How a Tariff Works
- A tariff is a tax on imported goods/services (customs duty)
- Domestic producers/retailers have to pay the tariff when the good/service crosses the border into the country
- This raises the cost of production for domestic firms
- Firms often pass on the increased costs to consumers in the form of higher prices
- These higher prices allow some domestic firms to increase their output (law of supply)
- Due to the tariff, more inefficient domestic firms are now producing more at the expense of more efficient foreign firms, which reduce their output due to the tariff
- With increased domestic output, employment may increase
- With increased domestic output, employment may increase
Diagram: Tariff Imposed on Imports
A tariff raises the price of world supply from PW to PW + Tariff. This reduces the quantity of imports from Q1Q2 to Q3Q4
Diagram analysis
- World supply (Ws) is considered to be infinite, and this supply curve is added to the domestic demand (DD) and supply (SD) curves
- The pre-tariff market equilibrium is seen at PwQ2
- Domestic firms supply up to Q1 at a price of Pw
- Foreign firms supply the difference equal to Q1Q2 (the level of imports), at a price of Pw
- After the tariff is imposed, the world price increases from Pw to Pw + Tariff
- Following the law of demand, the quantity demanded contracts from Q2 to Q4
- Following the law of supply, the quantity supplied by domestic firms extends from Q1 to Q3
- The new market equilibrium is seen at Pw+tariff Q4
- The level of imports is reduced from Q1Q2 to Q3Q4
- Domestic producer surplus has increased by area 2
- Domestic consumer surplus has decreased by areas 1, 2, 3 & 4
- The government receives tax revenue equal to ((Pw+tariff) - Pw) x (Q4-Q3)
- This is equivalent to area 3 on the diagram