Part (a): how a tariff causes a loss of welfare [10]
A tariff is a tax a government places on an imported good, which raises that good's price in the domestic market. To show why it causes a loss of welfare, compare the market under free trade with the market after a tariff, using the lettered areas on the diagram below.
Under free trade, a small country that cannot influence the world price imports the good at the world price (Pw), which lies below the price that would clear the domestic market on its own. At Pw, domestic consumers buy a large quantity (Q3) while domestic firms supply only Q0, so imports fill the gap from Q0 to Q3. Consumer surplus is the whole area above Pw and under the demand curve, A + B + C + E + F + G + H + I + J, while producer surplus is limited to area D. The sum of the two is at its maximum, because the good is supplied by the lowest cost producers in the world.
When a tariff (t) is imposed, the price domestic buyers face rises from Pw to Pw + t. That single price rise sets off a chain of effects. Consumers move back up their demand curve and cut consumption from Q3 to Q2. Domestic firms move up their supply curve and raise output from Q0 to Q1. Quantity demanded has fallen and quantity supplied has risen, so imports shrink to the range Q1 to Q2. The areas now redistribute:
- Consumers lose. Consumer surplus shrinks to A + B + E + F, so they give up areas C + G + H + I + J.
- Domestic producers gain. Producer surplus rises from D to C + D, a gain of area C, from the higher price and greater sales.
- The government gains revenue. It collects the tariff on each imported unit, t multiplied by the new level of imports Q1 to Q2, which is areas I + J.
The net effect is a loss of welfare. Counting the transfers, area C has simply moved from consumers to producers and areas I + J from consumers to the government. That leaves areas G + H as surplus that consumers lost but no one else gained. These two triangles are the deadweight welfare loss. Triangle G is a production distortion: the extra domestic output from Q0 to Q1 is produced by higher cost domestic firms when it could have been imported more cheaply, so resources are wasted. Triangle H is a consumption distortion: the units between Q2 and Q3 are no longer bought even though consumers valued them above the world cost, so mutually beneficial trades are lost. Because neither G nor H is gained by consumers, producers or the government, total welfare falls even though the tariff redistributes income towards domestic producers and the state.
Part (b): discuss the effects of a tariff on stakeholders [15]
Part (a) showed that a tariff redistributes welfare and leaves a deadweight loss. Whether imposing one is justified depends on its purpose, the elasticities involved and the risk of retaliation, so the effects on each group have to be weighed against one another rather than simply listed.
A developed real-world example
The United States' Section 232 tariffs on imported steel and aluminium, imposed in 2018, together with the broader US tariffs on Chinese goods under Section 301, show the full pattern. The steel tariffs raised the domestic price of steel, which benefited US steel producers, where output and employment rose, and raised revenue for the government. But steel is an input, so the higher price raised costs for the far larger group of firms that use steel: carmakers, appliance manufacturers and machinery producers. Independent studies estimated the cost to consumers and downstream firms for each steel job protected ran into the hundreds of thousands of dollars. The measures also triggered retaliation: China and the European Union placed counter tariffs on US exports such as soybeans, bourbon and motorcycles, which hurt US farmers and exporters who had nothing to do with steel. One episode therefore produced almost every effect a tariff can have, and shows why the net result is contested rather than obvious.
The case for and against
A fair discussion must concede that tariffs are not always harmful. They can protect output and jobs in the targeted industry in the short run. They can be defended to nurture a genuine infant industry until it reaches the scale at which it can compete, to counter dumping when foreign firms sell below cost, or on national security grounds for strategic goods. The revenue they raise can be valuable where other taxes are hard to collect. So in specific, time limited cases a tariff can be justified.
Against this, the costs are usually larger and wider. Consumers and downstream firms lose, and where the good is an input the tariff raises costs across the economy and feeds cost push inflationary pressure, making domestic manufacturers less competitive abroad. The welfare loss from allocative inefficiency is a permanent drag, and protection dulls the incentive for the sheltered firms to cut costs, so an industry that was meant to be protected briefly can stay protected for decades. Retaliation can turn a narrow gain in one sector into a broad loss across a country's export industries.
Judgement
Whether a tariff helps or harms depends on several things at once. The distribution of effects means a tariff is rarely good or bad for everyone: it moves welfare from consumers, downstream firms and exporters towards protected producers and the government, with a net efficiency loss left over for society. The purpose and time horizon matter, since a temporary, targeted tariff for a real infant industry or clear dumping is far more defensible than a permanent shield for an inefficient one. The elasticities of demand and supply set the size of the price rise and the welfare loss. The risk of retaliation is decisive for a large economy whose partners can hit back. And it matters whether the good is a final good or an input, because tariffs on inputs such as steel spread the damage across many domestic users. On balance, the imposition of a tariff redistributes welfare towards domestic producers and the government but at a larger cost to consumers and to economic efficiency. It is justified only as a temporary, targeted measure for a specific aim; as a general or permanent policy it tends to lower a country's overall economic welfare, especially once retaliation is taken into account.