Thursday, December 29, 2016

The economic effects of introducing tariffs on a national economy

Donald Trump has talked a lot about tariffs on China and Mexico. He has trash talked the TPP and NAFTA - which is what we use to trade with Japan and Canada. These four nations are our biggest trading partners and together with our financial partners in the UK and Europe - form the basis of the current global economic miracle.

I ran into this presentation on the effects of tariffs on a country [1]. It is pretty tersely written but slide 12-26 get into a macroeconomic description of the effects of tariffs on an economy as a whole. I am going to try and put this into words and fill out the missing parts of the presentation. I think this is a pretty decent discussion on econophysics.

For references keep this link to the wiki entry on supply-demand curves handy [2]

In any supply-demand curve there is a point at which the curves intersect. This point defines the price of a good/service in the market defined by that demand curve and the producers defined by the supply curve.

The area above the price point and below the demand curve is the benefit to the customer. If the price point is lower - the customer benefits more.

The area above the supplier curve and the price point is the benefit to the producer. If the price is higher the producer benefits more.

If you introduce tariffs - you increase the price of the good/service. This is basically the same thing as moving the supply demand curves relative to each other.

The result is a change in the areas corresponding to the customer benefits and the producer benefits.

When you have no tariffs the price is very low and there is a massive benefit to the customer. There is very little benefit to the producer.

Once you add tariffs to this situation, you move the price up and that decreases the consumer benefit but increases the producer benefits.

Now the part that is hard to understand is that the increase in producer benefit from tariffs does not have to equal or exceed the decrease in consumer benefit. 

Everyone who supports adding tariffs assumes this is a zero sum game - what you lose by way of increased prices is made back as salary people who produce the same good/service domestically. This is incorrect.

The supply demand curves do not have trivial shapes - the areas do not add up to the same amount. When you shut down free trade, you end up creating dead weight losses which are not picked up either by the producers or by the consumers. This is lost benefit that is never recovered.

Unless the amount of money earned in revenue to the government is somehow sufficient to overcome the dead weight losses - the act of introducing tariffs leads to a net loss of benefits to the nation.

This is not something that can be easily explained to people who want to use "common sense" instead of economics - but here is my attempt at translating this.

Currently you pay $100 for a Chinese smart phone. The US buys some 40 million of those a year. You might be willing to pay $200 per  smart phone so 40 M * (200-100) = $4B is you current consumer benefit. US manufacturers do not make any smart phone so there is no producer benefit.

Now tomorrow President Donald Trump introduces a 45% tariff on Chinese made smart phones. You have to pay $145 instead of $100. The high prices causes demand to drop by 25%. So now the customer benefits are 30M*($200-$145) = $1.95B. This is a net loss of customer benefit of $2.05B.

Now if it costs  $125 to make the smart phone in the US then by selling the same smart phone as the price of the import - US manufacturers could reap a benefit of $20*10 M =  $0.2 B. The US government would stand to get $45*30 M = $1.35B in taxes. A total producer benefit + tax gain would be $1.55B.

This would not be enough to offset the loss in consumer benefits. We would still be short by $.45B.

You can do this kind of calculation for every sector that we currently enjoy a consumer benefit in and the result is pretty much similar.

Applied across the hundreds of thousands of products we currently get from China alone - I think we would likely see a net consumer benefit loss of several trillion dollars.

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