Tariffs 101: What are they and how do they work?

1. Intro Tariffs: Welcome to our course on the economics of tariffs, micro and macro perspectives. In this course, we'll dive into one of the most debated tools in economic policy that is quite in vogue these days. They import tariffs. Are they a smart way to protect local jobs and industries or they do more harm than good? We'll explore this question from two angles, the microeconomic level, where we're going to analyze how tariffs impact consumers, producers, prices, and general welfare and from the macroeconomic perspective, where we are going to study broader effects on GDP, employment, inflation, and international trade dynamics. 2. Micro Tariffs: Hello and welcome. In this short course, we are going to cover the effects of the US import tariff hikes from a microeconomic perspective. So when the US raises import tariffs against the rest of the world, it will change the economic outcomes at both microeconomics and macroeconomics level. So this short course is about the microeconomics. Impact, later on, we will have another course about the macroeconomics aspects. So tariffs, which are basically taxes on imports, drive edge between world prices and domestic prices. They do protect some domestic industries, but they do raise costs for customers and downstream producers. First instance, we will examine the persim equilibrium. That means the macroeconomic view of how tariff on specific goods will affect customers, producers, government revenue, and the overall overall welfare in that particular market. Next, we will analyze the macroeconomic repercussions. This is the impacts on aggregate output, the GBT, inflation, employment, trade balances, exchange rates, and the international response. So as we can see, there is a lot at stake. Let's analyze the tariff effect. So there is a lot of real world evidence that goes 2018-2020 about the US China trade war, and there are a lot of official analysis from the WTO, IMF, World Bank, et cetera, to illustrate the concepts that we are going to talk about. So by late 2019, the US had imposed tariffs on about 350 million worth of Chinese imports. So that's a lot. Average US tariffs on Chinese goods rose from 3.1% in 2017 to 21% in 2020. So this isn't something as recent as SMs. At the time, there was retaliation from China. So China responded with tariffs on about 100 billion of US dollars. Of the US exports. Also, the average Chinese tariffs on US goods increased from 8% to 21% over the same period. There was some impact on the US labour market, so there was a decline on job posting. So this trade war led to an estimated loss of 175,000 job posting in 2018, and this represented a 0.6 decrease in total US job posting. Approximately two thirds of this decline were due to the tariffs, and lower skilled job postings were more adversely affected than higher skilled ones. Then we have to recognize the pattern. So US imports from China decreased while imports from other countries increased. So this would be expected. So if we are not importing from China, we have to import it from somewhere else. However, these alternative suppliers often sourced inputs from China. So this suggests that although we were not directly getting products from China, there was some indirect resilience on Chinese goods that persisted. Then we have to consider the economic costs and welfare losses from the consumer prices and welfare. There were studies that found that US importers bore nearly the full cost of tariffs, and this led to higher prices for consumers. So the trade war resulted in a significant welfare loss for the US economy with estimates of annual losses ranging from 7.8 billion to 62 billion. Let's start digging in the partial equilibrium effects of a tariff. First, we have the price effect. If we are in a single product market model, a tariff raises the domestic price of the important good above the world price. This creates winners and losers in the domestic economy and typically causes a causes an efficiency loss. The price of the output in the market rises from the free trade world price that we are going to denote as PW to tariff inclusive price, PT. This higher price is borne by domestic buyers, so the consumers or firms that use the good as an input. Another important thing to consider is the impact on consumption and production. There is the price increase, so tariffs will rise domestic prices above world prices. Then we have reduced consumption. The quantity demanded falls as customers move up along the demand curve. Increase domestic production. Domestic suppliers will increase their output due to the higher prices, so there will be a benefit to produce more and of course, fewer imports. The import volume will decline as the domestic production replaces imports. What happens is that we are going to have a consumer surplus loss. This means higher prices, meaning that consumers will pay more for each unit purchased. Reduced purchases. Some customers exit the market due to the price hikes. There will be a significant welfare loss, so the consumer surplus loss typically exceeds the gains elsewhere. On the other end, there will be producer surplus gain. This means increased sales volume because the domestic producers can sell more units as they replace some of the imports. There will be higher selling prices. Producers receive terracific inclusive prices, PT instead of the world price, PW. That's a big incentive for domestic production. There will be expanded producer surplus, Soria between the simply curve and price increases, transferring welfare from consumers to producers. There will be potential employment growth. So as we move production indoors, there will be some protected industries that will see higher revenues and expanded employment. And from the governmental perspective, there will be revenue from tariffs. The tariff will create revenue for the government on each imported unit. So everything that is coming for the country will generate revenue for the government. So if imports after the tariff equal k imports, which is basically the gap between domestic demand and supply is PT, then the government revenue is Q imports, X tariff per unit. This revenue comes out of what's the consumers pay. Every time a domestic consumer buys something external, there will be more revenue for the government. It is effectively a transfer from consumers or foreign exporters in some cases to the importing country. Then we will consider the deadweight loss. We have the lost trades, so beneficial exchanges between foreign producers and domestic consumers no longer occur under consumption. There will be customers who value goods above world cost, but below the tariff price, and they will exit the market. We will also have net welfare loss, pure efficiency losses to society. Areas B plus D in the diagram that we are just about to see in the diagram and overproduction. Domestic producers will make additional units at higher resource costs than world price. So this diagram basically illustrates the supply and demand and initial equilibrium at world price PW with domestic consumption, C one and domestic production one, so imports equal to C one minus one, as we can see here on the graph. Then we have the tariff implementation. A tariff rises the domestic price to PT equal to PW plus the tariff. Prices increase. It is expected to happen a market adjustment, the quantity demanded reduces to C two and domestic output increases to key two. Imports will shrink from C two to K two. Regarding the welfare analysis of tariff effects, areas A plus B, C, plus D, due to wire prices and lower consumption will determine consumer loss. Area A where there is more selling at a higher price means that there is a gain for production and Area C represents government revenue. It's the tariff revenue on each imported unit. Areas B plus D represents deadweight loss. The value that is lost to the economy. So in a nutshell regarding netw effects, we can consider that import competing products will benefit. The government will benefit because there will be more revenue. Consumers will have a significant loss. So prices will increase, and you won't be able to assess that many products as you used to do, and the ones that you find will be more expensive. And for the overall economy, there will be a generalized net welfare loss. So under these microeconomic lens, tariffs will benefit imports competing producers and generate the government more income, but they will hurt badly the customers far more than the producers, and that will lead for a net welfare loss. Seems to be some consensus about tariffs. Classic economic theory tells us that costs to consumers will exceed the gains to domestic firms and tariff revenues. Then there will be society wide effect. Society as all, it will be yours, except in rare cases like optimal tariffs for a large country. So economists overwhelmingly agree that the US steel and aluminum tariffs that happened in 2018 would improve welfare for a few producers at the expense of many, many others. So they did reduce overall the economic welfare. From distributional point of view, there are several effects of tariffs. First one that we are going to talk about is the consumer impact. So consumers, businesses or households. So basically, people that buy inputs will pay higher prices. Also, there will be a subset of workers and firm in the protected industries that might see higher income and jobs. So there will be essentially a concentrated subsidy paid by consumers. Regarding the taxpayer effect, the taxpayers will get some indirect benefits if government uses the tariff revenue productively. However, the efficiency loss means the economy's total surplus will shrink. So until now, we've seen the microeconomic effects of tariffs from a general point of view, and the general point of view includes small countries. In this case that we are debating here, we're talking about a large country like the US. So let's see the differences on the large country in terms of tariffs. So in the previous analysis, the importing country was assumed to be small in the world market. The world price PW was fixed. If the US was a large importer of good, in that case, a tariff can push down the world price of that good as foreign exporters reduce their prices to stay competitive. In theory, part of the tariff's burden then falls on foreign producers and the US might improve it in terms of trade. So let's jump to the practical implications. There are some theoretical benefits, this means that this could mitigate the US welfare loss or even create a net gain if foreign exporters absorb enough of the tariff. However, in practice and from the lessons learned from the US China tariff previous episodes, studies have found that foreign exporters did not significantly lower prices. Instead, US importers and consumers bore the tariff costs almost in full. So this means that the US behaved like a price taker from many goods, and the standard result of net welfare loss was applied. There is also a retaliation risk. Any potential term of trade gain is often eroded if other countries realiate. So retaliation and broader market impacts will be discussed on the next class. We have to mention the market power. When we have a large country imposing a tariff, it has market power. Is import demand is large enough to influence the world price. The big difference is there because small countries couldn't do that. Like a small country whose demand shifts don't affect the global supply conditions, large countries reduce import demand due to the tariff that we are analyzing here can drive down the world price of the good. This leads to the following effect. So at your left side, you can see the partial equilibrium diagram of an import market with the tariff, but this time of a large country. So from the domestic price increase point of view, as it happened before, domestic consumers face a higher price. So PT will be equal to PW plus T after the tariff. The world price would fall. So the world price, in our case, PW might decline due to PWs reduced demand from the large country. From the perspective of terms of trade gain, if the drop in PW is significant, part of the tariff burden is borne by foreign exporters. So, this means that in this case, the importing countries terms of trade will actually improve. Regarding the welfare effects. So the net welfare effect, it will be potentially positive in terms of trade gain exceeds loss from the trade distortion. From the government revenue perspective, it will increase due to the tariff collection. Regarding the producer surplus, it will rise as domestic producers benefit from higher prices. So if there is higher prices, there will be a benefit for local producers to produce. And the consumer surplus with no surprise would fall as consumers pay higher prices, so there is less incentive for consuming. The terms of trade gain offsets part of the deadweight loss. However, some empirical studies show that foreign suppliers did not reduce prices significantly in the US China trade war. This, there is a potential gain was largely unrealized in practical terms. Going back to our diagram, from a supply and demand point of view, our diagram will show market equilibrium shifts. From a price effect point of view, it will illustrate domestic and world price changes. You can see here on the on the vertical, on the price side that the price is climbing. Regarding the welfare impact, it will demonstrate the welfare redistribution. The way that welfare is going to be distributed will change dramatically. Still on our diagram, we can see that PW is the original world price. Then there is a new world price. PW is the new and in this case, lower price after the tariff is imposed. Regarding the domestic price, PT is the domestic price including the tariff, PT is going to be the second PW plus T. And regarding the initial trade, we will have DO, so demand at moment O, minus supply at moment O. So the initial demand and supply under the free trade. So the count we have to do is import imports will be the first demand situation minus the initial supply situation. Regarding the effects, there are trade volume changes. So when you do D one minus S one, there is a new domestic demand and supply at the IRPTimports will fall. Regarding the government revenue, the area between the NU PW and PT over quantity imported. So that will be the amount that the government is going to have in terms of tariff. Regarding the terms of trade, there will be again in the area representing the shift in PW due to the reduced world demand. The net effect, it will be smaller than in small countries case due to offsetting and the terms of trade gain. Finish our video today. I'm showing you the academic references that we use to support this model. We have Mr. Krugbn, Fenstra and Taylor, De Vause, MIT. These are where the academic references for the model that we use here as an explanation. I hope you enjoyed the class. Soon, we will have another short course covering the macroeconomic aspects of tariffs. See you soon. 3. Macro Tariffs: Hello and welcome. In this video, we are going to address the macroeconomic perspective. That is the aggregate effect of tariffs. So beyond individual markets, broad tariff increases can be a huge influence for the aggregate economic variables. Here, we are talking about GDP growth, employment, inflation, the trade balance, among others. Tariffs on many products can cumulate into economy wide demand and supply shifts. So we use the aggregate demand supply, ADAS framework to organize these effects. One of the effects of tariffs is that they directly reduce imports, which can improve net exports. Net exports are the difference between exports and imports in the national income identity. All else equal a decline in imports means domestic output might replace some foreign goods, potentially increasing the GDP. We are not buying from abroad, you are buying from the own country. This is a demand side stimulus to domestic production. However, on the other side of the coin, tariffs also tend to reduce exports through foreign retaliation and the stronger domestic currency as explained next. This works in the opposite direction. Ribs can dappen consumer demand if higher prices erode solds real income. Thus, the net effect on the aggregate demand is ambiguous. In a scenario with no retaliation at all, aggregate demand may shift right. That means higher net demand for domestic goods. But if there is retaliation or negative income effects are significant, the aggregate demand could shift left. From the aggregate supply perspective, it's important to note that tariffs often act like negative supply shocks in the economy. So there are higher import costs, especially on raw materials, parts, and capital equipment, and this means raise production on the costs for domestic firms. This can shift the short run aggregate supply curve left and upward because firms supply less output at any given price level because their costs are higher. So there is no incentive for production. In the long term, severe protectionism might also reduce productivity. For example, by disrupting supply chains or slowing down innovation. This will affect the long run aggregate supply. In the short to medium run, the US tariffs of, for instance, 2018, 2019, they did raise costs for manufacturers that relied on important inputs like steel, aluminum, and electronic components, and this led to higher output prices and some lost output. It's also important to note the relation between GDP and output effects. The interplay of AD NAS will determine the overall output. And there is plenty empirical analysis that suggests that broad US tariff increases will have a net negative effect on real GDP. For instance, the US Congressional Budget Office estimated that the tariffs enacted 2018-2019 would reduce the level of US really GDP about 0.5% in 2020, relative or in comparison to a non tariff baseline. The mechanism is that any demand side gains from import substitution were more than offset by losses from or production costs, reduced investment due to the uncertainty and the higher prices for capital of goods. And there was also foreign retaliatory hits to the export sectors. So all in all, there was no, there was a lot of uncertainty, and this meant that the production costs were higher and there was less investment. The 2019 Federal Reserve study found that industries that faced retaliation like agriculture and those using tariffed inputs saw declines, and overall, the trade war acted as a drag on growth. In fact, despite the tariffs aimed at reducing imports, the US trade deficit widened initially. I grew by 119 billion 2017-2019, and it reached 621 billion dis since 2008. This outcome underscores that macro factors like fiscal stimulus and strong domestic demand in the period of 2019, 2019, outweighted the tariff effects in the short run and that imports from non tariff countries filled in some gaps. It wasn't until the pandemic and later that the trade deficit narrowed. Under a scenario like this, one of the things that comes to mind almost immediately is what happens to employment. Tariffs relocate jobs between sectors, but have had a slight net negative impact on the US employment in recent history. Protected industries like steel, may add jobs due to the import protection, but industry that use those outputs like auto manufacturing might lose jobs due to higher costs. Exporters hit by foreign tariffs, like farmers losing sales to China will also cut jobs. There was a study by Oxford Economics and the US China Business Council that found that the Trump era tariffs, the first one, resulted in 245,000 fewer American jobs than would otherwise have been the case. This means job losses in downstream manufacturing and export agriculture outweighted job gains in the protected sectors. All in all, there was a loss on the employment market. Another analysis found that US counties more exposed to latory tariffs, so significant employment dropped compared to less exposed countries. Over time, as companies adjust supply chains, some lost jobs may not return. It's worth noting there are adjustment assistance programs, and for farmers, there was direct a payments of 28 billion in the period of 2018, 2019 to cash and the blow. But these are band aids on a broader trend and not really solving the problem at its root. Another big concern in a situation like this is about inflation and of course, consumer prices. Tariffs put upward pressure on inflation as important goods and goods that we use to import outputs become more expensive. In the US, the 2018, 2019 tariffs noticeably raise prices for certain consumer products. For instance, washing machines saw a sharp price increase after a tariff was imposed. So there was a study that noted a 20% jump in laundry appliance prices as the tariff cost was passed to consumers. Overall, US consumers price inflation was modestly higher due to the tariffs. CBO estimated a 0.5 percentage point increase in the price level in 2020 from the new tariffs. What this means is that American households paid more. CiBO calculated that the average real household income would be $277 lower in 2020 due to the cumulative tariffs, effectively dN tax of that amount. Businesses faced higher input costs as well. So firms absorb part of the cost, meaning that they reduced the profit margin while others raised prices to the consumers. In macroeconomic terms, the short run aggregate supply shift left from tariffs led to a sclnary tendency, higher prices and lower real outputs than otherwise. Indeed, multiple empirical studies have concluded that US import prices rose nearly one for one with the tariffs, indicating US importers and consumers but 100% of the tariff incidents in most cases. There was indeed little evidence of foreign exporters cutting prices sufficiently to offset tariffs. Another important economic factor to analyze is what happens to exchange rates. Currency movements can partially offset or amplify tariff effects. In a freely floating regime, reduced US imports mean reduced demand for foreign currency, which can put upward pressure on the US dollar. Stronger dollar makes imports cheaper and US exports more expensive, counteracting the tariff's intent. During the trade war, the Chinese Yen noticely depreciated against the dollar. It fell roughly 8-12% in 2018, 2019, reaching levels above seven yen per dollar. This depreciation made Chinese goods cheaper in dollar terms, offsetting a chunk of the US tariff. For example, a 10% drop in the one, value could absorb ten percentage points of the tariff. Chinese authorities were accused of allowing this depreciation to blunt the impacts of the tariffs and the US erasury even labeled China a currency manipulator in 2019. Overall, the US dollar straggened slightly during the episode, which diluded the trade balance improvement the tariff sought. Exchange range rate adjustments does distribute the tariff burden. Feign exporters get paid less in their own currency while the US consumers face a smaller price hike than they would have if the dollar were constant. That being said, the net effect still left the US import prices higher and the export competitiveness dented.