Tariffs · micro.sg

Idea

A tariff is a tax imposed by a domestic government on foreign imports. It is the central instrument of protectionism: by raising the price of imported goods, it induces consumers and producers to switch towards domestically produced substitutes, expanding domestic output and contracting imports. It is the one trade diagram the syllabus requires.

Diagram

Import market for t-shirts. With free trade the price is the world price P_w (horizontal world-supply line S_w); domestic firms supply Q1 and imports fill Q1–Q2. A tariff lifts the line to S_w + tariff at P2: domestic supply rises Q1→Q3, demand falls Q2→Q4, and imports contract to Q3–Q4. Area A is the producer-surplus gain; area C is government tariff revenue; triangles B and D are the two deadweight welfare losses (inefficient extra domestic production, and lost consumption).

Mechanism

Before the tariff (free trade). The domestic autarky price is $P_E$ . Once the economy trades, it can import any quantity at the world price $P_w$ , drawn as a perfectly elastic world-supply line (global supply comes from a very large number of producers). Because $P_w < P_E$ , $P_w$ becomes the ruling price: consumers demand $Q_2$ , domestic producers supply $Q_1$ , and imports fill the gap $Q_1Q_2$ . Consumers gain utility from cheaper, more plentiful goods; domestic producers lose revenue and profit, which may raise unemployment.
After the tariff. The tariff lifts the world-supply line from $S_w$ to $S_w + \text{tariff}$ , raising the price to $P_2$ . Domestic production expands from $Q_1$ to $Q_3$ , domestic consumption contracts from $Q_2$ to $Q_4$ , and imports fall from $Q_1Q_2$ to $Q_3Q_4$ .

Considerations

The intended effects. Domestic producers gain higher demand and profit; the government sees demand-deficient unemployment fall as producers hire more factors, an improved balance of trade as import expenditure falls, and actual growth as switching from imports to domestic consumption raises aggregate demand through the multiplier.
Deadweight welfare loss. Producer surplus rises by area A, but consumer surplus falls by area A + B + C + D; the government collects tariff revenue of area C. Netting these leaves a deadweight welfare loss to society of areas B + D — the standard efficiency cost of the tariff, named on the diagram above.
Retaliation. Tariffs cut trading partners’ export revenue and may invite retaliatory barriers — “beggar-thy-neighbour” policies — so that the initiating country also suffers a fall in exports.
Domestic price elasticity of supply. A tariff only protects effectively if domestic producers can raise output. If domestic supply is price-inelastic, the higher post-tariff price brings a less-than-proportionate rise in quantity supplied, and unemployment may not fall by much.