Tariffs are a tax placed by the government on imports. They raise the price for consumers, lead to a decline in imports, and can lead to retaliation by other countries.
They could be a specific amount (e.g. £1 per unit.)
Or they could be an ad valorem tax (e.g. 10% of the price)
Tariffs are an important barrier to free trade; they are often imposed to protect domestic industry from cheap imports. However, it often leads to retaliation with other countries placing tariffs on their exports.
In this case, the tariff is P1-P2.
The tariff leads to a decline in imports. Imports were Q4-Q1. After the tariff, imports fall to Q3-Q2.
Consumer surplus falls by 1+2+3+4
Government raises tariff revenue of area 3
Domestic suppliers gain an increase in producer surplus of area 1
The net welfare loss is (1+2+3+4) – (1+3) = 2+4
Effect of tariffs
Without any trade, the equilibrium price is £1.80 and a quantity of 40 million
With a tariff of £0.40, the price of imports will be £1.60.
The quantity of imports at £1.60 is (50-30) = 20 million.
With free trade (no tariffs) the price would be £1.20 and quantity bought 60 million.
Government tariff revenue
Tariff revenue = tariff × q. of imports (£0.40 × 20 million) = £ 8 million
Consumer surplus
This is the difference between the price consumers pay and the price they are willing to pay; therefore we find the area of the triangle between demand curve and price
With no trade = (£3.20 – £1.80 × 40) /2 = (£1.40 ×40)/2 = £28 million
After tariff – (£3.20 – £1.60) × 50)/2 = £40 million
With no tariff (free trade)- £3.20 – £1.20 × 60)/2 = £60 million
Tariffs reduce consumer surplus by £20 million
Diagram showing the effect of tariffs on consumer surplus
Tariffs lead to a decline in consumer surplus of 1+2+3+4.
Producer surplus
The difference between the price and the price firms are willing to supply at (supply curve
With no trade (£1.80 – £0.5) × 40)/2 = £24 million
With tariff (£1.60-0.50) × 30)/2 = £16.5 million
With free trade and no tariff (£1.20-0.50 × 20)/2 = £6 million.
Tariffs increase producer surplus by £10.5 million
Welfare effect of tariffs = gain in producer surplus (£9 m) + gain in tariff revenue (£8m) – loss of consumer surplus £20m)
Therefore net welfare loss = £3 million
Reasons for imposing tariffs
Raise revenue. If a country produces no oil, levying a tax on oil imports will raise money as people have no alternative put to pay the import tariff.
Environmental. A tariff could be placed on goods who may have negative externalities. e.g.
Protectionism. The most common reason for a tariff. Imposing import tariffs makes domestic firms more competitive.
Reasons for removing tariffs
Trade liberalisation involves removing barriers to trade such as tariffs on imports.
Free trade areas will have no tariffs between member states, though they may have a common external tariff if it is a customs union.
Lower prices for consumers
Increase specialisation and benefits from economies of scale.
Theory of comparative advantage states net welfare gain from free trade.
