Tariffs and Trade

The COVID-19 pandemic has brought plenty of changes in our lives. Social distancing, staying indoors, virtual seminars, workshops, etc. are the new normal. Likewise, the pandemic has also brought significant changes in the policies of states. Many states have reduced/removed their tariffs to foster free trade to meet the demand of their citizens as domestic industries were shut because of the threat of the disease.

Nepal also followed suit and imposed a lockdown throughout the country. To meet the medical needs of the citizens, the government removed all tariffs imposed on medical equipment. Nepalese people are now able to access medical products such as masks, gloves, etc. at a cheap price.

Let me illustrate the above phenomenon using a simple demand and supply graph for masks.

Here,

• Pw refers to the World Price of masks in general
• Pw+t refers to the price of masks in Nepal after the tariff
• S and D refer to Quantity supplied and quantity demanded respectively.
• S1, D1, and S2, D2 refers to the domestic Quantity supplied and Quantity demanded before and after tariffs respectively.
• Since the country chooses to engage in trade, the prices are assumed to be below the equilibrium in the domestic market.

As the graph represents, when the Nepal government imposed tariffs on medical equipment, the demand and supply for masks were D1 and S1. After the pandemic, when the government decided to remove the tariffs, the quantity demanded and supplied were S2 and D2. As we can see the quantity demanded masks has increased whereas the supply from Nepalese producers has decreased.

From the graph, we can see that since the products are now available at a lower price because of the free trade, consumer surplus has increased because they can buy a better-quality product at the same or lower price while the producer surplus has decreased because of the competition as consumers switch to different products.

This has been a case in Nepal as people started demanding N-95 masks rather than the cotton masks produced domestically because of the pandemic and the removal of tariffs.

So then, why does our government impose tariffs even when there is a loss to the consumers?

It is mainly because of the lobbying of the domestic producers and the revenue our government earns. As the graph shows, when tariffs are imposed, the consumers in Nepal are forced to pay a high amount for masks. The loss to a consumer because of the tariffs is the summation of a+b+c+d because of the extra amount that needs to be paid by the consumer for N-95 masks. The producers in the domestic market gain more revenue as people switch from N-95 masks to domestically produced masks which are denoted by a.

As the tariffs are imposed there is a loss of b+c+d in the operation. The area represented by b and d is efficiency loss as the tariffs cause distortion in the market mechanism and decrease the overall quantity demanded and quantity supplied in the country. ‘b’ is the production distortion loss whereas ‘d’ is the consumption distortion loss and ‘c’ represents Nepal Government’s revenue.

Before, when the government used to impose tariffs on the medical equipment, the government used to earn revenue share equal to ‘c’ but the consumers were facing loss in their surplus but now when there are no tariffs imposed on medical equipment the revenue of the government has decreased but there is a significant increase in the consumer surplus as the prices of masks has decreased and they get better protection from the virus.

Now imagine the increase in consumer surplus because of the availability of quality products at a cheaper price if the Nepal government did not impose any tariffs at all and accepted the policy of free trade.

It is not only the consumers who gain from free trade in Nepal. Even though the producer surplus decreases in the short run it is eventually beneficial for the producers as well. The import of raw materials to produce the products will be cheaper when there are no tariffs that raise the efficiency and production standards in the country, making it beneficial for all parties.

Originally published in econitynepal.com
https://econitynepal.com/tariffs-and-trade/