What is a trade war? - FreeEconHelp.com, Learning Economics... Solved!


What is a trade war?

This post is going to go over what a trade war is and what may cause them. It will also briefly discuss why they are not a good idea in general. While most economists tend agree that free trade is good for total economic surplus (meaning on the whole, or considering everyone), there are always going to individuals that lose some surplus from trade. This post goes through an example of why domestic firms producing shirts are angry with the fact that they must compete with foreign firms, so they ask for the government to impose tariffs.

The graph below shows the market for t-shirts within that country:

From this graph we can equilibrium occurs at P* and Q* 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 imports from another country, add a new supply curve at the world price or Pw. This new supply curve summarizes all of the foreign producers and consumers of shirts until we are left with a global shirt price. Countries have the option to buy or sell at this price if they decide to operate in the global economy

The domestic firms are now unhappy because with the lower world prices they sell less shirts (we can see that their quantity sold moved from Q* to Qd) and they also receive a lower price for the shirts that they do sell (lowered from P* to Pw).  We can see that the market is still in equilibrium, because the total quantity supplied (domestic supply of Qd, and foreign supply of Qw-Qd) is enough to satisfy the quantity demanded of Qw. 

Generally firms do not like having to compete with foreign companies.  This means that they produce less AND they have to sell their product for less. This is a lose lose scenario for domestics producers. This means that firms will try to get their government to impose tariffs as a way to raise the prices of foreign imports to make their own products relatively cheaper to the domestic market. We will explore this graphically below.

A tariff is like a tax only charged on goods that are imported into the country.  This will raise the price of the goods being imported into the country.  If we apply a tariff to shirts, we will see the World Price for shirts rise by the amount of the tariff.  

The graph shows that a tariff 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 to sell them at a higher price. However, the introduction of tariffs lowers total surplus (consumer plus producer surplus) for the entire economy, which is why most economists oppose tariffs and promote free trade. 

However, tariffs generally do not occur in a vacuum. If one country introduces a tariff then the recipient country is likely to impose their own retaliatory tariff. This sets off a chain reaction of tariffs that can very quickly erode free trade. With the addition of each new tariff, total global surplus is reduced as less trade occurs. This is generally good for domestic producers (eg. firms and companies) but bad for consumers who have to pay higher prices for everything.

To summarize, trade wars are bad because they result in tariffs that reduce economic efficiency and lower global trade. This tends to hurt consumers the most because they have to pay higher prices for everything. However, domestic firms that serve domestic customers will win because they get to sell more of their product at a higher price.