A tariff and what it does to an importing country

What a tariff is. A tariff is a tax on goods brought into a country from abroad, a form of trade restriction. Governments use it mainly to protect domestic firms and their workers from cheaper imports that might otherwise take their sales and jobs. It matters only for a good the country imports; for a good it exports, a tax on imports has no bite. Our example: suppose India puts a duty on imported solar panels to help Indian panel makers.

Effects on quantities. Under free trade the domestic price equals the world price. The tariff lifts the domestic price above the world price by the amount of the tax. At this higher price:

• imports shrink, since they only fill the gap between what the country buys and what it makes, and that gap narrows from both ends;
• domestic output expands, because home producers can now sell at the world price plus the tariff and compete with foreign suppliers;
• domestic purchases fall, because buyers want less at the higher price.

Who gains and who loses. The effects are judged by the change in consumer surplus, producer surplus and government revenue:

• the government collects revenue equal to the tariff per unit times the quantity still imported;
• domestic producers gain, as producer surplus rises with the higher price and larger sales;
• domestic buyers lose, as consumer surplus falls because they pay more and buy less.

The net loss to the country. The buyers' loss is larger than the producers' gain and the revenue added together, so total surplus falls; this fall is the tariff's deadweight loss. Like other taxes, a tariff distorts incentives. One part of the loss comes from extra home production at a cost above the world price, the other from purchases that buyers give up because of the higher price.

Conclusion. A tariff raises the domestic price of an imported good, expands home production and cuts purchases and imports. Producers and the government gain, but buyers lose more than the two gain together, so the country as a whole bears a deadweight loss.