Tariffs & Tariff Analysis

Perhaps, many would be surprised to hear that the study of international trade has been a cornerstone of Economics theory for many centuries. Such scholars as David Ricardo, David Hume, and Adam Smith were pioneers in development of ideas and models on the subject. Their pioneering work, and the subsequent theoretic development of the subject has been a controversial matter of debate among nation states ever since.

Stemming from the advent of globalization, enabled by technological advancements especially in the field of communication and rising importance of international institutions such as the United Nations (UN), World Trade Organization (WTO), International Monetary Fund (IMF) and the like, the debate surrounding the subject of international economics has never been as controversial and important as it is today.

Much of the old ideas, developed by the pioneers have stood the test of time and remain to be the bedrock of international trade economics in the 21st century. International Economic Policies, whether it be those designed and enacted by International Institutions (e.g. WTO), or those falling under the legislative power of national governments (e.g. Protectionist policies), have far reaching consequences for the global economy, and the lives of the citizens of each state.

To see the sweeping result of Trade Policies, one should not look beyond real-world examples of Trade Policy Instruments. One subject which can resonate with readers in hypothetical (perhaps real) failed states is that pertaining to the costs and benefits of high tariffs on automobile imports.

Let us get into the benefits and the costs of tariffs on automobile imports for our hypothetical failed state. The amount set as the tariff by policy-makers raises the domestic price of a hypothetical automobile from the World Price (Pw) which is determined to be 600 "Fails (the currency of our country), to the price with Tariff (Pt) of 900 "Fails.

While the tariff has raised the price from Pw to Pt by 300 "Fails Rials, Pt*, the potential effect of tariffs on foreign export markets, is not relevant as the Failed State's is considered a small country, and its market cannot affect world prices. For the Failed State, a tariff imposed cannot lower the foreign price of the good. As a result the import price rises significantly from Pw to Pw + t and the quantity of imports demanded falls from (D1 – S1) level to (D2 – S2) level.

As the Failed State is considered a small country in terms of international trade, the immediate effects of high tariffs is the domestic supply rise from S1 level to S2, with domestic consumption falling from D1 level to D2. The gain to domestic suppliers is that they receive a higher price and gain at a social cost.

Unfortunately, while the purpose of tariffs is protectionist in nature, to the benefit of local producers, tariffs forces consumers in the Failed State to face a higher price not only for imported automobiles but also for the domestically produced cars. Tariffs therefore leave consumers worse off by an amount equal to area a + b + c + d. This is caused by the price consumers face increasing by Pw to Pt because of the tariff A final market player is the government. The government gains by the amount of tariff revenue it collects on the imports of this hypothetical car.

This amount is equal to the tariff rate (t) multiplied by the amount of imports (D2 – S2) in figure 1. In a large country, the government would gain considerable amounts. As our Failed State is a small importing country that can not affect foreign market prices, the government only gains an amount significantly lower than the social cost to the population. Consumers lose because of increased prices for both domestically produced automobiles and imports, but producers in the country, as well as the government can appropriate net gains from high tariffs. (Tyranny of the minority).

As producers create jobs, and the government can use tariff revenue for the benefit of society, it is important to look at the net welfare effects of tariffs. If producer and the government gain from tariffs is distributed equitably, and this sum is greater than the losses faced by consumers, then atariff can be a good policy instrument (unlikely for a non democratic failed state).

As the Failed State has not been able to affect world prices in the international trade arena, high tariffs on automobile imports reduces overallwelfare in the country, as producers charge high prices for lower quality domestic automobiles, and consumers pay exponentially higher prices for higher quality imported automobiles by the amount of tariff, without terms of trade gains for the country up for distribution.

This welfare loss is brought about by distortion of incentives of local producers and the consumers acting on imports that are more expensive than they are globally. As the tariff raises the domestic price above the world price, the Failed state economy produces more cars than it should. In fact these units could have been purchased much more cheaply abroad.

Advocates of free trade (removing tariffs), would propose that since the Failed state can not influence foreign export prices, the tariff leads to a net loss to the Failed State economy. Removal of tariffs would make the efficiency losses disappear and increase national welfare.

Furthermore, the analysis above does not factor in the gains of free trade that are overlooked because of the simplifications. For example free trade advocates would argue that since protectionism limits competition, the scale of production for domestic producers is inefficient, leading to further increases in consumer prices.

Protectionists on the other hand would argue that since the government must have assessed that the Failed State has a comparative advantage in automobile production, then the industry must be supported, until it can stand on its own feet, and could compete with imports on both quality and price. For the advocates of protectionism, the inefficient scale problem would be solved when the industry that is protected can be induced (by government policy) to enhance their quality and in turn reach an efficient scale through exports.

As a result of economic rents to producers and high tariffs, local producers have no competition which would incentivize them to make quality gains. One benefit however is that local production supports the local workforce both directly, as well as those employed by the industry suppliers, but at what cost? The intangible social costs are insurmountable.

Does the above theoretical analysis help a failed state dealing with dutch disease? As long as the minority of stakeholders benefit (self interest), propaganda can easily be used to rally the uneducated masses behind the industry and speak of the high unemployment costs potentially stemming from layoffs if the country opens up, such theoretical experiments are either known and not acted upon, most likely those who need to use them to create policy do not have the expertise because of cronyism.

Western economies have to set the example for the rest of the world and remain committed to free trade and policy analysis, not slowly succumb to it!

August 13 2020

JHS | Vancouver BC | Canada