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A tariff is a tax on imports. It redistributes well-being from domestic consumers of the product to domestic producers and the government, which collects the tariff revenue. For a small country (one that cannot affect world prices), a tariff on imports lowers national well-being. It costs consumers more than it benefits producers and the government.
To reinforce your understanding of these basic effects of a tariff on well-being, imagine how you might describe each of them to legislators who are considering a tariff law. Remember what this performance in the policy arena requires. You have to speak in language that is clear to a wide audience. You can't use any diagram or equation—no legislator will be impressed by such abstractions. You can, however, use the following concise verbal descriptions to explain each of the key effects shown by lettered areas in Figures 8.2 through 8.4:- "By raising the price on strictly domestic sales, a tariff redistributes incomes from consumers to producers. The amount redistributed is the price increase times the average quantity of domestic sales." (This describes area a.)
- "A tariff shifts some purchases from foreign products to home products. This costs more resources to make at home than to buy abroad." (This describes area b, the production effect.)
- "A tariff makes consumers pay tax revenue directly to the government." (This describes area c.)
- "A tariff discourages some purchases that were worth more than they cost the nation." (This describes area d, the consumption effect.)
- "Both by shifting some purchases toward costly home products and by discouraging some purchases worth more than they cost the nation, the tariff costs the nation as a whole. The cost equals one-half the tariff amount times the drop in our imports." (This describes area b + d, the net national loss.)
The effects of tariffs on producer interests are further clarified by the concept of the effective rate of protection, which measures the percent effect of the entire tariff structure on the value added per unit of output in each industry. This concept incorporates the point that incomes in any one industry are affected by the tariffs on many products.
When a country as a whole can affect the price at which foreigners supply imports, the country has monopsony power. For such a large country, a positive tariff can increase national well-being because the tariff has a beneficial terms-of-trade effect. The nationally optimal tariff yields the largest possible gain. However, this tariff is only optimal if foreign governments do not retaliate with tariffs on our exports. With or without retaliation, the nationally optimal tariff is still bad for the world as a whole.
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