When watching the Libertarian Presidential debate, several candidates suggested that when tariffs are imposed in a foreign country, the US should allow complete freedom for importing from that country. How does this impact both the US economy and the foreign country?
Posted May 29, 2016, 1:53 AM UTC
The simple answer is, in most economic trade models, the imposition of a tariff decreases economic surplus in the country that imposes it (as well as possibly foreign countries). The diagram in this wikipedia page can be found in most textbooks on international trade and it makes the point pretty simply. On this analysis, countries should never impose tariffs if their goal is maximum efficiency (ie maximisation of consumer and producer surplus).
There are two major caveats to this. The first is that it assumes that the tariff doesn't change the "world price" of the good. This is sometimes called the "small country" assumption. In theory, it might be possible for a large country which dominates the market for a particular good to impose a tariff which increases the world price in a way that more than offsets the efficiency losses from the tariff. The world as a whole is worse off, but the country wins. This is called The Optimal Tariff. However, it is difficult to know all the information that is required to calculate that tariff and getting it wrong can easily make things worse.
The second caveat is that it doesn't consider the strategic interaction of other countries. Politically, one of the things restraining the imposition of tariffs is the threat of retaliation: It may seem politically beneficial to protect local steel producers (for example), but this may come at the cost of harming your computer export industry when your trade partners retaliate by putting a tariff on your exports. There may be cases where a country has to follow through in its implicit trade war threat to make sure that the threat remains credible in the future. Although this is made much less likely by the current functioning of the WTO system, within which countries promise to grant each other "most favoured nation" status which ensures that, outside of free-trade deals, countries cannot set different tariffs for different countries.
The answers so far neglect an important reason why a country cannot blithely ignore tariffs imposed by another country on it's exports.
The theory of the optimum tariff describes how, in the absence of retaliation, a government can exploit import tariffs to improve its terms of trade and generate government revenue.
Retaliatory tariffs usually render moot the theory of the optimum tariff. However, if a country were to adopt a policy of not responding to tariff increases, trade partners can take advantage of the situation by adopting optimal tariffs.
Theory/Background: In general, economists tend to view voluntary trades a beneficial to both sides of the exchange. We only trade if we value what we get more than what we give up. This is what economists call "gains from trade." An insight about this, which goes back to Adam Smith, is that the size of the market is important to how much one can benefit from trade. If you are just Robinson Crusoe on an island by yourself, you have no opportunities to trade, and, therefore, no opportunity to take part in the gains thereof. The bigger the market, the more people willing to trade, the more beneficial trade is. That is why many economists tend to support free trade; taking advantage of the whole world as a market is as big as it gets.
Tariffs throw a wrench in this process because they distort the prices of goods. Prices set by the market are signals about relative scarcity of goods which helps coordinate mutually beneficial exchanges. If the price is not set by the market but set, in part, by governments via tariffs, then it makes foreign goods appear cheaper relative to domestic substitutes. This is the rationale used by proponents of tariffs: they are meant to raise the price of non-domestic goods so that demand will shift to domestically produced substitutes. But what that essentially does is shrink the market; instead of having access to the whole world, the market has been distorted so that prices no longer accurately reflect people's preferences and mutually beneficial exchanges which would have happened without the tariff do not happen. Instead, consumer of the goods in question face higher prices, and, therefore, face more limited consumption options.
Answer: So tariffs hurt both the country on which the tariff is imposed (because their goods are made more expensive) and it hurts the country which imposes the tariff (because consumers then face those more expensive prices). That is why there is really no economic benefit to retaliating against countries which impose tariffs on us. Doing so just hurts us more; it's cutting off your nose to spite your face.
A good rule of thumb when thinking about trade is to scale it down. Think about an economy with only a few people who are obviously made better off if they specialize and trade. Or think of it as happening within the United States: if Vermont imposed a tariff on Georgia peaches would that make either state better off? Vermont gets higher orange prices and Georgia peach farmers get less revenue. Now ask, does it make sense for Georgia to impose a tariff on Vermont maple syrup in retaliation? That would just compound the problem.