The US is a Small Country

In my recent post on US manufacturing jobs and tariffs, I mentioned a Wall Street Journal article that pointed toward American tariffs having little impact on Chinese exports; the exports are simply being shifted to other countries.  In the earlier post, I discussed what that fact meant for US manufacturing jobs.  Here, I discuss what that shift means for who bears the burden of the tax.

Economists argue that the burden of a tariff falls primarily on the importing country.  In fact, the model we teach our Intro students shows that the burden falls exclusively on the importing nation.  In op-eds, that same model is what we generally present.  However, as readers of this blog know, it’s not completely correct to state that a tariff will always fall entirely upon the importing country.  Our Intro students also learn that who bears the burden of a tax depends on the relative elasticities of supply and demand.  Whoever is least sensitive to a change in price will bear a greater burden of the tax.  Consequently, whoever is the most sensitive to a change in price will bear the lower burden.  In the simple model of international trade, we economists typically show a perfectly elastic supply of the imported good.  In other words, foreign producers are highly sensitive to a change in price; foreign producers have many other consumers beyond the importing country and will simply shift their business elsewhere.  Consequently, the importing nation must face the entire burden of the tax.  This is called the small-country tariff model; the importing country is simply too small to influence the world price of the tariffed good.

But what if that condition does not hold?  What if the importing country is sufficiently large that it can influence the world price of the imported good?  This is called the large-country model.  When a nation is such a large importer of a particular good that their behavior can influence the world price, the global supply curve is relatively inelastic (upward sloping).  When the nation imports a lot, the world price rises and global producers produce more.  Likewise, when the importing nation purchases less, the global price falls and world producers supply less of the good.

The large-country model has an interesting implication.  With a sufficiently small tariff, the large country can actually improve its terms of trade and, consequently, the trading partner’s terms of trade will fall.  The terms of trade for a country is:

Terms of Trade = Export Price Index/Import Price Index

In other words, the terms of trade is how much it costs (exports) for a country to consume (import) foreign goods.  Imposing a tariff reduces the quantity demanded of the imported good. Under the large country model, the importing nation is sufficiently large that if the quantity demanded of the good falls, the world price falls, and the exporting nation must absorb some of the tariff, otherwise the transaction ceases to be profitable.  Domestic imports fall but the domestic price of the good does not rise by the full amount of the tariff. 

In sum: if a country is sufficiently large, the relative elasticities are known, and the exporting nations’ behavior does not change other than to reduce prices on the tariffed goods (i.e., no retaliation and no reduction of their own imports or investment into the domestic country), a sufficiently small tariff can improve the economic welfare of the importing country.  Yes, there is a loss from a reduction in imports (recall that imports are the benefit of international trade), but there is a gain due to the lower price of imports.  If the gain from the lower price outweighs the loss from the reduction of imports, then the country will marginally increase their welfare.  (This tradeoff is why the tariff must be sufficiently small; one wouldn’t want to reduce imports too much!).  The tariff that achieves this result is called an optimal tariff; it is a tariff that optimizes total economic welfare in a country.  

Any International Trade textbook will discuss these models.  I recommend International Economics by Robert Carbaugh.  The book is written on the assumption that the reader has no more than a principles of economics understanding.

Some argue that the US is sufficiently large that the tariffs imposed will increase welfare in the US.  We saw almost immediately that the argument for an optimal tariff was violated; shortly after tariffs were imposed in 2025, other countries retaliated with their own tariffs. Various studies indicate Americans are bearing almost all of the tariff.  

A recent WSJ piece points to another issue: at least as far as China is concerned, the US is not a sufficiently large country.  According to data from the US Census Bureau, US imports from China are down some 45.6% from last year, but China’s exports are up.  Rather than reducing prices, China simply found other buyers for their goods.  Consequently, these data imply that US consumers and individuals are likely bearing most, if not all, of the tariff on Chinese goods.  The tariffs reduced imports, increased prices for Americans, but the global price did not change. China simply found other buyers.  The supply curve was, for all intents and purposes, perfectly elastic.

The usefulness of a model derives from its ability to make sense of the real world and give us the ability to make predictions.  The “realism” or complexity of a model is not necessarily a feature.  In many ways, the large-country model is more realistic than the small-country model.  It’s quite unlikely that any country, let alone the United States, is so small that they cannot influence world prices at all.  Ultimately, all trade is done by individuals and not nations, so it’s reasonable to assume there will be some influence on a case-by-case basis.  However, the large-country model is not particularly helpful in explaining real-world outcomes.  The small-country model, despite its lack of realism, provides far clearer analysis, at least as a first approximation of effects.