Understanding Trade Policy: Tariffs, Effects, and Implications
Understanding Trade Policy: Tariffs and Their Effects
While free trade generally benefits all participating countries, trade policies are often used to influence trade relations. Common trade policy instruments include tariffs, fees, regulations, technical or administrative procedures, and controls.
What are Tariffs?
A tariff is a tax or levy imposed on goods crossing a national border. The most common type is the import tariff, while export tariffs are less frequent.
- Ad Valorem Tariff: A tax specified as a fixed percentage of the value of imported or exported goods, potentially including transportation costs.
- Specific Tariff: A fixed amount of money levied per physical unit of imported or exported goods.
- Composite Tariff: A combination of both ad valorem and specific tariffs.
For goods with varying qualities, an ad valorem tariff is generally considered more equitable than a specific tariff. The protection level offered by a specific tariff changes inversely with the general price level, while an ad valorem tariff provides consistent protection.
Specific tariffs are administratively simpler to implement, while ad valorem tariffs require establishing the value of the goods.
Impact of Tariffs on a Small Country
Consider a small country (one that cannot influence international market prices) imposing a tariff. An import tariff increases the domestic price of imported goods. This leads to:
- Expanded domestic production in industries competing with imports.
- Reduced consumption of imported goods.
- Decreased imports, narrowing the gap between domestic production and consumption.
- Tariff revenue for the government.
Effects of Price Increase Due to Tariffs
- Consumption Effect: Reduced household consumption of imported goods.
- Production Effect (Protection): Increased domestic production of goods that compete with imports.
- Trade Effect: Decreased imports, equivalent to the increase in domestic production minus the decline in domestic consumption.
- Income Effect: Increased government revenue.
- Redistribution Effect: Income redistribution from consumers to producers. Consumers experience a net loss, while producers gain. The government collects tariff revenue. Areas 2 and 4 represent the deadweight loss of the tariff.
Further Effects of Tariffs
- Effect on Domestic Prices: Increased domestic prices of imported goods, creating a distinction between domestic and world prices.
- Effect on Domestic Production: Resources shift from export industries to industries producing goods that compete with imports (tariff protection effect).
- Effect on Household Consumption: Reduced domestic consumption of imported goods.
- Tariff Income: The difference between the value of output and the value in consumption (domestic prices) represents the tariff revenue collected by the government. Aggregate expenditure exceeds direct input income by the amount of tariff revenue.
- Effect on the Volume of Trade: When the government redistributes tariff revenue to consumers, the tariff reduces the volume of trade in a small country.
When the tariff rate equals or exceeds the difference between the autarky price (price in a closed economy) and the world price, imports decrease to zero. This is a prohibitive tariff, effectively returning the country to autarky.