Tariffs: Two Countries

Udayan Royhttp://myweb.liu.edu/~uroy/eco41

Tariffs: Two Countries Case• For a country that is so large that it can by itself

affect the worldwide prices of the goods it imports, the gains from a tariff may exceed the losses and the country as a whole may benefit from the tariff.

• However, the imposition of the tariff will harm other countries more than the country imposing the tariff will gain.

• So, the world, as a whole, will be harmed by the tariff.

Prices after the tariff

• Suppose Japan imposes a tariff on its imports of European steel

• Then, Price in Japan = Price in Europe + Tariff – as long as some European steel continues to be

imported into Japan even after the tariff• Why?

Prices after the tariff• Suppose the price of European steel in Europe = 4 per ton• Suppose the tariff = 2 per ton• Then the price of European steel in Japan = 4 + 2 = 6 per ton• Therefore, Japanese steel producers can’t charge more than 6

in Japan• But can they charge less than 6? Can they charge 5.40?• No. I have assumed that some European steel continues to be

imported into Japan even after the tariff. That would not have happened if Japanese steel was selling for less than European steel

• Therefore, the price of Japanese steel in Japan is also 6• In general, the Price (of both European steel and Japanese

steel) in Japan = Price in Europe + Tariff

Demand, Before Tariff

• Under free trade, the price of steel in Japan is the same as in Europe

• Demand is DemandB

• When the price in Europe (and in Japan) is 6, the Japanese buy 10 tons of steel

6

10

DemandB

Quantityin Japan

Price(in Europe or Japan)

Effect of Tariff on Demand

6

4

10

DemandB

DemandA

Quantityin Japan

Pricein Europe 1. Before Japan imposes a tariff, Japan’s

demand curve is DemandB. When the price of steel in Europe is 6, so is the price in Japan, and the Japanese buy 10 tons of steel.

2. Then Japan imposes a tariff = 2 on European steel

3. Now, the Japanese will not buy 10 tons unless the price in Europe is 4.

4. This implies that the new demand in Japan after the tariff is DemandA.

5. That is, Japan’s demand corresponding to the price in Europe shifts downward by the exact extent of the tariff.

6. Japan’s demand corresponding to the price in Japan remains DemandB.

Effect of Tariff on Supply

• A similar logic shows that: – Japan’s supply

(corresponding to the price in Europe) shifts downward by the exact extent of the tariff.

– Japan’s supply (corresponding to the price in Japan) remains SupplyB.

6

4

10

SupplyB

SupplyA

Quantityin Japan

Pricein Europe

Price in Europe, after Japan’s tariff

• As Japan’s demand shifts left, so does the World’s demand

• As Japan’s supply shifts right, so does the World’s supply

• Therefore, the free trade price of Europe’s exports must fall– Note that Japan is indeed a “large country” in this

example• Japan may potentially benefit, by forcing

down the price of its imported good

Price

Europe Japan World+ = Quantity

Recall: The free trade worldwide price is the price at which excess demand in one country is equal to the excess supply in the other country.

Europe Japan

Price

Quantity

The price in Europe decreases because of Japan’s tariff.

1. Japan imposes a tariff on its imports.

3. Therefore Japan’s Demand curve corresponding to the European price (broken line) will be below its Demand curve corresponding to the Japanese price (unbroken line) by the size of the tariff.

4. The same is true for the Supply curve.

The price in Japan increases, but by less than the tariff.

2. As a result, the price in Japan exceeds the price in Europe by the size of the tariff.

A

B C

ED

F G

H I J K

L M N

O

Free Trade

Europe Japan

Price

Quantity

The price in Europe after Japan imposes a tariff

1. Japan imposes a tariff on its imports.

The price in Japan after Japan imposes a tariff

2. As a result, the price in Japan must exceed the price in Europe by the size of the tariff.

Tariff

3. And Japan’s imports must equal Europe’s exports.

Tariff

A

B C

ED

F G

H I J K

L M N

O

Europe Japan

Price

Quantity

The price in Europe after the tariff.

Japan imposes a tariff on its imports.

The price in Japan after the tariff.

Worldwide free trade price

In Europe, consumer surplus increases from A to AB.

Producer surplus decreases from BCDE to DE.

In Japan, consumer surplus decreases from FGHIJK to FG.Producer surplus increases from LO to HLO.

And tariff revenue increases from zero to JM.

Tariffs: Two Countries CaseEurope Japan

Before After Before After

Consumer Surplus

A AB FGHIJK FG

Producer Surplus

BCDE DE LO HLO

Tariff Revenue

-- -- -- JM

Total Surplus

ABCDE ABDE FGHIJKLO FGHJLOM

Gains and Losses from Tariffs: Importing Country

• The loss to the country that imposes the tariff (Japan) include I and K, which represents the loss of the gains from trade. But,

• Japan also gains M, which represents the improvement in its terms of trade.

• Had Japan been a “small” country, it would not have been able to force a reduction in the price of its imported good. Therefore, tariffs would have had only losses and no gains.

Effects of Tariff—Small Country

C

G

A

ED F

B

Priceof Steel

0 Quantityof Steel

Domesticsupply

Domesticdemand

Pricewith tariff Tariff

Importswithout tariff

Pricewithout tariff

WorldpriceImports

after tariff

QSQS QD QD

Deadweight Loss

Effects of Tariff—Large Country

C

G

A

E1D F

B

Priceof Steel

0 Quantityof Steel

Domesticsupply

Pricewith tariff Tariff

Importswithout tariff

World price before tariff

QSQS QD QD

World price after tariffDomesticdemand

E2

A large country can use tariffs to force down the price of its imported good. This leads to additional gain of E2. If E2 exceeds D+F, the country will be better off after imposing the tariff.

Gains and Losses from Tariffs: All Countries

• The country that imposes a tariff will gain (lose) if M exceeds (is less than) I plus K

• The other country will lose by the amount C• C exceeds M. Therefore, the world as a whole

loses

Retaliation

• The analysis so far has assumed that one country can impose tariffs on its imports without the other country retaliating with tariffs of its own

• If retaliation occurs, even the conditional support for tariffs outlined earlier has no basis

Textbook

• For more on this topic, see “Costs and Benefits of a Tariff” in Chapter 9. – See especially Figures 9-9 and 9-10.