In my recent post about U.S. manufacturing jobs and tariffs, I mentioned a Wall Street Journal article that noted that U.S. tariffs have had little impact on Chinese exports. Exports are simply being transferred to other countries. In a previous post, I discussed what this fact means for U.S. manufacturing jobs. Here we discuss who will bear the tax burden as a result of these changes.
Economists argue that the burden of tariffs falls primarily on importing countries. In fact, the model we teach introductory students shows that the burden lies exclusively with the importing country. This same model is commonly presented in editorials. However, as readers of this blog know, it is not entirely true that customs duties are always imposed entirely on the importing country. Introductory students also learn that who pays the tax depends on the relative elasticities of supply and demand. Those who are least sensitive to changes in prices will bear a greater tax burden. Therefore, the burden is lower for those who are most sensitive to price changes. In simple models of international trade, we economists usually show a perfectly elastic supply of imported goods. In other words, foreign producers are very sensitive to price changes. Foreign producers have many consumers outside of the importing country and will simply move their operations elsewhere. Therefore, the importing country must bear the full burden of the tax. This is called the small country tariff model. The importing country is too small to influence the world price of the goods on which the tariff is imposed.
But what happens when that condition does not apply? What happens when the importing country is large enough to influence the world price of imported goods? This is called the great power model. If a country is a large importer of a particular good and its actions can affect world prices, then the world supply curve will be relatively inelastic (sloping upward). When a nation imports in large quantities, world prices rise and world producers produce more. Similarly, if importing countries buy less, world prices fall and world producers supply less goods.
The great power model has interesting implications. If tariffs are low enough, large countries can actually improve their terms of trade, thereby destroying the terms of trade of their trading partners. A country’s terms of trade are:
Terms of trade = export price index/import price index
In other words, terms of trade are how much it costs a country to consume (import) a foreign product (export). Imposing a tariff reduces the quantity of imported goods demanded. In the great power model, the importing country is large enough that when the quantity demanded of a good decreases, world prices fall, and the exporting country must absorb some of the tariffs, or the trade becomes unprofitable. Domestic imports will decrease, but domestic product prices will not increase by the full amount of customs duties.
In summary, a small enough tariff can improve the economic welfare of an importing country if the country is large enough, its relative elasticity is known, and the exporting country does not change its behavior other than by lowering the price of the tariffed product (i.e., does not retaliate or reduce its own imports or domestic investment). True, there is a loss due to a reduction in imports (remember, imports are a benefit of international trade), but there is also a gain from lower import prices. If the gains from lower prices exceed the losses from lower imports, the country will experience a small increase in welfare. (Due to this trade-off, tariffs must be small enough; you don’t want to reduce imports too much!). A price list that achieves this result is called an optimal price list. It is a tariff that optimizes the overall economic welfare of the country.
International trade textbooks discuss these models. I recommend “International Economics” by Robert Carbaugh. This book has been written with the assumption that the reader has no knowledge beyond the principles of economics.
Some argue that the United States is large enough that imposing tariffs will increase its welfare. We realized almost immediately that the optimal price argument was violated. Immediately after the 2025 tariffs were imposed, other countries retaliated with their own tariffs. Various studies show that Americans pay almost all of the tariffs.
A recent WSJ article points to another problem: The United States is not a big enough power, at least as far as China is concerned. According to U.S. Census Bureau data, U.S. imports from China are down about 45.6% from last year, but China’s exports are increasing. Rather than lowering prices, China simply found other buyers for its goods. Therefore, these data suggest that U.S. consumers and individuals are likely to bear most, if not all, of the tariffs on Chinese goods. Tariffs reduced imports and increased prices for Americans, but world prices remained unchanged. China simply found another buyer. The supply curve was apparently perfectly elastic.
The usefulness of a model comes from its ability to understand the real world and provide the ability to make predictions. The “realism” or complexity of a model is not necessarily a feature. In many ways, the great power model is more realistic than the small power model. It is unlikely that any country, let alone the United States, is small enough to have any influence on world prices. After all, all trade is conducted by individuals, not nations, so it is reasonable to assume that there will be some impact on a case-by-case basis. However, the great power model is not particularly useful in explaining real-world outcomes. Despite its lack of realism, the small country model provides a much clearer analysis, at least as a first approximation of the effects.
