Chapter 9.1 : What are Tariffs?
What are tariffs and how do they work? Tariffs are a tax on imports and basically raise the price of imported goods relative to those produced domestically. We can get the best insights by focusing on a specific single-product market rather than all imported goods collectively. So in what follows assume the basic context: A single market (one domestic demand curve and one domestic supply curve) for a single product.
Goods are imported when they are cheaper than what at least some domestic companies are able to produce. That’s the whole point of imports in the first place! Imports allow domestic consumers to benefit by having access to more at a lower price. At least some domestic producers of that product are harmed because they’re out-competed by foreign rivals. Depending on the product even with international trade there can still be a quite vibrant local industry. It’s just that overall domestic production is not as efficient as foreign production.
When a tariff is applied to the particular product it raises the price that consumers have to pay and weakens the incentive to import. Consumers that still buy the good have to pay the same price whether they purchase a domestically produced version or an imported one. The difference is with goods produced domestically the entire purchase price goes to that firm’s revenues; but in the case of a foreign produced import, part of the purchase price covers the tax paid to the government and the rest goes to the foreign firm. A consumer that cares only about price should be indifferent between buying a local good or an import.
Tariffs are a bit like a national boycott on the imported good with the option to continue to purchase the imported product, but at a higher price. The idea is to divert business from foreign producers to domestic producers. Yes, tariffs are paid by the buyer of the good in the sense that more money comes out of their wallet. But like all taxes, the burden is shared between buyer and seller. Foreign sellers are harmed by tariffs.
By the law of demand we know that with higher prices there is a lower quantity demanded. So while the tariff raises the price of the good, it also lowers the quantity demanded: Consumers buy less. And with all price increases, it’s the consumers with the lowest willingness to pay that are harmed the most, they are priced out of the market. These could be the least well off consumers, but it could also simply be consumers that don’t value the good very highly in the first place and hence are easily convinced to stop buying when the price increases. In any case, we assume the consumers that value the good the most will keep buying it at the new higher price.
Fewer units of the good are produced once the tariff is applied, but there’s an increase in the proportion of total units of the good that are purchased from domestic sellers by domestic buyers. When tariffs are applied more of the transactions take place between domestic producers and consumers and fewer between domestic consumers and foreign producers.
Domestic producers gain with tariffs, domestic consumers lose, and foreign producers lose. But it’s not just all domestic producers uniformly: It’s specifically domestic producers of the good affected by the tariff. Economists are generally suspicious of tariffs because they reduce economic activity: Since the quantity demanded falls there’s fewer units exchanged and less economic value created. This is bad. The biggest cost is that tariffs introduce inefficiency: We can sum up the net effect as follows: “there’s winners and losers, but the winners win less than the losers lose”. Basically the domestic producers that gain business deflected away from foreign rivals are better off but their gain is smaller than the loss to their customers who now pay more and consume less.
Remember that this is the most basic version and the actual predictions and application depends on the circumstances, and importantly, on our assumption that there are no other important factors that the model has neglected to consider.
One important thing to remember is that ‘domestic buyers’ refer to all those who are purchasing the good in the domestic market but not necessarily to individual households or people. Domestic buyers may very well be other companies who are importing the imports necessary to produce their own products that may be sold locally or exported. In the U.S. this is very relevant for goods like steel or wheat: both are important imports and neither are purchased directly by households! We to pay attention to the larger set of circumstances in related markets and industries in order to understand the full effect of tariffs on intermediate goods like these.
As mentioned, domestic producers of the good affected by the tariff gain and domestic consumers of that good (On the other side of the market, foreign producers lose as they export fewer units and foreign consumers gain, other things equal). Importantly these gains and losses are not spread evenly. The gains to domestic producers as a result of the tariff are highly concentrated amongst the firms producing in that market; the losses to consumers are widely dispersed across all buyers. A few firms ‘win’ (a large amount) and many consumers ‘lose’ (a little bit). Generally speaking the few firms that stand to gain quite a bit by selling more at a higher price have relatively strong bargaining (and lobbying) power and the many consumers that each lose a little bit as a result of paying more and getting less have relatively weak bargaining (and lobbying) power.
Here’s a YouTube video I’ve created explaining the effects of tariffs carefully with more graphs: