4.3 - Tariffs

Common types of trade protection

Although free trade offers advantages such as increased efficiency and consumer choice, many governments limit international trade to safeguard domestic industries.

Main forms of trade protection:

Definition and features of tariffs

A tariff acts as a barrier to trade by increasing the cost of imported products. Governments often use tariffs to generate revenue or encourage domestic production. A tariff is a tax levied on goods entering a country, designed to reduce import volumes and support local industries.

Types of tariffs:

• Specific tariffs - A fixed charge per unit of the imported good.
• Ad valorem tariffs - A percentage of the good's value.

For example, a government might apply a tariff on foreign cars to make them costlier than locally made vehicles, boosting demand for domestic manufacturers.

Analysis of tariffs in a small country

In a small country that cannot influence global prices, introducing a tariff alters the domestic market by raising prices and adjusting supply and demand. Domestic supply is S_d and domestic demand is D. Because the country is small it can buy as much as it likes at the world price P_w, so world supply is the horizontal line S_w drawn at that price. The diagram below shows what a tariff does to this market.

How tariffs affect the market:

• Free trade scenario - The domestic price matches the world price (P_w). Domestic firms supply Q₁, consumers buy Q₂, and imports fill the gap between them.
• Post-tariff scenario - The tariff (t) increases the domestic price to P' = P_w + t, lifting world supply to the line S'_w.
  • Domestic production rises from Q₁ to Q₃.
  • Domestic consumption falls from Q₂ to Q₄.
  • Import quantities decrease. Imports are now only Q₃Q₄, the span marked on the diagram.

Welfare effects of tariffs

Tariffs redistribute economic benefits within a country but often result in an overall loss of efficiency. They affect different groups unevenly, creating gains for some while imposing costs on others. The diagram below shows the same market again, with domestic supply S_d, domestic demand D, world supply S_w at the world price P_w, and the tariff-inclusive line S'_w at P'. Production still rises from Q₁ to Q₃ and consumption still falls from Q₂ to Q₄, and the strip between the two price lines divides into four areas, numbered 1, 2, 3 and 4. Each welfare effect is one or more of those areas.

Impacts on welfare:

• Consumer surplus - Reduces by areas 1 + 2 + 3 + 4, the whole strip out to D, because buyers pay P' instead of P_w and consume less.
• Producer surplus - Increases by area 1, the part of the strip lying to the left of S_d, because domestic firms now sell Q₃ at the higher price P'.
• Government revenue - Grows from the tariff collections. This is area 3: the tariff t multiplied by the imports Q₃Q₄.
• Net welfare loss - Areas 2 and 4, which arise from two inefficiencies:
  • Production inefficiency - Area 2. Resources are diverted to domestic production at a higher cost than the world price.
  • Consumption inefficiency - Area 4. Consumers miss out on goods they would value more than the world price but cannot afford at the tariff-inflated price.

Calculations related to tariffs

Various calculations help quantify the impact of tariffs on markets, including revenues, expenditures, and government income. These are based on the adjusted domestic price (P') after the tariff.

Total revenues for domestic producers

$$\text{Total revenues for domestic producers}=P^{\prime }\times \text{domestic production}$$

Where:

• P' = Domestic price after tariff
• Domestic production = Quantity produced locally post-tariff

Total expenditures by domestic consumers

$$\text{Total expenditures by domestic consumers}=P^{\prime }\times \text{domestic consumption}$$

Where:

• P' = Domestic price after tariff
• Domestic consumption = Quantity consumed locally post-tariff

Import expenditures

$$\text{Import expenditures}=P_w\times \text{quantity imported}$$

Where:

• P_w = World price
• Quantity imported = Volume of imports after tariff

Tariff revenues

$$\text{Tariff revenues}=\text{tariff rate}\times \text{quantity imported}$$

Where:

• Tariff rate = Amount or percentage of the tariff
• Quantity imported = Volume of imports after tariff

Worked example - Calculating tariff revenues

In a small country, the world price (P_w) of a good is £15 per unit. A tariff of £5 per unit is imposed, raising the domestic price (P') to £20 per unit. Domestic production increases to 700 units, domestic consumption decreases to 1100 units, and imports fall to 400 units. Calculate the total revenues for domestic producers, total expenditures by domestic consumers, import expenditures, and tariff revenues.

Step 1: Identify the values

• P' = £20 per unit
• Domestic production = 700 units
• Domestic consumption = 1100 units
• Quantity imported = 400 units
• P_w = £15 per unit
• Tariff rate = £5 per unit

Step 2: Calculate total revenues for domestic producers

$$\text{Total revenues for domestic producers}=\pounds 20\times 700=\pounds \mathrm{14,000}$$

Step 3: Calculate total expenditures by domestic consumers

$$\text{Total expenditures by domestic consumers}=\pounds 20\times 1100=\pounds \mathrm{22,000}$$

Step 4: Calculate import expenditures

$$\text{Import expenditures}=\pounds 15\times 400=\pounds \mathrm{6,000}$$

Step 5: Calculate tariff revenues

$$\text{Tariff revenues}=\pounds 5\times 400=\pounds \mathrm{2,000}$$