Price Effects of a Tariff: Large Country Case
Suppose Mexico, the importing country in free trade, imposes a specific
tariff on imports of wheat. As a tax on imports the tariff will inhibit
the flow of wheat across the border. It will now cost more to move the product
from the US into Mexico.
As a result the supply of wheat to the Mexican market will fall inducing an increase in the price of
wheat. Since wheat is homogeneous and the market is perfectly competitive the price of all wheat
sold in Mexico, both Mexican wheat and US imports will rise in price. The higher price will
reduce Mexico's import demand.
The reduced wheat supply to Mexico will shift back supply to the US market. Since Mexico is
assumed to be a "large" importer, the supply shifted back to the US market will be enough to
induce a reduction in the US price. The lower price will reduce US export supply.
For this reason, a country that is a large importer is said to have "monopsony" power in trade.
A monopsony arises whenever there is a single buyer of a product. A monopsonist can gain an
advantage for itself by reducing its demand for a product in order to induce a reduction in the
price. In a similar way, a country with monopsony power can reduce its demand for imports (by
setting a tariff) to lower the price its pays for the imported product.
Note that these price effects are identical in direction to the price effects of an import quota, a
voluntary export restraint and an export tax.
A new tariff-ridden equilibrium will be reached when the following two conditions are satisfied.
where T is the tariff, 
is the price in Mexico after the tariff, and
is the price in the US
after the tariff.
The first condition represents a price wedge between the final US price and the Mexican price,
equal to the amount of the tariff. The prices must differ by the tariff because US suppliers of
wheat must receive the same price for their product, regardless of whether the product is sold in
the US or Mexico and all wheat sold in Mexico must be sold at the same price. Since a tax is
collected at the border, the only way for these price equalities within countries to arise is if the
price differs across countries by the amount of the tax.
The second condition states that the amount the US wants to export at its new lower price must
be equal to the amount Mexico wants to import at its new higher price. This condition guarantees
that world supply of wheat equals world demand for wheat.
The tariff equilibrium is depicted graphically on
the adjoining graph. The Mexican price of
wheat rises from PFT to
which reduces its
import demand from QFT to QT. The US price of
wheat falls from PFT to
which reduces its
export supply, also from QFT to QT. The
difference in the prices between the two markets
is equal to the specific tariff rate T.
Notice that there is a unique set of prices which
satisfies the equilibrium conditions for every potential tariff that is set. If the tariff were set higher
than T, the price wedge would rise causing a further increase in the Mexican price, a further
decrease in the US price and a further reduction in the quantity traded.
At the extreme, if the tariff were set equal to the difference in autarky prices, (i.e.
) then the quantity traded would fall to zero. In other words the tariff
would prohibit trade. Indeed any tariff set greater than or equal to the difference in autarky prices
would eliminate trade and cause the countries to revert to autarky in that market. Thus we define
a prohibitive tariff as any tariff, Tpro, such that,
For an intuitive explanation about why these price changes would likely occur in the a real world setting, read the following.
The Price Effects of a Tariff: A Simple Dynamic Story
A summary of the noteworthy price effects of a tariff is provided at the link below.
Noteworthy Price Effects of a Tariff
International Trade Theory and Policy - Chapter 90-7: Last
Updated on 2/25/97
