The costs of a tariff come from the higher price to consumers, but this is partly offset by the tariff revenue that goes to the government. This tariff revenue is a benefit and can be redistributed to consumers or spent on goods from which consumers derive a benefit. But there are also efficiency costs associated with tariffs—deadweight losses, as we call them. These are the real costs of the tariff, and they arise because the marginal cost of production does not equal the marginal benefit to the consumer. Let us see how these concepts apply with the help of Figure 15.4.
Consumer surplus is the area under the demand curve and above the equilibrium market price. It represents the total amount consumers would have been willing to pay for the product but did not have to pay at the equilibrium price. It is a measure of consumer welfare. The tariff raises the market price and reduces this consumer surplus by the amount LFGJ. This area measures by how much domestic consumers are worse off as a result of the price increase caused by the tariff. But this is not the net loss for the whole domestic economy, because the government obtains some tax revenue and domestic producers get more revenue and profit.
Government revenue accrues from the domestic sales of imports. On imports of (Q'D - Q'S), tax revenue is EFHI. Then, domestic producers obtain an additional profit of LECJ—the excess of additional revenue over their cost per additional bottle. If we are not concerned about who gains and who loses, it is clear that there is a net loss to the domestic economy equal to the areas A and B.
The area B is the standard measure of deadweight loss. At the quantity Q'D, the cost of an additional bottle is less than the value placed on it by consumers; and, by not having those additional bottles supplied, consumers forgo a potential gain. The area A tells us that when supply by domestic higher-cost producers is increased, and supply of lower-cost foreign producers is reduced, the corresponding resources are not being used efficiently. The sum of the areas A and B is therefore the total deadweight loss of the tariff.
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