How Much Do Tariffs Raise Prices?

We break down how much of a tariff is ‘passed through’ to customers

By Jason Douglas, Anthony DeBarros and Danny Dougherty of The WSJ. Excerpts:

"For example, a 10% tariff on shoes from China would raise their sticker price 4% or so, but on wine or olive oil from Italy, almost 10%.

Why the difference? Tariffs aren’t the only factor at work. Currency changes, the availability of alternatives, and the pricing strategies of producers and importers all play a part. All of this affects “pass-through”—how much of a tariff reaches the consumer."

the availability of alternatives is one of the determinants of "price elasticity of demand." Economists often call it "Number of close substitutes." There will be more on this below. When products are taxed (like in tariffs or excise taxes), the price rises more when the demand is inelastic than when it is elastic. So that is why the price changes from the tariffs will not be the same for all goods.

"Moody’s analysis suggests a 10% tariff on a tablecloth from India would only raise the final price 2%, from $25.99 to $26.51. Tariff pass-through on tablecloths from India is limited because a lot of countries produce tablecloths and compete fiercely for American consumer dollars." (so there are alot substitutes)

"Higher prices on Italian wine don’t drive down consumption much; someone who loves a particular Chianti is reluctant to switch. Sellers are more likely to pass through the full 10% tariff, then, betting they won’t lose many customers as a result." (this is like saying that are not very many substitutes for Italian wine because people have a very particular taste).

Price elasticity of demand-It tells us how responsive quantity demanded (Q_d)is to a change in price. That is, when price changes, will the change in Q_d be large or small? The bigger the change in Q_d  the greater will be the price elasticity of demand.

We will use E_d to stand for price elasticity of demand. Here is the definition

E_d = %DQ_d /%DP

where D (the Greek letter delta) means "change in."

OR  E_d = % change in Q_d divided by % change in P

Determinants of price elasticity of demand

1. Share of the budget going to a good

If this is low, then price elasticity of demand is low or inelastic. For example, if you only buy one box of cooking salt a year and the price doubles from $1 to $2, you will probably still buy that one box because this spending makes up a very small share of your budget.

If this is high, then price elasticity of demand is high or elastic. But if the price of cars doubles, you will probably buy fewer cars since that takes up a much larger share of your budget.

2. Adjustment time. 

In the short-run price elasticity of demand is low or inelastic. For example, if the price of gas doubles, you will probably only reduce your quantity purchased slightly because you still need to get to school and work.

In the long-run price elasticity of demand is high or elastic. In the long-run, when you have more time to adjust to the higher gas prices, you can shop around and buy a car with better mileage, move closer to your job, get into a car pool or find a bus route. So your quantity purchased of gas will decrease more than in the short-run.

3. Number of close substitutes.

If there are few substitutes for a good, then price elasticity of demand is low or inelastic. For example, if there is a drug you need to take (or something like insulin for diabetics), there will be few substitutes. So if the price increases, your quantity purchased will not change much because you must buy this drug.

If there are many substitutes for a good, then price elasticity of demand is high or elastic. For example, if the price of potato chips increases, your decrease in quantity purchased will be great because there are many substitutes for potato chips. You can get nachos, pretzels, corn chips, etc. instead.

Again, the article mentions that some prices will rise more than others.  How does this work? Let's look at the graph below.

What if there is a reduction in the supply of a good? (this happens when a product is taxed, like in a tariff although the supply line actually shifts upward by the amount of the tax). If we have demand 1 (D1), price will go up quite a bit (as shown by the long green line). This is inelastic demand.

But if demand becomes more elastic and we move to demand 2 (D2), the same decrease in supply means a much smaller increase in price (as shown by the short green line). So if we have more elastic demand (D2), the price is lower than at D1 when supply decreases.

So the products that don't go up as much that the article mentions will have more elastic demand like D1.

One caveat. Slope and elasticity are not the same thing. Elasticity usually changes as you move along a demand curve (the elasticity going from a price of 10 down to 9 is not the same as when the price falls from 2 to 1). But if we picked two prices (any prices that are not where the demand curve hits the price axis and zero) and the calculate the elasticity, the steeper line will have a lower elasticity.