As everybody knows from Econ 101, protective tariffs are harmful for the country that imposes them. A protective tariff is a tax on imports that is so high as to make all imports fall to zero.
But there is an argument why a low tariff may be better than no tariff at all. The reason is that a large country (large compared to its trading partners) faces an upward-sloping supply curve for its imports such that a fall in import demand lowers the world-market price of imported goods. Hence, part of the cost of the increased tariff would fall on the rest of the world due to lower export prices (a fall in the terms of trade) while the country that imposed the tariff might win overall.
Whatever the theoretical merits and demerits of this argument, recent experience with tariff increases in the US (aka Trump’s Trade War) provides powerful evidence against it.
In a newly released paper, Amiti, Redding and Weinstein show that the tariffs imposed last year by the Trump administration had two main effects:
1) US prices of imported goods rose one-for-one with increases in tariff rates.
2) Import demand decreased substantially with an estimated price elasticity of 6 (i.e. 6 percent lower imports for every 1 percent of higher tariffs).
As a consequence of these two results the paper estimates the welfare costs of the Trade War to be about 6.9 billion dollars. While that is not a huge number compared to the total size of the US economy, keep in mind that we’re only talking about a marginal change of the average tariffs from 1.5 to about 3.25 percent. And remember that the welfare costs rise with the square of the applied tariff rate. So should tariffs go up more in the future, the welfare costs will be much bigger.
I regard this as decisive evidence that the optimum tariff is indeed zero. Note that finding No. 1 implies that American consumers are paying the full cost of the tariff increase, with no terms-of-trade effect on the rest of the world. If even the largest economy in the world cannot improve their terms of trade by increasing tariffs, then smaller economies have no hope of doing so either. Raising tariffs is indeed shooting yourself in the foot.
Moreover, this paper is also a triumph for simple textbook economics. The results of Trump’s tariffs are exactly what one would expect from the kind of supply-and-demand model taught in Econ 101. As Tyler Cowen points out, the complete pass-through of tariffs to consumer prices also implies that monopoly power is not a big issue in these markets. It’s good to know that the much-maligned perfect competition partial equilibrium models still gets some important things right.
In what sense does Google “hold back” its products?
In this series of short posts I give you my personal opinion (as it is at the moment) and my reasons for this opinion about how good or bad I believe different monopolies to be. I am planning six mini-case studies of monopolies. When I talk about a monopoly in this post I simply mean a firm that has some power over its price: it can choose a lower price and sell a bit more (but not super much more) or a higher price and sell a bit less (but not super much less). A firm with such a power will typically – see a previous post – choose a higher price and sell less than would be Pareto-efficient. And this way such a firm will typically make “abnormally” high profits. While all this is probably true in all six cases, I am, for various reasons, in fact not equally worried about every one of these. I want to discuss the following six “monopoly” cases: Coca-Cola (or Red Bull), Google, Facebook, Scientific Publishers such as Elsevier (possibly also publishers of €100 textbooks such as Pearson), the OPEC cartel of a set of oil producers, and pharmaceutical companies (such as Novartis). This one is about Coca-Cola, and applies equally to Red Bull.
Economists tend to think that competition between firms is a good thing. In fact most countries (all?) have some anti-trust regulation in some form or another. Anti-trust means against “trusts”, where trusts are here meant to be cartels (groups of firms) that collude especially by determining prices together and thus avoid competitive pricing. But how would competition improve matters in the first place?
What if you, as a producer or at least seller of some good, face a “flat” demand function? With “flat” demand function I mean any demand function that has a non-infinite slope, that is any demand function where you can vary the price a bit and this does not immediately lead to a demand of more than you can provide (at a slightly lower price) or a demand of zero (at a slightly higher price). This means that in such a case you could choose a price, and different prices will have different consequences for you but also for your consumers.
To fix ideas consider the following situation. You are in charge of a student organization and you are trying to do a bit of fundraising. You are thinking of showing a movie in a university lecture hall at reasonable ticket prices to students. You have convinced the university that they let you have a largish lecture hall with 500 seats for free. You only have to pay for the cleaning cost, which say amounts to €200. You also have to pay for the right to show a movie, which say amounts to €500. You have otherwise convinced some of the other members of the student organization to help with ticket sales, advertising, and other matters, for free. The key question for you is now, what to charge the students for the tickets?
My students have played a short supply and demand experiment in class this year. The experimental design goes back to the work of Chamberlin (1948, JPE) and Vernon Smith (1962, JPE). I have used the beautiful online design developed by Heinrich Nax, Diego Gabriel Nunez Duran, and Bary Pradelski at the ETH Zürich. I ran three sessions and had 60 students participating in each. I am afraid I did not pay any money, so if you are interested in the experiment you may want to go back to the original Vernon Smith (1962) experiments and the literature that followed, in which subjects are almost always given (some) monetary incentives. The results I got with my students were not that different, however, to what researchers found with monetarily incentivized students.
This is to demonstrate the usefulness of the ideas from the last post. When Air Berlin went out of business in 2017 the prices for Lufthansa flights increased substantially (up to 30%). I have this from a news article from the ORF from the 26th of November 2017. Lufthansa, according to this article, claimed that this has nothing to do with them, it is simply a question of an increase of demand and as a consequence that their automated ticket booking system simply more quickly leads to higher price categories. Apparently Lufthansa uses up to 26 price categories (for the same seats). Which category you get depends on when you book your ticket and how full the plane is already and possibly some other things. This is actually a topic for another class – on price discrimination. But let me here only explain in which sense Lufthansa’s statement is right and wrong at the same time, or at the least on how one should perhaps read their statement.