by Steven M. Suranovic

# The Price Effects of a Tariff: A Simple Dynamic Story

Suppose the US and Mexico are initially in a free trade equilibrium. Mexico imports wheat at the free trade price of \$10 per bushel. Imagine that the market for unprocessed wheat in both the US and Mexico is located in a warehouse in each country. Each morning wheat arrives from the suppliers and is placed in the warehouse for sale. During the day consumers of unprocessed wheat arrive to buy the supply. For simplicity assume there is no service charge collected by the intermediary that runs the warehouses. Thus, for each bushel sold, \$10 passes from the consumer directly to the producer.

Each day the wheat market clears in the US and Mexico at the price of \$10. This means that the quantity of wheat supplied at the beginning of the day is equal to the quantity purchased by consumers during the day. Supply equals demand in each market at the free trade price of \$10.

Now suppose that Mexico places a \$2 specific tariff on imports of wheat. Let's assume that the agents in the model react slowly and rather naively to the change. Let's also suppose that the \$2 tariff is a complete surprise.

Each day, before the tariff, trucks carrying US wheat would cross the Mexican border in the wee hours, unencumbered, en route to the Mexican wheat market. On the day the tariff is imposed the trucks are stopped and inspected. The drivers are informed that they must pay \$2 for each bushel that crosses into Mexico.

Suppose the US exporters of wheat naively pay the tax and ship the same number of bushels to the Mexican market that day. However, to recoup their losses they raise the price by the full \$2. The wheat for sale in Mexico now is separated into two groups. The imported US wheat now has a price tag of \$12 while the Mexican supplied wheat retains the \$10 price. Mexican consumers now face a choice. However since Mexican and US wheat is homogeneous the choice is simple. Every Mexican consumer will want to purchase the Mexican wheat at \$10. No one will want the US wheat. This means that there will be an excess demand for Mexican wheat and an excess supply of US wheat in the Mexican market.

Mexican producers of wheat will quickly realize that they can supply more to the market and raise their price. A higher price is possible because the competition is now charging \$12. The higher supply and higher price will raise the profitability of the domestic wheat producers. [Note: supply of wheat may not rise quickly since it is grown over an annual cycle. However, the supply of a different good could be raised rapidly. The length of this adjustment will depend on the nature of the product.] US exporters will quickly realize that no one wants to buy their wheat at a price of \$12. Their response will be to reduce export supply and lower their price in the Mexican market.

As time passes, in the Mexican market, the price of Mexican supplied wheat will rise from \$10, the price of US supplied wheat will fall from \$12, until, the two prices are equalized. The homogeneity of the goods requires that if both goods are to be sold in the Mexican market then they must sell at the same price in equilibrium.

As these changes take place in the Mexican market, other changes occur in the US market.

When US exporters of wheat begin to sell less in Mexico, that excess supply is shifted back to the US market. The warehouse in the US begins to fill up with more wheat than US consumers are willing to buy at the initial price of \$10. Thus at the end of each day, wheat supplies remain unsold. An inventory begins to pile up. Producers realize that the only way to unload the excess wheat is to cut the price. Thus the price falls in the US market. At lower prices though, US producers are willing to supply less, thus production is cut back as well.

In the end, the US price falls and the Mexican price rises until the two prices differ by \$2, the amount of the tariff. A Mexican price of \$11.50, a US price of \$9.50 is one possibility. A Mexican price of \$11, a US price of \$9 is another. US producers now receive the same lower price for wheat whether they sell in the US or Mexico. The exported wheat is sold at the higher Mexican price, but, \$2 per bushel is paid to the Mexican government as tariff revenue. Thus US exporters receive the US price for the wheat sold in Mexico.

The higher price in Mexico raises domestic supply and reduces domestic demand, thus reducing their demand for imports. The lower price in the US reduces US supply, raises US demand and thus lowers US export supply to Mexico. In a two country world, the \$2 price differential that arises must be such that the export supply by the US equals import demand by Mexico.

International Trade Theory and Policy - Chapter 90-7A: Last Updated on 2/25/97