Do tariffs ALWAYS increase the cost to the consumer?
Big question, will the new tax on Chinese imports wreak havoc on our economy? Will prices skyrocket? Will shortages ensue? Lets look at this reasonably.
For the moment we will ignore the accusations of stealing technology where ever and whenever they can. We will ignore their apparent cyber attacks and their cheating on the world wide economic stage in various ways. Lets just focus only on the simple, basic rules of economics.
The Chinese have the advantage in manufacturing because they are a communist country using what amounts to slave labor in all their manufacturing processes. They parlay that advantage into considerable profit, which the people rarely see. This is certainly a great way to make stuff for worldwide consumption, but the question is: what will the results of additional tariffs be for us?
Lets look at this simplistically:
Manufacturers have only two basic factors to consider when determining the price to sell to consumers: Overall cost to produce and distribute, and profit desired. When cost to produce increases, usually the price paid by consumer does too – but in our international marketplace, - not always
Lets assume the Chinese are producing a magical miracle electronic gizmo. Also there are competing international companies with similar gizmos jockeying for the worldwide market.
The Miracle Gizmo
The Miracle Gizmo is an electronic device the size of a garage door remote opener. The Gizmo electronically locates all of those pesky things we constantly temporarily lose for hours or days at a time. It works either with different color lights, or an increasing sound of your choice. The closer you get to your lost item, the louder the sound, or the closer the color gets to red, you know you're getting warmer. Your keys, your glasses, TV remotes - whatever you program, pocketbook or wallet, your spouse - whatever you might lose, this handy dandy little hi tech doohickey will, after proper programming, locate your habitually lost items.
Like any manufacturer, the management and board of directors goal is to make a large profit for its shareholders. In a communist country like China, the profit goes to the nation itself rather than shareholders, and instead of the board members stealing the profits, the Chinese leaders do. ...but I digress.
CHINA VS. SOUTH KOREA
Lets compare China to South Korea. First let me be honest; I have no idea how much more efficient China may be in manufacturing, or how much more they may profit from the gizmo. Numbers below are just a guess, an example. Clearly their profit margins are higher. The point of the exercise is to try to see what a manufacturer might do when only their cost (as opposed to their competitors’ cost) increases through the addition of a specifically targeted tariff.
In order to bring a Gizmo to market, costs must be calculated to arrive at a price they believe they can charge for it which will be profitable enough to make production worthwhile. Keep in mind this is a very simple example; there could be many more cost categories. This is not meant to be an advanced accounting course.
To estimate the cost of marketing the Miracle Gizmo, we have to consider taxation in several forms, because all taxation reduces profit. Some are already factored in and paid by the suppliers in advance to arrive at the price that the suppliers then pass along to the manufacturer for materials.
Expense China S Korea
Plastic and other stuff $10 $10
Elec Components 15 15
Marketing 5 5
Payroll Wages 5 30
Plant Expenses 10 15
Total Costs $45 $75
Price to Consumer $100 $105
Expected Profit / unit $55 $30
Price is a very important factor for the consumer, but it isn’t the only one. Could be that South Korea makes a more reliable Miracle Gizmo, and some people may be willing to pay a little more for it. China sells their gizmo for $5 less than South Korea but still makes a much larger profit per unit, $55 as opposed to $30 for South Korea.
ENTER THE TARIFF
The evil one, Donald Trump, imposes a new tax on Chinese goods for their unfair trade practices, but NOT South Korea. The tax is $10 per unit. Chinese leaders are angry, claiming it is unfair to them.
China can react in only one of two ways; Increase the price of the gizmo to maintain their desired profit margin or at least minimize the profit margin loss,- or leave the price the same and absorb the entire tax accepting a reduced profit margin. They will make this decision based on what they believe is best for themselves. I suppose they could refuse to pay it by not selling to the U. S., - but that would be economic suicide, and not very logical
The Chinese could of course respond with retaliatory tariffs of their own against the U.S. If that should occur, they would be hurt more than we are, as they ship far more goods to us than we do to them. However slight inflation and certain minor market negativity could result. This will likely indicate that China is closer to the negotiating table than they are publicly willing to reveal, and would be in a more consiliatory mood as this type of response indicates a concern on their part. - or they could be just mad. Either way negotiations will happen and they will benefit us for a change.
Accepting the additional tax cost will still leave China with a considerably larger profit margin than that of South Korea. ($45 to $30 after the tax). Is that lower margin enough for China? It is more than enough for South Korea, but it may not be for China.
If China does not raise their prices, their market share will not change because of the new tariff. Their profit will of course be reduced as they have an added tax cost. The question is: Are they willing to accept the reduced profit to maintain market share, or will they raise prices and risk losing that advantage?
If China does raise their price per unit to maintain profit margin, more consumers will make the decision to purchase the higher quality gizmo from South Korea as the smaller difference in price makes a higher quality alternative somewhat more attractive to buyers. China still loses some profit as fewer units will be sold.
All things being equal, a new tax (tariff) will raise the price to the consumer when the markets are fair and competitive. To remain in business all manufacturers have to profit a certain minimum amount. What is that minimum? It depends on the manufacturer and their financial projections and particular policies. Is China well in excess of their required minimum? We don’t know, but we can guess.
All things are not equal
China is a powerful economic force, but they can’t yet dictate world markets. They hold an unfair advantage as their costs of production are much lower than other nations. We may see a slight increase in prices due to a new tariff, but one far less noticeable than predicted. The profit margin in goods coming out of China is so great, it is better for them to absorb much or all of this cost than to risk losing market share, which could be much worse for them.
Communists are not all that different from capitalists when profit is the goal. They prefer to make more money rather than less, so it will benefit China to do some bargaining. Less profit for them is still better than most countries can muster.
This tariff will not be the catastrophe many are predicting.
Christopher M. Barra, MS, EA