First let’s consider a domestic firm that produces t-shirts.The graph below shows the market for t-shirts within that country:
From this graph we can easily see where equilibrium price and quantity are (where supply and demand intersects). This is good for the domestic firm because they are selling an amount they are happy with for a reasonable price. Now if we allow cheaper products to be imported from another country, it will change this graph up a bit, and change around our equilibrium price and quantity. The domestic firms are unhappy with the lower world prices because they now sell less t-shirts (from Q* to Qd) and receive a lower price for the t-shirts they do sell (from P* to Pw). Notice that the market is still in equilibrium, because the quantity supplied (domestic supply equals Qd, foreign supply equals Qw-Qd) is still equal to quantity demanded of Qw.
The reason we see a lower world price is because of another supply and demand graph happening for the entire world. In this market a new equilibrium price is reached at a lower price, which then translates into the “world price” line we see for our domestic market of t-shirts.
Now firms do not like having business taken away by foreign competitors. This means less production going on in the home country, and a lower price received for the goods that they do manage to sell. What firms can try to do is get regulation or laws passed that potentially limit the amount of goods that can be imported. We will consider the impacts of tariffs on the previously described market.
The first we will look at is tariffs, a tariff is like a tax only charged on goods that are imported into the country. What this does is raise the price of the goods being imported into the country. If we apply a tariff to our market for t-shirts, we will see the World Price for t-shirts rise by the amount of the tariff. An example of this is shown below:
You can see from the graph that a tariff will increase the domestic price for t-shirts above the world price, and it will increase the quantity of t-shirts that are supplied domestically. This is good news for domestic firms because they get to produce more shirts, and get a higher price. If the domestic firms also don’t have to pay any lobbying fees, they will really like these tariffs. However, the introduction of tariffs produces a deadweight loss on the economy, which is why most economists oppose tariffs and promote free trade.
This deadweight loss occurs because the marginal benefits and the marginal costs are no longer equal to each other in the market. Before, when foreign firms supplied goods at the world price, the domestic firms competed by selling a lower quantity at a lower price. They still chose to sell at this price, but would prefer to get a higher price. Now with the tariff in place less t-shirts are demanded as a whole so consumer surplus goes down, even though producer surplus goes up. The net surplus of the domestic economy falls because of the introduction of tariffs. Check out the graph and equations below:
Consumer Surplus before tariff = a+b+c+d+e+f+g+h+i
Producer Surplus before tariff= j
Total Surplus before tariff = a+b+c+d+e+f+g+h+i+j
Consumer Surplus after tariff = a+b+c+d
Producer Surplus after tariff = j+e
Government revenue after tariff = g+h
Deadweight loss after tariff = f+i
So after the imposition of the tariff, the over surplus of the economy goes down by the amount of f+i. You can see this in the graph because it used to be part of the consumer surplus, and now it is neither in producer surplus or government revenue.
This post has gone over one of the dark sides of free trade by looking at its impact on firms and how firms can fight back by supporting tariffs. Even though tariffs make the economy as a whole worse off, they do make individual firms better off so we are likely to see their introduction and pressure for them into the future.