Are Businesses Absorbing the Tariffs or Passing Them On to Their Customers?

Jaison R. Abel, Richard Deitz, Sebastian Heise, Ben Hyman, and Nick Montalbano. They are all with the Federal Reserve Bank of New York. Excerpts:

"most businesses passed on at least some of the higher tariffs to their customers, with nearly a third of manufacturers and about 45 percent of service firms fully passing along all tariff-induced cost increases by raising their prices."

"As a result of the higher tariffs, manufacturers indicated that the cost of their tariffed goods had increased by an average of about 20 percent over the past six months, while service firms reported a roughly 15 percent average cost increase. While these figures are quite close to the increases in the firms’ average tariff rates, firms’ costs of tariffed goods may not have increased by as much as the tariffs in part because importers may have switched towards suppliers in other countries or in the United States; foreign suppliers may also have lowered their prices to help offset the tariffs."

"Almost a third of manufacturers and about 45 percent of service firms reported fully passing along all tariff-related cost increases, while 45 percent of manufacturers and a third of service firms said they passed along some but not all of the cost increase."

" a quarter of both types of firms said they absorbed all tariff-related cost increases and were not raising their prices. This pattern is consistent with other research using business surveys showing that in response to a hypothetical 5 percent cost increase, about a quarter of firms would fully pass through this cost increase into higher prices, while another quarter of firms would not change prices at all."

"Consistent with textbook economics, tariffs generally resulted in higher prices to customers. Indeed, roughly half of businesses reported raising prices of goods directly subject to tariffs. Interestingly, a significant share of businesses also reported raising the selling prices of their goods and services unaffected by tariffs. Many businesses indicated they increased prices to cover other rising costs such as wages and insurance"

The article mentions that some prices rose 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. 

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

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