Chapter 14 · International trade: Part I
Import tariff
Explain an import tariff’s effects on domestic price, output and imports. Identify tariff revenue and the production and consumption welfare losses.
The economic idea
Trade protection is government intervention that restricts imports or supports domestic and export production. Common instruments include tariffs, quotas and subsidies, which alter price signals in different ways.
An import tariff is a tax on imported goods or services. A specific tariff is a fixed amount per unit; an ad valorem tariff is a percentage of value. A tariff can protect domestic producers and raise government revenue, but it also raises the domestic price in the small-country model.
A transfer redistributes surplus between consumers, producers, government or licence holders without by itself using real resources. Deadweight welfare loss is the total surplus lost because production or consumption moves away from the efficient world-price allocation.
The production distortion occurs when the protected price induces higher-cost domestic output to replace lower-opportunity-cost imports, or excessive export production. The consumption distortion occurs when the higher domestic price prevents purchases whose willingness to pay exceeds the world opportunity cost.
Protection may be defended using infant-industry learning, national security, diversification, anti-dumping, employment or environmental arguments. Evaluation must ask whether a genuine market failure exists and whether the chosen instrument is targeted, temporary, enforceable and less costly than alternatives.
Reading the movement from Pworld to Pw + tariff
“Quantity” is measured horizontally and “Price” vertically.
“D domestic” and “S domestic” describe the domestic market; “Pworld” is the free-trade price.
“Pw + tariff” is the current protected domestic price. “Qs₁” and “Qd₁” are free-trade quantities; “Qs₂” and “Qd₂” are policy quantities.
Free-trade benchmark at Pw
At “Pworld”, domestic consumption exceeds production in the importing cases, while domestic production exceeds consumption in the exporting case. Their horizontal difference is the initial trade flow.
Policy wedge and domestic response at Pd
“Pw + tariff” lies above “Pworld”. The higher domestic price gives producers an incentive to increase quantity supplied from “Qs₁” to “Qs₂”, while consumers reduce quantity demanded from “Qd₁” to “Qd₂”. These are movements along the unchanged domestic curves. Imports decrease because the gap between domestic consumption and production narrows. Consumers lose and protected producers gain.
Welfare accounting
Government revenue equals the tariff wedge multiplied by remaining imports.
The policy expands higher-cost domestic production and prevents consumption whose willingness to pay exceeds the world opportunity cost. These changes create separate production and consumption welfare losses; they are not the same as the producer gain or fiscal transfer.
Locate the revenue rectangle and the two losses
The vertical gap between “Pw + tariff” and “Pworld” is the price wedge. Multiply it by the remaining imports, “Qd₂” minus “Qs₂”, to identify tariff revenue. The base is not all domestic consumption and not the fall in imports.
The production-loss triangle lies between “Qs₁” and “Qs₂”, above “Pworld” and below “S domestic”. The consumption-loss triangle lies between “Qd₂” and “Qd₁”, above “Pworld” and below “D domestic”. One represents costly extra domestic production; the other represents worthwhile consumption that no longer occurs.
Consumers lose more than producers and government gain together in this small-country model. Count government revenue as a domestic transfer before identifying the net loss; do not shade the revenue rectangle as deadweight loss.
From free trade to the current tariff
Begin at “Pworld” and read domestic production “Qs₁” and consumption “Qd₁”.
Introduce the tariff, creating the vertical price wedge to “Pw + tariff”.
Government revenue equals the tariff wedge multiplied by remaining imports. The policy expands higher-cost domestic production and prevents consumption whose willingness to pay exceeds the world opportunity cost.
Common mistakes to avoid
- Producer surplus gained from a higher protected price is largely a transfer from consumers, not automatically a new national benefit.
- Tariff revenue is not a deadweight loss; the two distortion triangles are the net loss.
- A policy that reduces imports does not necessarily improve the current account once exchange rates, incomes, retaliation and input costs adjust.
- Employment in a protected industry is not a complete welfare measure; jobs, inputs and finance have opportunity costs.
- The small-country result cannot capture a large country’s possible terms-of-trade effect or foreign retaliation.
How to draw this diagram
- Title the diagram “Import tariff”. Label the horizontal axis “Quantity” and the vertical axis “Price”.
- Draw D domestic first and label it clearly.
- Draw S domestic next and label it clearly.
- Draw Sworld (Pw) next and label it clearly.
- Draw Pw + tariff next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The economy is assumed unable to influence the world price; possible large-country terms-of-trade gains are omitted.
- Foreign retaliation, dispute settlement, exchange-rate adjustment and global value chains are not shown.
- The curves are static and omit learning, innovation, firm entry and exit, unemployment duration and regional adjustment.
- Externalities, security benefits and distributional objectives require evidence outside a conventional surplus diagram.
- Administrative costs, evasion, corruption, licence allocation and lobbying can materially change policy outcomes.