How Tariffs Affects the Trade?

Tariffs can affect import volume, prices, production and consumption. They also affect the terms of trade, the balance payments, etc.

The various effects of tariffs have been discussed in the following sections. For this purpose, we may draw a diagram of partial equilibrium framework relating to the market for a particular commodity. Here, we have assumed that demand and supply relationships of commodity X are given and remain unchanged throughout the analysis. Factors influencing demand such as income, tastes, habits of consumers are constant and prices of substitutes remain unchanged. Similarly, there is no change in technology, no change in factor prices, or no such other changes which may affect the supply position.

Price Effect :

Assuming that the foreign price of a commodity is unchanged, we find that the price in the tariff-imposed nation would rise by the full amount of the tariff duty.Diagrammatical,thus, P₁P₂ price-rise is the price effect . In this case,the incidence of tariff falls on the domestic consumers.

But this need not happen always. Sometimes price may not rise at all or it may rise by less than the amount of duty. When the price does not rise at all, it means that the entire burden of tariff is shouldered by the exporters; hence the incidence falls on them. Otherwise, when the rise in price is less than the full amount of duty, the tax burden is shared by both importers and exporters.

The exact price effect thus depends upon the volume and elasticity of supply and demand in the trading countries. The elasticity of supply, however, depends upon the costs conditions-constant, increasing or decreasing – which play an important role in determining the price effect of the tariff.

The Protective Effect :

A tariff is a restrictive measure which seeks to control the quantity of import so that, domestic industry may be protected. A tariff duty is purely protective only if it is so high as to prohibit total imports of a commodity. In practice, however, in its restrictive effect upon the quantity of imports tariff, no matter how high, need not prove absolutely protective. Obviously, any imports may flow in after the payment of duties, unless regulated otherwise.

Nevertheless, the protective effect of a tariff can be seen in the expansion of domestic production of a commodity which becomes possible due to rise in prices in the domestic market. High prices enable the home producers to cover their high rising marginal costs on a larger output.

The protective effect of a tariff can be exposed diagrammatically in a partial equilibrium framework as in.

However, the protective effect in money terms can also be seen from the producer’s increased receipts. Out of the total increase in receipts P₁P₂ a d, the triangular areas ade is the purely protective effect of tariff. This ade portion of receipts enables producers to cover their marginal costs on the larger output.

Revenue Effect :

Tariffs which are not totally prohibitive certainly bring some revenue to the state. Usually, the government collects customers’ revenue equal to the duty multiplied by the volume of imports.

Above, if import duty is fixed at P₁P₃ which is extremely high and prohibits imports, it has zero revenue effect. But if it is reasonably put like P1P₂, then the imports would be M₂M₃ Thus, revenue effect may be measured by the rectangular area abed.

Transfer or Redistribution Effect :

After the imposition of a tariff, domestic prices will rise; hence, receipts of producers will increase, while consumer’s surplus to that extent declines. This is called transfer effect. Thus, the increase in receipts which is in excess of marginal costs is an “economic rent” to the producers, which is derived by subtraction from consumer’s surplus.

Consumption Effect :

A tariff generally reduces the total consumption of a commodity because of the rise in its price.

There is a loss in consumer’s satisfaction shown by the difference between the possible total utility of larger quantity at a lower price, and the actual total quantity bought at a higher price after tariff. It is the real cost of tariff. Out of the gross loss in consumer’s satisfaction, the revenue received by the state and transferred to producer should be deducted to find the society’s net loss in consumer satisfaction as a result of tariff. This net loss is represented by the area ade and bcf in the diagram.

Terms of Trade Effect :

The imposition of a tariff may serve to improve a country’s terms of trade {i.e., the amount of imports it receives in exchange for a given quantity of exports). This the tariff can do easily when the foreign demand for the exports of the tariff imposing country is both large and inelastic. In such a situation, the effect of tariff is to reduce imports to some extent, thereby making it difficult for foreigners to earn (through their exports to this country) for their imports from the country. Thus, in an attempt to expand their exports (to the tariff imposing country) foreigners may be inclined to reduce their prices, so that, to the tariff imposing country the imported articles are now relatively
cheaply available in the foreign market. In this way, the effect of a tariff is to lower import prices relative to export prices, thereby improving the terms of trade for the tariff imposing country.

It should be noted that the improvement in the terms of trade through tariffs depends upon the extent of the price rise in the importing country and the extent of the price fall in the exporting country, which in turn depends upon the elasticities of reciprocal demand of the trading countries.

Following Kindleberger, we elucidate the terms of trade effect of tariff with the help of Marshallian offer curves in technical parlance, it must be remembered that a tariff can improve the terms of trade of a country only if the offer curve of the opposite country is less than perfectly elastic.

In, OE and OP are the original offer curves of England and Portugal respectively. The original terms of trade are shown by OT, indicating AN cloth = BN wine. Let, England levy a duty on her import of Portuguese wine, so that her demand for Portuguese wine, will become less intense. Hence, England would offer less cloth per unit of wine. Assuming that the range between G and H represents the tariff value in terms of wine (or K to G – the same value in terms of cloth), the new tariff-distorted offer curve may be derived as OE’. The intersection point M shows the new equilibrium indicating 0T as the improved terms of trade : RM cloth = QM wine. However, there is contraction of trade. England now exports less cloth (OQ intead of OA) at higher price and imports less wine (OR instead of OB) at a lower price.

It should be noted, however, that tariffs can improve the terms of trade under such circumstances only in the absence of retaliation. If both countries retaliate, the effect is nullified and both will lose.

As a result of retaliation, the terms of trade remain unchanged ultimately, but greatly reduce the volume of trade. Hence, both lose. On the other hand, the reciprocal removal of tariffs will enable both countries to gain as the volume of trade increases. For the same reason, today we find in international trade relations, programmes and policies like the General Agreements on Tariffs and Trade.

Balance of Payments Effects :

When a tariff affects the volume of imports and prices, it also affects the country’s balance of payments position. A country having a deficit balance of payments position can restore and maintain equilibrium by means of tariff restrictions upon imports.

Tariffs restrict imports through price rise and contraction in demand, and may lead to improvement in terms of trade also under appropriate circumstances, which helps in bringing about a balance of merchandise accounts.

Tariff as a means of correcting disequilibrium have been, however, criticised severely as follows:

1. It brings equilibrium through a contraction of foreign trade.

2. It thus, inhibits the advantages of a large and expanding world trade and prosperity.

3. It adjusts the equilibrium without mitigating the root causes of disequilibrium.

4. Sometimes, the imposition of a new or higher tariffs may aggravate a disequilibrium in case of a country already experiencing a surplus in its balance of payments. In such a case, new or higher tariffs will tend to intensify the existing maladjustment in the balance of payments.

5. Since the imposition of tariff duties does not necessarily imply a reduction in the value of imports, the effect of a tariff on the balance of payments cannot be very certain.

Income and Employment Effect :

It was firmly believed in the thirties that imposition of tariff would lead to expansion of employment and incomes.

By reducing imports, tariffs stimulate employment and output in the import-competing industries. A new flow of income will be generated with its ‘multiplier effect. ‘In an expanding economy, more capital goods investment will also be made which produces ‘acceleration effect.’ Thus, under conditions of less than full employment, the interaction of multiplier-accelerator will lead to a cumulative expansion of investment, employment, output and income in the country.

Another possible impact of tariffs is that the imposition of tariff duties may attract foreign capital in the country concerned, when they find that they may lose market for their products in the country due to contraction of import demand and expansion of home industries under the protective effects of tariffs.

Doubts have been expressed, however, against this income-employment effect argument for tariff as:

1. Under conditions of full employment, a tariff would raise only money income through inflation, leaving real income reduction by the altered allocation of resources.

2. Even when there are idle resoures, it is highly questionable to say that, tariffs would lead to the expansion of income and employment very effectively. ‘When a country curtails its imports through tariffs, the exports of other participating countries will be reduced to that extent. Thus, the exporting country’s employment, output and income in the export sector would contract, and a decline in employment is set in motion abroad. As employment and incomes fall abroad, foreigners would curtail their imports. Hence, tariff imposing country’s exports may decline. This will offset the import curtailment effect in improving income and employment position of the country. Further, other countries may also retaliate by imposing tariffs so that, benefit goes to none, and the result is overall contraction of trade, income and employment in the world as a whole. As Ellsworth puts a country attempting to increase income and employment at home by means of tariffs is in effect exporting its unemployment. This sort of beggar-my-neighbour policy will definitely provoke resentment and retaliation.

3. To generate employment through tariffs means a permanent allocation of resources which gives only a temporary gain. Hence the remedy proves to be costly.

Thus, instead of resorting to tariffs for solving the problem of unemployment and poverty in the country, appropriate monetary and fiscal policies should be resorted to.

In conclusion, thus we may follow Kindleberger in saying that tariffs can stimulate producion, raise revenue, redistribute income and re-allocate resources within and between countries, expand employment and bring about a favourable balance of payments position. But the same can be achieved in a better way with weapons of economic policy other than tariffs. Moreover, the other devices have no such undesirable effects of tariffs like distorting the allocation of resources and limiting consumption. For instance, direct taxes and transfer are better means of redistributing income than tariffs, as these least disturb production and consumption. Similarly, international transfers are superior to tariffs for improving the terms of trade. To solve the problems of unemployment and balance of payments, deficits, appropriate monetary and fiscal policies are much better than tariffs.

Nevertheless, tariffs continue to prevail strongly. This is because of emotions are self-interest. In fact, as Kindleberger puts it, producer interests in particular are politically more powerful than producer and consumer interests in general.