A tariff is a tax levied on foreign goods and services imported into a country. Tariffs make goods and services more expensive and thus, consumers shift to the domestic alternatives.
Tariffs are usually imposed as an economic tool to improve the balance of trade as they decrease the imports. They are also targeted at protecting the domestic producers from competitive foreign goods. Tariffs can also be imposed on exports of goods and services, although that is seldom the case. It is done to discourage exports of certain goods and services.
Tariffs are also used as a political tool. Governments may sometimes favour certain countries with whom they have political ties, while they may try to limit trade with other countries owing to technological, economic and political spats.
Tariffs have three broad types based on how they are levied:
Import tariffs can be beneficial to an economy in many ways. As imports become expensive, consumers shift towards domestic goods. This competitive advantage enjoyed by domestic goods translates into increased production along with higher profits to domestic firms. Thus, as firms start gaining increased profits, they expand and hire more workers. This increases the overall employment in the economy.
Therefore, tariffs affect two major areas positively: the domestic competitiveness of firms as well as the employment rate in the economy.
Tariffs can sometimes also be implemented to protect the domestic economy from infiltration of foreign produce. Sometimes, highly developed nations impose import duties to safeguard their economies from dumping of foreign goods. This kind of tariff is called an anti-dumping duty which is used when a country is suspected of exporting a good at a rate which is lower than the rate at which the same good is sold in their domestic markets.
Consider the following diagram:
In the figure above, point O represents the situation of autarky or a closed economy that has no trade with foreign countries. Now consider the effects of the economy opening its borders to international trade. The international price of the same good is Pw, which is significantly lower than Pd, the domestic price. Under the assumptions of free trade and a small domestic economy, the domestic prices would also become equal to Pw.
At price Pw, the domestic demand is Q4 while the domestic supply is Q1. The difference between the two is met by the quantity of imports.
The lower price of the imports would make them preferable to the domestic produce. However, when a specific tariff is introduced on the imports, the price of the imported good rises to Pw + T. This makes the good more expensive and thus reduces its imports into the economy from Q1Q4 to Q2Q3.
The welfare implications of a tariff are a subject of popular debate. Many theorists argue that tariffs bring distortions into the economy.
The red box ABCD represents the revenue earned by the government through the tariff. The line AD represents the value of tax while the link DC represents the amount of imports. The domestic prices would rise to Pw +T when the tariff is introduced. As a result, domestic consumption falls to Q3, while the domestic produce increases to Q2.
Therefore, domestic producers gain from a tariff. The supply has increased from Point E to point A. The demand has come down from point F to point B. The government also gains a lumpsum amount equal to AD multiplied with DC, which is the tariff revenue. Thus, both producers and the government are gaining from a tariff.
However, the entire process is giving rise to a deadweight loss which is represented through triangles AED and BCF, both coloured in blue. These two triangles are not utilised anywhere and are lost in the process of tariff implementation.
Thus, there is a welfare loss associated with tariffs, that is paid by the consumers. The consumers could afford a greater amount of the good at price Pw. However, when prices are increased to PW + T, part of welfare lost by consumers goes to producers, and a part of it goes to the government. But triangles AED and BCF are lost in this process.
Therefore, tariffs cause a distortion in a free market and can even lead to many adverse economic repercussions. Thus, for a small economy, tariffs need to be implemented with proper regulation and without any intent of harming any country’s producers. Rather, the intent should be to protect the domestic producers. The same might not be true for a large economy as any protectionist intent by one country can trigger a trade war between several countries as seen in a few past scenarios.
What is an Absolute Advantage? Absolute advantage is one of the key macroeconomic terms, which is based on the principles of Capitalism and is often utilised in international trade-related decisions. Absolute advantage refers to the competence of a company, region or country to produce goods or services in an efficient manner compared to any other economic entity. The efficiency in production can be achieved by: Production of the same quantity of good or services as produced by other entity by utilising fewer amount of resources Production of a higher quantity of good or services as produced by other entity by using the same amount of resources What is the Significance of Absolute Advantage? Different countries or businesses possess a different set of ability owing to their location, soil composition, weather, infrastructure, or human resource skills. When applied in the right direction, various factors may pan out to offer more cost-effectiveness and hence build absolute advantage of the entity in comparison to others. The absolute advantage remains one of the critical determinants for the choice of the goods or services to be produced. Absolute advantage in a particular area often translates into profitability in the area. The profit margin increases by the achievement of cost efficiency, allowing the entity to ensure higher profitability over the competitors. For example, let us assume that the US can produce ten high-quality aircrafts utilising a specific amount of resources. China, on the other hand, can build 6 similar quality aircrafts using the same amount of resources. Thus, in the production of an aircraft, the US holds Absolute Advantage Let’s say the US has the ability to manufacture a certain amount of steel using 10 tonnes of iron ore. China, on the other hand, can produce the same quantity of steel using 8 tonnes of iron ore.Here, China here holds Absolute Advantage in the production of steel. How Countries Build Absolute Advantage? While natural conditions, which include climatic factors, geometry, topography, cannot be altered for achieving absolute advantage, the countries use the underlying factors strategically in their favour. Furthermore, factors of production are focused at by many companies or nations for building absolute advantages. Some of the strategies for building absolute advantage includes: Development of Technological Competencies- The implementation of innovative or latest technological innovations allows the entities to lower their production cost, facilitating absolute advantage. Enhancing Skills of Human Resources- The improvement in the cost-efficiency, along with the quality of the products, is targeted through imparting varying skill development programs. Many countries subsidize or aid the apprentice or labour training for enhancing the absolute advantage in trade. Improving Infrastructure- The infrastructure enhancement in the form of road, telecommunications, ports, etc. can be useful in enhancing the cost-effectiveness across different industries. What Do We Understand by Comparative Advantage Vs Absolute Advantage? Evaluating the comparative advantage introduces the concept of opportunity cost, which is the deciding factor to determine the production of particular goods or services. Opportunity cost refers to the potential benefits associated with the next best possible alternative which is missed out when one option is chosen over another. The Absolute advantage simply considers the capability of a business or region to deliver goods or services in the most efficient manner. The Comparative Advantage, however, also takes into account the benefits that are forgone if an entity decides for production of a particular product or services. Comparative advantage, based on the notion of mutual benefits, is often used in international trade deals. The Comparative advantage has been the major factor driving the outsourcing of services in search of cheap labour. Understanding through an Example For instance, country A can produce ten televisions with the same amount of resources with which it can make 7 laptops. The opportunity cost per television is 7/10 or 0.7 laptops. Meanwhile, the opportunity cost per laptop is 10/7 or 1.42 television. It highlights that country A is forsaking the production of 0.7 laptops if it is deciding to manufacture one television. On the other hand, it is missing out the opportunity to manufacture 1.42 televisions for every single laptop manufactured. Now, say Country B’s opportunity cost for producing a television is 0.5 laptop, and that of producing laptop is 2 televisions. Then, country B will have a comparative advantage in making televisions, and country A will have comparative advantage in producing laptops. It has to be noted that despite country A having absolute advantages in both the products, it would be mutually beneficial for both the countries if country B produces television while country A produces laptops. Do You Know About Absolute Advantage Theory by Adam Smith? The concept of Absolute Advantage was indicated by Adam Smith in his book called ‘Wealth of Nations’ which focusses on International trade theory. Adam Smith, in his book attacked on the previous mercantilism theory, which mainly stressed for economies to maintain trade surplus in order to command power. The Absolute Advantage theory considered that the countries possess different ability with respect to the production of varying goods or services. It argued that it is not necessary that a state may hold an absolute advantage in the production of all goods, and here the relevance of trade comes into play. It advocates that countries should produce those goods over which they hold a competitive advantage. It would allow the countries to make the same amount of goods using few resources or in less time. The theory propagates the relevance of trade for economic sustainability. What Are the Limitations of the Absolute Advantage Theory? The assumptions used in the Absolute Advantage Theory by Adam Smith may limit the application in real bilateral trade. The limitations of the theory by Adam Smith include: Smith assumed that the productive capabilities of a country could not be transferred between the two countries. However, in practical terms, the competitive scenario aids the nations to acquire new capabilities and acquire new resources, especially in the technological and human resource skill aspects. The two-country trade which was used as a basis for the theory does not consider the trade barriers levied. The present scenario, however, is strikingly dominated by trade wars between economies. Nations impose huge tariffs, import duties and other type of barriers to promote local manufacturers. Absolute Advantage theory assumes that the trade between the two nations will take place only if each of the two economies holds an absolute advantage in one of the commodities traded. However, in general, countries despite not holding absolute advantage are engrossed in international trade, boosting their economic setup.
What is meant by Balance of Payments or BOP? Balance of Payments refers to the record of transactions maintained by a country with the rest of the world. It is a detailed list of international transactions that a country has with its trading partners. These transactions can be made by the residents, domestic businesses or by the government. In an ideal situation, the sum of all the elements of BOP should be zero. However, this is rarely witnessed as most countries do not have the exact same amount of inflow as that of outflow. The inflow and outflow from the rest of the world, can be with respect to goods, services, assets, investments, etc. Notably, a deflection from the ideal zero BOP state may not always be harmful. A surplus (positive BOP) might indicate a strong economy as it means exports are greater than imports. While, a deficit (negative BOP) might point to an increased debt on the home country. The Balance of Payments is highly reflective of the economic strength of a country. Most of the impacts of BOP are indirectly observed on various macroeconomic indicators. What are the Components of BOP? BOP comprises of two broad components, namely, Current Account and Capital Account. Sometimes the Capital Account is referred to as the Financial Account, along with a separate capital account. The Financial Account includes transactions in financial instruments and central bank reserves. While the capital account includes transactions in capital assets. A balance in inflow and outflow of all these accounts makes for a BOP equal to 0. CURRENT ACCOUNT: In technical terms, Current Account is the sum of Balance of Trade, Factor Income (net income from foreign investments) and unilateral transfers (net gifts and grants received). Put simply, current account records the transactions done in goods and services, investments and the net transfer payments or unilateral payments. Exports are maintained as credits, while imports are maintained as debits in the balance of payments. A positive current account balance means that the domestic country is a net lender, while a negative current account balance indicates that the home country is a net debtor. According to the double-entry accounting method, any entry on the export side would be adjusted with an appropriate entry on the import side. For example, for a good exported by the home country to a foreign country, the corresponding import transaction would be the inflow of foreign currency received in exchange for the good exported. CAPITAL ACCOUNT: The capital account involves all transactions relating to international asset It involves transactions made in the reserve account as well as loan payments and investment made across nations. These loans, however, do not include the future stream of interest or dividend payments as they are a part of current account. This is so because they form a part of nation’s spending or income, depending on the type of flow. A capital account is said to be in deficit when a country purchases more assets than the assets it sells to the rest of the world. An increase in assets is followed by a corresponding decrease in cash and vice versa. In some countries, the capital account is known as the financial account and has separate component called the capital account. This capital account records the transactions that do not affect the income, production or savings like international transfer of trademarks and rights, etc. What do BOP deficit and surplus mean for the home country? In layman’s language, BOP tells us whether the country is earning enough to meet its expenditure. If there is a deficit, then it can point towards the country’s growing expenses which are not sufficed by the income generated. Thus, there is a need to generate debt in order to fund the current requirements. Many a times the need to repay current debt gives rise to more debt. Therefore, an endless cycle of financing previous debt with current period loans takes place. The credit received from the rest of the world is generated either by taking a loan, which adds as a liability in the accounts or by selling off the assets currently possessed by the country. These assets can be natural resources, land, commodities, etc. A surplus on the other hand means that a country is exporting more than it is importing in all its existing BOP accounts. This can be a positive sign in most instances as it points towards stronger economic movements. A surplus can encourage the home country to invest in production of goods and services and in turn promote GDP growth. However, an export-driven growth in the long run could point to lack of sufficient demand in the home country. In such a case, the government should boost consumer spending in home country in order to become more self- reliant. What are the factors affecting BOP? BOP depends on various factors. These include: The domestic exchange rate: Exchange rate is a measure of foreign currency with respect to the domestic currency. Governments can revalue or devalue the exchange rate with the help of appropriate policies. This affects the BOP by making exports cheaper as the exchange rate falls and making imports cheaper when the exchange rate rises. The spending capacity of domestic consumers: As businesses and households are left with greater disposable income, they can spend more on imports and this can affect the BOP. Price competitiveness offered by domestic goods: For a country that is going through higher rates of inflation than its trading partner, the goods and services offered by it would be relatively more expensive. Thus, the country becomes less competitive in terms of price competitiveness. The country with lower inflation would thus have cheaper exports. In such a case, domestic consumers would prefer foreign goods and services causing increased imports and eventually a BOP deficit. Domestic policies: Trade based taxes and tariffs are a huge influencer on the BOP. Policies boosting exports are always beneficial to a country. It is important to pay attention to imports by imposing restrictions using tariffs or quotas. Apart from trade centric policies, domestic policies aimed at economic growth may cause changes in BOP. For instance, increased interest rates can promote FDI in the home country, which would affect the Current Account in BOP.
What is Trade War? The term trade war is applied when two nations proceed at war with each other, not through military operations but by imposing tariffs and quotas on imports from a trading partner. The term is commonly used worldwide as many nations are continually competing with each other over the supremacy of the economy. These restrictions are implemented to harm the rival country financially. The foreign country retaliates with similar types of trade sanctions which is referred to as trade protectionism. Under the protectionist policies, the government encourages the consumption of domestic products over imported goods. The trade barrier imposition damages trading partners' economies and devalue its domestic currency. Image Source - ©Kalkine Group 2020 What happens when countries indulge in the trade war? Trade war begins when a nation wants to protect their jobs and domestic industries. They may do this by an increase in import tariffs or imposing restrictions in trade. This may lead to a boost in domestic economy and reduction of dependence on the foreign country for goods and materials. As the products from the foreign country stop penetrating the market or its demand are lowered because of higher prices, the local products see a growing request from domestic customers. If the local business grows because of such policies, it results in the ever-increasing need for jobs as well; however, in the long run, trade war bequeaths its impacts on both the countries. The consequences of a trade war can be as severe as depressing economic growth and triggering inflation as the prices of imports increased because of the tariffs. A phrase Beggar-thy-neighbor policy refers to this situation when an economic policy is implemented to benefit the country while harming the country's neighbours or trading partners in international trade. Such policies are ideated to protect the domestic economy while reducing the dependency on imports and increasing exports. Adam Smith, a Scottish philosopher who is considered to be a founder of modern economics, referred to the beggar-thy-neighbour implementation in the trade war. He criticised mercantilism; a dominant economic system prevailed in Europe from the 16th to the 18th century. Economists soon concluded that such policies could trigger trade wars and push countries involved in autarky - a system of economic self-sufficiency and limited trade. A state like this is hugely detrimental for a country's economic growth. Image Source: Kalkine Group Image What are the advantages and disadvantages of the trade war? Advantages: Bolsters Domestic Business: The most important advantage a trade war offers is that the policies aid companies to flourish. When the government enforces tariffs on imports, these products become expensive. The similar domestic product in the market is, however, available at a competitive price. The buyers would prefer to obtain local goods compared to the imported product, which leads the domestic companies to grow and prosper. Once the company becomes a prominent player in the local region, it has a higher possibility to expand internationally and build a more influential company. Diplomatic Stand: Another benefit trade war provides is that if one country is imposing tariffs and restrictions policies on another country and the country in return is not offering any retaliation then in the international arena, the government will be considered weak. Diplomatically its reputation will be a vulnerable nation who does not retaliate to such grave threats. Countries usually retaliate if such a situation arises in order to safeguard its international status. Checks Wrong Trade Practices: Not all countries trade in an honest manner. Some dominating countries dump their inferior products to other countries. The consumers of the nation stand at risk by buying low-quality goods. So, when the trade war occurs, it ensures that such ill practices are restrained and kept in check. Disadvantages: Increases Inflation A biggest disadvantage trade war has is that it increases inflation exponentially. This tariff war tends to create an artificial shortage of goods, which leads to the surge price of goods—ultimately causing inflation which then lowers the standard of living for both countries involved in the trade war. Creates Strains between Countries: Once the trade war is started, it has a tendency to continue longer. It does not just damage the economic backbone of the countries involved, but diplomatically weaken the relationships. So instead of reasonably talking terms, the countries indulge in tariff and restrictions wars. Such consequential situations hurt the cultural connections as well, which the countries could be nurturing for many years. In the long run, trade war shows its repercussions by incapacitating both countries, if not equally but on similar levels. Increases Domestic Monopoly: Because trade war provides a suitable environment for the local companies to flourish, in the long run, both involved countries can eventually become big and act dominant. The lack of competition from the international market renders a safe haven to create a monopoly. With both country's companies behaving influential in their space, the customers have greater chances to suffer from higher prices and no alternative. Because of multinational companies, domestic companies always feel threatened by healthy competition and provide the customer with good quality goods at competitive rates.
What is Globalization? Globalization has long been supported in view of the economic, political and cultural benefits, supporting the exchange of ideas, talent, technology, culture, trade and investment. However, the trending phenomenon of Globalization is under the scanner, with increasing difficulties faced by policymakers in preventing the national economic crisis and economic depression from creating havoc across the globe. Be it 1930s Great Depression, 2008’s Global Financial Crisis or 2020’s Global Virus Crisis, Globalization has played a major role in the geographical spread of financial and economic turmoil. Globalization is defined as a phenomenon of the world becoming interconnected by the exchange of goods, services, people, trade, culture, money, ideas, technology and policies. It refers to the interdependence of human resources, corporates and governments across the world. Though it has been taking place for hundreds of years, the Globalization process has expedited over the last half-century, encompassing economic, cultural and political exchanges across the globe. How Do We Trace Back the Early Signs of Globalization? In the history books, the inter-state trade has its mention from the earliest civilizations dating back to roughly 1600s. Communities and states enlarged interdependence equations and trade, resulting in key exchange of social ideas and practices. Back in the third millennium BC, the economic trades happened between Sumer and Indus Valley Civilisation with the commercial urban centres opening between the Greek to Indians. This inter-state trade phenomenon was not only driven by Europe but also Old World centres - India, China, Japan. Further, free-trade agreements, global political and economic discussions, and free-flow of money, people and technology promoted the evolution of Globalization in different themes. How Do We See Current Globalization Trends? Since the beginning of the 19th century, Globalization has accelerated with the breakthrough in transportation and communication technology. In the late 20th and early 21st century, Globalization has also increased for the sports and entertainment sector. Besides, digital trade as a component of Globalization is gaining importance between the nations. Investment flows for accessing new markets in developing economies and associated investment, people and technology flows also shape the growing Globalization trends. Financial markets including commodity, debt, currency and stock markets are increasingly interconnected, with market players tapping buoyant investment opportunities across the world. On cultural exchanges, movement of students for academic purposes and learning is further supporting global interconnection trends. Although Globalization is probably serving as a bridge between countries to create more wealth, studies have shown it is not reducing the economic gap between the poorest countries and the richest. Conflicts between nations and irregular diplomacy have played a large part in the history of Globalization, and it continues to do so. What are the Key Drivers of Globalization? Transportation: The speed, length and breadth of Globalization has increased for a number of reasons. Developments in Information Technology, transport and communication sectors have rapidly grown over the past 40 years. The internet has been transformative in closing the gap in communication with providing fast and 24/7 access world over. The containerization system where large quantity goods and commodities are shipped using intermodal containers has also enabled trade around the globe at extremely low cost. Communications: The sharp rise in social and digital media has made the national boundaries absolutely irrelevant as any company can communicate and market its products and services in any part of the world directly connecting with its target audience. Easy access to virtual global market trade has grown substantially after the emergence of the internet. New electronic payment systems such as e-wallets, mobile banking, pre-pay have facilitated the increased global trade. For better or worse, globalised trade, supply chain, outsourcing have changed the way the world operates, and its impact on organizational operations and practices continues to grow. Free trade: Following the collapse of communism ideology, the trade has become increasingly free with many former communist countries opening for Foreign Direct Investment (FDI) and global trade. The emergence of global players such as Google, Facebook, Apple, Microsoft, etc are by-products of Globalization. Is Globalization Changing the World for Better or Worse? Globalization have several pros and cons attached to the international linkages between economies and markets. Current Globalization trends have largely integrated developing economies with less developed economies through Foreign Direct Investment (FDI); with the decrease in trade barriers like import quotas and tariffs as well as economic reforms like policies and regulations, and also at a large extent, immigration. International standards have created efficiency in the trade for goods and services, and the International Organization sets these standards. Currently, the most significant free-trade area is the European Union. EU policies implement the free movement of resources (human, capital and ideas) within the European Union market. Access to broader markets means higher demand for products and services. Though it can also lead to a lack of product diversity, like most of the world's computers, use Microsoft's Windows operating system, presenting barriers to small, local producers. Besides, global players are exerting downward pressure on wages below fair market equilibrium level. How is Globalization Influencing Culture and Political behaviors? At present, most of the cultures have been defused because of the internet, popular culture media and travel. As people are more exposed to other cultures, transition of ideas, values, meanings take place, which is also extended into fashion, food, languages and even religion. While Globalization’s impact on art and culture is clearly visible, but it also creates uncertainty in ideologies and disorientation in identities. Critics of Globalization argue that global connectivity poses thread to prevalent indigenous cultures. Globalization has also interlinked state governments, intergovernmental organisations, social organisations etc. This integration between national and international levels of authority have pushed the emergent global political economy. Some countries also allow its citizens to take citizenship of other countries. Another essential aspect of Globalization is the movement of people, not only limited to immigrants but also encompassing movement for travel and business. Foreign students' revenue across different courses and learning programs add to country’s economic growth, both financially and culturally. But overdependent on these interlinkages in terms of trade, money and culture can be harmful as the system may collapse when there is a sudden downturn in the world. Novel coronavirus (COVID-19) pandemic completely halted peoples’ movement, which impacted tourism, education, hospitality industries severely.