The Economy

Do Tariffs Really Raise Prices?

The effects of supply and demand dictate that in many cases, tariffs actually result in lower prices for consumers.
David McCannJune 18, 2019
Do Tariffs Really Raise Prices?

Will prices in the United States rise substantially because of President Trump’s import duties on Chinese goods, especially if he makes good on his threat to expand the tariffs to all Chinese products coming into the United States?

It’s a loaded question, because contrary to popular belief, tariffs don’t always raise prices.

One alarming study from The Trade Partnership, a think tank, estimates that an average American family of four may have to pay an extra $767, and if all Chinese exports are taxed, the cost could rise to more than $2,000.

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However, the effects of tariffs on prices are not as straightforward as may appear at first glance. Indeed, until the pioneering contribution by the late University of Chicago professor Lloyd Metzler, the question was not even explored. It was taken for granted that tariffs automatically raise the prices of imported goods.

But Metzler’s article, known in the literature on international economics as the Metzler Paradox, changed this view once and for all. Let’s analyze the problem without hysteria.

Tariffs have two effects on prices — one tending to raise them, the other tending to lower them. The overall impact depends on which effect is stronger.

It all comes down to supply and demand for goods in China. The United States is a very large importer of Chinese products, so tariffs will cause a huge fall in American demand for Chinese goods because of the initial rise in prices. But as demand falls substantially, prices of exportable goods inside China will also decline substantially.

Assuming that transportation costs are minimal, as they are nowadays, the American price of a Chinese product is determined as follows:

American Price = Chinese Price(1 + t)

where t is the rate of tariff. From this formula, it is clear that there are two countervailing effects on the U.S. price of a Chinese good. A rise in the tariff rate initially tends to raise it, whereas the resultant fall in the Chinese price tends to lower it. The final effect depends on whether the Chinese price declines more or less than the rate of tariff.

As a simple example, suppose Walmart imports a shirt from China for $20, and then faces a 25% tariff on that import. If China’s price is constant, then the same shirt will now cost $25.

But the Chinese price cannot stay constant. Since the United States imports a vast number of Chinese shirts, the demand for Chinese shirts will fall sharply, and that will lower the Chinese price. Say this price declines to $18; a 25% tariff will raise its U.S. cost by one-fourth, to $22.50, which is still higher than its free-trade cost of $20.

At a Chinese price of $16, the tariff-inclusive price will be the same as the free-trade price. But if the Chinese price were to fall below $16, the cost to Walmart will be less than $20. Thus, it all depends on the forces of supply and demand inside China.

The extent of the Chinese price decrease depends on the cost of producing the shirt. If this cost is low, the price fall can be large in the wake of declining demand, because a producer can still make some profit. Since Chinese wages are much lower than American wages, the Chinese cost of producing a shirt is likely to be very low, in which case the Chinese shirt price can fall substantially.

If that happens, American prices of goods imported from China could actually decline.

Indeed, this may explain why so far the U.S. tariffs that were imposed on Chinese exports in September 2018 have not been inflationary. In fact, even the Federal Reserve has been surprised by the recent cooling of core inflation, and, as result, pledged not to raise interest rates any further.

So the American consumer has nothing to worry about, especially when the consumer can easily switch to imports from other countries.

Large trade deficits with China have decimated American manufacturing and wages. U.S. industries need a revival, and tariffs are indispensable for this purpose.

In 1800, at the start of the American republic, barely 5% of the U.S. labor force was employed in manufacturing. Today, according to the “Economic Report of the President, 2019,” the share is about 8%, which is vastly below the 30% figure that prevailed in the 1960s. We are very close to where we were in 1800; clearly, the manufacturing sector still needs a lot of support.

Note that under Abraham Lincoln tariffs were as high as 60%. As a result, following the Civil War American manufacturing became the envy of the world. By 1900 the United States was among the nations with the highest living standard. Even though the tariff was so high, prices fell or remained stable for several years. And such price behavior helped raise the overall standard of living.

When a 60% tariff rate could not harm American consumers, how can a mere 25% do it? Free trade has been the holy grail of international economics for decades, but historically, the fastest growth in the American living standard has occurred under the umbrella of tariffs.

Note that I wrote this article on May 18, 2019, predicting a fall in Chinese prices. As the enclosed link indicates, this forecast is already coming true a month later. See how fast the laws of supply and demand work?

Ravi Batra is a professor of international economics at Southern Methodist University in Dallas. He’s the author of six books, including “The Myth of Free Trade” and “End Unemployment Now: How to Eliminate Joblessness, Debt and Poverty Despite Congress.”