Author’s Note: This post originally appeared on my (now defunct) personal website as a blog post on January 23, 2019. Since deleting my website, I have had several requests for this post. Econlib has kindly allowed me to repost it here. I’ve made minor changes for grammar and style, but otherwise the post remains identical. The original version is available through the Wayback Machine here.
In his Article from the 1987 Economic Review describing the history of optimal ratesThomas Humphrey writes:
[The optimal tariff model] unrealistically assumes (1) that foreign countries will not retaliate with their own tariffs, (2) that the elasticity of supply and demand in foreign trade is not so great in the long run that the tariff becomes ineffective, (3) that optimal tariff rates can be accurately identified and skillfully managed, and (4) that politicians can resist pressure to raise rates above optimal levels.
All four of these objections to the optimal tariff model are difficult to overcome if we view the model as a policy procedure. I’ve written about some of these other points before (as have many people much smarter than me). However, I want to focus on point 2 and I will try not to keep this shaky.
It is not controversial that the optimal tariff model depends on the elasticity of supply and demand. This is indeed how the rate calculation works. However, given condition (2) above, we can see that the optimal rate is at best a short-term policy. This follows from the Law of Demand.
Most people tend to think of the Law of Demand in its usual form: all else being equal, an increase in the price of a good will reduce the quantity demanded of that good. But there is a second law of demand: the longer a price remains relatively high, the more elastic the demand for a good becomes.
Given that the purpose of a tariff is to increase the relative price of a good, the demand for that good becomes more elastic as long as the tariff remains in effect. If the tariff remains in place and, again, all else equal, the tariff can, in sufficient time, cause the demand curve for a good to become perfectly elastic. A perfectly elastic demand curve would indicate that there are no welfare gains for consumers from trade. The loss of consumer prosperity would then mean that the tariff represents a net loss of prosperity for the country in question. So an optimal rate cannot persist in the long run, but only in the short run, given the Second Law of Demand.
Some might object, saying, “But wait, Jon, you cunning and handsome devil! That would just mean that the optimal rate would have to be lowered. There is no reason to think that the tariff would ultimately be a net welfare loss.”
In fact, it may well be that a benevolent government can milk the rate for all it’s worth, continually adjusting the optimal rate as elasticities change. However, this is where public choice comes into play. As Gordon Tullock discussed in 1975, government support for businesses is very difficult to remove. Domestic producers have benefited from the profits the tariff has brought them. Eliminating the tariff does not mean eating up “extra normal” profits for monopolizing companies, but rather eating up normal profits for them. These companies are legitimately harmed, profit-wise, by removing or changing these protections, such as an optimal rate. Any adjustment to an optimal rate, even if demanded by the economic scenario, is likely to be fought tooth and nail by the affected companies. The resulting stagnation will likely result in an optimal rate that is too high! Any short-term gains from the optimal rate (assuming all the above conditions are met) would likely be eaten by this non-optimal rate resulting from the changing elasticity and lack of change in the statutory rate.
In a theoretical framework of general equilibrium, an optimal rate makes perfect sense. But once time and public choice enter the fray, the reasonableness of an optimal rate disappears. And as GMU economist Garett Jones likes to say, in a downhill battle between general equilibrium and public choice, public choice wins every time.
Jon Murphy is an assistant professor of economics at Nicholls State University.