Why Tariffs Hurt Everyone

Tariffs have been making headlines again. The U.S. government, under President Donald Trump, imposed a 25% duty on imports from Canada and Mexico and an additional 10% duty on goods from China. There were also threats to impose tariffs on other countries with which the U.S. has a trade deficit. Since India has a trade surplus of about $35 billion with the U.S., Indian exports could also face punitive tariffs soon.

At first glance, tariffs might seem like a good way to protect domestic industries. However, history and economic theory show that tariffs often end up harming not only global trade but thereby the very people they are meant to protect.

The Case for Free Trade

To understand why free trade is beneficial, let's consider two fictional countries, A and B, producing and trading two products: apparel and shoes.

What Happens When Countries Operate in Isolation?

If Country A and Country B decide to produce and consume goods independently, their production might look like this:

Country A produces 100 units of apparel and 50 units of shoes, using 200 and 400 resource units, respectively.

Country B produces 100 units of apparel and 150 units of shoes, using 100 and 300 resource units, respectively.

In total, they produce 200 units of apparel and 200 units of shoes with their available resources.

A closer examination reveals that Country B is more efficient because it uses fewer resources per unit for both goods. It uses 1 unit of resources per apparel and 2 units per shoe, whereas Country A requires 2 units per apparel and 8 units per shoe. This might suggest that Country B has no need to trade with Country A. However, a deeper look reveals a better possibility.

How Trade Benefits Both the Countries

To be able to trade, the two countries reallocate resources, deploying more resources to the product for which they are relatively more efficient producer.

Country A decides to focus more on Apparels, shifting 120 resource units from Shoes to Apparels. As a result, it now produces 160 Apparels and 35 Shoes.

Country B does the opposite - it shifts 50 resource units from Apparels to Shoes, leading to production of 50 Apparels and 175 Shoes.

As a result of the reallocation, the two countries collectively now produce 210 Apparels and 210 Shoes - 10 more of each product, using the same resources (600 units for Country A, and 400 units for Country B).

Then They Trade With Each Other

Country A needs 50 shoes but now makes only 35, so it imports 15 shoes from Country B.?

Country B needs 100 apparels but now makes only 50, so it imports 50 apparels from Country A.

Resulting in a Win-Win Situation!

Even after meeting their domestic demand through trade:

Country A still has 10 extra apparels to export to another country.

Country B still has 10 extra shoes to sell elsewhere.

As a result of the willingness to trade, the overall production of goods has increased, and each country can consume more than it originally could in isolation.

This example shows that international trade allows countries to specialize, increase total production, and meet demand efficiently - while also creating surplus for further trade!

Trade Deficits and Why They Aren’t Always Bad

Now, let’s introduce pricing:

If one unit of apparel is priced at $100, and one unit of shoes $150, then:

Country A will pay Country B, $2250 (15 x 150) for the imported shoes, and

Country B will pay Country A, $5000 (50 x 100) for the imported apparel.

The net result of the trade is that Country B will have a trade deficit of $2750 vis-à-vis Country A.

Does this mean Country B is at a disadvantage? Not necessarily. It can export its extra 10 units of shoes to another country to balance its trade. It may have trade surpluses with other countries, offsetting the deficit. It might receive foreign capital flows, helping fund its trade deficit.

A trade deficit isn’t always a sign of weakness. It often indicates that a country is consuming more because it has access to external financing or foreign capital inflows.

What About the U.S.?

The U.S. has a large overall annual trade deficit (around $900 billion, or 3% of its GDP), especially with China. However, this deficit is funded by capital inflows from other countries (including China), as the U.S. is seen as a safe place for investment.

The argument, advanced by the U.S. President repeatedly, that tariffs will be borne by other countries is misleading. U.S. consumers will pay higher prices for imported goods, despite possible mitigation to some extent, through some price reduction by the exporting countries. The cost of living for Americans will rise significantly.

Implications for India

As the U.S. accounts for nearly 30% of global GDP, any disruption in trade caused by tariffs has ripple effect worldwide. Countries like China, which are significantly impacted, may seek new markets, possibly affecting India’s trade balance.

India already runs a trade deficit (importing more than it exports), but it has managed to sustain this by attracting capital inflows. In the long run, India must identify and strengthen industries where it holds a comparative advantage (that is, it is relatively more efficient producer) and explore new export markets to mitigate risks from shifts in trade preferences.

Final Thoughts

The principles of free trade, based on the theory of comparative advantage, enunciated by David Ricardo in 1817, remains relevant even today. Even a country that is inefficient in producing most goods still has something to export if it specializes wisely. This leads to mutual economic benefits for trading nations.

Tariffs, on the other hand, are blunt instruments, that disrupt the possibility of such mutual benefits, and lead to higher prices, inefficiencies, and reduced economic growth for everyone.

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