Our President, in his wisdom, has proposed a 20% tariff on imported goods. Or goods from Mexico? Or maybe that was just an example? Like most things the White House does now, it was a bit confusing.
At any rate, it inspired a fair few of you to ask about tariffs. Who actually pays for them? What effect do they have on the economy? I am happy to oblige. If you are not here for econ lesson, but just want my opinion or juicy quotes, skim until you see the “Conclusion” header. It’s about 1200 words south of here; sorry.
I will be showing the graphical analysis in the least technical language I can manage because I find the graphs visually intuitive. Further, I will be giving some hypothetical numbers to go with it. This is not an actually economic prediction as the graphs I’ve put up or extremely stylized. It is just to give a sense of the magnitudes at work.
Let’s use the example of tomatoes as imports. (Lindsay Graham humorously defended the virtue of Mexican spirits, but I worry that we are losing sight of how much food, cars, and appliances account for our trade relationship.) If America were to simply close her borders, tomato production might well look like this next graph. Again, these numbers are simply for illustration; this is not meant to be a literal model of the tomato market.
The idea behind this representation is pretty simple. Starting with the red line, Demand, it shows the more expensive something is, the less you will buy. Likewise, the green line, Supply, shows that the more expensive something is, the more that will be sold. The tenuous point where they are equal is where they cross. Easy enough.
How much better off are we for being able to trade? Think about someone who would pay 10 dollars for tomatoes. They are paying 4 dollars less for the same amount of tomatoes. You can figure out exactly how much that is worth by finding the area of the triangle A, which in our example is $18. the same idea applies to Supply, but we want to look above the curve. If you would produce at 2 dollars, you make 4 dollars more by selling your tomatoes in this market. I have labeled that “B+C+D” for reasons that will become clear as we go along. Because of the arbitrary shapes I chose, it is also worth $18.
Let’s allow Mexico ship us tomatoes. Mexico has a warmer climate and it is easier to grow tomatoes there. As a result, the market price is going to be lower. I set it at $3 on this graph:
The mustard colored line is the price of goods now that we trade. It changes things quite a bit. First, it drives out anyone in the US not willing to sell as cheap as Mexico can. It pushes the area that producers benefit from all the way down to “D”, which is $4.50, a quarter of before. (It would be hasty to say that there would be a quarter as many jobs for tomato growers, but as a first approximation, that would make sense.) I presume this what Trump means when he says we are “losing” to Mexico. But we’re not finished. Consumer benefit is now everything above the mustard line and below the red line. That’s “A+B+C+E+F+G+H”. Here our numbers come out to be $40.5 dollars. It is a matter of simple arithmetic to figure out if we are collectively better off. We subtract closed economy numbers from the open economy numbers.
What we find is that Americans are better off for allowing trade by the size of the triangle “E+F+G+H”, which you can also see by comparing the areas on the graphs. This is an area of $9. That means that the tomato market makes us 25% better off if we open the economy to trade.
Now, let’s imagine that we elected a furious basketball to the White House and he decided to demand a 20% tariff on tomatoes imported to the US from Mexico. That graph would like this:
This is where things get complicated. To start, you can see that producers are a bit better off, now benefiting in the area “C+D” Consumers are pushed back to the area “A+B+F”. Its the rest of the areas we have to grapple with. Each of “E”, “G”, and “H” has different meaning.
“E” is the increase in costs that domestic producers pay because of they are less efficient. (This is not an increase in price, but rather how much they pay to grow tomatoes.) “G” is how much goes to the government, presumably to pay for the wall. “H” is how much less consumers get because Mexican producers leave the country. It is standard to presume that tax money counts towards societal benefit, and despite how doubtful I am the wall counts, I will follow suit. Because E and H alone count as waste, it is “only” $0.36 of waste over the open economy case, or .8%. If you can justify the spending, you can probably justify the tariff. Except…
We benefit enormously from our trade with Mexico. We send a good deal of corn south of the border—enough that we actually upended the entire farming sector after NAFTA was signed. Following our earlier analysis, we can see how a trade war might begin. The above analysis, in order to keep things simple, implicitly assumed that Mexico had exactly benefit from trading with us. Obviously, this is not realistic, but insofar as we don’t care about what our trade policy does to Mexico, there is no reason to make it more complicated. Now, though, we care about how a tariff impacts American businesses. this is a graph that could represent a tariff on corn, levied in retaliation.
Before the tariff is levied, the United States benefits at “G+I+J+M+N”. After, it is reduced to “I+G”.While it also reduces Mexican welfare (by “F+L”), the greater burden falls on the country receiving the tariff. That is why countries get into trade wars when tariffs start going up. They can retaliate with less damage to themselves than to the other. It can quickly spiral out of control.
The best way to avoid this is trade deals—NAFTA and TPP, populist boogeymen both. Unilaterally breaking those trade deals is a good way to reduce producer welfare in your country.
Bearing in mind that I literally just made up the numbers above, it nonetheless might help to put some numbers on this. Assuming that Mexico levied the tariff against the US:
Cost of Mexican Tariff to Mexico: 7 cents.
Cost of Mexican Tariff to America: $2.43.
The damage of this tariff is 35 times higher for the people it is leveled against. Of course we get into trade wars. Standard theory advises against them, but once our furious basketball has started one, retaliation makes a certain amount of sense. Other countries watching do not want in on that action. There is no world where a tariff makes sense, except when someone has raised a tariff against you.
Here is the part you came for. The part you can lob into comment sections. The following things are basically agreed upon by economists, with pretty little mainstream dissent:
- Tariffs always decreases the general welfare in both countries.
- The benefit business interests for the countries that raise them.
- They hurt consumers in country where the tariffs were levied.
- Consumers effectively pay 100% of tariffs EVEN IF the tariff is legally raised against foreign companies.
- Tariffs do, broadly but not absolutely, hurt the country they are raised against more than the country that raises them. (Both cases appear in this article.) That makes retaliation politically attractive and a real threat.
- Finally, the benefit of the tariff assumes you don’t spend it on something worthless—not a forgone conclusion, it turns out.
Protectionism is cutting off your nose to spite your face. Don’t do it.