Economic theory predicts that, except in certain edge cases, tariffs will increase the domestic price of imported goods and services in a country. The way economists present the effects of tariffs to students is generally through a simple supply-and-demand model (see for example this discussion about rates that is reasonably representative of the presentation of the textbook). In this model we posit the direct exchange of goods between buyers and producers (foreign and domestic).
One of the logical outcomes of this model is that the tariff burden will be shared between buyers and producers, with their respective shares determined by how sensitive each party is to a price change. Thus, if consumers do not pay the entire tariff, some of it will be borne by foreign producers, resulting in a possible net welfare gain if the gain from producer surplus plus the gain from government tariffs of foreign producers exceeds the welfare gain. loss of consumers.
There are many practical problems with this so-called “optimal rate” model, which is why many economists reject its usefulness for policy purposes. I will not repeat these arguments (interested readers may find a useful summary here). Rather, what I want to emphasize is that the textbook model of supply and demand, while extremely useful, is limited in crucial ways when discussing the practical effects of particular policies. Failure to understand these limitations can lead to incorrect conclusions.
The main shortcoming of the model for the discussion here is that it flattens the trading process too much. The simple supply and demand model states this directly exchange between the consumer (end user) and the producer. As a literal translation of the model, this means that every consumer goes to the factory/farm/etc. where the goods are produced, buys directly from the producer and transports the goods back themselves. The reality is not that simple. Transaction costs are incurred during the exchange process and there are various intermediaries to reduce these costs. For example, instead of buying my coffee directly from the coffee company, I buy it from my grocer, who bought it from a wholesaler, who bought it from an importer, and who bought it from the roaster. Instead of a single exchange between me and the producer, there are four exchanges. Every producer is a consumer at different stages of the process.
These middlemen make the conversation about rates (indeed, most taxes) a bit more complicated. We need to examine how much prices change at each stage of the exchange (called “pass-through”). If some stock market actors are more sensitive to price changes, their prices are less likely to rise. Those who are more insensitive to price changes will see their prices rise. Therefore, we want to look not just at one set of prices (for example, the consumer price index, the producer price index, etc.), but at the entire price schedule on the stock exchange.
Looking at just one price can lead to wrong conclusions. For example, let’s say a 10% tariff is applied to imported widgets. Widgets are a common item with many substitutes. Widget end users have many options and are therefore very sensitive to price changes. Widget retailers, on the other hand, are very insensitive to prices. For the sake of argument, let’s further assume that widget importers are insensitive to price. In this scenario, the burden of the tariff would be borne by the retailers and importers. Their margins would shrink. Consumers would see a very small price increase. If you were to look only at consumer prices, you would wrongly conclude that the tariffs had no effect on prices. You might even conclude that the fare was paid by the foreigners! What they would do not See is that the fee is paid by other domestic members of the exchange.
A recent one Wall Street Journal article demonstrates this problem (“American comparison countries are stocking up to stay ahead of Trump’s Chinese tariffs”, November 20, 2024). Two American entrepreneurs discuss the problem of raising prices for their consumers and how it affects their business:
In addition to tariffs on Chinese goods, Trump proposed tariffs of 10% to 20% on imports from all countries. That would be the worst-case scenario for Leah Dark-Fleury, co-founder of Stone Fleury, a natural stone and porcelain wholesaler in San Francisco. She has been purchasing natural stone from the same supplier in China for twenty years and imports most of her other materials from Europe. When Trump imposed a tariff on Chinese natural stone during his first term, Dark-Fleury continued to buy from China as usual. The company raised prices to compensate, but tried not to charge the full increase to stay competitive.
Toni Norton, owner of Fine Fit Sisters in Charlotte, NC, sources body oil from China that is popular with customers in the summer. Normally she wouldn’t stock up until the new year, but she’s trying to order about 20,000 units before the end of the year.
If tariffs on Chinese products do indeed reach 60%, Norton says she may have to stop selling body oils and focus more on her fitness coaching services. She said she doesn’t have much room to raise prices on the body oil, which she primarily advertises on TikTok and sells for about $13, because “people like cheap things.”
The Trump/Biden tariffs are characterized by such spillover effects. A 2021 paper by Cavallo et al notes that the tariffs are borne almost entirely by American companies. Looking at (inflation-adjusted) retail prices is not enough to tell us whether or not tariffs are harmful. We need to look at the entire exchange process.
PS: This recently published document looks at the longer-term effects of the Chinese tariffs. The authors find: “There is no consistent evidence of reshoring, but evidence of nearshoring to border countries. Despite significant reforms, China remained the largest supplier of directly imported goods to the US in 2022.”
Jon Murphy is an assistant professor of economics at Nicholls State University.