Tariffs
Also known as 'customs duties', they are taxes imposed on imported goods.
Tariffs serve two purposes for an economy:
- Reduce foreign competition and protect domestic producers (protective tariff).
- Earn revenue for the government (revenue tariff).
Regardless of the purposes, the effect on the economy remains the same.
Free Trade
An absence of government intervention in international trade, resulting in no imposing restrictions of any kind on imports and exports.
Trade Protection
When the government intervenes in international trade by imposing restrictions to reduce free imports.
Governments usually impose tariffs to reduce competition and protect their domestic workers and firms (or so they say) as the reasoning behind it is:
- Countries usually trade due to comparative advantage (4.1).
- If the world prices are lower, domestic firms are forced to accept the lower prices, affecting domestic workers' wages.
- Therefore, the country is worse off with free trade.
Tariff Diagram
The figure above shows the effect of a Tariff on a country engaged in free trade.
- Initially, the domestic economy has a price $P_d$ while the world price is lower at $P_w$ (the domestic country has a comparative disadvantage in the following good).
- Recall, when there is free trade, the domestic economy will operate on the lower world prices.
- This causes the quantity supplied to reduce from $Q_e$ to $Q_1$ and quantity demanded to increase to $Q_2$ from $Q_e$, resulting in the excess demand $Q_2-Q_1$ to be imported.
- By using the tariff of amount $t$ imposed on imports, this causes the domestic (current) prices to rise to $P_w + t$.
- This leads to the quantity supplied to increase to $Q_3$ and the quantity demanded to fall to $Q_4$, causing the imports to fall to $Q_4 - Q_3$.
$P_w+t$ is the new domestic price after tariffs! The world price is still the world price of $P_w$ but domestically, the prices have risen to $P_w + t$. $P_d$ would be the domestic price if there was no free trade initially, and hence no tariffs.
The Effects of a Tariff
We can classify the stakeholders into categories of winners (those who mainly gain) and losers (those who mainly lose) from the inclusion of the tariff after initially being free trade.
Winners
Domestic Producers
- Domestic producers are supplying more ($Q_3$ instead of $Q_1$) at a higher price $(P_w + t)$, earning higher revenues.
- Producer surplus increases by the area marked as $c$, indicating the gain from the new prices.
Producer surplus
The difference between the price sellers receive and the lowest price that they are willing and able to accept.
Workers
- As producers are now supplying a larger quantity, this leads to increasing employment and providing protection for the industry.
Government
- The government earns revenue equal to the tariff ($t$) multiplied by the quantity of imports ($Q_3 - Q_2$), represented by area $e$.
Losers
Even though domestic producers of the industry who were protected are better off, it does not mean domestic producers of the export industry are better off as well. In fact, domestic producers of the export industry might even be worse off.
Consumers
- Consumers lose as they pay a higher price for the good ($P_w +t$).
- Hence, they can only purchase a lower quantity ($Q_4$ instead of $Q_2$).
- This causes the consumer surplus to fall by $c + d + e + f$.
Consumer surplus
The difference between the highest price consumers are willing and able to pay for a good or service and the actual price they end up paying.
Income Distribution
- As the tax is on goods and services, it's regressive since it takes up a higher proportion of income from low-income individuals and households.
- This increases the disparity between incomes (3.4.9).
Inefficiency of Production
- The reason world price $P_w$ is smaller than domestic price without trade $P_d$ is because foreign producers are more efficient.
- The increase in quantity supplied from $Q_1$ to $Q_3$ represents the domestic production increase that is inefficient as there is a waste of scarce resources by producing at $P_w +t$.
Foreign Producers
As foreign producers supply fewer goods ($Q_4 - Q_3$ instead of $Q_2 - Q_1$) at the same price $P_w$, their revenues decrease to only $(Q_2-Q_1)*Pw$.
Welfare Effects
Initially, before the tariff is imposed:
- The producer surplus is the area marked by $g$ and the consumer surplus is the area marked by $a + b + c + d + e + f$.
- Thereby, the initial social surplus was $a + b + c + d + e + f+ g$.
Social surplus
The sum of consumer surplus and producer surplus. Maximised in the free market, when the market operates at its equilibrium point.
Remember:
- the producer surplus is the area below the price they earn and above the supply curve up till the quantity sold.
- the consumer surplus is the area above the price of the good and below the demand curve up till the quantity bought.
After the tariff was imposed:
- The producer surplus increased by $c$ such that it is $c +g$ now.
- The consumer surplus fell by $c+d+e+f$ down to only $a+b$ now.
- Further, the government revenue is the area $e$.
- Therefore, the social surplus is $a + b + c +e+g$.
The change in social surplus is a decrease of:
$$ a+b+c+d+e+f+g - (a+b+c+e+g) = d+f$$
This change leads to a welfare loss of the area $d+f$ due to the misallocation of resources where:
- The area $d$ welfare loss occurs due to inefficient production by domestic firms.
- The area $f$ welfare loss occurs due to the decreased consumption of consumers.
When analyzing welfare loss, remember that it represents the net loss to society, not just a transfer between stakeholders.
Calculating the Effects of Tariffs (HL Only)
The figure above showcases a tariff diagram with numerical values this time for calculation.
Tariff Per Unit
The tariff can be calculated by subtracting world price from world price plus tariff:
$$ t = P_w+t - P_w $$
$P_w+t - P_w = 20 - 15 = 5$
Hence the tariff or $t=\$ 5$.
Imports Quantity
Before the tariff, the imports can be calculated by finding the excess demand at world price $P_w$.
At $P_w = \$ 15$ we have imports $200000 - 50000 = 150000$
Hence, there were $150,000$ units of the good imported.
After the tariff, the imports can be calculated by similarly finding the new excess demand or imports but at world price plus tariff $P_w+t$.
At $P_w+ t =20$ we have imports $150000 - 75000 = 75000$
Therefore, now $75,000$ units of good are imported.
Hence, the imports decreased by $75,000$ units after the tariff of $\$ 5$ on the good.
Import Expenditure
To find the import expenditure:
- We can multiply the import quantity before the tariff by world price.
- Then, we can multiply the import quantity after the tariff by world price.
We don't use $P_w + t$ because the tariff is what government collects.
You can find the expenditure on imports before & after the tariff respectively.
Before the tariff:
$150,000 \times 15 = \$ 2.25$ million
After the tariff:
$75,000 \times 15 = \$ 1.125$ million
Hence import expenditure fell by:
$ \$2.25 - \$ 1.125 = \$ 1.125$ (million)
Consumer Expenditure
For consumer expenditure:
- Before tariff, we multiply the world price by initial quantity demanded.
- After tariff, we multiply world price plus tariff with new quantity demanded.
Before:
Consumer expenditure is $200,000 \times 15 = \$ 3$ million
After:
Consumer expenditure is $150,000 \times 20 = \$ 3$ million
Hence in this specific case, there is no change in consumer expenditure, but they are still worse off as less consumers can afford and buy the good as it is more expensive.
Consumer expenditure can be both higher or lower after the tariff. However they're still worse off either way due to lower consumption.
Consumer Surplus
- Before the tariff, consumer surplus is the area of the triangle above the world price and below the demand curve, up till the quantity bought.
- After the tariff, consumer surplus is the area of the triangle above the world price plus tariff and below the demand curve, till the quantity bought.
Consumer surplus depends on how much is actually bought, not just demanded. In this case, as excess demand is covered by imports, they're equivalent.
Before:
$P_w = 15, Q_d = 200000$ and $P_{max} = 35$
Therefore we can calculate:
$$ CS = \frac{(35-15)\times 200,000}{2} = 2,000,000$$
Hence the consumer surplus was $\$ 2$ million.
After:
$P_w +t= 20, Q_d = 150$ thousand and $P_{max} = 35$
Therefore we can calculate:
$$ CS = \frac{(35-20)\times 150,000}{2} = 1,125,000$$
Hence the consumer surplus was $\$ 1.125$ million
Therefore the change in consumer surplus was a decrease of $\$ 875,000$
Producer Revenue (Domestic)
For (domestic) producer revenue:
- Before tariff we multiply world price by the initial quantity supplied.
- After tariff we multiply world price plus tariff with the new quantity supplied.
- As both price and quantity supplied increase, producers always earn more revenue.
Before:
The revenue is $50,000 \times 15 = \$ 0.75$ million
After:
The revenue is $75,000 \times 20 = \$ 1.5$ million
Hence the revenue of domestic producers increased by:
$ 1.5 - 0.75 = \$ 0.75$ million
Producer Surplus
- Before the tariff, producer surplus is the area of the triangle below the world price and above the supply curve, up till the quantity sold.
- After the tariff, producer surplus is the area of the triangle below the world price plus tariff and above the supply curve, till the quantity sold.
Before:
$P_w = 15, Q_s = 50000$ and $P_{min} = 5$
Therefore we can calculate:
$$ PS = \frac{(15-5)\times 50,000}{2} = 250,000$$
Hence producer surplus was $\$ 250,000$.
After:
$P_w +t= 20, Q_s = 75000$, and $P_{min} = 5$
Therefore we can calculate:
$$ CS = \frac{(20-5)\times 75,000}{2} = 562,500$$
Hence the producer surplus was $\$ 562,500$.
Therefore the change in producer surplus was a increase of $\$ 312,500$.
Government Revenue
The revenue from tariff is calculated by multiplying the tariff per unit $t$ with the imports after the tariff represented by area $e$.
At $t=5$, $75,000$ units are imported.
Hence, the revenue for the government is: $$ 75,000 \times 5 = \$ 375,000 $$
Welfare Loss
The areas of triangles $d + f$ showcase the welfare loss where:
- The first triangle can be calculated by multiplying the change in quantity supplied by the tariff (then dividing by two).
- The second triangle can be calculated by multiplying the change in quantity demanded by the tariff (then dividing by two).
First welfare loss (triangle):
$$ \frac{25,000 \times 5}{2} = \$ 62,500 $$
Second welfare loss (triangle):
$$ \frac{50,000 \times 5}{2} = \$ 125,000 $$
Hence total welfare loss is: $$ \$ 187,500 $$
Foreign Producers
Foreign producers' revenues will fall by the amount that import expenditure falls by.
From the example above, the import expenditure and hence the revenue of foreign producers fell by $\$ 1.125 $ million.
The U.S.-China Trade War and Steel Tariffs
Context:
In 2018, the United States imposed a 25% tariff on steel imports and a 10% tariff on aluminium imports. The move was primarily aimed at reducing the U.S.'s reliance on foreign steel and boosting domestic production. China, a major exporter of steel to the U.S., retaliated with tariffs on American goods like soybeans and automobiles.
Effects of the Tariffs:
- Domestic Producers Benefited:
- U.S. steelmakers experienced increased demand for their products as imported steel became more expensive.
- This led to a temporary rise in production and job creation within the domestic steel industry.
- Increased Costs for U.S. Companies:
- Industries that rely heavily on steel and aluminum (e.g., construction, automotive, and manufacturing) faced higher input costs.
- Higher Consumer Prices:
- Consumers indirectly bore the cost of tariffs through higher prices for goods like cars and household appliances.
- Global Trade Tensions:
- The tariffs escalated trade tensions between the U.S. and China, leading to a broader trade war that impacted global supply chains and slowed economic growth.
Outcomes:
- The U.S. steel industry saw short-term gains, but downstream industries like manufacturing suffered from higher input costs and reduced competitiveness.
- Retaliatory tariffs from China hurt American farmers, leading to government subsidies to offset their losses.
Questions:
- Were the tariffs successful in protecting U.S. steelmakers, or did their negative effects on other industries outweigh the benefits?
- How could the U.S. have achieved its objectives without triggering a trade war or hurting its own consumers?
How do governments balance the short-term benefits of protecting domestic industries with the long-term costs of reduced efficiency and higher consumer prices?
- Explain how a tariff works using a diagram.
- Discuss the impacts on stakeholders.
- Construct a labelled tariff diagram using letters (don't use numbers) as values and calculate.
