Tariffs are commonly used trade restrictions that can prove detrimental to free trade. A tariff is nothing more than a tax levied on imports from foreign countries. And taxes are a trade barrier that can sometimes prove quite harmful to the economy. A perfect example is that of the Smoot-Hawley Tariff Act of 1930, which pushed the average tariff rate up to sixty percent. In fact, many economists argue that this significantly contributed to the severity and length of the Great Depression. Therefore, it is of the utmost importance to understand how tariffs work and their side effects.
To illustrate the effect of a tariff, it is necessary to explain the effect on the economy when a tariff is in effect and when it is not. In the absence of a tariff, the domestic price of a good will be the same as the world market price, so consumers can purchase the good at a lower price. Domestic producers will keep their prices low in order to compete with the world market, which results in favorable prices for the consumer.
On the other hand, if a tariff is put into effect, consumers will no longer be able to afford to buy the good at the world price. They will then have to pay whatever the good cost in addition to the cost of the tariff. Therefore, they will buy from domestic producers who will raise their prices in accordance to the world price and make more profits. So the tariff results in a higher domestic price but a lower domestic consumption.
Essentially, a tariff benefits domestic business firms and the government at the expense of the consumers. Producers will simply expand their output at the higher market price and gain more revenues. In addition, the government receives the tariff since it is a tax. However, there are deadweight losses that must be incurred as the results of a tariff. These losses are realized in the form of the consumer and producer surpluses that could have occurred in the absence of the tariff. Moreover, by imposing the tariff on the economy, some resources that could have been put to better use are diverted away from those better uses, which causes the potential gains from specialization and trade to go unrealized. If each country specialized in the production of the good that it produces at the lowest cost and then traded with other countries, there would be many more benefits for all.
If not implemented carefully and correctly, tariffs can have an adverse effect on the economy. They are trade restrictions that can negatively impact specialization and trade. Therefore, they can stunt economic progress.