Price Effects of a Tariff: Large Country Case
by Steven Suranovic ©1997-2004
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, andis 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.
A summary of the noteworthy price effects of a tariff is provided at the link below.
International Trade Theory and Policy Lecture Notes: ©1997-2004 Steven M. Suranovic