7.3 Import Tariffs
Import tariffs are a tool through which the State intervenes in international trade by imposing an additional cost on goods produced abroad. These measures aim to protect domestic producers from foreign competition, but they also have negative effects on the efficiency of the economic system.
Import Tariffs in a Small Open Economy
For the same reason that, in a competitive market, the individual consumer faces a horizontal supply curve and the individual firm a horizontal demand curve, in a country where domestic demand and supply are small relative to the rest of the world—and therefore do not influence the world price—that price will be taken as given. In a small open economy engaged in international trade, domestic consumers and producers will thus adjust to the world price, which we denote by $P_W$.
What happens if The conclusions of our analysis would be identical if the tariff were levied on foreign producers rather than domestic consumers. the State introduces an import tariff? Let us assume that the tariff is paid by consumers and is equal to $T$ euros per unit (e.g., per kilogram) purchased. This measure has no effect on the world market, which is unaffected by what happens in the small economy we are considering. The world price remains at $P_W$, and foreign producers will therefore not be willing to sell below that price. This implies that the price paid by domestic consumers for imported goods must rise to $P_W + T$. Domestic producers will in turn begin to sell at this price (thus increasing their supply). In effect, it is as if consumers were paying an excise tax equal to $T$ in any case, regardless of whether the good is imported or domestically produced. The only difference is that these €$T$ go to the State if the good is imported, whereas they go to domestic firms if the good is produced locally.
From this discussion, it should be clear that we can analyze the impact of the tariff in much the same way as we analyze a per-unit excise tax on consumers, as illustrated in the figure below.
In conclusion, introducing a tariff in a price-taking country increases the profits of domestic producers and generates tax revenue for the State, but it reduces the welfare of domestic consumers. The net effect is a reduction in overall welfare—a deadweight loss—for the country.
**Import Tariffs in a Large Open Economy
The impact of a tariff can be very different in the case of a large economy—that is, a country whose domestic demand is not negligible compared to global demand. To simplify the analysis in this case, The analysis would be similar, though more complicated, if we assumed that domestic demand were a large fraction (rather than all) of world demand. in the figure below we assume that domestic demand coincides with global demand—that is, the country in question is the only consumer of the good.
Let us again suppose that a tariff of $T$ euros per unit is levied on consumers. As before, this can be represented as a parallel downward shift of the domestic demand curve by $T$ euros. However, in this case, the global demand curve (which coincides with the domestic one) also shifts downward by $T$ euros. This results in a new world price, $P’_W$, lower than the one prevailing in the absence of the tariff, $P_W$. As in the small economy case, the tariff worsens the welfare of domestic consumers and improves that of domestic producers (since $P’_W + T > P_W$), and generates tax revenue for the State. Unlike in the case of a small economy, however, the net effect on total surplus is not necessarily negative. As illustrated below, a high tariff reduces total surplus, but a sufficiently low tariff increases it.
Why is it that, unlike in a small economy, a large economy may experience an increase in total surplus when a sufficiently low tariff (in the figure above, $T < 3$) is introduced? The explanation lies in the fact that, following the introduction of the tariff, foreign producers are willing to sell at a lower price (the world price falls from $P_W$ to $P’_W < P_W$)—something that cannot happen in the case of a small economy. This mitigates the effect of the tariff on domestic demand, which remains relatively high if the tariff is low enough. A relatively high domestic demand, in turn, means a relatively small loss in consumer surplus and relatively high imports (and thus tax revenue).