Oct 04 2010

The high cost of tariffs

CBC News – Money – Shipping industry gets tariff break

A tariff is a tax on imported goods or services aimed at raising the price of foreign products to make domestically produced substitutes more attractive to consumers. A tariff is a form of protectionism, which we study in unit 4.1 of the IB Economics course.

Tariffs are appealing to policymakers as a tool for protecting domestic firms from foreign competition. Used wisely, a barrier to trade such as a tariff can promote the development of certain vital industries in the domestic economy that might otherwise not exist due to the existent of more efficient, lower cost foreign competition. Tariffs benefit domestic producers but harm domestic consumers, who must pay a higher price for the imported good than they would have to under purely free trade.

The Canadian government has, until recently, charged a 25% tariff on cargo ships, tankers and large ferries built in foreign countries. As of this month, however, this tariff is being removed.

Imported cargo ships, tankers and large ferries will no longer be subject to a 25 per cent tariff, Finance Minister Jim Flaherty announced Friday.

The measure is aimed at making it cheaper for Canadian shipowners to replace aging fleets with more modern and more efficient vessels.

Waiving the tariff will save the industry $25 million a year for the next 10 years, the government estimates.

“These were tariffs that don’t serve any purpose because … the ships to which they apply are not capable of being made competitively in Canada,” Flaherty told reporters…

The effects of a tariff in the Canadian ship market can be illustrated using a simple supply and demand diagram. The diagram below shows the Canadian ship market before the removal of the 25% tariff and after its removal.

The domestic supply and demand curves for ships in Canada are shown above. Notice that the domestic equilibrium price for ships in Canada without trade is very high. This is because Canadian ship builders have high costs of production and therefore would require a very high price in order to be able to build ships domestically.

So where do Canadian ship buyers get their ships from? The article mentions that one Canadian company bought ships from a Turkish ship builder. Besides Turkey, some of the other countries that specialize in ship production include Denmark, South Korea, China and Japan. The world supply of ships is represented by the blue line. In a purely free trade environment, the price of ships in Canada is determined by the intersection of domestic demand and world supply, at a price of Pw.

The world price of ships is completely unresponsive to changes in demand from Canadian ship buyers. This explains why world supply is horizontal. Since the Canadian market makes up such a small proportion of the total market for ships, an increase in demand in Canada will have no impact on the world price of ships. Therefore, the world supply curve as seen by Canada ship buyers is perfectly elastic. Canadian ship buyers can buy as few ships or as many ships as they like without affecting world price.

A tariff is a tax, and a tax is a determinant of supply. A tariff of 25% increases the costs of imported ships, and shifts the world supply curve upwards. This raises the price of imported ships, and decreases the quantity demanded of ships in Canada from Q3 to Q2 ships. Notice that at the higher world price of Pwt, there are a few domestic ship builders in Canada willing and able to produce and sell ships, so domestic quantity supplied increases from 0 to Q1.

The existence of a tariff reduces the number of imported ships in Canada from 0Q3 to Q1Q2. Domestic producers of ships, who without protection would not be able to compete and therefore produce zero ships, instead produce Q1 and enjoy producer surplus represented by the triangle X. The Canadian government collects taxes on the imported ships represented by the area Z, found by multiplying the number of imported ships (Q1Q2) by the amount of the tariff (Pwt-Pw).

The tariff on imported ships did little good for the Canadian ship market. Canadian ship builders were already uncompetitive and benefited little if at all. While the government did earn revenues from the tax, the net effect on the market was a loss of welfare represented by the triangles labelled Y in the graph above. These gray areas represent the net welfare loss (or dead weight loss) of the ship tariff.

The consumers of ships, which are in fact Canadian companies that produce other goods and services, such as the ferry companies that provide access to Canada’s several remote coastal and island communities, were clearly harmed by the 25% tariff, since the price of ships is a resource cost and the tariff translated into lower supply and higher prices for consumers of ferry services. The tariff’s effect on ship buyers in Canada is visible in the graph above. At a price of Pw, the total consumer surplus in the ship market is the area of VXYZ. With the higher price resulting from the tariff, however, consumer surplus is only the are V, while producer surplus increased only to the area X and government surplus (the tax revenue from the tariff) is area Z. The net effect, however, is a loss of total welfare of the triangles labelled Y.

The tariff’s removal, on the other hand, increases the welfare of ship consumers back to VXYZ, eliminating the dead weight loss and increasing total welfare and efficiency in the ship market. This also benefits the customers of the companies that buy ships, including ferry passengers, as evidenced in the article

“The duty remission to BC Ferries will allow it to implement a two per cent rate reduction for its users later this month, the Finance Department said.”

A tariff on imports is a protectionist measure aimed at increasing domestic producer surplus in a market in which domestic firms face competition from lower cost foreign producers. However, it should be observed that a tariff generally creates a net loss of welfare for society as a whole, as the consumers of the taxed good face a higher price and demand a lower quantity of output. While a tariff reduces imports may increase domestic production, the benefit to producers comes at the cost of lost consumer surplus and a net loss of welfare in the market as a whole. The tariff also leads to allocative inefficiency in a market, as domestic resources are over-allocated towards the production of a good on which imports are subject to tariffs.

Removing tariffs on ships increases the benefit to ship buyers, who in turn pass that benefit on to their own customers, lowering the prices of important services such as shipping and ferry service to Canadian consumers. In addition, foreign producers of ships increase their sales in Canada and experience greater demand, benefiting foreign producers and workers. The increase in foreign income may mean more demand for Canada’s exports in turn, increasing employment in other sectors of the Canadian economy in which they do have a comparative advantage over their trading partners. Overall the elimination of tariffs increases total welfare, eliminates dead weight loss, and leads to a more efficient allocation of a nation’s resources towards the goods it is able to competitively produce in the global economy.

Discussion Questions:

  1. What was the intended purpose of the 25% tariff on imported ships? Was this a valid reason to tax foreign built ships?
  2. Who are the various “stakeholders” affected by a tariff on imported ships. Try to identify five different stakeholders who are affected by the tariff and its removal.
  3. Why does the removal of a tariff improve allocative efficiency in a country? Does it also improve productive efficiency?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

15 responses so far

15 Responses to “The high cost of tariffs”

  1. Shayne Ferrymanon 30 Nov 1999 at 1:00 am

    “Persians claim that Azerbaijanis were once Persians and forced to speak and adopt Turkish language and culture with the invasion of Oghuz Turks. Azerbaijanis, however, describe that they have been a distinct ethnicity long before the the Indo-Aryan settlement of Iran.”

  2. Grace Forsython 07 Oct 2010 at 5:02 pm

    1. The tariff increases the costs of imported ships and so causes the price of imported ships to rise. This decreases the quantity demanded of ship in Canada. This tariff protects the domestic firms within Canada that are struggling to compete with more efficient producers in countries such as Turkey. This tariff however didn’t work effectively as Canadian ship builders benefits. This is a valid reason to tax foreign built ships as it is in the interest of governments to protect their country and their domestic industries however in this case it was not successful and so was eliminated.

    2. There were various different stakeholders that were affected by the tariff on imported goods. One of these stakeholders is the international firms that lose out as they are not able to import as much as their costs increase due to the tax, thus causing them to have to price their goods at a higher cost. Their revenue decreases. The tariff was designed to help increase the producer surplus within the domestic firms however they did not actually benefit from this as they were still not able to provide enough ships. The government receives more revenue to the fact that the money from the tax goes to them and they have to pay less unemployment benefits as more ships are being built within the Canada so more workers are needed. The workers are the last stake holder and they benefit from this as the unemployment rate decreases. Domestic consumers do not benefit as the price of the good increases for them and so they start demanding less.

    3. The removal of the tariff improved allocative efficiency as the domestic resources are over-allocated towards the production of a good on which imports are subject to tariffs. It does improve productive efficiency as now Canada can focus on producing something that they have comparative advantage in and will allow them to compete in the international market.

  3. Jacopo Buttion 07 Oct 2010 at 6:39 pm

    1. The 25% tariff on imported tariffs was made to aid the local shipbuilders, who could not compete with the world producers, because of the extremely high production prices in Canada. By placing the tax, domestic suppliers were meant to be aided, by lowering foreign competition. It was a valid reason to put the tax in place, unfortunately it did not work.

    2.

    a. Domestic suppliers are negatively affected by the removal of the tax because their producer surplus is decreased entirely.

    b. International suppliers are aided, because they have less domestic competition, so they are able to sell boats at a low price and profit from the Canadian boat market.

    c. Consumers profit from the decreased tax, because their consumer surplus increases, due to lower prices of boats, which means that they will be able to spend their money on other markets.

    d. The government loses money with the abolition of the tax, because they do not make any profit off the tariff any longer.

    e. International workers also benefit from the removal of the tariff, because, with higher revenue in Canada, they are able to increase the amount of workers they employ, which will decrease unemployment in the world.

    3. Allocative efficiency is achieved because ship buyers, i.e. the providers of services such as shipping and ferrying to remote parts of Canada are able to buy ships for lower prices, which allows the aforementioned services to be provided for lower prices, which benefits the whole country. Productive efficiency is achieved as well, because the Canadian ship builders can now redirect their resources onto the production of other goods or services, and international ship builders can continue to provide the majority of Canada’s ships, because they have a perfectly elastic supply and are able to sell the ships at very low prices.

  4. Gustavo Proeglhoefon 10 Oct 2010 at 3:22 pm

    This is not an answer to the Discussion Questions…

    In my opinion, this blog post is a fantastic example of the complexity of economies and of one of the most basic ideas related to international trade – even though there might be costs, trade always happens when the benefits are much greater.

    In the case of the tariff imposed in the Canadian market for cargo ships, tankers and ferries, we have seen that there is always a bad side and a good side for protectionism. First of all, some of the benefits that are generated by the tariff are associated with the domestic (Canadian) producers of the goods that are taxed. For these people, the tariff will allow them to have higher prices and work more inefficiently without being forced to leave the market. In this sense, the tariff will work as a barrier that will not allow firms and goods from abroad to compete in the Canadian market. This will increase the surplus of the firms in this market, and permit them to continue with their normal production.

    On the other hand, however, there are also significant problems related to this tariff. Firstly, by decreasing the tariff, more consumers would be able to purchase more products and at much cheaper prices (international supply prices). As a result, the utility of the consumers would increase, and the international suppliers would have more sales. Simultaneously, due to the greater competition that would be imposed in the market, the domestic suppliers would be forced to be more efficient and productive. This would avoid the misallocation of resources and result in products of higher quality or lower prices. And finally, as it is mentioned in the text, we must remember that the consumers of the products that are being taxed are mostly suppliers of other goods. Therefore, with a lower tariff, other firms would have lower costs, which would generate lower prices in many other sectors of the economy, This would produce something similar to a supply-side multiplier effect, where one action generates many other effects as the ‘benefits’ are passed on to other producers and consumers. At the end, it is possible to say that there is a chance that even the domestic suppliers (who suffered from a lower tariff) might have some benefits due to the lower prices of other products that they use in their production.

  5. Sakkti Elangovanon 11 Oct 2010 at 4:16 am

    1. The purpose of the 25% tariff on imported ships was to help the domestic Canadian ship manufacturers be globally competitive. The tariff was a form of protectionism and it is a valid reason to protect the domestic built ships because the foreign ship manufacturers are much more efficient and competitive.

    2. The five main stakeholders of the tariff on imported ships are: domestic producers, foreign producers, the government, domestic consumers, and foreign labor. Domestic producers are hurt by the removal of the tariff because their ships are now much more expensive compared to the foreign ships, which are not heavily taxed anymore. The foreign producers benefit from the removal of the tariff as they don’t have to pay the extra cost of production that was imposed by the tariff. Their producer surplus is now greater. The government both benefits and loses because they are more popular amongst the nations of the foreign ship manufacturers, but they do not gain tax revenue anymore from the import of ships. The domestic consumers are benefited because the price of foreign ships is much lower. This results in an increase in consumer surplus and increase in overall economic activity in Canada because now these consumers have a surplus of money that they can use to spend in other markets and sectors of the economy. The foreign labor is benefited from the removal of the tariff because the cost of production for firms is much lower now. Hence, the amount of foreign labor increases and decreases unemployment rate because firms have make higher profits and can spend it on more labor to manufacture ships more efficiently.

    3. The removal of the tariff will allow the equilibrium price to confirm the price of ships through the interactions between the supply and demand. If ships are sold at the equilibrium price and equilibrium quantity, there will be allocative efficiency because there are neither shortages nor surpluses in ships. In other words, the correct amount of resources is allocated towards the production of ships. With the removal of the tariff, the Canadian ship manufacturers are now truly competing against foreign ship manufacturers without any protectionism policies from the government. Therefore the domestic firms are forced to produce efficiently. This means that they have to produce the ships in the least costly manner – this is represented by the ships being sold at equilibrium price. If the Canadian firms are inefficient and have too high costs of production, they won’t be able to sell the ships at equilibrium price.

  6. Marina Antoniazzion 11 Oct 2010 at 6:39 pm

    1. The intended purpose of the 25% tariff on imported ships was to increase the price of foreign ships, thus allowing the domestic firms to produce more ships in return. This was a valid reason to tax foreign built ships because the government will always play a role in protecting the domestic firms, as the foreign ship manufacturers are more competitive and efficient.

    2. There are several stakeholders that are affected by the tariff on imported ships. Domestic consumers will not benefit due to the tax on foreign ships due to the increase in price, thus the quanity has decreased which caused a lower demand for ships. Tax on imported goods has also introduced dead weight loss, so consumer surplus has decreased. Domestic producers would benefit because the quantity supplied would increase, and so consumer surplus would also increase. However, this leads to a lower unemployment rate in the economy. Also the domestic production of ships is inefficient, as the resources are being misallocated, so we are allowing uneffiecient firms to produce in the market. International suppliers will be exporting smaller quantities, but at the same price as they were before the tariff was introduced. This will decrease the foreign firms import revenue, and so has not benefitted. Foreign workers will suffer because international firms will be producing less quantity at higher costs, which will increase the unemployment. With the removal of the tariff, foreign workers would greatly benefit as more workers would be higher, and wages would increase. Lastly, the government would benefit from taxes set on imports as this would create a government revenue. There is a decrease in unemployment, which means the government is paying less transfer payments, and able to tax more people because they are now employed.

    3. The removal of a tariff would improve allocative efficiency because the market would move to an equilibrium state, the point at which supply meets demand. The domestic resources would not be over allocated towards the production of a good on which the imports are subject to tariff. This will able Canada to be more productively efficient as they have the ability to produce something that they have a comparative advantage in. The resources can now be used to produce more efficient goods and services which would create an incentive for domestic workers to produce more, and so the unemplyment rate would also decrease.

  7. Patrick Schlumpfon 13 Oct 2010 at 3:25 am

    1. The 25% tariff on imported tariffs was implemented to help the Canadian shipbuilders, who, before the tariff was implemented, were not able to compete with the large ship manufacturers around the world. By implementing these tariff on foreign goods, domestic producers were meant to be helped, by decreasing foreign and giving them more incentives to continue with the production of ships. This could be considered a valid reason to help domestic producers, but it did not quite work.

    2. Tariff:

    Consumers

    oUnhappy as price are higher (Pw->Pw+t) and lower quantity (Q3->Q2)

    oSmaller consumer surplus

    • Producers

    oHappy as they are willing and able to produce more at higher prices (Pw->Pw+t)

    oLarger producer surplus

    • International Business

    oSmaller import revenue

    oHigher unemployment

    oCreates bad relationship with other nations

    • Workers

    oHappy as more jobs are created

    • Government

    owelfare is diminished

    oDWL is created

    oUnemployment decreases

    oLess efficiency in the market, as inefficient firms are able to enter the market

    oMisallocation of resources

    oBut still better than before trade

    oGovernment revenue generated

    oBad relationship with other nations

    oTariff wars

    • Tariff removal

    • Consumers

    oAre very happy as they now are able to enjoy lower prices from and higher quantity

    oLarger consumer surplus

    • Producers

    oUnhappy as they produce less at lower prices

    oSmaller producer surplus

    oMany firms run out of business

    • International Business

    oGreater revenue

    oLower unemployment

    • Workers

    oUnhappy as domestic workers lose jobs

    • Government

    oMore welfare is created

    oUnemployment increases

    3. It does so as inefficient firms are forced out of business, removing the misallocation of resources in this market. It does also improve the productive efficiency since Canada can now focus on the production where they have the comparative advantage in, and so, they can aim to produce where ATC equals demand.

  8. Nicolo' Fanellion 19 Oct 2010 at 12:17 am

    The purpose of the 25% tariff on imported ships was to protect the domestic Canadian firms, to allow them to produce and sell their ships, so that more Canadian companies would now be more willing and able to produce and sell these at the higher price. This tax might have seemed valid from a protectionist point of view, protecting domestic firms, the quality of products, product standards, raise government revenue and protect workers from low wages. There is however a huge trade-off cost in this choice, choosing not to opt for efficiency, creating inefficiency and decreasing the total welfare gain from trade. Moreover, from a neo-classical point of view, the government should not have intervened with such policy, as in their opinion an economy will fix always itself, and the only purpose of a government is to protect property rights and to have a juridical system.

    Stakeholders involved in transaction:

    – Domestic Consumers:

    ? Benefit from the removal of the tariff, as they are able to buy more ships at a lower price. Represented on the diagram by an expansion of their surplus.

    – Domestic Producer:

    ? Hurt by the removal of the tariff, as they are not anymore able to compete with the international firms producing the ships at a more competitive price. Represented on the diagram by the shrinking of their surplus.

    – International Producers:

    ? Benefit from the removal of the tariff, as they are able to sell a greater amount of exports without the added tax. Represented on the diagram by the Q1Q2 to 0Q3 change in quantity demanded.

    – Domestic Government:

    ? Hurt by the removal of the tariff, as they will not be getting any revenue anymore from the tariff which is removed. Represented in the diagram by the 'disappearing' of rectangle Z to consumer surplus.

    – International Government:

    ? Better relations with other countries after the removal of the tariff, helping them by lowering the prices of their exports.

    – Domestic Labor Force:

    ? Increase in unemployment after the removal of the tariff, as now no Canadian-built ships are demanded, thus the AD for labor in those industries will decrease (although in theory they will find jobs in other industries where Canada has a comparative advantage).

    – International Labor Force:

    ? Decrease in unemployment after the removal of the tax, as now more international ships are demanded at a lower price, thus AD for labor in that industry will increase, reducing unemployment.

    The removal of the tariff improves allocative efficiency in a country, as the resources which before were going to inefficient firms, only able to produce at higher prices, will now only be allocated to the international firms, which are more efficient and competitive. This is represented in the diagram above by the absence of dead weight loss after the tariff is taken away. Thus, this will also improve productive efficiency, as only the producers who can limit their costs will be willing and able to sell the ships at the world price.

  9. Daniel Graberon 21 Oct 2010 at 2:52 am

    When a government implements a tariff, their goal is to increase the price of foreign products to make domestically produced substitutes more attractive to consumers. They use this as a tool for protecting domestic firms from foreign competition. A tariff will allow the development of certain domestic industries that would otherwise not exist due to the more efficient and lower costs of foreign firms.

    At first, a tariff sounded like the most rational idea. The government is doing its job by protecting the domestic producers. The tariff allows domestic firms to produce ships. To do so, firms must employ people. With more labor needed, unemployment would stay lower. After all, low unemployment level is one of the four macroeconomic goals! Furthermore, less unemployment means less transfer payments. Also, income tax revenue for government goes up. So what is the big issue with the tariff? After giving this more thought, I came to the conclusion that the government's reason for taxing foreign built ships is not a valid idea.

    First, there are two stakeholders that are clearly hindered by the tariff: the domestic consumer and the international supplier. Due to the tariff, the domestic consumer must now pay a higher price for ships so their quantity demanded has gone down. Their consumer surplus has also decreased. The international supplier is now willing and able to produce less because the cost has increased. So, their revenue has gone down. This leads to more unemployment overseas.

    In the short-run, the domestic producers are benefiting from the tariff because they are able to continue producing ships. One of the main reasons for implementing a tariff is to protect rising industries so that they can eventually be competitive with foreign ones. However, this is not the case for Canada. As Falherty stated: “These were tariffs that don’t serve any purpose because … the ships to which they apply are not capable of being made competitively in Canada”. The Canadian producers will never be as efficient and have the low costs of foreign firms. Therefore, in the long-run, they will be beat by foreign competition and will be forced to stop producing ships. The tariff, I believe is only delaying the inevitable. If the tariff is removed now, the people that produce ships can quickly learn new skills and begin to work for something that Canada is better at. On the other hand, if the tariff stays in place for longer the domestic producers will suffer. When people stop demanding domestic ships because of the higher prices, the local producers might become structurally unemployed and might never be able to learn the skills needed for another job. This would lead to a higher unemployment rate; if these people continue to stay unemployed, the natural rate of unemployment in Canada will increase.

    In conclusion, I agree with the government's decision to remove the tariff. This will allow consumers to pay a lower price, increasing consumer surplus. Foreign countries like Turkey, Denmark, South Korea, and Japan will have higher revenue and less unemployment. And the government only has to ensure that the domestic producers can find new jobs in industries that Canada is good at and has the comparative advantage over other countries.

  10. Michelleon 21 Oct 2010 at 9:06 pm

    Discussion Questions:

    1. What was the intended purpose of the 25% tariff on imported ships? Was this a valid reason to tax foreign built ships?

    To protect the domestic ship-producing industry, who without the tariffs would not stand a chance competing against the more productive foreign ship-producing firms. No, because it's misallocating resources, allowing inefficient firms to produce a good and creating DWL in the economy, decreasing a nation's total welfare.

    2. Who are the various “stakeholders” affected by a tariff on imported ships. Try to identify five different stakeholders who are affected by the tariff and its removal.

    Canadian ship buyers – can now buy ships at a cheaper price, lower production costs

    Foreign workers at ship producing companies – experience more demand, higher employment

    More foreign income may lead to increase in demand for Canada's goods, so Canadian companies

    Specialization in comparative advantage of Canada, because ship-building was inefficient

    Canadian gov't: less tax revenue but more specialized economy and more total welfare of nation

    3. Why does the removal of a tariff improve allocative efficiency in a country? Does it also improve productive efficiency?

    It improves allocative efficiency because resources that were used to inefficiently build ships before are now put into other productive industries who are in fact more productive and will thus bring in more welfare for the nation, expand and provide the country with more jobs.

  11. Polijneon 22 Oct 2010 at 4:51 am

    Why does the removal of a tariff improve allocative efficiency in a country? Does it also improve productive efficiency?

    Allocative efficiency in a country is achieved when it produces the right goods at the right time, for the right people without reducing the welfare for other consumers. The removal of a tariff improves allocated efficiency in Canada as it eliminates the dead weight loss furthermore increasing total welfare in the country. Removing the tariff will harm domestic producers as it is a “tax on imported goods or services aimed at raising price of foreign products to make domestically produced substitutes more attractive to consumers”, therefore it protects the domestic firms in the country. However, the cost of production in Canada is high therefore the price for the good will also increase, therefore in the diagram the equilibrium price for ships in Canada is very high. Removing the tariff will increase productivity as more goods will be sold at a lower price, therefore also increasing imports from more competitive firms. Thus, it will improve allocative efficiency because more resources will be used efficiently in the industry for example building ships. Therefore it will allow more welfare for the nation, increase employment and expand the growth of the country

  12. Miss-T-ESLon 27 Dec 2014 at 6:35 pm

    Miss-T-ESL

    The high cost of tariffs | Economics in Plain English

  13. Anonymouson 13 May 2015 at 6:51 am

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    The high cost of tariffs | Economics in Plain English