Tariffs:

A  tariff or import duty essentially alters the relative prices of  traded goods vis a vis non-traded goods in the domestic market. Tariffs may be specific or ad valorem. Specific tariffs are levied as a fixed amount per unit of the good. While,  ad valorem duties are levied as a fixed percentage of the total value of the goods (e.g., 30% duty on imported computer parts).  

Using Figure, we will cany out a simple cost-benefit analysis of the impact of a  tariff on various economic agents like consumers, producers  and  the government in  a partial equilibrium framework. We  assume  that  the country  is a small open economy that cannot affect  world  marketprices. The implication of  this assumption is that the tariff leaves world market price of the good unaffected, while raising its price.in the domestic market.

In the Figure above we consider  the domestic demand and supply curves of the imported good. The world market price of the good is Pw, and this is the price that would prevail in the domestic market under  fiee trade. Thus with free trade, domestic production of the good would be Q₁,  domestic demand Q₂,  and the difference Q₁Q₂ would be imported. A specific  tariff rate of per unit drives a wedge between the world price and domestic market price of the imported good. Post-tariff, price in the domestic
market rises to (P_w + t).  As a result, domestic production increases  from Q₁ to Q₂,  while consumption falls from Q₂  to Q₄. Now let  us  consider the costs imposed by  the tariff. Owing to the tariff, domestic consumers suffer a loss in consumer surplus equal to the area (a + b +  c + d),  compared to free trade. This loss arises because consumers must now pay a higher price (P_w + t) for the good and also because they now consume Q₄Q₂  amount less of the good than with free trade. However,  domestic producers gain from the price rise, with the area a representing the increase  in producer surplus. The government also gains from the tariff as it earns a revenue. The imports are now Q₃Q₄  units, each paying a tariff oft per unit, so the tariff revenue is given by the rectangle with area c. Clearly  the loss to  consumers exceeds  the  gain to producers and  the government taken together, indicating that the tariff results in a net social loss to society  equal to the sum of the areas b and d.

In Figure:

Area b measures the loss in social welfare from the production distortion due  to  the tariff.  It  represents the higher cost of producing Q₁Q₃ domestically rather than importing this amount; Area d  is the welfare loss due to the consumption distortion created by the tariff. It represents the cost ofnot consuming Q₄Q₂,  an amount whose value to consumers exceeds the cost of importing it.

You should note that our partial equilibrium analysis of the impact of a tariff, focuses simply on the market for the imported good. Repercussions on a number of important issues like terms of trade, BOP, factor markets etc., are left out of  this framework, as in  case of our analysis of the benefits  of free trade.

In particular, our analysis does not attach any weight  to employment in  the sector being granted tariff protection. If the import-competing sector accounts for a significant share of total employment, the measures of welfare loss would have to be adjusted accordingly.  In  reality, employment  is often the most important reason underlying the imposition of protectionist trade policies.