Tariffs, the Terms of Trade & the Distribution of National Income

Lloyd A. Metzler

Introduction:

The law of comparative advantage:

The law of comparative advantage allows all countries to consume more of all commodities through international trade. Mills added to this, stating how international trade affects the distribution of world income among countries.
However, this does not consider the impact that international trade has on the distribution of income between the factors of production. This has resulted in the discussion of income distribution having been separated from discussion of productivity and of gains and losses to a country. Despite this separation it is clear that a country’s terms of trade have an effect on the distribution of national income.
For example, country Alpha has a large amount of land per worker, in comparison with country Beta. Therefore land will be relatively cheaper in Alpha. Both produce wheat & textiles, wheat is relatively land intensive & textiles relatively labour intensive. Therefore the unit cost of producing wheat will be lower in Alpha; Alpha has a comparative advantage in wheat production. If international trade occurs Alpha will export wheat & Beta textiles. The wheat industry expands in Alpha & textiles contract. The shift from textiles to wheat increases the relative scarcity of land in Alpha. As a result, wages per unit labour fall relative to rent per unit of land. Therefore land now has a larger share of total product. Int’l trade increases demand for each country’s abundant factors, thereby equalising the relative returns to the factors of production.


Elasticity of Demand:

The ratio of the percentage change in demand for an item to the percentage change in its price. Demand is elastic if this ratio has a value of greater than one, and inelastic if it is less than one.






Section II

Tariff:

A tariff is a tax on foreign goods upon importation.

Owners of the factor of Production which is relatively scarce want to introduce tariffs so as to restrict trade. The tariff preserves the relative scarce factor i.e. in Alpha this would be labour (textiles), textiles from abroad (which are imported) are more expensive. One of the problems with this is that it only takes account of the relative position of a factor of production and not the absolute position i.e. the absolute return may decrease even though the relative return increase. This leaves the scarce factor of production (which in Alpha is labour) with a larger share of a reduced total, which is placing them in a worse off position than before.

Stolpher & Samuelson have shown that this is not a major concern as real and relative returns move in the same directions. So Alpha could increase the real wage rate by the introduction of the tariff even though national income would decrease. The negative effect of the tariff moves onto the abundant factor i.e. in Alpha this is land. Tariff causes the factors of productions to be moved from export industries (Alpha wheat) to industries competing with imports (textiles)

It is assumed that the marginal product of a factor declines as the ratio of that factor to others in a particular industry is increased. i.e. if you have a lot of land an extra acre will not make much difference whereas if you have very few employees and you get one more that will make a lot of difference.

When wages rise relative to rents its causes a substitution of land for labour i.e. more money in labour, thus causing the ratio of labour to land to decline in all industries.


Impact on World Markets:

If a country’s exports and imports are important influences on world markets and a tariff reduces the external prices of imports, relative to the prices of exports, to such and extent that real income for the country as a whole is clearly increased. Assuming the country has a scarcity of labour and so imports goods that require a high labour content it may seem that real wages would increase. But it must be remembered that the improvement in terms of trades affects real income as well as degree of scarcity of the scarce factor of production. So when changes in the terms of trade are taken into consideration, tariffs do not always protect the scarce factor.








Case 1: Elastic Demand for Alpha’s Exports (Fig 1)


• Beta’s demand for exports of Alpha is elastic.

• Alpha imposes 50% tariff on imported textiles from Beta. Demand schedule falls from A to A’.

• Equilibrium now moves to P’. The world price of textiles (exclusive of tariff) has fallen since

OT’/OW’ > OT/OW

• But, domestic price of textiles has increased since

OT’/OW’’ < OT/OW

• P’P’’ is 50% of T’P’ i.e. P’P’’ is tariff revenue

Impact on Dist of Income:

As a result, resources shift away from the wheat industry to textiles and the relative share of labour increases, as does the wage rate. This situation holds only if Beta’s demand is elastic and the tariff revenue is assumed to be spent on domestic goods. The improvement in terms of trade is not sufficient to offset the tariff, therefore resources shift to the protected industry and this becomes relatively more profitable.

Fig 1:















Case 2: Inelastic Demand for Alpha’s Exports (Fig 2)


• Beta’s demand is now inelastic. Therefore, when the world price of textiles falls (as it does after the imposition of a tariff) Beta will offer an increasing amount of textiles for a lower amount of wheat.

• Movement of equilibrium to P’, this improves Alphas terms of trade as they can now import OT’ units of textiles for only OW’ units of wheat.

• This ∆ in terms of trade is so large that the domestic price of textiles (including tariff) actually falls in Alpha.

• This can be seen by the fact that:
OT’/OW’’ > OT/OW

• As a result, the ‘protected’ industry actually suffers with resources shifting to the export industry, wheat.

Impact on Dist of Income:

The scarce factor of production (in this case labour) actually suffers both a relative and an absolute decline in income if export demand is sufficiently inelastic. The Gov. of Alpha use the tariff revenue to soak up the excess supply of wheat (W’W’’).

Fig 2:

















Case 3: Tariff Revenue Spent Entirely on Imports (Fig 3)

• In last two situations the tariff revenue was spent entirely on domestic goods.

• What happens if tariff revenue is spent entirely on imports?

• If tariff is not spent on imports Alpha’s demand curve falls to A’.

• At P’’ traders in Alpha give OW’ units of wheat for OT’’ units of textiles (Tariff revenue is SP’’).

• Assuming OSP’ is exchange rate line Alpha gives T’’S units of wheat to Beta for OT’’ units of textiles & SP’’ to Gov. in tariff revenue.

• If Gov. of Alpha spends entire tariff revenue on imports they receive P’’P’ units of textiles for SP’’ units of wheat.

• Terms of Trade of Alpha have improved (OT’ textiles for only OW’ wheat), however, domestic price of textiles has increased as trades in Alpha only receive OT’’ units of textiles for OW’ units of wheat.

• Therefore, if tariff revenue is spent entirely on imports, resources shift to the protected industry regardless of the foreign elasticity of demand.

• Impact on Dist of Income:

Resources shift from wheat to textiles & the relative share and absolute return to the scarce factor of production (Labour) increases.

Fig 3:
















Case 4: Tariff Revenue used to Reduce Domestic Taxes

• In a more realistic world the tariff revenue will be spent on both imports & exports.

• Tariff revenue now divided in the proportions of k and 1-k between purchase of imports & exports.

• Where:
k = Marginal Propensity to Import in Alpha
n= price elasticity of demand for Alpha’s exports.

• In this case ∆ in terms of trade offsets tariff revenue; therefore domestic price ratio remains unchanged.

• OP’ is the world rate of exchange, Alpha imports OT of textiles for TU of wheat, but Gov. receive wheat = UP.

• The amount UP is returned to citizens of Alpha through reductions in income taxes & a proportion of this is now used to purchase extra imports, i.e. US/UP = k

• Traders in Alpha now receive additional textiles = SP’ & equilibrium moves to P’ on A’’.

• Alpha’s terms of trade have clearly improved (Import OT’ for only OW’ wheat).

• However, domestic price ratio remains at P since this point is 50% above U. Therefore, no shift in resources between the industries & distribution of income remains the same.

Fig 4:


How can Alpha import more if domestic price ratio remains unchanged?

This occurs because the tariff revenue allows the Gov. of Alpha to reduce other taxes, there is now more disposable income in Alpha and this is used to purchase both goods that would ordinarily have been exported and also increase imports. Therefore imports rise by TT’ & exports fall by W’W as output remains unchanged.







Generalised Model: Can tariffs be implemented without impacting on the domestic price ratio?

• Can a tariff leave the domestic price ratio unchanged?

• If the price ratio is to remain the same the ∆ in the domestic price of imports must exactly offset the ∆ in terms of trade.

• The relative increase in demand for imports = kr

• Where:
k= Marginal Propensity to Import
r = Tariff Rate

• Assuming that demand in Beta is inelastic, the relative increase in supply of textiles from Beta = TT’/OT

• This is equal to –β(W’W/OW)

o Where β is the elasticity of the reciprocal demand schedule B.

• But, W’W/OW = (1-k)r since the increased consumption of wheat is the indirect result of the tariff.

• Therefore the increase in supply of textiles:

= –β(1-k)r

• If supply equals demand:
kr = –β(1-k)r

• Divide across by r:
k = –(1-k)β

But: β = 1 – 1/n

• Where n = elasticity of the ordinary money demand schedule.

Therefore k = -(1-k)(1-1/n)

Simplifying:

n = 1-k

• Therefore, if a tariff is to have no effect on the domestic price ratio, the foreign elasticity of demand for the country’s exports must be equal to the difference between unity & the Marginal Propensity to Import of the tariff charging country.


Section III: Real World Applications

Australia

• Argued reducing tariffs would shift resources from manufacturing to agriculture.
• Metzler argued that the reduction would in fact shift resources into manufacturing.
• Australia increased tariffs in 1921.
• Long term negative effect on exchange rates and relative costs.
• Tendency to look at immediate effects of tariffs vs. long term effects.

Latin America

• These governments encourage domestic manufacturing by means of tariffs on importing competing products.
• A good means of achieving more favourable terms of trade.
• Metzler argued that any benefits they confer upon one industry will be at the expense of another.
• Inelastic demand for their exports as they are generally agricultural in nature.

Friedrich List

• Believed in general protective duties on manufacturers were a useful means of promoting industrial growth.
• Divided economic growth into 4 periods.
• Found that in only 2 of these periods protective duties were beneficial to manufacturers (2nd and 3rd).

• Period 1: Agriculture is encouraged by importation of manufactured articles.
• Period 2: Manufacturers begin to increase at home.
• Period 3: Home manufactures mainly supply home market.
• Period 4: They export and import raw materials and agricultural products.

• List concludes like Metzler that a policy of protection is a questionable method of increasing manufacturing in an undeveloped country.

• Conclusion: Changes in duties have much less effect upon protected industries than is generally supposed.









Conclusions:

(i) A shift in resources from one industry to another will increase the real income & relative share of the total income of the resource that is required in relatively large amounts (i.e. the scarce resource).

(ii) A tariff has two effects:

(a). It causes a direct increase in import prices.

(b). It causes a reduction in the world price of the goods.

The overall impact on domestic prices depends on which force is stronger.

(iii) If MPI = 0 a tariff does not increase domestic price of imports unless foreign elasticity of demand for exports >1

(iv) If MPI = 1 a tariff always increases domestic price of imports regardless of n

(v) If 1-k < 1 and n is elastic a tariff always increases domestic import prices.

(vi) However, if foreign demand is inelastic a tariff may actually cause a shift in resources from the ‘protected’ industry to the export industry.