How tariffs really work in the most simple terms possible

Last updated on March 10th, 2018  

I am going to attempt the impossible and explain tariffs in the most simple terms possible.

I am going to assume 4 companies:

US Steel, inc
China Steel, inc
US Cups, inc
Mexico Cups inc.

I am also going to assume that everyone always pays the lowest price for equivalent goods and I am going to assume that the US and China steel are the same quality as are the US and Mexico cups. And lastly I am going to assume that given a choice between domestic and foreign goods at the same quality and price the consumer will choose domestic.

I am just using Mexico and China as names. I could just as easily have used other countries.

The numbers I am going to use are mostly made up and were chosen to make as clear as possible the effects of tariffs. However, the real numbers do not make any real change in the outcomes.

Let’s assume that US Steel sells steel for $1000 per ton, and China Steel sells  for $800 per ton.

US Steel sells steel for $1000 per ton
China Steel sells steel for $800 per ton

And let us assume there are no tariffs.

US Cups, Inc. and Mexico Cups, Inc. both make stainless steel coffee cups from the steel they buy. Roughly speaking both companies end up selling their cups for around 1/100th of the cost of the steel. You can also think of this as each company making 100 cups from a ton of steel.

So both US Cups, Inc and Mexico Cups, Inc buy steel from China Steel Inc for $800 per ton, because it is the cheapest price, and both companies end up selling their cups for $8 each ($800 per ton/100 cups per ton = $8 per cup)

US Cups Inc buys a ton of steel from China Steel Inc for $800
US Cups sells their cups for $8
Mexico Cups Inc buys a ton of steel from China Steel Inc for $800
Mexico Cups sells their cups for $8

Pretty simple.

Since no one is buying from US Steel because its price is higher, US Steel fires all its workers, closes its doors, and goes bankrupt. Not only is US Steel gone but so is the entire supply chain of businesses that used to support US Steel.

A lot of people consider this a bad outcome. And this is exactly what has happened.

Some people suggest fixing this problem with tariffs.

So what happens when the US adds a 25% import tariff on the price of steel?

A lot of seemingly complex things occur immediately. Among them are arguments as to who is actually “paying” the tariff.

I am going to skip those arguments and just look at the checking account balances of the different companies involved in the transactions.

If US Cups Inc buys a ton of steel from US Steel Inc

US Cups Inc’s checking account is debited $1000.
US Steel Inc’s checking account is credited $1000.
US Cups sells their cups for $10 each

If US Cups Inc buys a ton of steel from China Steel Inc:

First let us see what happens without a tariff:

US Cups Inc’s checking account is debited $800.
China Steel Inc’s checking account is credited $800.
US Cups sells their cups for $8 each

The first thing you will notice is that without the tariff US Cups saves $200 per ton buying from China Steel Inc and thus can sell their cups for the lower $8 price.

US Cups Inc buys a ton of steel from China Steel Inc with tariff:

Now let us look at what happens when there is a 25% tariff on imported steel.

Usually a 25% tariff is applied to the “value” of the imported item. Thus the tariff is $800*0.25 or $200, and thus the “price” for the imported steel with the tariff added on is $800+$200 or $1000.

US Cups Inc’s checking account is debited $1000.
China Steel Inc’s checking account is credited $800.
US Customs Service’s checking account is credited $200

Are you surprised that the US Customs Service has stepped into the mix? That is, in fact, generally how tariffs work. The charge is applied by the US Customs Service as the item is coming into the country.

Now looking at the change to the checking accounts, it sure looks like US Cups Inc paid $200 more and the $200 went to a checking account at the US Customs Service.

That is how tariffs actually work. What happens to the $200 at the US Customs Service will be discussed shortly.

Now what is going on at Mexico Cups Inc?

Mexico Cups Inc buys a ton of steel from China Steel Inc

The US tariff does not affect the price Mexico Cups pays for steel from China Steel.

Mexico Cups Inc’s checking account is debited $800.
China Steel Inc’s checking account is credited $800.

With the US tariff in place we find the following situation:

Mexico Cups sells its cups for 1/100th of the cost of steel or $8 each
US Cups sells its cups for 1/100th of the cost of steel or $10 each

Now it should be pretty clear that US cups sell for $10 each, and Mexico cups sell for $8 each.

Everyone will be buying Mexico cups and no one will by US cups.

So clearly imposing tariffs is insane right?

Well we have not determined what happens to the $200 that the US Customs Service ended up with.

The US Customs Service did not really end up with $200. It is a fiction because given the model above no one buys from US Cups because of the higher price so US Cups does not buy any steel at all. Everyone is buying $8 cups from Mexico Cups and no one is interested in buying $10 cups from US Cups or starting a new Cup business in the United States to sell cups for $10.

The reason the model above is not perfectly evident to everyone is that policy changes take time to propagate through the economy. When a country changes its trade policies businesses cannot move their factories instantly. But they do move them eventually or go out of business. And so bad trade policies are allowed to carry on for years before the destruction they cause is evident to everyone.

In other words, creating the steel tariff destroys both the US Steel industry and the US Cups industry.

So if tariffs are so horrible why does anyone implement them?

It is foolish to implement a tariff as described above, unless the country you are trading with is more of a fool than you. And believe it or not the people of the US have been fooled on a massive scale. More on that later.

Only the worst fools implement tariffs as described above. Most tariffs are implemented with a second tariff.

A solution that partially fixes the price problem created by the tariff described above, is for a country like the US which has imposed a tariff on steel imports to also impose a similar tariff on foreign products made from foreign steel.

In other words, the US must also impose a 25% tariff on the cups Mexico Cups Inc sells into the United States which were made with steel from China Steel.

So when a Mexico Cup cup is sold into the US the following happens:

US Consumers’ checking account is debited $10.
Mexico Cups Inc’s checking account is credited $8.
US Customs Service’s checking account is credited $2

At this point cups from Mexico Cups Inc and US Cups Inc both sell for $10 in the US.

However, while the price is the same, the US consumer choice to buy a US cup or a Mexican cup can have a really big additional effect.

When the US consumer chooses to buy from US Cups Inc the whole $10 cost of the cup goes to US Cups. US Cups spends the money on their supply chain, employees, partners, workers, investors, and so on. In other words, the whole $10 goes into the US economy.

When the US consumer chooses to buy from Mexico Cups Inc $2 goes to the US Custom Service Account and $8 goes to Mexico Cups Inc. People get jobs in Mexico but not in the US.

So where does the $2 go? That is incredibly difficult to determine. The best I can say, or hope for, is that it goes into the US economy somewhere, but as I will describe shortly that $2 does not exist either.

So let us compare the outcomes of these various tariffs.

That is 25% on foreign steel **and** 25% on foreign goods made from foreign steel.

In the case of no tariffs:

No one buys US steel it is too expensive. The US steel industry dies.
Everyone buys $8 cups from Mexico Cups or US Cups (both using China Steel).

In the case of just a steel tariff:

No one buys US steel. The US steel industry dies.
No one buys US Cups. The US Cups industry dies.
Everyone buys $8 cups from Mexico Cups

In the case of a steel tariff and a cups tariff:

US Cups buys from US Steel ($1000 per ton)
Mexico Cups buys from China Steel ($800 per ton)
US Cups sell for $10 in the US ($1000/100 = $10)
Mexico Cups sell for $10 in the US ($800+25%tariff/100 = $10)

Now this has worked out fine for the US domestic market where Mexico cups and US cups now both cost the US consumer $10, but what about the world market? What about sales abroad?

Mexico Cups does not pay a tariff on cups it sells to other countries. Thus:

US cups sell for $10 in the world market
Mexico cups sell for $8 in the world market

In the world outside of the United States, everyone buys the less expensive $8 Mexico cup. Not the more expensive $10 US cup.

So while the US can maintain US sales of US cups domestically via the two tariffs, it cannot do so in the world market.

Because of the tariffs no one outside the US will buy the expensive $10 cups from US Cups Inc.

This is often looked at as one of the biggest negatives of tariffs.

But what are the positives?

The US gets to have domestic steel and domestic cup manufacturers that sell into the US marketplace. The US does not have to worry about losing these industries entirely.

However US steel and cups do not sell well outside the country.

Rather than steel let us think about food for a moment.

Say we are talking about two companies:

US Wheat Inc sells wheat for $100 per ton
Russian Wheat Inc sells wheat for $80 per ton

Without a tariff everyone buys Russian Wheat, US Wheat goes bankrupt, and the US becomes entirely reliant on Russian Wheat. If Russian Wheat were to stop selling wheat to the US there could be starvation  and death in the US.

So the US implements a 25% tariff on foreign wheat imports. People in the United State buy US Wheat, US Wheat thrives and the US has “food security” as it is growing its own wheat.

This “food security” also applies to “steel security”. Without the steel tariff the US steel industry goes bankrupt and the US government is dependent on foreign suppliers of steel like China Steel. This can be risky when it comes to making war ships and the other weapons of war which need steel.

So tariffs are often imposed in the name of security. Food security or steel security, with both often being called ‘national security’.

So to summarize tariffs:

provide food and steel security (continued domestic production) (a positive)
keep employment dollars and profit in the US (a positive)
make US food and steel less competitive in the world market (a negative)

For some the question of tariffs comes down to “do the positives outweigh the negatives?”

Does keeping the production and employment in the US outweigh that lost revenue in world markets? For many the answer is yes.

However, that question assumes that tariffs are being intelligently levied.

If you think back to the original steel tariff discussed above ultimately the tariff had to be applied to both steel imports from China Steel and cup imports from Mexico Cups in order to work sensibly within the United States.

Without both tariffs US Steel and US Cups are both destroyed and both the steel and cups industries in the United States disappear.

You may also remember way back at the beginning of this article I discussed foolish trading partners.

This article has looked at imposing tariffs entirely from point of view of the US, but what about when foreign countries impose tariffs on US goods?

Americans have a rather strange point of view in that they believe tariffs, if implemented, should be “fair.”

No one anywhere else in the world thinks this way. Everyone else thinks tariffs should be levied to create advantages for domestic industry. And this is how everyone else in the world acts.

The US is the fool. It allows the worst possible outcomes.

The US allows other countries to impose tariffs on it without imposing reciprocal or balancing tariffs on those  countries.

The US creates tariffs on foreign steel but not the foreign cups made from foreign steel. This destroys both the US steel and US cups industries, and in fact, it destroys all US industries that derive their products from steel.

This is exactly what has happened over the last 50 years, and is exactly why manufacturing has left the United States and moved abroad.

Ross Perot said in the 1992 election that NAFTA would create a giant sucking sound from the south. He was entirely right. That is exactly what happened. And the above is exactly why.

But you said tariffs make a country’s products less competitive on the world market, why would they do this?

Most countries impose tariffs on products they do not sell in the world market.

Say a country makes cars which they sell domestically, and food which they sell both domestically and to the world.

If they impose a tariff on imported cars, imported cars become more expensive, so their citizens buy locally produced cars. This keeps the money and employment related to the car industry inside the country.

Food products, which they sell to the world, they do not impose any tariffs on so the food products remain competitive on the world market.

Being able to create these kinds of targeted tariffs is a big win for the countries that can do so.

The United States has troubles implementing these kinds of tariffs because the US sells everything. There are few markets in which the US does not export goods, so it has a difficult time creating these sorts of advantageous tariffs.

The US steel vs US cups tariffs problem is an example of exactly why this is the case.

More generally a country asks the following question:

If I implement a tariff will my local economy benefit more than I will lose via reduced exports?

Countries around the world ask this question and then implement advantageous tariffs for themselves.

Then the fools in the United States do not respond leaving all the advantage to the foreign countries and foreign producers while the US loses their domestic industries.

Why is the US so foolish?

To be frank, the US has simply been sold out by its elected representatives and lawmakers.

When the US does not respond to foreign tariffs with reciprocal or balanced tariffs this creates an advantage for foreign businesses.

US politicians have foreign interests via their family members and extended relations.

The “extended family”, whether actual family or friends, are investors in foreign companies or  domestic companies with foreign interests which benefit from the poor trade decisions made or not made by the politicians and negotiators.  Often the trade, or sell out, is not so direct.  Often times the family or friends are compensated with jobs and directorships at a later date.

US politicians simply doing nothing, while other countries erect advantageous tariffs against the US, allow the US politicians’ family, friends, and business associates to profit from their foreign investments. Their knowledge of or inaction in responding to foreign tariffs allows their extended family and friends to profit from this knowledge or inaction.

Assuming consumer preference for domestic product.

I assumed in this article that given the same price for foreign and domestic goods the domestic consumers will choose the product from the domestic manufacturer.

This assumption is not actually necessary.

The US can create a real preference for domestic goods by raising the tariff a little more such that the domestic price of domestic goods is actually lower than the foreign price.

Continuing the steel and cups example, consider what happens when the tariff is 37.5% instead of 25%.

US Steel is $1000 per ton
China Steel is $800 + 37.5% tariff or $1100 per ton

Now China Steel is more expensive that US Steel, so all US manufacturers buy their steel from US Steel.

US Cups buys US Steel and sells their cups domestically for $10

Mexico Cups buys China Steel but their product now has a 37.5% tariff so their cups sell for $11 each in the US market.

US consumers all have a reason buy US cups now. They are lower cost.

This is why countries create targeted tariffs focusing on products they import but do not export.

Note that Mexico Cups could  choose to buy their steel from US Steel.  Cups made from this steel would not be subject to the tariff, and Mexico Cups would be able to sell their cups into the US for $10 as they are now buying US steel.

The 25% or 37.5% tariff does not change the sales of US Cups abroad

With either tariff US Cups are still too expensive to sell on the world market, $10 vs $8.

In the case of both the 25% tariff and the 37.5% tariff US Cups will not sell in the world market, so in both cases the tariff has no effect on US Cups sales abroad. In both cases US Cups sells the same amount abroad: Zero cups.

So who wins with tariffs?

The largest economy wins. In other words, the US should win.

Why isn’t the US economy winning?

Because US politicians are failing to at least implement reciprocal or balanced trade policies.

Because foreign countries are able to implement advantageous trade policies for themselves and the US does not respond.

Is free trade the right answer?

My articles tend to focus on the math behind what is actually happening and how the decisions or the lack of decisions affects your life and well being.

Rather than free trade I tend to focus on the ideas of voluntary exchange see this article.

When you read the trade deals like NAFTA and TTP you will find they are not only impossible to understand but they are the opposite of free trade deals.

What is Trump trying to do?

In a strangely American only way of thinking, that is that tariffs must be”fair”, Trump is trying to erect reciprocal or balanced tariffs against those who have tariffs against US products.

Every other country in the world has erected what American’s would think of as “unfair” tariffs.

If everyone else in the world does not think their targeted tariffs are **unfair**, why should American thinks their tariffs are?

What about the $2 collected from the US consumer by the US Customs Service?

Remember that due to the tariffs the US has given up on selling in the world market? US Cups at $10 each simply will not sell against $8 cups from Mexico Cups.

But what if the US Customs Service gave the $2 it collected from the US Consumer when the US Consumer purchased the cups from Mexico Cups to US Cups when US Cups sells abroad?

This would allow US Cups to sell their cups for $2 less, or $8 abroad.

It works like this

US Cups buys US Steel for $1000 per ton so their cups are $10 each
US Consumer purchases a cup from Mexico Cups for $10
• Mexico Cups get $8
US Customs Service gets $2 (25% tariff on $8)
US Cups sells a cup on the world market for $8 (losing two dollars)
US Custom Service gives  $2 to US Cups
US Cups gets (or nets) $10 for its sale abroad.

This creates what it known as a world price and a domestic price for a good.

In this example, the domestic price for US Cups and Mexico Cups is $10, while the world price for US Cups and Mexico Cups is $8.

Now look what happens when the tariff is 37.5%

US Cups buy US Steel for $1000 per ton so their cups are $10 each
US Consumer purchases a cup from Mexico Cups for $11
• Mexico Cups get $8
US Customs Service gets $3 (37.5% tariff on $8)
US Cups sells a cup on the world market for $7 (losing three dollars)
US Custom Service gives $3 to US Cups
US Cups gets (or nets) $10 for its sale abroad.

Now US Cups are cheaper on the world market at $7, while Mexico Cups are $8.

While this last case looks like a big win for the US, it is also a fiction.

No one in the US is going to pay $11 for a Mexico Cup, when they can get a US Cup for $10, so the US Customs Service is not actually collecting any money.

This case does not really exist except on a transitory basis while trade policies are changing.

What are transitory trade policies?

Trade polices drive people towards sane behavior (except possibly for Americans) over the long run. (Maybe even Americans, we shall see)

However, short term trade policies can be used to create temporary or permanent trade advantages depending on how foolish the other country is.

The unrealistic or fictional cases described above can exist while countries and businesses are adjusting to changes in trade policies.

Transitory trade policies can be like a shell game where one country always knows where the ball is, while the other does not.

The US has not known where the ball is for many decades now.

Why are tariffs considered unfair?

Tariffs are only considered unfair by Americans. Everyone else in the world understands what they really are and the advantages they provide.

What should the US do?

The US should at least implement reciprocal and balanced tariffs.

US citizens should elect politicians who are not selling them out to foreign interests.

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