International trade exists for reasons – and for one, amongst others, is the fact that at a given amount of resources and level of technology , it is unlikely for a country to produce all types of goods and services at once; and at the volume and quantities demanded in its domestic market. This is especially so for a small nation with scarce resources, where a domestic economy thrives on the domestic consumption and expenditure and international trade allows maximization of economic welfare of the nation.
The newsletter seeks to offer explanations on how import tariff works and its effect on the domestic market of a small nation by analysing the aggregate supply & demand curves and diagrams.
Import tariff is a policy tool which takes the form of taxes or excise duties levied on foreign imports into the importing country. It is used by local government to change the consumption behaviour of domestic consumer market and offer protection to the domestic producers in certain industries. It also adds to the revenue stream of the importing country.
Two key points to note – Pt#1: Tariffs levied on the imported goods are not collected from the foreign producers nor are they collected from the exporting country. Pt#2: The amounts of import tariff levied on imported products are essentially passed to or borne by local consumers through their consumptions of these goods at higher purchase price.
It is through international free trade that makes it possible for the domestic market disequilibrium of aggregate demand and supply curves to be filled by quantity imports from foreign producers and at the prevailing international price.
Exhibit A: Assuming in this small nation, the domestic market only imports one type of goods from another country (Country Z) - total quantity consumed by the domestic market (at Q2) is met by quantity produced by domestic producer at Q1, with shortage in the local supplies met by the imports from foreign producers. It is assumed that the small nation has a perfect competition market in that some of the local producers in the small nation are able to compete against the foreign producers and sell the products at the prevailing international price level which is lower than the domestic price had all the goods been supplied domestically solely.
It is also assumed that those domestic producers who are not cost efficient in their production are phased out of the domestic market.
(Exhibit A)
Exhibit A1: At this point, the consumers enjoy maximum utility welfare brought by the imported goods at the prevailing international price offered by the foreign producers. Consumers’ satisfaction or consumer surplus is derived, being the differential amount between price the consumers are willing to pay and price that are actually paid, which is represented in GREEN-shaded area. On the other hand, Producer Surplus (measured by the differential amount between expected price at which the local producers are willing to sell their goods and the actual price of goods being sold) is area shaded in BLUE.
(Exhibit A1)
Exhibit B: For some reasons, if the local government has decided on imposing 10% tariff on all imported goods from Country Z into the domestic market., this will result in a rise in price level of imported goods to be purchased by local consumers. On the other hand, the increased price level entices local producers to produce more of the goods knowing that the goods will be sold at a higher price (capped at Price-International plus 10% tariff) and profit margin will improve.
(Exhibit B)
Exhibit C: Resulting from price increase by the portion of tariff, the local producers are willing to produce more of these goods regardless of inefficiency in their production process – this leads to quantity produced by domestic producers to expand from Q1 to Q3. At the same time, due to budget constraints, consumers will have to either tighten their purse string or look for other alternative products, which will cause the consumption of the goods to shrink from Q2 to Q4. At this point, the domestic consumers who are unsatisfied due to lower consumption accompanied by higher price level , continue to seek to purchase less desired products, leading to the decline in consumer surplus which affects the economic wellbeing of the nation.
(Exhibit C)
Exhibit D: Through marginal utility theory and welfare effect analysis, the implication of import tariff on a small nation can therefore be explained as follows:
(1) Re-distribution effect – efficient domestic producers benefit from import tariff as they are now able to sell more quantity of goods at a higher price (capped at international price + tariff), which is borne by the domestic consumers.
(2) Protective effect – Profit margin of inefficient domestic producers are protected and inefficient producers continue to devote more resources to producing goods in an inefficient manner, causing more resource wastage to the society.
(3) Revenue effect – Import tariff on goods passed on to the domestic consumers at higher purchase price, provides new revenue stream to the government.
(4) Consumption effect – loss of welfare to the nation whereby consumers are to purchase either the same goods at higher price or less desired alternatives; and those with tight budget are precluded from consuming the goods.
(Exhibit D)
Note that the combined protective and consumption effects are the real loss to the small nation, resulting from import tariff - While tariff induces higher domestic productions, increases producer surplus and government’s revenue; these are achieved at the expense of the welfare of domestic consumers, marked by the reduced consumer surplus (from originally a larger area per Exhibit A1 , to area less out the 4 welfare-effects in Exhibit D). Premised on this, the welfare of that nation as a whole will be adversely affected due to the imposition of import tariff, all things being equal. One may wonder the severity of import tariff has on the foreign producers. This would depend on whether the foreign producer is flexible to make adjustments on its operating cost structure in order to stay cost effective and price competitive. Even so, and in reality, there is no shortage of trade opportunities elsewhere for foreign producers to look out for in filling the gap caused by the reduced quantity imports by a small nation.
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