A tariff is a tax on imports.
Examples of tariffs include:
- Tariffs imposed by the US under President Trump on steel produced in the UK, EU and China.
- The UK Global Tariff (UKGT) set on goods coming from the rest of the world, exempting countries with which the UK has trade deals.
What are the effects of a tariff? Below I give key analysis and evaluation points for tariffs with applications.
First, for more A-level resources, practice papers and model answers, check out the links below:
Back to tariffs!
This blogpost will cover the following key points on tariffs, with eight analysis points and seven evaluation points.
Contents
Why impose a tariff?
Reasons to impose a tariff could include:
- Protect domestic employers and jobs.
- Protect in particular infant industries – small firms where there are significant economies of scale.
- Raise revenue for government.
- Prevent dumping of goods at excessively low prices to force out competitors (similar to predatory pricing).
- Disincentivise production of goods abroad that have poor working conditions or pollute heavily. For example the EU is considering a “carbon border tariff”, taxing goods that produce a lot of emissions in their production.
1 Main tariff graph
On a supply and demand diagram, there is one demand curve and two types of supply curve. There is domestic supply (upward-sloping) and world supply (horizontal).
The tariff increases the world price, so the world supply line shifts upwards on the diagram.
The tariff diagram shows the following key effects from a tariff:
- The first order effects are: higher prices and reduced volume of imports.
- Decrease in consumer surplus
- Increase in domestic producer surplus. In other words, tariffs tend to be pro-producer and anti-consumer.
- Increase in government revenue
- Welfare loss – shown by the two pink shaded triangles.
Two welfare loss areas in the diagram. They both represent loss in consumer surplus that is not transferred either to the government as tariff revenue, or to producers as producer surplus. Specifically:
- The right hand triangle is loss due to reduced consumption because of higher prices caused by the tariff. As the quantity demanded falls, these lost units are not facing tariffs and nor can the producers gain revenue from these units. In other words, the consumer surplus loss here is not replaced by producer surplus gain or government revenue gain.
- The left hand triangle is loss due to a switch to a less efficient producer. Previously, without the tariff, these units were produced by foreign producers and imported into the country. However with the tariff, the domestic producer produces these units instead. But at this point, the domestic producer has higher costs compared to the foreign producer, which get passed on to the consumers in higher prices. So the consumer loses out in terms of higher prices.
AS-AD effects of tariffs
2 Effect on AD
A tariff increases the price of imports. This reduces demand for imports, which reduces leakages from the circular flow of income.
So aggregate demand (AD = C + I + G + X -M) shifts right.
While net trade may be a relatively small component of GDP, in 2021 imports made up 28.25% of GDP for the UK (source: World Bank and Trading Economics here).
Note this logic assumes the price elasticity of demand for imports is elastic, so that a rise in price of imports decreases the total value of imports.
For notes on the balance of payments and net exports, see the link below:
3 Effect on AS
For firms relying on imports to produce their products, there are now increased costs of production because of the tariff.
This shifts the short-run aggregate supply to the left. This will reduce real output and employment as well as increasing inflation, as the rise in production costs may be passed on to consumers in the form of higher prices.
Consider for example car manufacturing. These often feature “just-in-time” manufacturing processes, where components from several different countries reach the plant at the same time so that the car can be assembled all at once. For these types of processes, imports, without paperwork or extra tariff costs are particularly important, for example at the Oxford MINI car plant.
Other tariff impacts
Other possible impacts to consider could include but are not limited to:
- 4 Reduced specialisation via comparative advantage
- 5 Yet for new industries, it is easier to exploit economies of scale.
- 6 Use of government revenue, for example to cut other taxes or to further support firms.
- 7 Effects on downstream and upstream industries of tariff support.
- 8 Linked to the above diagrams, tariffs may raise inflation.
For notes on comparative advantage, click the blue button below:
Evaluation points for tariffs
1. Risk of retaliation
If one country puts in place tariffs, the other country may retaliate with their own tariffs. This could reduce demand for exports for the original country, mitigating any gains to domestic producers from imposing tariffs.
Consider the so-called “chicken war” example in the 1960s. The European Economic Community put in place tariffs on U.S. chicken. The U.S. retaliated with its own tariffs on for example Volkswagen cars and brandy to hit French brandy producers.
2. Small country vs large country
The A-level tariff diagram assumes effectively that the country is small. This means tariff changes have no impact on the world price. However if the country is large, the tariff may influence the world price.
For example if the U.S. puts in place a tariff and is a net importer of a good, the global demand for imports from the rest of the world falls, reducing the world price of that good. Therefore a tariff both raises the domestic price and lowers the world price, meaning the price may not rise as much for consumers and producers, while the same government revenue is guaranteed. [This explanation is beyond A-level economics. But for further explanation you could look up “large country tariff welfare effect”. For example you could use the link here]
For a large country, a tariff may therefore lead to welfare gains.
3. Inequality impacts
Who gains and who loses from tariffs?
In theory the protected group, domestic producers, should gain. Employees in that industry should see higher employment and wages too. Usually tariffs are more likely to be imposed for agricultural and manufacturing industries.
On average these industries are likely to have lower wages when compared to say services. Hence at a first glance, tariffs may reduce the degree of income inequality. More generally free trade is associated with an increase in inequality.
But consumers may lose out from all income groups. We have also not accounted for the effect on importing firms and income distribution in that instance.
There is evidence that US manufacturing centres and nearby communities have faced reduced employment where competition from imports has been most intense. For more on this, I recommend the links here and here.
4. Elasticities
Elasticities for example the price elasticity of demand may determine the extent of welfare loss
The price elasticity of demand (PED) for example may determine the extent of any welfare loss. If the PED is inelastic, then a given tariff rise will lead to less of a fall in quantity demanded, reducing the extent of any welfare loss. This could apply where the goods are necessities, for example to raw materials.
Other evaluation points
There are other evaluation factors we could also consider, for example:
- 5 The extent of any economies of scale.
- 6 Importance of imported inputs for firms, which may depend on the industry. This dependence may also change over time, for example as firms gradually adapt to the tariff and reduce reliance on foreign imports.
- 7 Whether historical job losses are caused by globalisation (including free trade) or automation and the extent to which tariffs can bring back jobs that may just be automated.
The issues with the A-level economics tariff model for the impact of tariffs
The basic A-level tariff diagram is simple but it does not account for a few key facts. For example:
- Trading of the same goods. The basic model does not explain why the UK both exports and imports the same good.
- Increasing returns to scale may provide a role for tariffs (infant industry argument).
- “Gravity” – we find that countries that are geographically closer to each other trade more and at an increasing rate. Just like how the gravitational pull between two bodies is related to the distance between and the mass of both bodies.
- Market power of different countries as mentioned in the evaluation.
- Who receives welfare gains / losses – the question of distribution. Again this I mention in the evaluation.
Other questions
What is a tariff?
For the purposes of this article, a tariff is a tax on imports.
[Not relevant here, but: You may also see the word tariff used in other contexts, for example with mobile phone or energy contracts. In this case the tariff is effectively a price].
Why are tariffs important?
Tariffs affect the prices of goods and services you import from abroad.
A tariff makes goods imported such as cars and fruits more expensive, but may help support domestic industries and jobs.
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