Welfare Effects of a Tariff: Small Country

Consider a market in a small importing country that faces an international or world price of P_FT in free trade. The free trade equilibrium is depicted in the adjoining diagram where P_FT is the free trade equilibrium price. At that price, domestic demand is given by D_FT, domestic supply by S_FT and imports by the difference D_FT - S_FT (the blue line in the figure).

When a specific tariff is implemented by a small country it will raise the domestic price by the full value of the tariff. Suppose the price in the importing country rises tobecause of the tariff. In this case the tariff rate would be , equal to the length of the green line segment in the diagram.

The following Table provides a summary of the direction and magnitude of the welfare effects to producers, consumers and the governments in the importing country. The aggregate national welfare effects is also shown. Positive welfare effects are shown in black, negative effects are shown in red.

Tariff Effects on:

Importing Country Consumers - Consumers of the product in the importing country are worse-off as a result of the tariff. The increase in the domestic price of both imported goods and the domestic substitutes reduces consumer surplus in the market. Refer to the Table and Figure to see how the magnitude of the change in consumer surplus is represented.

Importing Country Producers - Producers in the importing country are better-off as a result of the tariff. The increase in the price of their product increases producer surplus in the industry. The price increases also induces an increase in output of existing firms (and perhaps the addition of new firms), an increase in employment, and an increase in profit and/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of the change in producer surplus is represented.

Importing Country Government - The government receives tariff revenue as a result of the tariff. Who will benefit from the revenue depends on how the government spends it. These funds help support diverse government spending programs, therefore, someone within the country will be the likely recipient of these benefits. Refer to the Table and Figure to see how the magnitude of the tariff revenue is represented.

Importing Country - The aggregate welfare effect for the country is found by summing the gains and losses to consumers, producers and the government. The net effect consists of two components: a negative production efficiency loss (B), and a negative consumption efficiency loss (D). The two losses together are typically referred to as "deadweight losses." Refer to the Table and Figure to see how the magnitude of the change in national welfare is represented.

Because there are only negative elements in the national welfare change, the net national welfare effect of a tariff must be negative. This means that a tariff implemented by a "small" importing country must reduce national welfare.

In summary,

1) whenever a "small" country implements a tariff, national welfare falls.

2) the higher the tariff is set, the larger will be the loss in national welfare.

3) the tariff causes a redistribution of income. Producers and the recipients of government spending gain, while consumers lose.

4) because the country is assumed "small," the tariff has no effect upon the price in the rest of the world, therefore there are no welfare changes for producers or consumers there. Even though imports are reduced, the related reduction in exports by the rest of the world is assumed to be too small to have a noticeable impact.

International Trade Theory and Policy - Chapter 90-11: Last Updated on 10/11/00