4
Trading equilibrium in the presence of a tariff
Global demand expands the small open economy’s export sector, but also changes the prevailing relative price of the import-competing good which induces contraction in that sector. No one likes seeing their workplace contract or even close, and employees are often better organized than consumers to lobby the government for protection from lower cost imports coming into the market from abroad. A tariff will definitely reintroduce jobs into the import-competing sector, but it’s easy to show that this familiar commercial policy helps some while hurting others.
While the desire to put a tariff into place is understandable to slow plant closures and unemployment, it is distortionary. The consumption benefits of the global market’s lower priced imports accrue to everyone across the economy, regardless of what sector they work in. Protection in the form of an import tariff pushes the price of that good up in the small open economy, whether it’s produced domestically or abroad. Consequently a tariff’s impact is larger than just the lost income earned from moving resources back out of producing exports. A tariff also means everyone experiencing higher prices for the imported good.
A tariff is sometimes justified as a way to punish foreign competitors, but for a small open economy the truth is, a tariff only distorts domestic prices. In other words, a tariff is always paid by domestic consumers. Using the standard indifference curve analysis, the tariff policy conveys consumer losses through two channels: the substitution effect arises directly from the import-competing good’s artificially higher relative price in the small open economy, while the income effect is due to a lower national income when the tariff shrinks the export sector. The result is lower gains from trade than the small open economy could achieve at world prices, given its comparative advantage.
