Tariffs: It'snot as bad as you have been told

Listening to the Pundits, you would think that if a tariff of X percent is imposed on a product, the price to consumers will increase by X percent. Nothing could be further from the truth.

Consider an upward sloping supply curve (higher prices imply more quantity supplied) and a downward sloping demand curve (higher prices imply less is demanded). Suppose Country A puts an X percent tariff on a product from Country B. Any elementary microeconomics text shows that the consumer price paid by Country A’s citizens rises less than X percent and a lot less, given reasonable demand and supply curves.

To see why, suppose that the tariff leaves the quantity supplied unchanged. Then it must be that the suppliers’ after tariff price must be the same as before, because that is the only way to stay on the supply curve. That implies that the demanders’ (consumers’) after tariff price must be X percent higher than before. This is the picture Pundits present. But this cannot be, because such a price-quantity point is above the demand curve. A downward sloping to the right demand curve implies that at the initial price plus X percent demanders will not want to buy as much as before. If not as much is bought, then not as much is sold. Since the supply curve is upward sloping to the right it is downward sloping to the left. To stay on the supply curve, moving to the left toward lower quantity implies moving to a lower after tariff price to suppliers. The effect of the tariff on suppliers will be both a lower quantity sold and a lower after tariff price received. To the extent the suppliers receive a lower after tariff price than before demanders will pay an after tariff price less than X percent higher than before. Depending on the slopes of the demand and supply curves, the consumers may pay a lot less than X percent more, e.g., if the demand curve is not steep and the supply curve is steep.

The above discussion ignores that the likelihood that the country imposing the tariff often imposes it on only a limited number of other countries.

Suppose Country A imposes a tariff on a Country B product that is a commodity produced and consumed in many countries (Country C, for short). Country A’s consumers can evade the tariff by buying the product from Country C instead of from Country B. Country B is can then sell more of the product to Country C. In effect Country B will lose sales to Country A and make up the difference by sales to Country C. The result is that each country’s consumers will buy about the same amount of the product as before at about the same price. The tariff does not get paid.

Suppose Country A imposes an X percent tariff on zPhones produced by Country B. The Country A demand for Country B’s zPhones will decline to the extent that Country A’s after tariff consumer price of Country B’s zphones rises. But other countries (Country C) have the capability of producing the same zPhones at about the same cost as Country B. Country C can increase its production of zPhones and sell them to Country A. While that may be feasible only if Country C reduces its production of, say, TVs, Country B can use its erstwhile zPhone productive capacity to produce the same number of the same TVs that Country C fails to produce. The result is that Country A buys about the same number of zPhones as before at about the same price, but from Country C, Country C produces more zPhones and fewer TVs than before, and Country B produces fewer zPhones and more TVs than before. There need not be much change in worldwide production or consumption of either zPhones or TVs. In this case, nobody is likely to pay a significant zPhone tariff.