The optimal tariff theory discussed by economists refers to countries, typically large, powerful importers of goods, using tariffs as a means to control the world prices of these goods. Large countries have power over pricing because they have created a monopsony, which has a similar yet opposite definition as that of a monopoly.
Instead of the only seller or largest seller of certain goods, these countries function as the largest buyer of goods, giving them the power to influence global prices through tariffs, knowing that foreign suppliers will accommodate their wishes because they're such a large buyer.
The tariff becomes an optimum situation for the country imposing it under certain conditions, unlike smaller countries with little buying power that miss out on the opportunity to influence prices at all through tariffs.
Definition of Tariff
A tariff works as a kind of border tax that countries charge on goods they've imported from foreign suppliers. A tariff does not apply to services, only goods. When goods from a foreign country arrive at a domestic location, customs officials in the receiving country collect the tariff money, which is paid by the foreign supplier. The government that imposed the tariffs collects the funds.
Generally speaking, tariffs around the world continue to drop. Due to various free-trade agreements, tariffs have continued to fall for decades around the world on most products. Agriculture is an exception, however, and tariffs tend to stay high because countries want to make sure that they can protect their farmers.
An example of tariffs in action would be the tariffs placed on imports of steel and aluminum imported into the United States. If the U.S. imposes a tariff on these products, they become more expensive if purchased from foreign suppliers. This in turn provides some protection to American workers in these industries. In theory, as foreign steel and aluminum become more expensive, domestic companies will turn to American makers of steel and aluminum to fill their needs, which could revive industries that have been troubled for years.
Definition of Optimum Tariff
The concept of optimum tariff concerns large countries that carry the bulk of the purchasing power for various goods. Instead of having a straightforward definition, the optimal tariff is more of a theory that says large importing countries can force their foreign suppliers to lower their prices through the application of a tariff.
If a country has a monopsony – in other words, if it's a primary buyer from many foreign suppliers that compete for its business – the purchasing country can increase its tariff, and instead of its own citizens having to pay increased prices for the tariffed goods, the foreign suppliers absorb the tariff increase as an attempt to maintain the same level of sales to their main buyer. If the purchasing country continues to increase its tariff, as the theory goes, the foreign supplier would keep the product sales price the same but would pay more fees and receive less profit.
In accordance with the optimum tariff theory, countries that function as large importers of goods can improve their trade terms by increasing their tariffs to force foreign suppliers to lower prices to them and also to other countries. This works best with products that have a very elastic demand. Elastic demand means that customers will move to an alternative product if the price for a given product increases.
The more elastic the demand, the quicker a customer looks for a cheaper alternative if the product price starts increasing. Companies that produce products with the opposite, inelastic demand, can increase prices without losing customers because the customers need the product so much that they'll pay the price regardless of how high it goes. Insulin for diabetics and other life-sustaining medications are perfect examples of products with inelastic demand.
When a large country applies a tariff, due to the elasticity of a given product the supplier may not be able to keep the same price and continue to sell the same volume, forcing them to accept less money and absorb the tariff fees.
Large Country vs. Small Country
When discussing the optimum tariff, large country purchasers, such as the U.S., have a distinct edge over small countries. If a small country imposes a tariff, suppliers won't absorb the cost to keep the sales price stable because they don't sell much volume to the smaller countries. They have much larger customers to keep happy, and the suppliers won't lose much if the small country stops buying their product.
When suppliers sell to large countries, however, they're more motivated to maintain a certain level of product demand, so if tariffs increase, the supplier has to find a way to still offer the item to the purchasing country at the same price or close to it while covering the cost of the tariff increase themselves. In an optimum tariff situation, the only choice the suppliers have is to cut into their own profits so their large customer doesn't go away. Smaller countries, however, are forced to accept whatever prices the foreign suppliers offer them because they have no volume-buying leverage.
Tariffs and Free Trade
What are some of the advantages of free trade? It's harder to see the benefits of free trade and much easier to witness the visible and immediate changes coming from protecting certain groups of people from foreign competition through tariffs. Free trade works for consumers because it increases the available choices of products and brings reduced prices. It allows people to have more high-quality goods for less money. Free trade drives companies to be more competitive by allowing others to compete with them on price. Conversely, placing restrictions on trade can hurt the people the countries are trying to protect, placing limits on what people can buy and driving prices up on everything from groceries to clothing to components for manufacturing products.
Free trade causes companies to be more adaptable to changing demands in a global marketplace. Free trade can also serve as a vehicle for fairness because it represents just one set of rules, rather than a list of tariffs or trade barriers that differ by country. This means fewer opportunities exist for nations to skew any trade advantages in the direction of their preferred trading partners.
Read More: The Benefits of Tariffs & Quotas
Reasons for Tariffs and Trade Barriers
Governments use several types of tariffs and trade barriers to raise revenue, attempt to influence prices and protect the jobs and wages of domestic workers. Governments can charge tariffs in two different ways. They might levy a fixed tariff per unit of imported goods, such as a $10 tariff per pair of imported tennis shoes or a $200 tariff on each imported computer.
Other tariffs work on the principle of ad valorem, which is Latin for "according to value." Countries levy this type of tariff on goods based on a certain percentage of the goods' value. For example, Japan might levy a 15-percent ad valorem tariff on automobiles coming from the U.S. The 15-percent tariff becomes an increase in the amount of the car's value, so now Japanese consumers will have to pay $11,500 instead of $10,000 for the vehicle. This serves to protect vehicle producers from being undercut by other suppliers, but it also keeps the price of cars artificially high for car shoppers in Japan.
Countries also use other means to influence pricing and the flow of goods from foreign countries, called trade barriers. For example, these barriers consist of a license to import certain types of goods or placement of a quota as a restriction on how much of a certain good can be imported. Some countries, instead of putting a quota on the volume of goods allowed for import, place a government requirement for a certain percentage of goods to be manufactured domestically. For example, a computer import restriction might require that either 20 percent of the parts used to make a computer must come from domestic manufacturers, or the government could require that 10 percent of each computer's value must be derived from components produced domestically.
Impacts on the Price of Goods
Tariffs drive up the prices for imported goods, and domestic producers of the same items can maintain higher prices because the competition can no longer undercut them on pricing. This means that domestic consumers have no choice but to pay higher prices for these goods. Tariffs are bad for business in the sense that since they reduce price competition, companies that would not be able to perform in a more competitively priced market can remain open.
As tariffs and trade barriers are enacted, prices increase and the volume of imports is capped. The rising prices appeal to domestic companies, causing them to start producing the same goods and causing an increase in the supply. The country succeeds in keeping down the volume of imports and stimulating domestic production, although the result for consumers is higher prices.
The Benefits of Tariffs
In general, governments will enjoy increased revenue as they allow imported goods into their domestic market. When incoming goods have a tariff, this benefits domestic competitors because it reduces competition since the prices are now artificially inflated on the imported goods. Higher prices on imports typically translate to higher prices for the end consumer, so trade barriers and tariffs tend to be more beneficial for producers and less of a benefit to consumers.
When a tariff or trade barrier is first put into place, the higher prices of goods cause people and businesses to reduce their consumption. The government has more revenue coming in from the fees, and some businesses will see a profit. In the long term, however, these same businesses may suffer in terms of efficiency because they don't have competition keeping them on their toes, and they might also have other new companies competing by selling consumers substitutes for their products.
The Future of Tariffs With Modern Trade
Tariffs continue to play less of a role in international trade over time, primarily because of international organizations that work to improve free trade between countries, such as the World Trade Organization. These organizations focus on making it harder for countries to introduce tariffs or taxes on goods imported from other countries and also work to reduce the chance of supplier countries enacting their own taxes in retaliation. Many companies have subsequently changed and moved away from tariffs by using trade barriers, such as imposing import quotas and placing certain restraints on exports.
The WTO and other organizations also work to resolve the production and consumption issues that tariffs create. When tariffs increase the price of products to artificially inflated levels, domestic producers become interested and start manufacturing the same goods, although consumers purchase fewer of the goods because of the price increases.
Global integration continues to develop, eating away at existing tariffs and trade barriers. Additionally, many governments currently have multilateral agreements in place that increase the chances for further reductions in tariffs.
An optimum – or optimal – tariff can be defined as the level of tariff that optimizes a large country's welfare in terms of the volume and price of imported goods. Small countries with no real buying power have an optimal tariff of zero.
- CNN Money: What Is a Tariff? Your Trade Questions, Answered
- Chicago Policy Review: Rethinking the Optimal Tariff Theory
- The Wall Street Journal: Why Aren’t Americans Getting Raises? Blame the Monopsony
- Intelligent Economist: Price Elasticity of Demand
- Business Insider: Trump's Trade War with China Is Intensifying – Here's What Tariffs Are, and How They Could Affect You
- Mercatus Center at George Mason University: The Benefits of Free Trade: Addressing Key Myths
Cynthia Gaffney started writing in 2007 and has penned tax and finance articles for several different websites. She brings more than 20 years of experience in corporate finance and business ownership. Gaffney holds a Bachelor of Science in finance and business economics from the University of Southern California.