Tariffs (HL IB Economics)

Revision Note

An Introduction to Protectionism

  • Free trade aims to maximise global output through national specialisation

  • However, there are numerous reasons why countries would seek to limit free trade in order to protect themselves from certain outcomes

  • This is called protectionism and may take the form of import tariffs, export subsidies, the use of quotas or embargoes

An Explanation of Tariffs

  • The most commonly used forms of trade protectionism include tariffs, subsidies, quotas and administrative barriers 

  • A tariff is a tax on imported goods/services (customs duty)

    • The tax raises the selling price of the good/service within the country
         

  • The higher price allows more inefficient domestic firms to increase their production and market share

    • More efficient global competitors reduce their output due to the tariff

    • With increased domestic output, employment may increase
       

4-1-6-restrictions-on-free-trade

A tariff raises the price of the world supply from PW to PW + Tariff. This reduces the quantity of imports from Q1Q2 to Q3Q4

Diagram Analysis

  • World supply (SW) is considered to be infinite and this supply curve is included with 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 at a price of Pw (imports)
       

  • After the tariff is imposed, the world price increases from Pw to Pw+ tariff 

  • The new market equilibrium is seen at Pw+tariff and Q

    • 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 level of imports is reduced from Q1Q2 to Q3Q4

An Evaluation of Tariffs

  • The best way to consider the impact of a tariff on stakeholders is to explain it using a diagram

4-1-6-restrictions-on-free-trade

A tariff impacts domestic producers, consumers, foreign producers and the government

The Impact of Tariffs on Stakeholders 


Stakeholder


Explanation of Impact

Domestic Producers

  • Before the tariff domestic producers produced output equal to 0Q1 and their revenue was equal to Pw x Q1

  • After the tariff was imposed domestic producers produced 0Q3 and their revenue was equal to Pw+tariff  x Q

  • Domestic producer surplus has increased by area 1

Foreign Producers

  • Before the tariff foreign producers sold output equal to Q1Q2 and their revenue was equal to Pw x (Q2 - Q1)

  • After the tariff was imposed foreign producers sold output equal to Q3Q4 and their revenue was equal to Pw x (Q4 -Q3

  • Foreign producer surplus has decreased by the areas underneath 2 and 4

Domestic Consumers

  • Before the tariff domestic consumers consumed Q2 products at a price of Pw

  • After the tariff domestic consumers consumed fewer products (Q4) at a higher price of Pw+tariff

  • Domestic consumer surplus has decreased by areas 1,2 3 and 4

  • Some consumers have been priced out of the market (contraction of quantity demanded from Q2 → Q4

The Government

  • After the tariff is imposed the government receives tax revenue equal to ((Pw+tariff) - Pw) x (Q4-Q3)

    • This is equal to area 3

Downstream Producers

  • Other producers who rely on the imported product as a raw material in their own production process, now have to pay more for it as prices are higher

  • This increases their costs of production

  • They may have to reduce output which could impact unemployment levels and government tax receipts in their industry

Society (welfare loss)

  • Less efficient domestic firms are now producing at the expense of more efficient foreign producers - there is a welfare loss equal to area 2

  • Consumers are frustrated with the higher prices and there is no longer allocative efficiency - there is a welfare loss equal to area 4

  • The net welfare loss is equal to areas 2 and 4

Worked Example

The diagram below illustrates Ukraine's wheat market. The EU implemented a 20 % tariff on the price for wheat which was selling at US$6.00 per kilogram. S is EU domestic supply, D is EU domestic demand, Sw is world supply and St is world supply with the tariff.

ibdp-economics---calculating-tariffs-from-a-diagram

Answer:

Using information from the diagram

a) Calculate the consumer surplus prior to the imposition of the tariff [2]

Step 1 - Identify the market equilibrium without a tariff

(70m kg's, $6)

Step 2 - Calculate the area of the consumer surplus

It is split into two parts - a rectangle and a triangle

A r e a space o f space t r i a n g l e space equals space fraction numerator b space x space h over denominator 2 end fraction space plus space a r e a space o f space r e c tan g l e space equals space straight L space straight x space straight B

Area space of space triangle space equals space fraction numerator 60 straight m space straight x space 12 over denominator 2 end fraction space plus space area space of space rectangle space equals space 12 space straight x space 10 straight m

Area space of space triangle space equals space 360 straight m space plus space area space of space rectangle space equals space 120 straight m

Consumer space surplus space equals space $ 480 straight m

[1 mark for any correct working and 1 mark for correct answer]
 

b) Calculate the producer surplus prior to the imposition of the tariff [2]

Step 1 - Identify & calculate the area of the domestic producer surplus

Domestic producers produce up to 30m kg's at a price of $6

Producer space surplus space equals space fraction numerator straight b space straight x space straight h over denominator 2 end fraction

Producer space surplus space equals space fraction numerator 30 straight m space straight x space 6 over denominator 2 end fraction

Producer space surplus space equals space $ 90 straight m

[1 mark for any correct working and 1 mark for correct answer]

 

c) Calculate the consumer surplus after the imposition of the tariff [2]

Step 1 - Calculate the loss in consumer surplus as a result of the tariff

After the tariff, the price is$7.20 and the quantity 64m kg's

Consumer surplus lost = the trapezoid formed between Sw and St

A r e a space equals space fraction numerator a space plus space b over denominator 2 end fraction space x space h

A r e a space equals space fraction numerator 64 m space plus space 70 m over denominator 2 end fraction space x space 1.20

Area space equals space 80.4 straight m  [1 mark]

 

Step 2 - Subtract the loss of consumer surplus from the original consumer surplus (answer for a)

New space consumer space surplus space equals space $ 480 straight m space minus space $ 80.4 straight m

New space consumer space surplus space equals space $ 399.60 straight m   [1 mark]

 

d) Calculate the producer surplus after the imposition of the tariff [2]

Step 1 - Identify & calculate the new area of the domestic producer surplus

After the tariff, domestic producers produce up to 36m kg's at a price of $7.20

Producer space surplus space equals space fraction numerator straight b space straight x space straight h over denominator 2 end fraction

Producer space surplus space equals space fraction numerator 36 straight m space straight x space 7.20 over denominator 2 end fraction

Producer space surplus space equals space $ 129.60 straight m

[1 mark for any correct working and 1 mark for correct answer]
  

e) Government revenue after the imposition of the tariff [2]

Step 1 - Identify the area of Government tax revenue

It is the rectangle formed between Sw and St - and the two quantity points (36m, 64m)

 

Step 2 - Calculate the area of the tax rectangle

Tax space revenue space equals space straight L space straight x space straight B

Tax space revenue space equals space open parentheses 64 straight m space kg apostrophe straight s space minus space 36 straight m space kg apostrophe straight s close parentheses space straight x space 1.20
space
Tax space revenue space equals space $ 33.6 straight m

[1 mark for any correct working and 1 mark for correct answer]
 

f) The welfare loss caused by the imposition of the tariff [2]

Step 1 - Identify the two welfare loss triangles

The welfare loss is represented by the two small triangles either side of the government tax revenue rectangle

Triangle to the right represents inefficiencies from domestic producers

Triangle to the left represents frustrated consumers who are priced out of the market

 

Step 2 - Calculate the area of each triangle and add them together

Welfare space loss space equals space fraction numerator straight b space straight x space straight h over denominator 2 end fraction space plus space fraction numerator straight b space straight x space straight h over denominator 2 end fraction

Welfare space loss space equals space fraction numerator 6 straight m space straight x space 1.2 over denominator 2 end fraction space plus space fraction numerator 6 straight m space straight x space 1.2 over denominator 2 end fraction

Welfare space loss space equals space $ 7.2 straight m

[1 mark for any correct working and 1 mark for correct answer]

Remember to check the units on the graph (and use them!). Consumer and producer surplus and welfare loss are always monetary values. Don't forget to round your answers to 2 decimal places

Examiner Tip

Tariffs are one of the most frequently examined sub-topics in Paper 2. When evaluating their use, consider how many jobs are protected (or created) in the industry that is targeted by the tariff as opposed to jobs which may be lost in multiple downstream industries due to higher prices.

For example, a tariff on solar panel imports protects a few firms who manufacture solar panels. However, the higher prices can cause a significant fall in the quantity demanded leading to the possible loss of thousands of jobs for installation experts.

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