A tariff is a type of trade barrier that acts a tax on imports. The tariff maybe in the form of a specific or ad valorem tax. Tariffs raise the price of the imported good to lowers its consumption. Tariffs encourage consumers to pick the local option.
A specific tax is imposed on each unit, i.e., $0.50 on a pack of cigarettes, while an ad valorem tax (or percentage tax) is a percentage of the price like a sales tax of 10%.
Effect of Tariffs
In the diagram below, we see a Local Demand and Supply curve and the imported goods are demoted by the World Supply curve. The supply curve is flat because it is assumed that the supply is infinite.
The world price is P2 and at price P2, domestic consumption is QD1 and production is QS1. This point is the intersection of the world supply curve and the local demand and local supply curve. The quantity that is imported is the difference between QD1 and QS1.
With the tariff, the price becomes P1 (The intersection of the World Supply with Tax and the local demand and local supply curves). Domestic consumption decreases to QD2 and domestic production increases to QS2. The difference between QD2 and QS2 is the amount that is imported.
The difference between the two imported quantities is the change in quantity with the tariff. As we can see, the economy consumes more of the local good, and less is imported.
Consumer Surplus – decreases by area 1, 2, 3, 4
Producer Surplus – increases by area 1
Government Revenue – area 3
Therefore, the welfare loss is area 2 and 4 that comes from production inefficiency (since it costs the domestic company more to produce than the foreign firm) and consumption inefficiency (units aren’t consumed because of the increase in price) respectively.