The Caffeinated Penguin

musings of a crackpot hacker

Protectionist tariffs are ultimately self-defeating

Posted By on December 17, 2015

So, the whole idea that we’re “losing the trade war” gets trotted out as a populist meme every few elections, and it’s apparently that time again, because I’m hearing it again, this time from a rather loud fellow with bad spray-tan-esque makeup and vastly more hair than I have. At the risk of trying to resist the idea that bravado and follicular fortitude automatically win arguments, allow me to try and offer some logic. Typically, the way you fight in the trade war is to adjust your tariffs to protect domestic industries, which is what I will address here.

So, a parable of what actually happens.

Alice starts a company making widgets. She is an excellent widget maker, and her widgets are top notch. Perhaps they are patented, perhaps not, not really relevant. She makes widgets for years, is renowned for the quality, and her widgets are sold for $500 each.

Now, some time passes, the patent expires, or someone else sees a market opportunity. Enter Bob. He makes widgets similar to Alice’s, but at about half the quality, and he can charge $200 for his (either because of lower cost or lower profit margins, but that’s not really relevant, it’s merely his business model).

Time passes and Alice starts to notice her sales drop, investigates why and finds out that some foreigner, Bob, is making widgets. She does some market research and finds out that the people buying her widgets are willing to pay for quality whereas the people buying Bob’s widgets don’t care that the widgets wear out, because they’re used in more disposable or lower use applications. (This is akin to the whole “if you want a tool that lasts, go to Lowe’s or Home Depot and select said tool from the good/better/best sections. If you want to tool that is cheap, you go to Harbor Freight. The Lowe’s/Home Depot tool will generally be better and last longer, but the Harbor Freight tool is so cheap you can literally throw it away when you’re done with it, and thus build it into the cost of the project.)

Let’s assume that half of the widget buyers in the world want quality, and half of the widget buyers want cheap. Hence, Alice and Bob each control half of the worldwide market.

Now, Alice has a few options:

  1. Compromise on quality, perhaps by introducing a cheaper version to compete with Bob.
  2. Compromise on price, likely either by investing more heavily in automation thus lowering the cost of production, or by cutting profits.
  3. Convince people that they should buy her widgets and not Bob’s due to some motivator (superior quality, “buy local”, etc.). This is essentially advertising.
  4. Lobby the government for protection. Of course, since we’re talking about tariffs, she’s going to lobby for protection.

So, she goes to her friendly local government and convinces them that she is facing unfair competition from that evil foreigner Bob, that her business is vital to the local economy since she provides jobs, and that they should help her by “leveling the playing field” and “making it fair” (two common phrases I hear a lot). The government looks at it and says “well, if Alice sells for $500 and Bob sells for $200, let’s charge a $300 tariff on Bob’s widgets because then people will buy Alice’s widgets because they get superior quality for the same cost”. So, what happens when they do that?

  1. Many people in Alice’s domestic market will switch to buying Alice’s widgets.
  2. Any one who doesn’t will pay $200 to Bob and $300 to the government. This is, of course, the government’s incentive – they get money here. If they were truly clever about it, they might make Bob’s tariff slightly less so that more people would buy Bob’s widgets than if the costs were equal, thus increasing tariff revenue. Meanwhile, Alice can’t complain because some people switched back to buy her widgets, so she is made better off.
  3. Since the tariffs are for domestic sales, worldwide sales are unaffected.
  4. Anyone who had been Bob’s stuff domestically is made worse off because they need to spend $300 more than they used to because Bob’s widgets at $200 are no longer an option. Hence, their costs go up and they have to raise prices or reduce profits. So, we’ll say that Alice now has 90% of the domestic market, with Bob having the remaining 10% and Bob and Alice both still have 50% of the worldwide market. Alice is not as well off as she was before Bob’s competition, because then she had 100% of both markets, but she’s better off than in a truly free market, because the government has effectively subsidized her business for the cost of some amount of lobbying.

Then time passes and there are more entrants into the market. On the worldwide scale, they have to all compete with each other on delivering varying quality for the cost. However, in the domestic market, cost is fixed, so you can only compete on quality. Alice remains strong domestically, because her quality is still the best, but her worldwide sales are gradually eaten by competitors.

Then, however, tragedy strikes. The domestic market slows, if not outright implodes, and Alice now has nearly no domestic revenue and only a very small amount of worldwide revenue. Alice goes out of business.

So, in the end:

  1. Alice is out of business.
  2. Domestic customers had to pay more for widgets for years, thus driving up the cost of their widget-using products which limits their ability to compete on the world stage because their parts cost is higher. Now, if the government had told Alice “no”, what would have happened? She would have either gone out of business right then (which happened eventually anyway) or (more likely) she would have had to actually compete, meaning she would have probably ended up with a greater worldwide market share (because her quality/cost ratio would have been better) and a lesser domestic share and thus have been more insulated from domestic demand fluctuations.

Hopefully this makes sense and explains things a bit for folks.

Comments, as always, are welcome.


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