Tariffs and Protectionism

We’ll look at the costs and consequences of tariffs, quotas, and protectionism. How do tariffs affect consumers? What about producers? Who wins and who loses? Find out with this video.
We’ll apply the fundamentals we learned in the supply, demand, and equilibrium section of this course to real-world examples — like that of protectionism in the U.S. sugar industry — to determine lost gains from trade or deadweight loss, the tariff equilibrium vs. the free trade equilibrium, and the value of wasted resources as a result of tariffs.
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- [Alex] Okay, now we're going
to discuss international trade

and how to model international trade
using demand and supply.

We'll also look at how to model
the consequences of a tariff,

a tax on trade.

We'll look at the consequences
and also the cost of the tariff

and the cost
of protectionism in general.

By the way, remember
when we did demand and supply,

I said that these concepts
are really, really important?

Well now you see why:
it's because we're simply applying

the same tools
over and over again.

So if you understand
the fundamentals,

then the applications
become much, much easier.

So do make sure you understand
the fundamentals.

Okay, let's get going.

First, some quick definitions.

Protectionism:
This is the economic policy

of restraining trade
through tariffs, quotas,

or other regulations
that burden foreign producers

but not domestic producers.

In particular, a tariff is simply
a tax on imports

and a quota is
a quantity restriction on imports.

For example, a quota may say
you're only allowed

to import 10,000 automobiles
from Japan.

Okay, let's get right into it.

Here is the domestic supply curve.

This is the supply curve
of the home country firms.

If we're thinking about the US,

this is the supply curve
from US firms.

Here is the demand curve,
domestic demand,

this is demand from US consumers.

If we had no international trade
then as usual,

we would find the equilibrium
where the quantity demanded

is equal to the quantity supplied.

That would give us the price
with no international trade

and the quantity
both produced and consumed

with no international trade
down here.

Now let us suppose that the
consumers in this country

can go out into the world
and they can buy

as much of these semi-conductors
as they want at the world price.

So in that case
if we had complete free trade,

consumers would be able to buy
as much as they want

at the world price or as given
by this world supply curve.

The free trade equilibrium, then,
would involve greater consumption.

That is, at the high price

with no international trade,
the quantity demanded is here.

With international trade,

consumers get to buy
at the lower world price

so their quantity demanded
increases.

In terms of the diagram

the quantity demanded
will increase to QD free trade.

So domestic consumption
is equal to this distance

or domestic consumption is equal

to the quantity demanded
with free trade.

Now what about production?

Well, the domestic producers
can only charge

as much as the world producers.

They can't charge a higher price.

So when the world price falls,

when domestic consumers are able
to buy at the world price,

domestic producers can only sell
at the world price,

and they're going to be
less willing to sell.

So the domestic production will fall,

domestic production will fall
to this lower amount right here.

At a lower price

the domestic suppliers
are only willing to produce

a less amount or lower amount
as given by QS free trade.

Now notice that domestic consumption
is QD free trade,

domestic production
is QS free trade

and demanders are demanding

more than the domestic suppliers
are willing to supply.

The difference of course
is made up by imports.

So with trade, domestic consumption
will be at QD free trade.

Some of that will come from imports

and some of that will come
from domestic suppliers.

That's it. That's our analysis
of international trade

using supply and demand.

Now make sure you understand
each step in this diagram

because the next slide,

when we're going to add tariffs

it's going to make the diagram
more complicated.

Each step is actually simple,

each step is actually no different

than the ones we've already done,

but the diagram will look
a little bit messier.

So if you need to go through
this slide again

make sure you understand
each step along the way.

Okay let's do the same diagram

but now we're going to do it
with a tax or a tariff.

Let's remember that here
is the quantity

demanded with free trade,

here is quantity
supplied with free trade.

The difference
between the quantity demanded

and the quantity
supplied domestically

is of course imports,
so this is imports with free trade,

this distance right here.

Now, a tariff is simply
a tax on imports.

What the tariff does is
it raises the world price

by the amount
of the tariff or the tax.

So the world supply curve
or the world price shifts up

until we get
to the new equilibrium.

Of course what this means
is at a higher price

domestic consumers are going
to demand a lower quantity.

Domestic consumption falls
from Q free trade

to Q quantity demanded
with the tariff.

Domestic production falls
by this amount,

or let's just add that
to the diagram,

domestic consumption falls
from here to here.

Okay, what about
domestic production?

Well with a higher price,
domestic suppliers

are now willing to supply more.

Here is the price
of the world price,

here's the world price.

With a higher world price
domestic suppliers

are willing to supply more
up until this point.

Let's add that to the diagram.

Domestic production
is going to increase

from the quantity
supplied with free trade

to the quantity
supplied with the tariff

or again just putting that
into the diagram

it's going to increase
from here to here

along the domestic supply curve.

But what about imports?

Imports remember are the difference

between the quantity demanded
and the quantity supplied.

The quantity demanded
with the tariff is here,

the quantity supplied is here,

so imports are the difference
which is this distance right here.

So notice that imports have fallen.

Final thing to add, a tariff
is just a tax on imports,

this is the quantity of imports,

this is the amount
of the tax or the tariff.

So the tariff will also
generate some revenues.

This is the revenue from the tariff

which is going to go
to the government.

It's the tax or the tariff amount

times the quantity
of imports with a tariff,

so this is revenue
that flows to the government.

Okay, that's it,
that's analysis of tariffs,

now what I want to do

is say what are
the welfare consequences of this?

The welfare consequences
are going to depend

upon this factor
the domestic production falling

and this factor
the domestic consumption increasing.

Let's take a closer look.

Okay let's take a look
at the welfare costs

and here I'm going to look
at the net costs.

What I mean by that is
we could actually find the cost

in two different ways.

We could look at the costs
and the benefits to the consumers,

the costs and benefits
to the producers,

the cost and benefits
to government.

We could sum all those up,
that would give us the net cost.

I want to jump straight
to the net welfare costs

of protectionism
and I'm going to do that

by focusing on
the real factors which change

and these are two;

first domestic consumption
as I said falls,

second domestic production
increases.

Notice I haven't said anything here

about the revenue from the tariff,

that's because that's
a cost to consumers,

they've got to pay more

but it's a benefit
to the government,

they have this revenue
that nets out

so it's not going
to affect the net welfare.

Instead the net welfare

is going to depend
upon these two real changes.

What I'm going to show is
that both of these effects

somewhat surprisingly
reduce welfare.

Why is this?
Well domestic consumption falls,

the reason that reduces welfare

is because there are
lost gains from trade

and I'll say more
about that in a minute.

Second, domestic production
increases,

you might think that's
a good thing, except, however,

we're going to have
wasted resources

because the domestic producers
have higher costs

than the world producers.

On a net level there's going to be

more resources going to production
than are necessary,

there's going to be wasted resources.

Can we measure
the value of these losses?

In fact we can and I'll show that
in the next slide

in a little bit more detail.

In order to focus
on the welfare costs,

I'm going to make
two simplifying assumptions.

First I'm going to assume
that the world price is so low

that if there were
complete free trade

there would be
no domestic supply whatsoever.

Think about a good like sugar,

if we had complete
free trade in sugar

we in the United States

would probably import
all of our sugar.

It's simply much more expensive
to produce sugar in Florida

than it is to produce sugar
in a country such as Brazil.

The problem is is that in Florida

the opportunity cost of land
is very high

and the climate in Florida
is not ideal for growing sugar

so you have to invest
more real resources

to produce sugar in Florida

than you do
to produce sugar in Brazil.

So if we had complete free trade,
there would be no domestic supply.

I'm also going to assume
that with the tariff or the tax

that it raises
the cost of imports so much

that there are no imports,

that it's simply too expensive
to import the good.

Again this is actually
quite accurate or quite similar

to what we have
for the case of sugar.

With this very high tariff,

the entire domestic consumption
is produced by domestic suppliers.

Our tariff equilibrium
is given by this point

and notice that
domestic consumption is lower.

Okay, so what are
the costs of the tariff?

There are two.

First of all
the lost gains from trade.

The demand curve can be read
as the willingness to pay.

This is the willingness
to pay for sugar

by domestic consumers.

The world supply curve can be read
as the cost of producing sugar.

This is the price
at which world suppliers

are willing to supply the sugar.

So there's lots of gains
from trade here.

Consumers are willing to pay
more than the suppliers require

in order to produce the good.

So by getting together

the consumers
and the world suppliers

can earn these gains from trade.

With the tariff however,
that's not possible.

With the tariff,
we have reduced consumption

and with that reduced consumption
is lost gains from trade

given by this purple area.

What else?

Well the US supply curve
can be read as US costs.

So what happens with the tariff

is that instead of producing
the sugar in Brazil

where it's cheap to produce sugar

we produce the sugar in Florida

where it's expensive
to produce sugar

where we have to invest

more real resources
in producing sugar.

We've got to invest more
in irrigation,

more in valuable land,
more in fertilizer.

So these are wasted resources,
when the domestic industry expands.

Because of the tariffs
we invest more resources

in producing sugar
than are necessary.

It would be cheaper,

we would be able to import sugar
using fewer resources.

We would be able to produce
that sugar internationally

using fewer resources
than we can produce it

in the United States.

What the tariff does is
it switches production

from the low-cost world producers

to the high-cost
domestic producers,

and that generates
wasted resources.

Now in fact, with these numbers
we can calculate the sizes

or the amount
of these wasted resources.

What economists do quite often
is they make assumptions

about these supply curves
and these demand curves

and they can make
some of these calculations.

Let's take a quick look.

So with these numbers,
we can calculate these areas.

This triangle for example
is half base times height.

So the base is 20,
this is a base of 20.

The height is 20 minus 9,
there's the 20, there's the 9.

So the area of the triangle
is half base times height

or 1.1 billion.

What about the deadweight
loss triangle?

You do the same calculation
it's 0.22 billion.

So with these kind of numbers

we can find out the cost
of the sugar tariff

are $1.32 billion

and economists do these kinds
of calculations all the time.

Okay, let's summarize
and point out some further reading.

First, tariffs increase
prices to consumers

so domestic consumption falls
and that creates a deadweight loss.

Second, tariffs divert production
from low-cost world producers

to high-cost domestic producers
and that wastes resources.

Now I haven't said much here

about the distribution
of the losses and gains,

exactly who benefits and who loses.

Let me give you just a short story.

Tariffs are bad for consumers
who have to pay more,

they're good for domestic producers
who get to expand production.

They're bad overall precisely
because of these two reasons

which I've just described.

If you want to look in detail,
I focused on the bad overall,

if you want more detail on dividing
in between consumers and producers

and the political economy of this,

take a look at lots
of different textbooks

but the one of course
I would recommend,

Cowan and Tabarrok,
Modern Principles of Economics,

that will go into more detail
on the distribution.

Thanks.

- [Narrator] If you want
to test yourself

click Practice Questions.

Or, if you're ready to move on
just click Next Video.

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