Imagine a firm that sells a product—production costs are 2 ounces (oz.) of gold—only to the US, which has a 10 percent tariff on the import. The firm correctly estimates the aggregate demand schedule for its product as follows:
Note that the firm’s profit for the product in question is maximized at the price of 3.2 oz. of gold (yellow row). At that price, the firm can sell 11,500 units in the US, for which it must pay 3,680 oz. in import duties, and earns 10,120 oz. in profit.
Now assume the government increases the import duties from 10 percent to 25 percent. In this scenario, the firm maximizes its profits at a price of 3.5 oz., at which it can sell 8,500 units, paying (at the new tariff rate of 25 percent) 7,437.5 oz. in duties and earning 5,312.5 oz. in profits.
What are the immediate consequences of the increase in tariffs? The firm will increase its price and scale back production to achieve its new optimum price-quantity sales combination, which leads to the following outcomes: First, the government increases its income from raising the tariff from 10 percent to 25 percent by 3,757.5 oz. and the firm loses 4,807.5 oz. in profits compared to what it would have earned at the lower price and 10 percent tariff rate. Second, Americans make do with 3,000 fewer units of the good in question and those who are still able to buy it are forced to pay almost 0.3 oz. more per unit. In short, the foreign firm has lost more money than the government has collected in duties and the degree and quality of provision of American consumers has fallen substantially. The only beneficiary of the increase in the tariff is the government, while everyone else is worse off.
Now let us examine a more typical scenario: The firm has the choice of selling the same product in two countries, Mexico and the United States. Furthermore, let both countries have a tariff of 10 percent, and, once again, let the firm correctly estimate the aggregate demand schedule for its product in each country:
Let us further assume that the maximum supply is limited to 1,000 units. Note that, in this price region, it is always advantageous to the firm to lower its price and increase its supply as much as possible, and so the limitation on supply has nothing to do with so-called monopolistic pricing, but is instead a necessary consequence of scarcity. Such a state of affairs is almost always the case in the free, unhampered market. Since the firm has a financial incentive to produce as much as possible, it produces the full 1,000 units. The profit-maximizing distribution between Mexico and the US—as can be seen in the following chart—is one in which 600 units are sold in Mexico at a unit price of 5.6 oz., yielding 336 oz. in tariffs, and 400 are sold in the US at 5.5 oz., yielding 220 oz. in tariffs. This distribution generates profits of 3,004 oz. for the firm.
Now let us assume that the US raises its tariff from 10 percent to 25 percent. The new, profit-maximizing distribution for the firm is to reduce its supply in the US from 400 to 100 units and raise the price for Americans by 0.2 oz., while increasing the supply in Mexico from 600 to 900 units and lowering that price by 0.2 oz. In this configuration, the firm’s profits are only 2,801.5 oz. but, tellingly, the tariffs paid to the US have dropped to 142.5 oz., while duties paid to the Mexican government have increased to 486 oz.
In summary, in the first example, we assumed that the firm could only sell its product in the US and had no incentive to expand production and subsequently saw that the tariff increase doubled the government’s income payment, halved the firm’s profits, reduced supply for consumers by a quarter and raised their prices by a tenth. In the second case, we assumed that the firm had every incentive to increase supply and was free to sell its product in another country that did not raise its tariff. In that case, the American tariff increase lowered the firm’s profits by one-fourteenth but also reduced US government revenue by a third while increasing that of Mexico by almost half.
It also reduced the supply of the good to the US by three-quarters, increased that of Mexico by half, while raising the former’s price and lowering the latter’s by one-twenty-fifth each. Since in the real world, firms have the option of selling to multiple countries, it is important to note the unintended consequence that an increase in American tariffs may well raise the revenues of other governments while reducing that of the former, all while substantially benefitting foreign consumers and harming Americans.
