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Chapter 7
Analysis of a Tariff
This chapter begins the analysis of government policies that
limit imports, by examining the tariff—a government tax
on imports. The chapter has two major purposes.
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First, the analysis shows the effects of a tariff when
the importing country is small, so that its import
policies have no effect on world prices.
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Second, the analysis of a large importing country—
one whose policies can affect world prices—shows
that a large country can use a tariff to lower the price
that it pays foreigners for its imports.
A tariff could be either a specific (per unit) tariff -t dollars
per unit of imports or ad valorem tariff or percentage tariff.
Effect of tariff on a small economy
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We use supply and demand analysis. Since foreign
exporters do not change the price that they charge for the
product, the domestic price of the imported product rises by
the amount of the tariff. Domestic producers competing
with these imports can also raise their domestic prices as
the domestic price of imports rises. Domestic producers
gain when the government imposes a tariff on competing
imports.
They get a higher price for their products, they produce
and sell a larger quantity (a movement along the domestic
supply curve), and they receive more producer surplus.
Raise Domestic consumers of the product are also affected
by the imposition of the tariff. They must pay a higher price
(for both imported and domestically produced products),
they reduce the quantity that they buy and consume (a
movement along the domestic demand curve), and they
suffer a loss of consumer surplus.
The government also collects tariff revenue, equal to the
tariff rate per unit imported times the quantity that is
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imported with the tariff in place (less than the free trade
imports quantity).
We thus have two domestic winners (domestic producers
and the national government) and one domestic loser
(domestic consumers) because of the imposition of a tariff.
We can evaluate the net effect on the whole country, if we
have some way of comparing winners and losers. As we
did beginning in Chapter 2, we can, for instance, use the
one-dollar-one-vote metric.i.e. Every dollar of gain or loss
is just as important as every dollar of gain or loss,
regardless of who the gainers or losers are. Part of what
consumers lose is matched by the gain to domestic
producers, and another part is matched by the revenue gain
to the government.
Is there a net gain or loss overall:
Consider Fig 7.4 (modified as will be shown in class). The
diagram represents a 10% ad valorem tariff of $10 dollar
per unit tariff.
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Free Trade
With Tariff
Gain/loss
CS
e+a+b+f+c+d e+f
-(a+b+c+d)
PS
g
a+g
a
Tariff
-
C
c
Revenue
Total
a+b+c+d+e+f a+c+e+f+g
-(b+d)
+g
Therefore there is an additional amount that consumers
lose and that is not a gain to the other groups. This is the
net national loss or deadweight loss from a tariff (for a
small country). In the national market graph this loss is two
triangles b+d and as one triangle in the import graph.
Numerically we can calculate the loss/gain
Consumers loose a+b+c+d = -$45m
Producers gain a
= $21m
Tariff Revenue c
=$18m
-------------------------------------------Net National loss b + d
= $6m
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If we look at the national market graph, we can see why
these are deadweight losses. The consumption effect of the
tariff is the loss of consumer surplus for those consumers
who are squeezed out of the market because the tariff
“artificially” raises the domestic price, even though
foreigners remain willing to sell products to the importing
country at the lower world price. The production effect of
the tariff is the loss from using high-cost domestic
production to replace lower-cost imports (available to the
country at the unchanged world price). The high production
cost is shown by the height of the supply curve, for each of
the extra units produced because of the tariff.
Large Economy
The analysis is affected in important ways if the importing
country is a large country, one that has monopsony power
in world markets. A large country can gain from the termsof-trade effect when it imposes a tariff. E.g. US placing
tariffs on imports of autos. The tariff reduces the amount
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that the country wants to import, so foreign exporters lower
their price (a movement along the foreign supply-ofexports curve).
See figure 7.5
Impose a $6 dollar tariff on imports. The tariff drives a
wedge between import demand and export supply, so the
price to the import buyers exceeds the price received by
foreign exporters by the amount of the tariff. . Domestic
buyers pay For the large importing country, the imposition
of the tariff causes a triangle of national loss (comparable
to the one shown for the small country) but also a rectangle
of national gain because the price paid to foreign exporters
is lowered, for the units that the country continues to
import.
Effect: CS reduces by a+b+c+d
PS increases by a
Tariff Revenue c +e
Importing country looses b +d
Who really pays the tariff?
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Domestic consumers pay c
Foreign producers pay e because of lower export price.
The net effect on the importing country depends on which
of on whether e > b + d.
For a suitably small tariff, the rectangle is larger, so the
importing country has a net gain from imposing a tariff
However a very high tariff might prohibitive. From the
supply of exports a tariff that would lead to 0 exports i.e.
foreign producers receiving less than $225 would lead
exports to 0. A prohibitive tariff would cause a net national
loss, because the rectangle would disappear. It is possible
to determine the country’s optimal tariff—the tariff rate
that makes the net gain to the importing country as large as
possible. The optimal tariff rate is inversely related to the
price elasticity of foreign supply of the country’s imports.
The more inelastic foreign supply of our imports the higher
the optimal tariff.
We conclude by pointing out that the optimal tariff causes a
net loss to the whole world. The loss to the foreign
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exporting country is larger than the net gain to the
importing country. And a country trying to impose an
optimal tariff risks retaliation by the foreign countries hurt
by the country’s tariff.
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