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Tariffs are the most common kind of barrier to trade; indeed, one of the purposes of the WTO is to enable Member countries to negotiate mutual tariff reductions. A tariff is a tax imposed on the import or export of goods.In general parlance, however, a tariff refers to “import duties” charged at the time goods are imported.Tariffs have three primary functions: to serve as a source of revenue, to protect domestic industries, and to remedy trade distortions (punitive function).
The most basic effect that an import tariff has is to raise domestic prices in the country imposing the tariff. In “small countries” (defined for our purposes as countries that do not have an influence on international prices), the rise in domestic price is equivalent to the amount of the tariff. In “large countries” (those that have an impact on international prices), the price rises somewhat less than the amount of the tariff because part of the tariff is reflected in a reduction in international prices.
A tariff-induced price rise creates a gap between prices in the importing and exporting countries. This in turn causes supplies (production) to rise in the importing country, while demand (consumption) falls, which is the essence of the “industrial protection” function of tariffs. Obviously, a tariff also generates revenues for the government of the importing country (revenue function). Tariffs, therefore, benefit the government and producers of the importing country in the form of tax revenues at the expense of its consumers in the form of higher prices.
Because tariffs bring different benefits and costs to different groups, the net cost to the importing country is the “cost to consumers minus profits to producers minus government revenues.” This is equal to the sum of the “efficiency loss” caused by distortions to the pricing system and the “profits from improved terms of trade” brought by a reduction in international prices.
Therefore, for “small countries” which see no improvement in their terms of trade because their tariffs have no influence on international prices, the benefits from a tariff will necessarily be negative. However, for “large countries” that can expect an improvement in terms of trade because part of the tariff will lead to a reduction in international prices, the pros and cons are not so easily weighed. Economists sometimes refer to “optimal tariffs” that are low enough for the improvement in the terms of trade to exceed the costs, thereby maximizing economic welfare.
The degree of protection afforded by a tariff (the effective protection rate) is not equal to the tariff rate. The first reason for this is because of the potential influence of an improvement in the terms of trade. The second reason is that the effective protection rate will differ depending on which stage of the production process the tariff is applied (tariffs on parts or tariffs on finished goods). it, therefore, points out that even a relatively low tariff rate can function adequately as a means of protecting domestic industry
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