What a tariff is and what it does to an importing country

Meaning of a tariff. A tariff is a tax levied on goods brought in from abroad, a restriction on trade that works through price. It is relevant only when the country imports the good; if the country exports the good, a tax on its imports has no effect. Governments use tariffs, along with quotas and voluntary export restraints, mainly to shield domestic firms and their workers from foreign goods that are cheaper than home-made ones and that may cost domestic jobs.

Effects on price, production, consumption and imports. Under free trade, the domestic price of an imported good equals the world price. A tariff raises the domestic price above the world price by the amount of the tariff. At the higher price:

• domestic production rises, since home producers can now sell at the world price plus the tariff and compete with imports;
• domestic consumption falls, since buyers buy less at the higher price;
• imports fall, because imports fill the gap between domestic consumption and domestic production, and that gap narrows from both sides.

Effects on welfare. The gains and losses are measured by consumer surplus, producer surplus and government revenue:

• Consumers lose. They pay more and buy less, so consumer surplus falls.
• Domestic producers gain. They sell more at a higher price, so producer surplus rises.
• The government gains tariff revenue equal to the tariff per unit times the quantity still imported.
• The country as a whole loses. The fall in consumer surplus is larger than the rise in producer surplus and the revenue taken together, so total surplus falls.

Deadweight loss. The fall in total surplus is the tariff's deadweight loss. Like any tax, a tariff distorts incentives and moves the market away from the efficient outcome. It has two parts:

1. Over-production: the higher domestic price leads home producers to expand output, including units that cost more to make at home than the world price at which they could have been imported.
2. Under-consumption: the higher price leads buyers to give up units they valued above the world price but below the tariff-inclusive price. So the tariff's losses are larger than its gains.

A worked illustration (our own figures). Suppose India's domestic demand for an imported good, say edible oil, is Qd = 100 − P and domestic supply is Qs = P − 10 (P in Rs per litre, Q in lakh litres). Without trade the domestic price would be Rs 55, where 100 − P = P − 10; the world price is Rs 30, so India imports the good. The government then imposes a tariff of Rs 10 a litre.

• Consumer surplus falls by 10 × (70 + 60) ÷ 2 = 650 (Rs lakh).
• Producer surplus rises by 10 × (20 + 30) ÷ 2 = 250.
• Tariff revenue is 10 × 30 = 300.
• Deadweight loss = 650 − 250 − 300 = 100, made up of over-production ½ × 10 × (30 − 20) = 50 and under-consumption ½ × 10 × (70 − 60) = 50.

Conclusion. A tariff is a tax on imports. It raises the domestic price above the world price, so home production rises while consumption and imports fall. Producers and the government gain, but consumers lose more than the two gain together, and the difference is a deadweight loss from over-production and under-consumption. A tariff therefore protects the domestic industry at a net cost to the country.