What Is A Tariff?

A tariff is a tax on domestic suppliers who import from the targeted country. A tariff can be levied against specific goods (such as steel, sugar, etc.) or it can apply to all goods. For example, if the US implemented a 10% tariff on all goods imported from China, this would mean that US importers would pay an additional 10% for any Chinese imports.

A Brief Look At The Real Economy

The real economy is composed of 2 main ingredients:

1. Labor
2. Capital

'Labor' is the human capacity to do work. 'Work' takes place whenever anyone uses their time and energy for the sake of production. So, someone who farms and produces fruits, vegetables, flowers, etc. is 'working' and therefore utilizing their 'labor'. The same applies to someone filling out paperwork in an office, or making videos of themselves playing video games, or managing a group of employees. This might be more or less productive labor, but all of it is labor.

In order to utilize labor, you need 'capital'. Capital is any physical good that isn't immediately consumed and can be utilized for the sake of further production. For example, the farmer mentioned above might utilize a hoe - without utilizing the hoe, his capacity to farm would probably be very little. On a larger scale, he might use a tractor - this is also capital. The same applies to the camera, computer, video game console, etc. utilized by the professional gamer. Something often overlooked in this domain is 'land', which also counts as capital.

Ideally, on a large scale, we want to utilize both our collective labor and collective capital as efficiently and productively as possible. This means that what we do produce should match the demands of consumers. 'Capitalism' is the economic system we live under that seeks to meet this demand by allowing citizens to privately own capital and choose how they would like to utilize it. The people who own capital are called 'capitalists'. We assume that capitalists are motivated, primarily at least, by profit - they would only choose to utilize their capital if it resulted in greater revenue than cost. That greater revenue (if the system properly functions) comes from more efficient use of resources (capital and labor).

What Is Trade?

Trade is what it says on the tin: You give me an apple and, in exchange, I give you an orange. If I like apples and you like oranges then both of us are happy. If one of us didn't like the other's offer, we wouldn't trade. This is why trade is good: both parties benefit.

Absolute Advantage vs Comparative Advantage

This is where things get a little tricky. Let's say Country A can either produce 1 million tables or 3 million chairs in one month. Country B, meanwhile, can only produce 1 million tables or 2 million chairs in the same amount of time. In terms of producing tables, both countries seem to be equally efficient. However, when it comes to chairs, Country A has an ABSOLUTE ADVANTAGE over Country B - it can produce 3 times more chairs in the same amount of time.

But now let's ask: What should each country actually produce: tables or chairs? Well, in order to produce 1 chair, Country A has to give up producing 1/3rd of a table. On the other hand, in order to produce 1 chair for Country B, they have to give up 1/2 of a table. Therefore, the cost to produce 1 chair is lower in terms of tables for Country A, and Country A should produce chairs while Country B produces tables. Then, of course, they should trade to meet their individual demand for chairs and tables.

But why? Well, let's imagine they didn't trade and instead produced everything themselves. As an example, let's say they dedicated half their time to producing chairs and half their time to producing tables. Ultimately, Country A would end up with 500,000 tables and 1.5 million chairs. Country B, meanwhile, would end up with 500,000 tables and 1 million chairs.

Now let's look at the other scenario, where each country specializes in its comparative advantage and then trades. To start, Country A has produced 3 million chairs and Country B has produced 1 million tables. Country B will now trade over 500,000 tables to Country A and, of course, the question becomes: how many chairs should Country A trade for those tables? Well, any amount between 1 million chairs and 1.5 million chairs would be worthwhile for both parties. For example, let's say we went with 1.2 million chairs. Now, Country A has 500,000 tables and 1.8 million chairs, while Country B has 500,000 tables and 1.2 million chairs. Both countries are better off with trade than going it alone!

What About Money?

What I've described thus far is called 'bartering', which is where you trade goods directly. But let's say, for example, I wanted to trade you for your apples and I didn't have any oranges on hand. Instead, I could give you a promissory note (or an I.O.U.) - an agreement to give you oranges at a later date (say, a week) in exchange for your apples now. As long as you don't need oranges right now and you trust that I will uphold my end of the bargain, you'd gladly agree to this. In fact, let's say that along comes Joe and he wants to trade pears for oranges. I have oranges, but I don't want to trade my oranges for pears. You want pears, but you only have an I.O.U for oranges. If Joe is willing to wait 1 week, though, he can trade his pears for your I.O.U. and everyone's happy! I get my apples, you get your pears, and in a weeks time Joe gets his oranges.

Thus money is born as a means to facilitate trade. The story of how this evolves into modern money is long, complicated, and involves a great deal of politics. Currently the money we use is called 'fiat money', which means that it's not representative of any physical asset (i.e. gold). Instead, the US Federal Government (specifically the Federal Reserve and the Treasury) are in charge of managing the amount of USD floating around. All of this is, in my opinion, very interesting but it's not particularly important for explaining the effects of tariffs.

What Is A Trade Deficit?

A trade deficit is when you export less goods and services than you import. To thoroughly trace this out, let's take an example. Let's say that I produce tables in the US and I export them to the UK. Now, unlike in our bartering example, the UK isn't going to be sending me chairs. Instead, they're going to take their money (denominated in pounds sterling) and buy USD on the foreign exchange market. Then they're going to take that USD and trade me for my tables. Typically that whole foreign exchange bit is handled by the banks, so it seems (from the perspective of the UK importer) that he's paying for my tables with pounds but, ultimately, I'm ending up with USD.

Of course this also works in reverse - when I want to buy something from the UK, my USD gets converted into pounds sterling. So when the US is in a 'trade defecit' with another country that means we are exporting less goods and services than we're importing, but it also means we're exporting more USD than we're importing. This leads to higher demand for USD, which makes our currency able to buy more of their currency, which is ultimately why it's cheaper to import from (for example) China than it is to buy things domestically. If you look at it this way, we are exporting bits of paper in exchange for real, tangible goods and services.

But what does the surplus country do with all this USD? Well, they don't want to just hide it under their mattress when it could be put to more efficient use, so they'll either invest in US stocks or invest in US bonds. That means, ultimately, all the money is flowing back to the US while we're getting cheap imports from abroad.

Finally, Back To Tariffs

Like I said in the beginning, tariffs are a tax on domestic importers. Based on what I've gone over above, what can we predict will happen? Well, foreign exporters are competing with domestic producers and, as a consequence, driving prices below what they would be if there were no imports at all. A tax, then, causes the overall price to go up - but part of that price, for domestic importers, goes to the government. Consequently, unless foreign exporters can offer prices that are significantly lower, there will be a drop in imports. Similarly, because the price is now higher, there will be a drop in domestic demand. Also, because imports have gone down, the value of the dollar has gone down relative to other currencies, which means that the cost of foreign goods is higher too.

The 'winners' in this scenario are domestic businesses, but (as we saw with the benefits of trade) their resources are now being allocated to less efficient endeavors based on a completely artificial scenario. Similarly, the government now gets tax revenue from imports, but because imports go down, all the job creation that comes from the interdependent nature of the global economy goes down, and ultimately they LOSE tax revenue. In the end, nobody truly wins and the world is in an overall worse place than it was before.

Also, usually, a trade war will happen - which is where the country being targetted by the tariff will respond with a tariff of their own. It might seem like that response makes sense, but again - nobody wins when you implement tariffs, so responding to tariffs with tariffs just ends up with you cutting off your nose to spite your face. Sometimes very limited tariffs can be beneficial for offsetting market inefficiencies, but those are few and far between. Generally speaking, tariffs are very bad for everyone involved.