4.2.1 Tariffs Notes

Tariffs serve two purposes for an economy:

1. Reduce foreign competition and protect domestic producers (protective tariff).
2. Earn revenue for the government (revenue tariff).

Regardless of the purposes, the effect on the economy remains the same.

Governments usually impose tariffs to reduce competition and protect their domestic workers and firms (or so they say) as the reasoning behind it is:

1. Countries usually trade due to comparative advantage (4.1).
2. If the world prices are lower, domestic firms are forced to accept the lower prices, affecting domestic workers' wages.
3. 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.

1. 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).
2. Recall, when there is free trade, the domestic economy will operate on the lower world prices.
3. 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.
4. By using the tariff of amount $t$ imposed on imports, this causes the domestic (current) prices to rise to $P_w + t$.
5. 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 $Q_4 - Q_3$.

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

1. Domestic producers are supplying more ($Q_3$ instead of $Q_1$) at a higher price $(P_w + t)$, earning higher revenues.
2. Producer surplus increases by the area marked as $c$, indicating the gain from the new prices.

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

Consumers

1. Consumers lose as they pay a higher price for the good ($P_w +t$).
2. Hence, they can only purchase a lower quantity ($Q_4$ instead of $Q_2$).
3. This causes the consumer surplus to fall by $c + d + e + f$.

Income Distribution

1. 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.
2. This increases the disparity between incomes (3.4.9).

Inefficiency of Production

1. The reason world price $P_w$ is smaller than domestic price without trade $P_d$ is because foreign producers are more efficient.
2. 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:

1. The producer surplus is the area marked by $g$ and the consumer surplus is the area marked by $a + b + c + d + e + f$.
2. Thereby, the initial social surplus was $a + b + c + d + e + f+ g$.

After the tariff was imposed:

1. The producer surplus increased by $c$ such that it is $c +g$ now.
2. The consumer surplus fell by $c+d+e+f$ down to only $a+b$ now.
3. Further, the government revenue is the area $e$.
4. Therefore, the social surplus is $a + b + c +e+g$.

The change in social surplus is a decrease of:

$$ a+b+c+d+e+f+g - (a+b+c+e+g) = d+f$$