How do we estimate the impact of changes in import tariffs?
Suppy-Demand Model of an Imported Commodity
This analysis uses a simple one-commodity model of supply and demand to estimate the impact of various changes in the market for an imported commodity. It allows simulations of changes in import tariffs, as well as changes in the world price, supply shifts, and changes in income. The model simulates the effect of these changes on production, consumption, imports, and prices. It also generates estimates of the economic impact of the change on consumers, producers, and the overall economy.
In order to make the model represent a specific commodity market in a specific country, the following information is needed:
- Domestic production of the commodity
- Quantity imported of the commodity
- Domestic price of the commodity
- World price (CIF) of the commodity
- Import tariff rate
- Exchange rate
- Price elasticity of supply of the commodity
- Price elasticity of demand of the commodity
This analysis uses a simple single-commodity model of supply and demand to analyze different scenarios related to an imported commodity. It makes the following simplifying assumptions that:
- We can adopt the small-country assumption for this commodity in this country.
- We can ignore the interaction between the market for this commodity and the market for other commodities.
- The imported commodity and the domestically produced commodity are perfect substitutes
- The supply curve has a constant elasticity of supply
- The demand curve has a constant price elasticity of demand
Because it is difficult to estimate supply and demand elasticities, models often adopt estimates from other studies. In the absence of other information, it is even possible to make an educated guess regarding the elasticity based on the characteristics of the product. Staple foods tend to have low demand elasticities (-0.3 to -0.6), while goods with many good substitutes (such as fruit) have high demand elasticities (-1.5 to -3.0). In the short term (within one year), agricultural supply elasticities are close to zero because it takes farmers at least a season to respond to price changes. Major crops grown for subsistence with few purchased inputs tend to have low supply elasticities, even in the long term (0.2 to 0.6). Minor crops grown for commercial production with purchased inputs have larger long-term supply elasticities (1.0 to 2.0).
The linked spreadsheet can be used to answer several types of questions:
- What is the impact of a change in import tariff?
- What is the impact of a change in world prices?
- What is the impact of a change in domestic income, which affects demand for the commodity?
- What is the impact of a shift in supply due to, for example, the adoption of higher-yield varieties?
There are three steps in using this spreadsheet model. First, the model needs to be calibrated, meaning that the model is adjusted to describe the market for a given commodity in a given country in a given year. This is done by setting the values in the green cells C4 to C13: production, imports, the domestic price, the original import tariff, and the elasticities for the commodity being simulated. This is called the base scenario.
Second, we design an alternative scenario to simulate with the model. This is done by setting values in the blue cells C16 to C19. As noted above, the model allows alternative scenarios with regard to the import tariff, world prices, domestic income, and production technology.
Third, we compare the outcome in the base scenario and the alternative scenario. The spreadsheet automatically compares the base scenario (before) and the alternative (after) and gives the percentage change. The outcome variables are shown in the yellow block of cells from C22 to E34. The outcome variables include:
- Import tariff revenue
- Autarky price, which is the price at which domestic supply equals demand
- Import parity price, which is the price at which imported goods can be sold on the domestic market, including import tariffs
- Domestic price in local currency and in US$
- Change in consumer surplus, which is the benefit (or cost) to consumers resulting from the change
- Change in producer surplus, which is the benefit (or cost) to producers of the commodity resulting from the change
- Change in welfare for producers and consumers, which is the sum of the changes in consumer surplus and producer surplus
- Change in tariff revenue
The spreadsheet also shows the simulation graphically with a supply and demand curve:
- The supply curve is in blue
- The demand curve is in red
- The world (CIF) price of the commodity is the black line. Under the small-country assumption, we assume that the country is too “small” to influence the world price, so the world price is represented by a horizontal line.
- And the domestic price is the green horizontal line. For an imported good, the domestic price is normally set by the import parity price. However, if the import parity price rises above the autarky price (or the autarky price falls below the import parity price, then imports stop, the country becomes self-sufficient in this commodity, and the commodity becomes non-tradable.
- After defining an alternative scenario, the new lines are shown in the same colors but they are dashed, rather than solid.
Below, an example is used to demonstrate the model and to illustrate some concepts in international trade.
What is the impact of a change in the import tariff?
The import tariff is initially set at 10%. Note that the tariff is applied to the CIF price, not to the full import parity price. The tariff represents part of the gap between the world price (in black) and the domestic price (in green), the other part being port-to-destination marketing costs.
We can set a new tariff rate of 20% by typing “20” or “0.20” in cell C19. The impact of this change is shown in the “after” column of the table marked in yellow and in the dashed lines on the graph. The new domestic price is 7% higher than in the base scenario. The higher price causes consumption to contract and production to expand, though the increased production would typically take at least one year to occur because of the planting cycle. As a result, imports decline by 23%. Although the tariff rate is doubled, the tariff revenue increases by only 55%. This is because higher tariff reduces the volume of imports, which partially offsets the higher rate. The import parity price (which includes the tariff) rises, thus increasing the domestic price by 7%.
The change in producer surplus is about US$ 13 million. This represents the benefits to farmers of the higher price of the commodity. On the other hand, the negative consumer surplus indicates that consumers lose US$ 10 million. The net loss to farmers and consumers is US$ 3 million, but the government gains US$ 2.5 million in tariff revenue. The net impact of the higher import tariff on the economy is a loss of US$ 700 thousand.
If the tariff is raised from 20% to 30%, the tariff revenue increases to US$ 6.1 million, but the net cost to the economy rises by a factor of three. If the tariff is raised to 40%, the tariff revenue falls to US$ 2.15 million, but the overall cost to the economy increases to US$ 5.2 million. This illustrates two patterns with tariff rate changes:
- Tariff revenue rises at low rates, but eventually it reduces imports so much that tariff revenue begins to decline.
- As the tariff rate is increased, the net effect on the economy is initially small but rises proportionately faster than the tariff rate. When the tariff rate rises by a factor of four (from 10% to 40%), the net loss to the economy increases by a factor of seven (from US$ 700 thousand to US$ 5.2 million).
If the tariff is increased above 60%, it becomes prohibitive, meaning that it chokes off all imports. The country becomes self-sufficient in the commodity, though the net cost to the economy is more than US$ 13 million. Farmers have gained about US$ 54 million, but this is offset by US$ 63 million in losses to consumers in the form of higher prices. In addition, tariff revenue, which was US3.6 million when the tariff was 10%, disappears with prohibitive tariffs. A further increase in tariffs has no effect on the economy because imports are no longer profitable.
This analysis measures only the economic benefits and costs of the rise in food prices. The impact of the higher prices on the nutrition and welfare of the poor depend on the characteristics of the commodity in question. The effects will be very negative if the commodity is the dominant staple food crop and the poor are mainly net buyers; it will be somewhat less if it is one of several main staple food crops and the poor include both net buyers and net sellers; and it will be relatively minor if the commodity is mainly consumed by high-income residents. It is also possible that the higher prices would have a positive effect on the poor if they are mainly net sellers of the commodity. This type of analysis, however, is outside the scope of this simple single-commodity model.