3.1 Tariffs and their economic effects

Tariffs are trade barriers that affect global commerce. They come in various forms, including ad valorem, specific, compound, and tariff rate quotas, each impacting imports differently. Understanding these types helps grasp how nations regulate international trade.

Tariffs have wide-ranging economic effects. They shield domestic producers but can lead to inefficiency. Consumers face higher prices and limited choices. Governments gain revenue but may see decreased imports. These impacts ripple through supply and demand, altering market equilibrium and welfare distribution.

Tariffs and Their Economic Effects

Types of tariffs

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• Ad valorem tariffs
  • Calculated as a percentage of the value of the imported good
  • Increase in proportion to the price of the imported product (10% tariff on imported cars)
• Specific tariffs
  • Fixed amount charged per unit of the imported good
  • Remain constant regardless of changes in the price of the imported product ($5 per pound of imported coffee)
• Compound tariffs
  • Combination of ad valorem and specific tariffs applied to the same imported good
  • Provide a higher level of protection for domestic industries (5% tariff plus $2 per unit of imported smartphones)
• Tariff rate quotas
  • Two-tiered tariff system with lower rates applied to a specified quantity of imports and higher rates applied to quantities exceeding the quota
  • Designed to provide some level of market access to foreign producers while still protecting domestic industries (5% tariff on the first 1,000 tons of imported sugar, and a 20% tariff on any additional imported sugar)

Economic effects of tariffs

• Effects on domestic producers
  • Shielded from foreign competition, enabling them to charge higher prices and earn greater profits
  • May lead to complacency, inefficiency, and reduced incentives to innovate and improve productivity
• Effects on consumers
  • Face higher prices for imported goods and domestically produced substitutes, reducing their purchasing power
  • Experience a decrease in consumer surplus, the difference between their willingness to pay and the actual price paid
  • May have limited access to a wider variety of goods and potentially experience a decrease in product quality
• Effects on government revenue
  • Generates additional revenue through the collection of tariffs on imported goods
  • May experience a reduction in tariff revenue if high tariffs lead to a significant decrease in the volume of imports
  • Incurs administrative costs associated with implementing, monitoring, and enforcing tariff policies

Tariffs in supply and demand

• Market equilibrium before tariffs
  • Determined by the intersection of the supply curve ($S_0$) and the demand curve ($D_0$)
  • Results in an equilibrium price ($P_0$) and quantity ($Q_0$) in the absence of trade restrictions
• Market equilibrium after the imposition of tariffs
  • The tariff shifts the world supply curve upward from $S_0$ to $S_1$, reflecting the increased cost of importing goods
  • Leads to a higher equilibrium price ($P_1$) and a lower equilibrium quantity ($Q_1$) compared to the pre-tariff equilibrium
  • Domestic producers increase their supply from $Q_S$ to $Q_{S1}$ in response to the higher price
  • Consumers reduce their demand from $Q_0$ to $Q_1$ due to the higher price
  • The volume of imports decreases from $Q_0 - Q_S$ to $Q_1 - Q_{S1}$ as a result of the tariff

Welfare impact of tariffs

• Consumer surplus
  • The difference between what consumers are willing to pay and the actual price they pay for a good
  • Tariffs reduce consumer surplus by increasing prices and reducing the quantity of goods consumed
• Producer surplus
  • The difference between the minimum price producers are willing to accept and the actual price they receive for a good
  • Tariffs increase producer surplus for domestic producers by enabling them to charge higher prices and increase their output
• Deadweight loss
  • Represents the net loss of economic welfare resulting from market distortions caused by tariffs
  • Arises because the combined loss in consumer and producer surplus exceeds the government's tariff revenue
• Tariff revenue
  • The government collects revenue equal to the tariff rate multiplied by the volume of imports after the tariff is imposed
  • Represents a redistribution of wealth from consumers and foreign producers to the domestic government
• Net welfare effect
  • The overall impact of tariffs on economic welfare, considering changes in consumer surplus, producer surplus, government revenue, and deadweight loss
  • In most cases, tariffs lead to a net welfare loss for the economy as a whole, despite benefiting specific groups such as domestic producers and the government