Tariffs (HL IB Economics)

Revision Note

Author

Steve Vorster

Expertise

Economics & Business Subject Lead

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

A tariff raises the price of the world supply from P_W to P_W + Tariff. This reduces the quantity of imports from Q₁Q₂to Q₃Q₄

Diagram Analysis

World supply (S_W) is considered to be infinite and this supply curve is included with the domestic demand (D_D) and supply (S_D) curves
The pre-tariff market equilibrium is seen at P_wQ₂
- Domestic firms supply up to Q₁ at a price of P_w
- Foreign firms supply the difference equal to Q₁Q₂ at a price of P_w(imports)
After the tariff is imposed, the world price increases from P_wto P_w+ tariff
The new market equilibrium is seen at P_w+tariff and Q₄
- 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

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 P_w x Q₁ After the tariff was imposed domestic producers produced 0Q₃ and their revenue was equal to P_w+tariff x Q₃ 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 P_w x (Q₂ - Q₁) After the tariff was imposed foreign producers sold output equal to Q₃Q₄and their revenue was equal to P_w 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 P_w After the tariff domestic consumers consumed fewer products (Q₄) at a higher price of P_w+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 ((P_w+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 o f t r i a n g l e = \frac{b x h}{2} + a r e a o f r e c \tan g l e = L x B Area of triangle = \frac{60 m x 12}{2} + area of rectangle = 12 x 10 m Area of triangle = 360 m + area of rectangle = 120 m Consumer surplus = $ 480 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 surplus = \frac{b x h}{2} Producer surplus = \frac{30 m x 6}{2} Producer surplus = $ 90 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 S_w and S_t

$A r e a = \frac{a + b}{2} x h A r e a = \frac{64 m + 70 m}{2} x 1.20 Area = 80.4 m$ [1 mark]

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

$New consumer surplus = $ 480 m - $ 80.4 m New consumer surplus = $ 399.60 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 surplus = \frac{b x h}{2} Producer surplus = \frac{36 m x 7.20}{2} Producer surplus = $ 129.60 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 S_w and S_t - and the two quantity points (36m, 64m)

Step 2 - Calculate the area of the tax rectangle

$Tax revenue = L x B Tax revenue = (64 m kg' s - 36 m kg' s) x 1.20 Tax revenue = $ 33.6 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 loss = \frac{b x h}{2} + \frac{b x h}{2} Welfare loss = \frac{6 m x 1.2}{2} + \frac{6 m x 1.2}{2} Welfare loss = $ 7.2 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

Exam 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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Tariffs (HL IB Economics)

Revision Note

An Introduction to Protectionism

An Explanation of Tariffs

Diagram Analysis

An Evaluation of Tariffs

Worked Example

Exam Tip

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Author: Steve Vorster