First published in Forbes by Dr. Ferlito
The recent wave of sympathy for protectionist policies following the election of Donald Trump and dominant in European countries like Italy and France is nothing new if we look at international trade from a historical perspective. Over the past centuries, decades of free trade cyclically danced with protectionist periods.
Here I would like to explain how an eventual new protectionist wave would affect consumers and producers. The common ground of debate is contended between free-trade supporters (and I am among them) and protectionists. However, while both parties try to explain the benefits brought in by their views, the debate seldom focuses on who ultimately pays the duties (or other taxes). My explanation will follow what I normally teach to my students with the support of the Principle of Microeconomics by Tyler Cowen and Alex Tabarrok. The points I raise are: 1) Who ultimately pays the duties does not depend on who materially pays the check to the government; 2) Who ultimately pays the tax depends on the relative elasticities of demand and supply. Therefore, the laws of supply and demand matter.
Let us make the explanation simple, with examples and easy-to-understand definitions. First of all, it has to be noticed that consumers apparently bear the cost of taxes on imported commodities, while the real aim is to attempt to punish foreign suppliers reducing the demand for their products. Duties are typically taxes imposed on buyers for every unit bought; if it has happened to you when buying a car or wine in countries like Malaysia with a protectionist policy on such goods, you know what I mean. What happens in reality, however, is that the burden is shared between consumers and suppliers. Let us suppose that, without duties, demand and supply for Italian wine in the USA meets at $7 a bottle for 1,000 bottles a year. At a certain point the American government imposes a duty of $2 per bottle; it is easy to understand that demand for Italian wine will decrease. We might imagine that the new equilibrium rests at 800 bottles a year, at $6.50 a bottle (the decrease in demand brings down the price). Buyers pay now $(6.5+2)=8.50 a bottle, while suppliers receive $6.50. We can say that the duty burden on buyers is given by the new price ($8.50) minus the old equilibrium ($7), which means $1.50; on the other hand, the burden on suppliers is $(7-6.50)=0.50. In this example, the higher share of the duty is on consumers’ shoulders.
Is there a way to establish if a certain duty will affect more consumers or suppliers? Yes, there is. Using the typical economics jargon, we can state that who pays a duty (or a tax in general) is not who ultimately pays the physical amount of money; rather, it is determined by the relative elasticities of demand and supply. Elasticity measures how responsive (sensitive) quantities demanded (or supplied) are to price changes. A demand is considered to be elastic if the reaction to a price change is quite sensitive. For example, we can say that demand is more elastic when it is easier to find a substitute for certain goods; on the contrary, commodities creating a certain degree of addiction (like cigarettes) present a less elastic demand. As explained very well by Cowen and Tabarrok, when demand is more elastic than supply (demand is more sensitive to price changes than supply), consumers pay less of the tax than sellers. On the other hand, if supply is more elastic than demand, then suppliers pay less of the tax than buyers. This means that elasticity offers a way to escape the tax burden; indeed, the mechanism is easy to understand. If it is easy to stop consuming a good because of the presence of a number of substitutes, instead of paying a higher price, we prefer at a certain extent to switch consumption habits; on the contrary, if we are addicted to a commodity, we would rather pay the higher price than stop consuming the good.
It has to be added, in support of free trade, that duties, as other taxes on commodities, always produce a deadweight loss, which means that overall the general gain from trade is reduced, occasions of exchange are deleted. Part of the consumer and supplier benefits from trade are literally swallowed by tax revenues, and part of the trade simply does not happen anymore. Such deadweight loss will be higher when the elasticity of demand or supply is higher.
In conclusion, the laws of demand and supply firstly demonstrate that a duty will reduce the actual volume of international trade, reducing consumers and suppliers benefits; the higher the sensitivity of supply and demand is to price changes, the higher will be the size of the general loss. If governments are ready to accept this general fact, they should ask themselves if a duty will really damage the foreign suppliers they wish to punish, or if the duty burden will be shifted on (national) consumers’ shoulders. This will depend on the relative elasticity of demand and supply. Ignoring such basic facts of economics means to incur the risk not only to lose international business, but also to punish your own citizens.