Tariffs always cause a net welfare loss

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Tariffs always cause a net welfare loss

Explain and critically evaluate this statement.

In this essay, I will be discussing the impact of protectionism, in
focus, the impact of tariffs, import duties. As well discussing the
overall effect on welfare from the tariff, the gainers and the losers
will need to be identified. I will illustrate this diagrammatically. I
will then move to discuss the value of the optimal tariff imposition.
As well as discussing the first best argument, I will also look at the
value of second best arguments, examining whether or not tariffs do
always cause a net welfare loss.

A tariff requires the importer to pay a given fraction of the world
price to the government. This protects domestic producers by raising
the world price well above the domestic price; this of course has a
downside for the consumers. A tariff works like a tax from the
consumer's perspective: there are transfers from the consumers to both
the government in the form of revenue and to the producers in the form
of higher profits. This can be illustrated effectively by looking at
Figure A, it shows the demand and supply curves for the home economy,
Pa is the point where there is no trade, where supply meets demand. Pw
is the world price for the commodity, the point of free trade and Pw +
t is the price plus the tariff. We can see that during free trade, at
Pw the home economy should import (Qf - Cf) but when a tariff is
implemented this means they will import (Qt - Ct). As we can see from
Figure A, the government will gain the revenue from the tariff, area
B. The price rise in imports means that there is a reduced demand for
them and increased demand for domestic producers. This results in a
gain for the producer, area E. The loss for the consumer, area C, this
is where consumption is cut when Cf moves to Ct. Area A, is also a
loss area, as when production increases from Qf to Qt production is
inefficient, over the world price so this area is the extra cost that
the economy pay for producing the good at home. We can summarize these
gains and losses we can see that there is indeed a net loss for
welfare: B - (E+A+B+C) + E = - (A-C).

So are there any valid 'justifications' for the imposition of tariffs.
The strongest argument (some would say the only) in favour of a tariff
comes with the recognition that a domestic economy imports such a
significant supply of the world market for a commodity that an

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increase in imports will affect the world price. If this was the case
then the cost of the last unit imported may exceed the benefit, as all
consumers must pay the higher world price. The economy as a whole
could gain by imposition of an optimal tariff, which restricts imports
to the point where the marginal benefit of importing was equal to the
marginal cost. This could be seen as a gain in welfare, which could be
seen as offsetting other welfare losses. In Figure 2b, at point b,
this is where demand is for imports once the tariff is in place, Ct -
Qt; this tariff results in reducing the home demand below the quantity
demanded at the world price. So the demand for imports, the gap
between home demand and home supply at the world price, will fall,
from Cf - Qf to Ct - Qt. Now the supply of imports exceeds demand at
the old world price; therefore the world price must fall to reduce the
quantity of imports supplied. So, by reducing the price of world
imports, the tariff has improved the terms of trade of the country,
area F. This is the first-best argument in favour of a tariff as
policy targeting states that the most efficient way to attain a given
objective is to use a policy that has a direct influence on that
activity.

We can now see how the optimal tariff can in fact provide a gain in
welfare but we have not considered the effect of this tariff on other
countries. One country could gain from the imposition of this kind of
tariff, but very likely at the expense of others. Retaliation by other
countries in this situation would more than likely end with everyone
being worse off. But, what if all where to impose them, would they all
benefit? We are now starting to see how this could be seen as another
instance of Prisoners' Dilemma game and if this is the case then there
is not always a net welfare loss. This is why the General Agreement on
Tariffs and Trade (GATT) is very important as this co-ordinates the
behaviour of countries internationally so to avoid mutually damaging
trading behaviour.

Policies, which operate indirectly through other activities, are known
as second best because of the distortions they introduce. Most of the
other arguments in favour for tariffs fall into this category. We must
consider the value of them while considering the welfare effects.
Firstly, lets consider the argument of infant industries. The argument
is that in the long run the industry will be profitable but will need
some initial help to get started, like an import tax. But, does a
venture of this kind require help because it cannot secure bank
backing. So, what would happen then if the banks judgement on the
long-run viability on the venture was right and the infant never grows
up? I feel that this is not a valid justification for the imposition
of a tariff and would agree that if a tariff were imposed in these
circumstances there would be a net welfare loss. Other arguments for
tariffs are also mainly groundless.

Although there may be a small case for protecting domestic industries
against temporary 'dumping', of foreign produce, but perhaps another
method of protectionism could be used here such as export subsidies to
reduce the welfare loss. Complaints from Governments about cheap
foreign labour cannot be sustained either on the light of comparative
advantage.

As I have discussed, there is a strong case that tariffs always cause
a net loss. The optimal tariff may look to be producing welfare gains
for one country but as I discussed this will have effects for other
countries. Although there is a net welfare gain for one country there
will be loss for others. Therefore tariffs do always cause a net
welfare loss. Also as I discussed, this can also be seen as another
instance of the prisoners' dilemma game. I also briefly discussed the
value of second-best arguments to find that these are arguments do not
provide a sufficient welfare gain to offset other welfare losses
incurred. So, if the case is so strong why do tariffs exist, perhaps
the answer is partly political, perhaps politically its more tactful
to collect tariff revenues and allow consumers to suffer high prices
rather than taxation to subsidise production. But perhaps it's purely
because the costs of tariffs are diffuse and the benefits are
concentrated.

Bibliography

Mackintosh, M., Brown, V., Costello, N., Thompson, G., Trigg, A.,
Dawson, G., (2000) D216 Economics and Changing Economies, Chapters
9-15. Glasgow, The Bath Press/The Open University.

Trigg, A., Atkinson, B., Dawson, G., Mackintosh, M., D216 Economics
and Changing Economies, Workbook. Kent, Thanet Press Ltd.


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