How Do Tariffs Work?

We live in an era of international trade where companies buy and sell goods overseas and do business across national borders. This allows businesses to sell their products wherever there's a market and to share goods worldwide. Look closely at international trade, however, and you'll see that most domestic governments impose some sort of intervention to protect themselves from incoming cheaper goods. The most common protectionary measures are known as tariffs.

TL;DR (Too Long; Didn't Read)

A tariff is a tax on goods coming into or leaving a country. Governments impose tariffs to discourage consumers from buying products made in another country by making them more expensive.

The Problem With Free Trade

The easiest way to explain free trade is to look at an example: Consider two countries, the United States and Vietnam. Both countries produce fashion clothing of similar style and quality. Looking at the hypothetical supply and demand for shirts manufactured and sold within the U.S., let's assume the average price per shirt is $25, and U.S. producers sell 75 million shirts every year. In Vietnam, the average price is $7 per shirt.

If the U.S. allowed foreign businesses to trade freely within the country, Vietnamese producers would be able to import as many shirts as they liked at $7 per shirt. Consumers invariably will purchase more Vietnamese shirts because they are cheaper. This raises demand for Vietnamese shirts and reduces the demand for domestic shirts. U.S. manufacturers might then sell only 40 million shirts per year, which significantly cuts their profits and could even drive some producers out of business.

Tariff Definition

A tariff is a tax on goods coming into or leaving a country. That tax might be an ad valorem tax, which is a fixed percentage of the product's price from time to time, or a specific tax that stays the same no matter what happens to the product's price. Either way, the aim of import tariffs is to stop cheap goods from coming into the country from overseas and stealing market share of domestic producers. In this sense, tariffs are a form of protectionism, imposed to save industries that are especially vulnerable to competition from overseas.

Supporters say tariffs protect jobs and wages from cheaper foreign labor. Without tariffs, a company could lay off its expensive U.S. workforce, move its manufacturing operations to Asia, then ship the goods back into the country to sell at a profit. If the tariffs were higher than the costs associated with outsourcing, then companies would start to use domestic labor to produce goods instead.

Free Trade and Tariffs Example

Returning to our free trade example, suppose the government imposes a $10 tariff on every shirt coming into the country from Vietnam. The price of a Vietnamese shirt would rise to $17. This upsets the demand because now consumers are buying fewer Vietnamese shirts due to the increased price. Vietnamese producers will suffer because of higher selling prices, although they should continue to export goods to the U.S. as long as they are still selling shirts at the higher price of $17 per shirt. Domestic producers are the winners in this situation. They will lose much less market share than they would have lost through free trade. Tariffs give them more power in the fashion market.

Who Benefits From a Tariff?

Import tariffs are taxes on imports, so this means that the U.S. government will earn money every time someone imports a product from overseas. In the case of our Vietnamese shirts, the government would make $10 for every shirt that arrives in the country from Vietnam. If 15 million Vietnamese shirts were imported, the government would make $150 million. So, the benefits of a tariff are twofold: The government earns money through the taxation of imports, and U.S. producers are able to produce and sell more goods and gain greater market power.

Arguments Against Tariffs

Not everyone agrees with the idea of import tariffs. Opponents argue that, for every action, there is an equal and opposite reaction. When a government imposes tariffs, it can start a tit-for-tat retaliatory trade war, with other countries imposing ever-higher import tariffs of their own. This essentially blocks exporters from selling their goods overseas and exploiting their own country's natural resources.

A tariff that is prohibitive, or so high that it stops goods from being imported, reduces competition. Consumers end up paying far more for products as the tariff gets added to the price of goods, or they don't get access to cheap products at all. As with most government interventions, it's a balancing act between domestic protectionism and revenue-raising versus lower prices for consumers.