Tariff Diagram Step by Step

Without a tariff:

• Supply can come from domestic firms or from abroad (“World Supply”). World supply is perfectly elastic at world price p_w.
• Here, all producers, domestic and abroad, set their price at the world price.
• Domestic supply = q; domestic demand = q₁; imports = q₁ – q

With a tariff in place, imports are taxed and become more expensive.

• Specifically, the world supply line shifts upwards from World Supply to World Supply + Tariff.
• This raises the world price from p_w to p_w+T.

The tariff causes domestic supply to rise and domestic demand to fall.

• As the tariff increases the world price from p_w to p_w+T, domestic supply rises from q to q₂.
• Domestic demand also decreases from q₁ to q₃

The tariff causes the quantity of imports to fall too.

• Specifically, imports fall from (q₁-q) without the tariff to (q₃-q₂) with the tariff.

Domestic producer surplus (PS) without a tariff:

• Domestic producers were receiving price p_w for producing q units.
• PS is the difference between the price producers are willing to sell for (shown by the supply curve) and the price producers actually receive (p_w).
• This gives PS as the triangle ACp_w, shown in the diagram.

Domestic producer surplus increases with the tariff.

• The new producer surplus is shown by the blue area in the diagram. This is the triangle AJ(p_w+T).
• This is again the difference between the domestic supply curve and the price domestic producers actually receive (p_w+T).

The increase in producer surplus from the tariff is shown on the diagram in blue.

• The increase (change) in domestic producer surplus because of the tariff is area p_wCJ(p_w+T).

Consumer surplus without the tariff:

• Consumer surplus is the difference between what consumers are willing to pay (represented by the demand curve) and what consumers actually pay (p_w).
• Without the tariff, consumers consume quantity q₁ at price p_w. So the domestic consumer surplus is BEp_w.

With the tariff in place, consumer surplus falls to BF(p_w+T). The higher price makes consumers worse off.

The fall (change) in consumer surplus, due to the tariff, is the shaded area.

• This is area p_wEF(p_w+T).
• The tariff increases the world price that consumers pay and reduces the quantity demanded. This is why consumer surplus falls.

The government earns revenue from the tariff. This is shown by the green area JFGH.

• With the tariff, the number of units imported is (q₃-q₂).
• The tariff per unit is the vertical distance GF or HJ.
• Tariff revenue = (tariff per unit imported) x (quantity of imports). That gives the area JFGH.

Without the tariff, the total welfare is the sum of the domestic producer surplus (blue) and domestic consumer surplus (red).

With the tariff, the total welfare is the sum of the domestic producer surplus (blue), domestic consumer surplus (red) and government revenue (green).

Comparing slides 12 and 13, overall the tariff leads to a welfare loss of the two triangles shown: CHJ and GEF.

• The decrease in consumer surplus, because of the tariff, is larger than the sum of the increase in government revenue and domestic producer surplus.

❮ ❯

Questions about the tariff diagram

Why is world supply assumed perfectly elastic?

This is a simplifying assumption.

It implies that individual countries are price takers and that changes in their demand for imports do not affect the world price.

Why do domestic firms price at the world price?

Assume the country is a net importer of the particular good or service.

Suppose domestic firms were pricing at a higher level than the world price. Then all consumers would import and no consumers would buy the more expensive domestic supply.

Conversely, suppose domestic prices were lower than the world price. Then there is a shortage of the good at the domestic price. The price mechanism will lead to the domestic price rising to clear the shortage. Another way to see this domestic firms could sell abroad at the higher world price.

Summarise what the tariff diagram shows

A tariff raises the world price. This leads to a decrease in imports, an increase in domestic supply and a fall in domestic demand.

As a result, the tariff increases domestic producer surplus and decreases domestic consumer surplus. The government raises tax revenue from the tariff.

Overall, the tariff leads to a welfare loss. This is because the fall in consumer surplus outweighs the rise in domestic producer surplus and government revenue.

Related posts

About the author

Tom Furber

Helping economics students online since 2015. Previously an economist, I now provide economics resources on tfurber.com and tutor A Level Economics students. Read more about me here.