of the non-traded
home industry. Due to symmetry between the two countries, the imports of
one country equal the exports of the other country and vise versa. N and N̂
define large numbers of potential variants in each industry. The number of
variants actually produced n and n̂ are assumed to be large, although smaller
than N and N̂ .
For the moment we examine the properties of the export industry alone,
bearing in mind that the free-trade equilibrium of the export industry is
identical to the equilibrium of the non-traded industry. On the supply side
we assume that there exists only one factor of production which is labour.
All variants will be produced with the same cost function:
li = α + βxi
i = 1, . . . , n
(2)
where li is labour used in the production of the ith variant in the traded
industry and xi is output of that variant. This specification includes fixed
costs α and constant marginal costs β and hence average costs decline at
a diminishing rate. This assumption ensures that each variant is produced
by only one firm, hence the number of variants equal the number of firms.
Also since (2) implies that the labour requirements are identical for every
variant, we can restrict our analysis to one variant, since all other variants
will behave identically. Hence, in the remainder of the paper the subscript
i can be omitted. Labour requirements are converted into nominal costs by
multiplying (2) by the wage rate, w.
The market clearing condition demands that the output, x, of each variant
should be equal to the total consumption of all individuals in the economy
6
of that variant. We will assume full equality between the number of workers,
L, and consumers. Hence,
x = Lc
(3)
Equilibrium with free trade
Finding equilibrium in this model follows the standard procedure assuming
profit maximisation, free entry and exit of firms resulting in the zero-profit
condition, labour market clearing at full employment, and goods market
clearing (see e.g. Krugman 1980). The equilibrium is characterised by prices
p, output per firm x, and the number of firms n. From (1) the demand an
θ−1
individual firm faces is given as p = λθcP cθ , where λ is the shadow price on
the budget constraint. It is assumed that – since there are a large number
of goods – the pricing decision of any one firm has a negligible effect on λ.
Then, using the fact that c = Lx , profits π = px − (α + βx)w are maximised
by setting the price,
βw
(4a)
p=
θ
Equating the profit-maximising price with the price implied by zero profits,
p0 = (α+βx)w
, gives the per firm output quantity, x, under free entry and exit:
x
x=
θα
(1 − θ)β
(4b)
Finally, the number of firms actually producing in equilibrium can be deduced
via market clearing conditions using the x just derived. In particular labour
market clearing demands that ˆln̂ + ln = L. More useful in our case is the
following: Individuals, by maximizing utility (1), will attempt to use one-half
.
of their income on imports and one-half on home goods; hence, pxn = wL
2
Using the p and x just derived this condition determines the number of firms
in equilibrium.
(1 − θ)L
n=
(4c)
2α
Since (4a–4c) characterises the export industry in both countries, it also
states the import conditions. In fact, (4a–4c) also states the equilibrium in
the non-traded sector under free trade. Thus we have p̂ = p, x̂ = x and
n̂ = n.
Defining a restriction on import volume
In order to model tariffication we need to define an initial restriction on
imports. Noticing that the import volume of a country under free trade is
7
given by χ = nx =
Lθ
,
2β
a restriction on imports is defined as:
χ̄ = γχ =
γLθ
2β
0≤γ<1
(5)
Thus, the parameter γ measures how severe the initial import restriction is.
In the analysis that follows, the different trade policy tools – tariffs (either
an ad valorem or a specific tariff) or quantitative restrictions (either sold or
shared quotas) – are set such as to ensure that the resulting import volume
is identical to the restricted import volume χ̄.
3
Effects of Trade Policy
This section analyses the effects of the different trade policy tools, i.e. the
effects of applying sold and shared quotas and specific and ad valorem tariffs that generate exactly the import volume given by the initial import restriction. We focus on the market equilibrium in the traded industry. Appendix A.1 derives the impact of these trade policies on the non-traded sector. Throughout the paper it is assumed that all revenue that accrues to
the government – either quota earnings or tariff revenues – is completely
redistributed to consumers.
Import restriction - sold quota
The overall restriction on imports (5) is announced by the home country.
We assume that the actual implementation of this quantitative restriction is
left to the foreign country. The quota is sold either by a competitive bidding
auction or by direct sale of export licenses; i.e. there exist clear property
rights to the quota, and the foreign country (government or industry) can
hence control the supply of exports.3 Paying the fee F allows a foreign firm
to export one unit of its product. Hence, the number of firms/variants in
the export industry remains endogenous. By adjusting F , the quota administering authority controls the total amount of exports such that the import
restriction set by the home country is met. What is decisive is that the quota
rent is actually realised and (in our case) accrues to the foreign country where
it is ultimately redistributed to consumers.
Under the regime of a sold quota, the profit of an exporting firm producing
one variant is given by π q = (pq − F )xq − (α + βxq )w. Defining the quota
3
Due to symmetry it is in effect inessential which country does administer the quota
and where the quota rent occurs. What is important, however, is that the property rights
to the quota ensure that the quota can and will be sold.
8
fee in real terms by f = Fw , the profit function can be written as π q =
pq xq − (α + (β + f )xq )w. Hence, a sold quota system can be interpreted as
an increase in marginal cost. Thus the profit maximising price charged by
all firms in the export industry is now:
pq =
(β + f )w
θ
(6a)
Free entry and exit ensure that firms compete industry (and firm) profits
)xq )w
down to zero. Equating pq with the zero profit price pq0 = (α+(β+f
,
xq
defines the per firm export quantity:
xq =
θα
(1 − θ)(β + f )
(6b)
To complete the characterisation of the equilibrium under a sold quota system, where the overall import volume is restricted to χ̄, the number of firms is
q q
derived from market clearing, pq xq nq = Lw+F2 x n , whereby the redistributed
quota revenue, F xq nq , has to be included in household income.
nq =
γ(1 − θ)L β + f
2α
β
(6c)
Furthermore, the fee f can be calculated from the condition that total consumer expenditure on the import industry must equal consumer expenditure on any industry, given that the import restriction χ̄ is fulfilled, i.e.
q
pq χ̄ = wL+R
, where Rq = f wχ̄ is again the revenue stemming from the sold
2
quota.
β(1 − γ) 2
f=
(6d)
γ
2−θ
Plugging in this value for f in (6b) and (6c) the actual per firm export
quantity and the number of firms can finally be stated in terms of the degree
of import restriction, γ:
θα
(1 − θ)β
L(1 − θ)
nq =
2α
xq =
γ(2 − θ)
<x
2 − θγ
2 − θγ
>n
2−θ
(6b’)
(6c’)
Thus, output per firm under a sold quota is less than under free trade. However, the number of firms in the traded sector has increased, even above
the equilibrium number of firms under free trade. What motivates this increase? As can be seen from (6a) the cost connected with the quota fee is
9
shifted onto prices with the factor 1/θ. The intuition is that firms – since
they act as monopolists – set their price as a mark-up over marginal costs.
As shown above, the quota fee is in fact a marginal cost increase. Thus, in
a sense firms overcompensate the fee, increasing profitability (their operating surplus) and accordingly creating entry into the industry. Also, since
the revenues stemming from the fee are redistributed, consumers’ spending
power is maintained, thus eventually pushing the number of firms beyond
the number of firms under free trade. However, as will be shown in section 4,
this increase in the number of firms is not a free lunch. The spending power
stemming from the redistributed fee can be calculated:
Rq = θ(1 − γ)
Lw
2−θ
(7)
Finally, due to the import restriction the number of workers employed in the
traded sector is reduced compared to the free trade case, i.e. l(xq ) nq < L2 .
Plugging in the values from above, the amount of labour reallocated from
the export sector into the unrestricted non-traded sector can be calculated:
∆Lq = θ(1 − γ)
L 1
22−θ
(8)
Import restriction – shared quota
A shared quota regime is envisaged as a system where there are no clear
property rights to the quantitative restriction. Combined with free entry
and exit this implies that the rent or revenue of the restriction can not be
harvested. The lack of a clear allocation of property rights makes it impossible to sell or auction the quota; on the contrary, the system will suffer from
the ‘tragedy of the commons’. Such situation can for example occur under a
VER (where firms know that once the VER target is filled, prohibitive duties
will be imposed by the importing country) or a tariff rate quota system (low
(zero) within-quota tariffs and prohibitively high outquota tariffs). Since the
quantitative restriction (VER or tariff rate quota) must be defined over some
time period each firm can, by exporting early on in the period, realise some
sales – knowing that later on, the quota will be filled and market access prohibited. In effect this means that the exporting firms compete on the market
to get a share of the overall trade volume defined by the import restriction.
With full symmetry among firms and ignoring strategic issues, this implies
that each firm that wants to export can get a share 1/nv of export sales, subject to the overall quantitative restriction being fulfilled. Hence, the number
of firms/variants in the export industry is still endogenous.
10
The profit of a firm exporting a variant under these conditions is given by
π v = pv xv − (α + βxv )w. Accordingly the price and per firm quantity must
be the same as under free trade:
βw
pv =
(9a)
θ
θα
xv =
(9b)
(1 − θ)β
However, the quantity sold by each firm is restricted by xv = nχ̄v . Firms are
aware of this overall limit on sales when making their entry and exit decision.
In fact even though the industry could make a profit (quota rents) due to
the imposed restriction, firms are unable to maintain a higher price, since
this would generate profits in turn attracting more entry, in turn reducing
the sales of each firm (the ‘tragedy of the commons’). Hence the zero profit
condition under a shared quota becomes π v = pv nχ̄v − (α + β nχ̄v )w = 0, solving
for nv yields:
γ(1 − θ)L
nv =
= γn
(9c)
2α
Comparing the shared quota with free trade we see that prices and output
of each variant are identical in the two situations. The only thing that differs
is the number of variants, which is lower in the case of shared quota, with
γ determining the reduction in the number of variants. The stricter the
import constraint, the fewer variants will be available. Also, less labour is
employed in the traded sector under a shared quota compared to the free
trade equilibrium. In fact, the amount of labour reallocated from the export
sector into the unrestricted non-traded sector is given by
L
(10)
2
Furthermore, since prices have not risen, consumers can not spend the same
amount of money on imported goods as in the unrestricted equilibrium. The
amount of funds reallocated to other goods is:
∆Lv = (1 − γ)
Lw
(11)
2
This spending power enters the non-traded sector, so that a restriction on
the traded sector again has a spillover effect in the non-traded industry.
Rv = (1 − γ)
Tariffication - ad valorem tariff
An ad valorem tariff t affects firms like a tax. In particular, only the fraction
1−t of total sales revenue enters the exporting firm’s profit function. Hence,
11
the revenue part of the profit function changes, resulting in the profit function π t = (1 − t)pt xt − (α + βxt )w. Free entry and exit ensure that firms
compete industry profits to zero. Using the same procedures as above, the
equilibrium under an ad valorem tariff that generates the import volume χ̄
is characterised by:
βw
(1 − t)θ
θα
xt =
(1 − θ)β
γ(1 − θ)L
nt =
2α
2
t = (1 − γ)
2−γ
pt =
(12a)
(12b)
(12c)
(12d)
The tariff level is derived from the condition that total consumer expenditure
on the import industry must equal consumer expenditure on any industry, i.e.
t
pt χ̄ = wL+R
, where Rt = tpt χ̄ is the tariff revenue which is redistributed to
2
t t t
consumers. Subsequently the market clearing condition, pt xt nt = wL+tp2 n x
is solved for nt . From (12a-12c) it is found that tariffication utilising an ad
valorem tariff results in the same number of variants (firms) and the same
amount of output per firm as as a shared quota. However, what has changed
is that prices have risen. In fact, what happens in the case of an ad valorem
tariff, is that the foreign producers pass the entire import tax on to the
consumers via the increase in prices. Yet, all tariff revenue is redistributed.
Using the derived tariff level, t, one can calculate:
Rt = (1 − γ)Lw
(13)
It should be noted that there are two opposing effects at work when
imposing a tariff. An increase in the tariff level does decrease imports because
of increased prices, but it also increases imports because of the increased
spending power available to consumers. Since half of these funds are spent
on non-traded products, however, tariff regulation of the import volume is
possible. Note also that there is less labour employed in the traded sector
(compared to the free trade equilibrium) and thus, the labour force employed
in the non-traded sector is increased (compared to the free trade equilibrium)
by the amount:
L
∆Lt = (1 − γ)
(14)
2
12
Tariffication - specific tariff
Let T denote the specific tariff, then the profit function of a firm becomes
π τ = (pτ − T )xτ − (α + βxτ )w. Defining the specific tariff in real terms by
T
τ = w
the profit function can be written as π τ = pτ xτ − (α + (β + τ )xτ )w.
Hence, when a specific tariff is imposed it enters the exporting firms profit
function like an increase in marginal cost. Note, that this case is in fact
identical to the sold quota case with T = F and τ = f , except for the fact
that the tariff revenue under a specific tariff accrues to the home country
while the quota rents of the sold quota accrued to the foreign country.4
However, due to the symmetry assumption of this model this does not affect
the characterisation of the equilibrium, and hence (6a), (6d), (6b’) and (6c’)
also apply to the equilibrium under specific tariffication. In particular,
(β + τ )w
θ
θα
γ(2 − θ)
xτ =
(1 − θ)β 2 − θγ
L(1 − θ) 2 − θγ
nτ =
2α
2−θ
β(1 − γ) 2
τ=
γ
2−θ
pτ =
(15a)
(15b)
(15c)
(15d)
Thus, a specific tariff (tariffication using a specific tariff) results in more
firms selling at higher prices, but with less output per firm, compared to
free trade (an initial shared quota). Furthermore we have ∆Lτ = ∆Lq and
Rτ = Rq , the increased expenditures on fixed costs α (due to more variants
under a specific tariff) resulted in higher employment in the traded sector,
hence fewer workers will transfer into the non-traded industries, compared
to the shared quota and compared to ad valorem tariffication.
What drives the difference between the specific and the ad valorem tariff
is the interaction of industry and firm profitability. As the ad valorem tariff
is simply passed along to consumers (via the price increase), the individual
firm’s profitability (operating surplus) remains unchanged, hence their maximisation results in the same firm-level output volume as before. However,
since prices have risen, industry profitability suffers and there is less room
for firm entry before industry profits turn zero. In the specific tariff case,
firms’ profitability is in fact increased, i.e. the operating surplus is increased.
Since a constant fixed cost αw has to be offset exactly for a firm to enter
the industry, then with a larger operating surplus smaller output runs suffice to achieve breakeven. Hence, industry profitability is also larger than
4
This is a finding in line with Gros (1987).
13
in the ad valorem case, allowing more firms to enter before industry profits
turn zero. So as a revenue extractor, the ad valorem tariff is more efficient
than the specific tariff.5 However, due to this efficiency, industry profits and
firms’ operating surpluses are lower than under a specific tariff, resulting in
fewer firms. To verify this point consider industry profitability Πs , which we
represented by the profits that a single firm would achieve under the prices,
tariffs and quantity χ̄ that were derived above, and the operating surplus
σ s , given by the difference between marginal revenue and marginal cost. In
2−θγ (1−θ)wγL
particular it turns out that: Πt = (1−θ)wγL
− αw < (2−θ)γ
− αw = Πτ
2
2
and σ t =
4
(1−θ)βw
θ
<
(1−θ)(β+τ )w
θ
= στ .
Welfare Results
The welfare comparison of the different trade policy regimes is complicated
by the spillover effects from the restricted sector into the unrestricted (nontraded) sector. In appendix A.1 we show that reallocated labour and spending power from the constrained export sector will, when entering the nontradable sector, result in a larger number of available variants, thus increasing
utility. However, intuitively it is clear that since a loss of utility from the
constrained traded sector has to be compensated by increases in utility from
the non-traded sector, and since we assume diminishing marginal utility, the
utility gain in the non-traded sector is insufficient to compensate consumers
up to the free trade utility level.
Given the initial import restriction – secured by either a sold or shared
quota – and the two forms of tariffication, it is possible to calculate the
gains and losses in welfare. Since all spending power is with consumers, we
know that everything that is produced will actually be consumed, hence the
relevant values for n and x can be plugged directly into the utility function,
and one can compare the utility levels in the different scenarios. Inserting
equations (4a-c) into (1) gives total consumer utility U under free trade:
L
1−θ θ−1 θ −θ
U = 2 ln
(1 − θ) α θ β
(16)
2
Utility depends positively on the size of the economy and falls with an increase of the fixed cost α and variable cost β.
5
This is in line with findings that e.g. Lockwood and Wong (2000) and Kowalczyk and
Skeath (1994) have made in settings of monopoly and oligopoly.
14
Using (1), (6)-(15) and appendix A.1 utility under the four different trade
regimes is given by:
1−θ !
2
−
θγ
2
−
θγ
U q = ln
Ω + ln γ θ
Ω
(17a)
2−θ
2−θ
U v = ln ((2 − γ)Ω) + ln (γΩ)
U t = ln ((2 − γ)Ω) + ln (γΩ)
1−θ !
2
−
θγ
2
−
θγ
Ω + ln γ θ
Ω
U τ = ln
2−θ
2−θ
(17b)
(17c)
(17d)
where Ω = L2 (1 − θ)1−θ αθ−1 θθ β −θ , and q, v, τ and t denote the scenarios
of the sold quota, the shared quota, tariffication via a specific tariff, and
tariffication via an ad valorem tariff respectively. The first term of each
expression states the utility stemming from the consumption of non-traded
products, while the second term measures utility from the consumption of
imports. The following result immediately follows from (17a-17d):
Proposition 1. Given a certain import restriction, consumers are indifferent
between a sold quota and specific tariffication; and consumers are indifferent
between a shared quota and ad valorem tariffication. In particular,
U q = U τ and U v = U t
Utility under the specific tariff is identical to utility under the sold quota
as both the maximization problem of the firms and the revenue gain (even
though it accrued once to the foreign and once to the home country) is the
same in the two cases. The ad valorem tariff is identical to utility under
the shared quota, even though the reallocated tariff revenues Rt have been
larger than the retained funds Rv that occurred under the shared quota. Still
the two scenarios arrive at the same utility level. This is because the price
level in the tariffication case has also increased (pt > pv ). In particular this
is because under tariffication, consumers actually do use half of their total
funds on all sectors, while in the shared quota case, a smaller share of income
is used on the import sector. In fact, the higher spending power under ad
valorem tariffication is offset exactly by the higher price level in the traded
sector. From (16 ) and (17a-17d) it is possible to deduce the following welfare
ranking:
15
Proposition 2. Given a certain import restriction, consumers strictly prefer
specific tariffication to ad valorem tariffication. Yet, free trade is preferred
to any level of the import restriction. In particular,
U > Uτ > Ut
Proof is given in appendix A.2. Total consumer utility is larger under a
specific tariff than under an ad valorem tariff (given the same trade restriction), yet both tariff regimes are dominated by free trade. The superiority
of the specific tariff compared to the ad valorem tariff stems from the fact
that under a specific tariff (and in fact also under a sold quota) more profits
remain in the traded sector, allowing more firms to exist. Since consumers
love variety, this policy generates the higher welfare, even though the total
import restriction is the same.
Given the results in proposition 1 and 2 one can draw conclusions on the
impact of tariffication. Consumers prefer specific tariffication to ad valorem
tariffication. However, whether the tariffication process is at all desirable
from the consumers’ point of view depends on the nature of the initial import
restriction.
Corollary 1. (a) If the initial import restriction is given by a shared quota,
then tariffication will at least be welfare neutral (using ad valorem tariffs)
and at best be welfare improving (using specific tariffs). In particular,
Uτ > Uv = Ut
(b) If the initial import restriction is given by a sold quota, then tariffication
will at best be welfare neutral (using specific tariffs) and at worst be welfare
reducing (using ad valorem tariffs). In particular,
Uτ = Uq > Ut
From corollary 1 it follows that when the initial trade barrier (to be converted into a tariff) is constructed from a mix of sold and shared quantitative
restrictions, then specific tariffication will be welfare increasing, while ad valorem tariffication will be welfare reducing.
5
Conclusion
The 1990s have seen widespread tariffication for the members of GATT and
later WTO. This process of converting quotas, VERs, import licenses and
other trade barriers into their tariff import-equivalents has been endorsed
16
by governments and economists alike. This paper argues that, in a world
of monopolistic competition, tariffication may cause a welfare reduction, depending on the method of tariffication (ad valorem versus specific tariffs) and
the nature of the initial trade protection regime (sold versus shared quotas).
The distinction into sold and shared quotas is driven by the property rights
to the quantiative restriction. In particular with clear property rights a quota
can be sold and entry be limited such that rents accrue. However, without
clear property rights – shared quotas – a quantitative restriction suffers from
the ‘tragedy of the commons’ where excessive market entry reduces the sales
of each firm such that neither rents nor revenue can be harvested.
The model of the paper builds on Krugman (1980 and 1981). In a symmetric, two country, general equilibrium model, the case of bilateral tariffication of a sold quota and a shared quota is addressed. All results are
obtained under the assumption of complete redistribution of all tariff revenues and quota rents. The main results of this analysis are that, under the
assumption of monopolistic competition, sold and shared quotas and their
import-equivalent tariffs can result in different effects in terms of prices, the
number of firms/product variants and the output per firm. In particular, in
the traded goods sector a sold quota (shared quota) results in higher (the
same) prices, less (the same) output per firm, and an even higher (lower)
number of firms than under free trade. Enforcing the same amount of total imports via an ad valorem tariff results in the same number of firms as
the shared quota (hence, also the same output per firm), however prices are
higher than in the shared quota case. Enforcing the same amount of total
imports via a specific tariff results in exactly the same equilibrium as under
the binding quota.
In terms of the effect on consumers’ utility, it is established that utility
under specific tariffication – though less than under free trade – is higher than
under ad valorem tariffication; a result that is opposed to existing findings
in oligopoly or monopoly settings. Furthermore, utility under ad valorem
tariffication is identical to utility under a shared quota, whereas utility under specific tariffication is identical to utility under a sold quota. This paper
has thus established that when evaluating the welfare impact of tariffication for industries that feature monopolistic competition, it is important to
distinguish between both the tariff tool used and the initial trade regime.
Nevertheless, despite the findings of this paper, ad valorem tariffs might be
preferred to specific tariffs on grounds of transparency, ease of administration, and fairness – issues left aside in the present analysis. Yet what this
paper has shown is that an undue reliance on ad valorem tariffication under
the rules of WTO might have an opportunity cost in terms of the lost number
of product variants and could even be welfare reducing.
17
A
A.1
Appendix
Impact on the Non-traded Industry
Both labour and spending power (including redistributed funds from quota
rents and tariff revenue), stemming from the constrained export industry
will move to the non-traded industry. Formally, the labour supply for the
non-traded industries, L̂s , can be written as:
1
L̂s = L + ∆Ls
2
s = q, v, τ, t
(A.1)
The increase in available labour does not influence the equilibrium output and
price of the individual firm in the non-traded industry and hence output and
price is equal to p̂ and x̂ given implicitly in (4a) and (4b). This reallocation
of labour is identical to an increase in market size, and thus only influences
the equilibrium number of variants, and hence also total industry output.
The equilibrium number of variants, n̂s , is found by using the labour market
clearing condition for the non-traded industry given by:
L̂s = (α + β x̂)n̂s
s = q, v, τ, t
(A.2)
Combining (A1) and (A2) and inserting ∆Ls found in (8), (10) and (14), we
find the equilibrium number of variants in the non-traded industry under the
different trade policies:
2 − θγ
n
2−θ
n̂v = n̂t = (2 − γ)n
n̂q = n̂τ =
(A.3)
(A.4)
From (A3) and (A4) it immediately follows that n̂q , n̂v , n̂t , n̂τ > n and n̂q =
n̂τ < n̂v = n̂t .
A.2
A.2.1
Proofs
Proof that Uq , Uv , Uτ , Ut < U
Consumer utility under trade protection, but with full reallocation of tariff
revenues and quota rents, is less than utility under free trade. Recall from
proposition 1 that U τ = U q and U t = U v .
Proof. U t < U . From (17c) it follows that U t = U + ln(2 − γ) + ln γ. Hence,
one has to show that:
K t = ln(2 − γ) + ln γ < 0 .
18
(A.5)
It follows from (A.5) that limγ→0 K t = −∞ and limγ→1 K t = 0. Since
2−2γ
∂K t
= (2−γ)γ
> 0, K t is monotone increasing in γ for all 0 < γ < 1, (A.5) is
∂γ
fulfilled.
Proof. U τ < U . From (17d) it follows that U τ = U +(2−θ) ln 2−θγ
+θ ln γ.
2−θ
Hence, one has to show that:
2 − θγ
τ
+ θ ln γ < 0 .
(A.6)
K = (2 − θ) ln
2−θ
It follows from (A.6) that limγ→0 K τ = −∞ and limγ→1 K τ = 0. Since
2(1−γ)
∂K τ
= θ (2−θγ)γ
> 0, K τ is monotone increasing in γ for all 0 < γ < 1, (A.6)
∂γ
is fulfilled.
A.2.2
Proof that Uτ > Ut
Tariffication with a specific tariff and complete reallocation of all tariff revenues gives higher consumer utility than tariffication with an ad valorem
tariff.
Proof. U τ > U t . From (17c) and (17d) it follows that:
2 − θγ
τ
t
U > U ⇔ (2 − θ) ln
+ θ ln γ > ln(2 − γ) + ln γ
2−θ
(A.7)
Define the function:
F (z) = (2 − z) ln
2 − zγ
2−z
+ z ln γ
(A.8)
If F (z) is monotone decreasing in z, then b > a implies F (a) > F (b), and
hence (A.7) is fulfilled as 1 > θ. From (A.8) it follows that
∂F
(2 − z)γ
2(1 − γ)
= ln
+
(A.9)
∂z
2 − zγ
2 − zγ
One has to show that for a given z (A.9) is negative for all γ, 0 < γ < 1. It
follows from (A.9) that
∂F
∂F
= −∞ and lim
=0
γ→0 ∂z
γ→1 ∂z
lim
and since
(A.10)
∂ ∂F
4(1 − γ)
∂z
=
(A.11)
∂γ
γ(2 − zγ)2 > 0
(A.9) is monotone increasing in γ for all z and thus negative in the relevant
parameter intervals, such that (A.8) is monotone decreasing and hence U τ >
U t holds.
19
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