Noteworthy Price Effects of a Tariff

Two of the effects of a tariff are worthy of emphasis.

First, although a tariff represents a tax placed solely on imported goods, the domestic price of both imported and domestically produced goods will rise. In other words a tariff will cause local producers of the product to raise their prices. Why?

In the model it is assumed that domestic goods are perfectly substitutable for imported goods (i.e. the goods are homogeneous). When the price of imported goods rise due to the tariff, consumers will shift their demand from foreign to domestic suppliers. The extra demand will allow domestic producers an opportunity to raise output and prices to clear the market. In so doing they will also raise their profit. Thus as long as domestic goods are substitutable for imports and as long as the domestic firms are profit seekers, the price of the domestically produced goods will rise along with the import price.

The average consumer may not recognize this rather obvious point. For example suppose the US proposes to place a tariff on imported automobiles. Consumers of US-made autos may fail to realize that they are likely to be affected. After all, they might reason, the tax is placed only on imported autos. Surely this would raise the imports' prices and hurt consumers of foreign cars, but, why would that affect the price of US cars? The reason of course is that the import car market and the domestic car market are interconnected. Indeed, the only way US-made car prices would not be affected by the tariff is if consumers were completely unwilling to substitute US cars for imported cars, or if US automakers were unwilling to take advantage of a profit-raising possibility. These conditions are probably unlikely in most markets around the world.

The second interesting price effect arises when the importing country is "large". When a large importing country places a tariff on an imported product, it will cause the foreign price to fall.

The reason?

The tariff will reduce imports into the domestic country and since its imports represent a sizeable proportion of the world market, world demand for the product will fall. The reduction in demand will force profit-seeking firms in the rest of the world to lower output and price in order to clear the market.

The effect on the foreign price is sometimes called the terms of trade effect. The terms of trade is often defined as the price of a country's export goods divided by its import goods prices. Here since the importing country's import good will fall in price, the country's terms of trade will rise. Thus a tariff implemented by a large country will cause an improvement in the country's terms of trade.

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