Beautiful Tariffs?

The Economic Case Against Tariffs

Donald Trump is very keen on tariffs. The word tariffs, he says, is the most beautiful word in the dictionary. But for most economists, few words are uglier than the word ‘tariff’. Indeed, the origins of modern economics and the theoretical vindication of the benefits of free competitive markets were largely wrapped up with the struggle to overturn the British government’s use of tariff. (Tariffs were used to raise revenue and protect domestic industry). This battle came to a head in the controversy over the Corn Laws, a piece of legislation designed to limit the importation of cheap wheat and barley into the UK until the domestic price of these products reached a certain minimum price. The case against the Corn Laws was developed by such classical economists as David Ricardo and James Mill and in 1846 the prohibition on the import of grains was lifted and Britain entered the golden age of free trade policy. In this article we set out the classical free trade case against tariffs.

The Neo-Classical Case Against Tariffs

Consider the domestic market for a good, say electric cars. Assume, first, that there is no trade. All cars in country X are manufactured and purchased within that country and no other cars are available. The initial domestic market equilibrium is shown below.

Figure 1. Domestic Market for Electric Cars

In Figure 1, the domestic equilibrium price is P*, with the quantity of electric cars Q* being bought and sold. The consumer surplus of car buyers (the difference between what consumers are willing to pay for cars and what they actually pay is the area beneath the demand line abP*, while the producer surplus (the difference between what producers require to produce cars and what they are actually for cars) is P*bc. The total social benefit from car production and consumption is consumer surplus plus producer surplus, namely abc.

To see how free trade can benefit country X, imagine that the global price of cars outside country X is Pw. This is the world price of electric cars. We assume these cars are identical with the cars currently being made in country X and we assume that this world price of electric cars is below the existing domestic price. In Figure 2 we take this global price to be Pw as indicated.

Figure 2. Domestic Market for Cars with Free Trade

Since country X can now access the global price of cars at Pw, no consumer will pay more than Pw for an electric car. We assume that, at first, they buy cars made in country X, but at price Pw the domestic supply of cars is only OQ1, whereas the demand for cars is OQ2. Hence the difference between the domestic demand for cars and the domestic supply of cars is met by imported cars. Thus, in Figure 2, when the price is Pw the domestic supply of cars is Q1 and the domestic demand for cars is Q2 and the difference Q2 — Q1 is met by imported cars. As can be seen, we assume that any number of cars can be purchased abroad at the price Pw, which is to say that the global supply curve of cars is perfectly elastic.

What, then, has been the effect of opening up country X to trade in electric cars?

• The price of cars has fallen significantly, from P*to Pw.
• With the fall in the price of cars, domestic demand for cars has also increased, from Q* to Q2.
• The combined effect of the fall in the price of cars and the increased consumption has been to result in a large increase in consumer surplus, from abP* to aePw. This is a measure of the gain to consumers of free trade in cars.
• However, the fall in the price of cars means that for most domestic car producers it is no-longer profitable to make cars in country X. Only a few home producers with low costs survive, producing OQ1. As a result, producer surplus falls from P*bc to Pwdc. The area P*bdPw is a measure of the loss to producers of the introduction of open trade in electric cars.
• To calculate the net welfare effect of trade we must deduct the loss to producers from the gain to consumers, that is P*bePw minus P*bdPw. The difference is the shaded area dbe. These are the net gains from trade. Since the gain to consumers exceeds the loss to producers, in theory the consumers could compensate the producers for their welfare loss and still be better off.

Thus can be understood the classical economic case for free trade, which has been shown to yield a clear social welfare gain. Such a conclusion is reinforced when we consider the impact on social welfare of imposing a tariff.

The Effect of a Tariff

A tariff is a tax levied on a good when it is imported. It is levied (initially) on the importer. A specific tariff is a fixed charge per unit of the import — such as £1000 per electric car imported. An ad valorem tariff is a tax levied as a percentage of the initial import price — such as 20% on the import price of an electric car. In both cases the tariff increases the cost of importing a good into the country.

For simplicity we take a specific tariff and assume it is set at the amount t. The effect of imposing such a tariff is illustrated in Figure 3.

Figure 3. The Impact of a Specific Tariff

The effect of imposing the tariff t is to raise the import price of cars from Pw to Pw + t. An importer no longer just buys cars in the world market at price Pw; they also have to pay the government the tariff t to bring that car into country X. Hence, the price at which country X accesses the global market for electric cars rises from Pw to Pw + t. What are the effects of the new domestic price of Pw + t?

• The domestic price of electric cars rises from Pw to Pw + t. With the rise in price, the demand for electric cars falls from Q2 to Q4.
• The domestic output of cars rises from Q1 to Q3 since, at the higher price, more firms find it profitable to produce cars for the domestic market.
• With demand falling and home production increasing, imports fall from Q1Q2 to Q3Q4.
• The chief loser from the tariff is domestic consumers. They now pay more for cars and they consume less. Consumer surplus falls from aePw to agPw+t, a net decline of Pw+tgePw.
• The chief gainer from the tariff is domestic producers — they are producing more at a higher price. Their producer surplus increases by Pw+tfdPw.
• Another gainer from the tariff is the government. Given that the tariff is t and imports are Q3Q4, the tariff generates revenue for the government equal to fghi. This revenue can be used to cut other taxes.

Thus, a tariff brings winners and losers. What is the overall outcome? A tariff is generally held to bring a net welfare loss to society. This is because the welfare loss of losers (consumers) exceeds the welfare gain of the winners (producers and government). We can see this from the diagram. As we have seen, the loss in consumer surplus from the tariff is Pw+tgePw. Of this welfare loss, the amount Pw+tfdPw is re-located to increased producer surplus and is not a net loss to society, and fghi is re-located to the government and can be used to increase welfare by cutting taxes or funding benefits, so again is not lost to society. However, this still leaves the amounts dfh and egi which are not redistributed but are simply lost to country X. Together these two amounts represent the deadweight welfare loss from a tariff and are indicated at the two shaded segments.

This deadweight loss has two components. First, there is a production distortion which arises from the fact that domestic producers have increased car production. This is a loss to society since these domestic producers make cars at a higher cost than the cars that could be bought on the open market: so society is using resources to make cars at a higher cost than they could be obtained from the world. This is a waste of domestic resources since these resources could have been used to make something more valuable to society. This production loss is the left-hand triangle dfh. Second, there is a consumption distortion loss, which is the right-hand triangle egi. This arises from the fact that, due to the tariff, consumers have been forced to cut back their consumption of cars. At consumption Q4 the consumers demand line is above the world price of cars Pw. Consumers would benefit from consuming more cars at the price Pw but they cannot access these cars due to the tariff. Hence their deadweight loss from the tariff is egi.

Figure 3, then, sets out the essential free-trade case against the imposition of tariffs. There are many other points that could be made against tariffs, but the basic argument is that tariffs raise prices, reduce consumption, reduce consumer surplus, and lead to excessive high-cost domestic production of the protected industry. This is the reason economists have traditionally considered tariffs very far from beautiful. And why a Trump Tariff war is a very unappealing policy choice.