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.
Tariffs
- 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.
- The reduction of tariffs leads to trade creation.
Winners and Losers
Benefits from tariffs
- Domestic industries which are protected from imports by tariff charges, for example, US steel companies, may benefit from US tariffs on imports of steel.
- Some workers who work in these internationally uncompetitive industries may benefit from tariffs which help firm stay in business
- Government revenue increases
- It may give countries a geopolitical advantage to promote a domestic industry and not rely on cheap imports from unreliable countries. For example, Europe suffered when they lost cheap gas from Russia. The US may need to rely on its own rare earths, rather than import from China.
Losers from tariffs
- Foreign exporters who see drop in demand
- Domestic consumers who pay an effective tax and higher prices
- Other domestic industries who see lower demand, because consumers have less disposable income after paying tariffs
- Domestic exporters who experience retaliatory tariffs
- Domestic firms that have to pay for more expensive imported goods, which now attract tariffs. For example, US car industry in 2025, faces higher input costs because of tariffs on Canadian imports.
- Long-term reduction in efficiency because firms are encouraged to spend time lobbying for tariffs rather than promoting efficiency.
What determines the Effect of Tariffs – Evaluation
- It depends on elasticity of demand. If demand for imports is price inelastic, then firms will pass most of the tariffs onto consumers. If demand is price elastic and firms have large profit margins, they may absorb the tariffs and not pass them on. However, it is most likely that consumers will face a large share of tariffs.
- Uncertainty. A feature of tariff war of 2025 was the uncertainty about what would happen to tariffs. President Trump increased tariffs and decreased them. It meant firms couldn’t predict what would happen, and this uncertainty can be as costly as tariffs themselves. It can lead to lower investment and lower growth
- Extent of retaliation. If other countries retaliate with similar tariffs the negative effect will be greater, especially if it spurs a tit for tat approach.
Tariff War of 2025
Tariff and game theory
- In this case, if both countries, pursue low tariffs, the outcome is £3m net welfare for each country. If A places tariff, then its net welfare will be £2m, and country B who keeps low tariffs will make £1.5m.
- If B retaliates and places tariffs on too, it will make itself worse of – welfare falls to £1m, but it will effectively punish A whose welfare falls from £2m to £1m.
- If firms wish to maximise welfare, they would stick to low tariffs. That is their dominant strategy and nash equilibrium.
- However, for political reasons, countries may impose tariffs for politically sensitive industries.
Examples of tariffs
The US has tariffs on many imports, such as:
- Most vegetables 20% tariff.
- Asparagus and sweetcorn – 21.5%. See: UTSC for more
- EU has tariffs on many food imports.
- See: Examples of protectionism
See also:
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