In this post we want to analyse the effects of the government imposing a tariff on imports. We will analyse what happens to the quantity produced, supplied and the prevailing market price.
The above diagram characterizes a market with an import tariff. To analyse the effects of such a policy, the best step is to first see what happens in the market when there is no trade between the countries.
No trade equilibrium
Consider the case where our economy (or country) does not trade with the rest of the world. In this case, we can ignore any of the horizontal lines relating to the "Tariff" and "World Price" and just look at our supply and demand lines.
It should be relatively straight-forward to see that the prevailing price will correspond to the point where supply equals demand so price in this economy is P*. The quantity that will be produced is Q*.
Now consider the case where this country starts trading with another country. Let's first make some simplifying assumptions:
1) There are only one good being traded, for example, wheat.
2) Both countries share the same currency, so there are no issues to do with currency conversion (we could simply assume that their price has been converted into our currency as well)
3) The other country can produce the good cheaper than we can and they sell the good for the price Pf.
4) The other country is so much bigger than us that regardless of how much we sell or buy from them, the price does not change.
5) there are no other costs associated with doing business: no shipping costs etc.
6) Local consumers will purchase the good from whoever is the cheapest producer. However, they will purchase goods from local producers instead of foreign producers as long as the price is the same. Given that they can purchase as many units as they want from overseas, this means that suppliers will now have to charge a price which is the same that overseas companies charge.
These assumptions may seem a bit restrictive, but allow us to isolate the effects of trade.
In this case, we get a straight line which we have labelled world price. This is essentially a supply curve from the other country and says that for the price Pf we can purchase as many units as we desire. We can now solve for the quantity being produced and sold.
The first thing we might like to find out is how much is being consumed. To do this we find t he point that our demand curve intersects the world price curve. The logic for this is that consumers will continue to purchase goods up until the point that how much they are willing to pay equals the price they can purchase it for from the rest of the world. Thus, the price that they will pay is Pf and the quantity that they consume is Qdf. Therefore, the quantity that consumers gets to consume increases because of trade. It increases from Q* to Qdf.
Given that the maximum price that suppliers can charge is now only Pf (If they tried to charge a higher price consumers would just buy from overseas), they will only produce Qsf units of production. This means that the level of production will decrease from Q* to Qsf when the economy trades with another country.
The amount of goods being imported can simply be calculated as the difference between what is being consumed and what is being produced. Thus the imports in this economy are Qdf - Qsf. The overall effects are that the quantity being consumed increased, produced decreases and the price level is cheaper.
Suppose a tariff is imposed on all imports
Now let's consider the case where the government imposes an import tariff on all imports. This means that you need to pay tax from any good which is imported from overseas. It's the same as increasing the world price. This causes the World price line to shift up to the Tariff line.
The price increases from Pf to Pt. This causes the quantity demanded from overseas to decrease from Qdt from Qdf. Since the price has increased, suppliers are willing to produce more goods so their production increases from Qsf to Qst. Imports are now only Qdt - Qst. The size of the tariff can be calculated as the difference between Pt and Pf. Overall, tariffs decrease the amount of imports relative to free trade, they increase the price, reduce the amount consumed and increase domestic production.
In a later post, we will go over the welfare effects of tariffs and show how tariffs tend to reduce the welfare of a country.