Tariffs and Protectionism

Okay, now we're going to discuss international trade and how to model international trade using demand and supply. We'll also look at how to model the consequences of a tariff, a tax on trade. We'll look at the consequences and also the cost of the tariff and the cost of protectionism in general. By the way, remember when we did demand and supply, I said that these concepts are really, really important? Well now you see why: it's because we're simply applying the same tools over and over again. So if you understand the fundamentals, then the applications become much, much easier. So do make sure you understand the fundamentals. Okay, let's get going.

First, some quick definitions. Protectionism: This is the economic policy of restraining trade through tariffs, quotas, or other regulations that burden foreign producers but not domestic producers. In particular, a tariff is simply a tax on imports and a quota is a quantity restriction on imports. For example, a quota may say you're only allowed to import 10,000 automobiles from Japan.

Okay, let's get right into it. Here is the domestic supply curve. This is the supply curve of the home country firms. If we're thinking about the US, this is the supply curve from US firms. Here is the demand curve, domestic demand, this is demand from US consumers. If we had no international trade then as usual, we would find the equilibrium where the quantity demanded is equal to the quantity supplied. That would give us the price with no international trade and the quantity both produced and consumed with no international trade down here.

Now let us suppose that the consumers in this country can go out into the world and they can buy as much of these semi-conductors as they want at the world price. So in that case if we had complete free trade, consumers would be able to buy as much as they want at the world price or as given by this world supply curve.

The free trade equilibrium, then, would involve greater consumption. That is, at the high price with no international trade, the quantity demanded is here. With international trade, consumers get to buy at the lower world price so their quantity demanded increases. In terms of the diagram the quantity demanded will increase to QD free trade. So domestic consumption is equal to this distance or domestic consumption is equal to the quantity demanded with free trade.

Now what about production? Well, the domestic producers can only charge as much as the world producers. They can't charge a higher price. So when the world price falls, when domestic consumers are able to buy at the world price, domestic producers can only sell at the world price, and they're going to be less willing to sell. So the domestic production will fall, domestic production will fall to this lower amount right here. At a lower price the domestic suppliers are only willing to produce a less amount or lower amount as given by QS free trade.

Now notice that domestic consumption is QD free trade, domestic production is QS free trade and demanders are demanding more than the domestic suppliers are willing to supply. The difference of course is made up by imports. So with trade, domestic consumption will be at QD free trade. Some of that will come from imports and some of that will come from domestic suppliers.

That's it. That's our analysis of international trade using supply and demand. Now make sure you understand each step in this diagram because the next slide, when we're going to add tariffs it's going to make the diagram more complicated. Each step is actually simple, each step is actually no different than the ones we've already done, but the diagram will look a little bit messier. So if you need to go through this slide again make sure you understand each step along the way.

Okay let's do the same diagram but now we're going to do it with a tax or a tariff. Let's remember that here is the quantity demanded with free trade, here is quantity supplied with free trade. The difference between the quantity demanded and the quantity supplied domestically is of course imports, so this is imports with free trade, this distance right here.

Now, a tariff is simply a tax on imports. What the tariff does is it raises the world price by the amount of the tariff or the tax. So the world supply curve or the world price shifts up until we get to the new equilibrium. Of course what this means is at a higher price domestic consumers are going to demand a lower quantity. Domestic consumption falls from Q free trade to Q quantity demanded with the tariff. Domestic production falls by this amount, or let's just add that to the diagram, domestic consumption falls from here to here.

Okay, what about domestic production? Well with a higher price, domestic suppliers are now willing to supply more. Here is the price of the world price, here's the world price. With a higher world price domestic suppliers are willing to supply more up until this point. Let's add that to the diagram. Domestic production is going to increase from the quantity supplied with free trade to the quantity supplied with the tariff or again just putting that into the diagram it's going to increase from here to here along the domestic supply curve.

But what about imports? Imports remember are the difference between the quantity demanded and the quantity supplied. The quantity demanded with the tariff is here, the quantity supplied is here, so imports are the difference which is this distance right here. So notice that imports have fallen.

Final thing to add, a tariff is just a tax on imports, this is the quantity of imports, this is the amount of the tax or the tariff. So the tariff will also generate some revenues. This is the revenue from the tariff which is going to go to the government. It's the tax or the tariff amount times the quantity of imports with a tariff, so this is revenue that flows to the government.

Okay, that's it, that's analysis of tariffs, now what I want to do is say what are the welfare consequences of this? The welfare consequences are going to depend upon this factor the domestic production falling and this factor the domestic consumption increasing. Let's take a closer look.

Okay let's take a look at the welfare costs and here I'm going to look at the net costs. What I mean by that is we could actually find the cost in two different ways. We could look at the costs and the benefits to the consumers, the costs and benefits to the producers, the cost and benefits to government. We could sum all those up, that would give us the net cost.

I want to jump straight to the net welfare costs of protectionism and I'm going to do that by focusing on the real factors which change and these are two; first domestic consumption as I said falls, second domestic production increases. Notice I haven't said anything here about the revenue from the tariff, that's because that's a cost to consumers, they've got to pay more but it's a benefit to the government, they have this revenue that nets out so it's not going to affect the net welfare. Instead the net welfare is going to depend upon these two real changes. What I'm going to show is that both of these effects somewhat surprisingly reduce welfare.

Why is this? Well domestic consumption falls, the reason that reduces welfare is because there are lost gains from trade and I'll say more about that in a minute. Second, domestic production increases, you might think that's a good thing, except, however, we're going to have wasted resources because the domestic producers have higher costs than the world producers. On a net level there's going to be more resources going to production than are necessary, there's going to be wasted resources.

Can we measure the value of these losses? In fact we can and I'll show that in the next slide in a little bit more detail. In order to focus on the welfare costs, I'm going to make two simplifying assumptions. First I'm going to assume that the world price is so low that if there were complete free trade there would be no domestic supply whatsoever. Think about a good like sugar, if we had complete free trade in sugar we in the United States would probably import all of our sugar. It's simply much more expensive to produce sugar in Florida than it is to produce sugar in a country such as Brazil. The problem is is that in Florida the opportunity cost of land is very high and the climate in Florida is not ideal for growing sugar so you have to invest more real resources to produce sugar in Florida than you do to produce sugar in Brazil. So if we had complete free trade, there would be no domestic supply.

I'm also going to assume that with the tariff or the tax that it raises the cost of imports so much that there are no imports, that it's simply too expensive to import the good. Again this is actually quite accurate or quite similar to what we have for the case of sugar. With this very high tariff, the entire domestic consumption is produced by domestic suppliers. Our tariff equilibrium is given by this point and notice that domestic consumption is lower.

Okay, so what are the costs of the tariff? There are two. First of all the lost gains from trade. The demand curve can be read as the willingness to pay. This is the willingness to pay for sugar by domestic consumers. The world supply curve can be read as the cost of producing sugar. This is the price at which world suppliers are willing to supply the sugar. So there's lots of gains from trade here. Consumers are willing to pay more than the suppliers require in order to produce the good. So by getting together the consumers and the world suppliers can earn these gains from trade. With the tariff however, that's not possible. With the tariff, we have reduced consumption and with that reduced consumption is lost gains from trade given by this purple area.

What else? Well the US supply curve can be read as US costs. So what happens with the tariff is that instead of producing the sugar in Brazil where it's cheap to produce sugar we produce the sugar in Florida where it's expensive to produce sugar where we have to invest more real resources in producing sugar. We've got to invest more in irrigation, more in valuable land, more in fertilizer. So these are wasted resources, when the domestic industry expands. Because of the tariffs we invest more resources in producing sugar than are necessary. It would be cheaper, we would be able to import sugar using fewer resources. We would be able to produce that sugar internationally using fewer resources than we can produce it in the United States.

What the tariff does is it switches production from the low-cost world producers to the high-cost domestic producers, and that generates wasted resources. Now in fact, with these numbers we can calculate the sizes or the amount of these wasted resources. What economists do quite often is they make assumptions about these supply curves and these demand curves and they can make some of these calculations.

Let's take a quick look. So with these numbers, we can calculate these areas. This triangle for example is half base times height. So the base is 20, this is a base of 20. The height is 20 minus 9, there's the 20, there's the 9. So the area of the triangle is half base times height or 1.1 billion. What about the deadweight loss triangle? You do the same calculation it's 0.22 billion. So with these kind of numbers we can find out the cost of the sugar tariff are $1.32 billion and economists do these kinds of calculations all the time.

Okay, let's summarize and point out some further reading. First, tariffs increase prices to consumers so domestic consumption falls and that creates a deadweight loss. Second, tariffs divert production from low-cost world producers to high-cost domestic producers and that wastes resources. Now I haven't said much here about the distribution of the losses and gains, exactly who benefits and who loses.

Let me give you just a short story. Tariffs are bad for consumers who have to pay more, they're good for domestic producers who get to expand production. They're bad overall precisely because of these two reasons which I've just described. If you want to look in detail, I focused on the bad overall, if you want more detail on dividing in between consumers and producers and the political economy of this, take a look at lots of different textbooks but the one of course I would recommend, Cowan and Tabarrok, Modern Principles of Economics, that will go into more detail on the distribution. Thanks.