The big deception behind tariffs and geopolitics

The big deception behind tariffs and geopolitics

China and the United States have been engaged in a 15-month-long trade war, with an end that is not in sight. As parties and candidates gear up for next year’s elections, all manner of claims are being made about the goals of the trade war and its effects. Basic tools of economics and political science can help adjudicate the merits of those claims.

Barely a day goes by without the claim being made that the trade war hurts U.S. producers and consumers. There are special conditions under which this claim is true. But, as a general statement, it runs counter to international trade theory

The more that the goods being traded approximate a globally-traded commodity – that is, there are multiple producers and consumers – the more a targeted tariff has the same effect as a unilateral trade sanction, which is to say that it barely has any effect at all. Rather, it simply redirects trade flows.  

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For example, when China levies a tariff on U.S.-produced wheat, purchasing managers in China can shift to wheat produced by another country – say, Canada – which already was exporting wheat to Bangladesh, Nigeria and Indonesia. As Canadian exports get redirected to China, U.S. capacity that had previously been dedicated to the Chinese market is redirected to those other markets. 

There is a short-term, non-trivial readjustment cost created by the rerouting of logistics, and there will be some minor increase in global transport costs. But the redirection of trade flows washes out the effect of the Chinese tariff.  

The question of who pays the Chinese tariff – American producers or Chinese consumers – is a red herring: Neither pays. The same is true about a targeted U.S. tariff on a Chinese good; if the product in question is a globally-traded commodity, neither American consumers nor Chinese producers pay a tariff.

The exception to this general rule about targeted tariffs is when the two countries in question account for the vast majority of world production and consumption of a particular good. In that case, their bilateral trade is the equivalent of world trade, and the effect of the tariff cannot be undone by the redirection of trade flows. In such a special case, who pays the tariff depends on whether producers or consumers are more responsive to changes in prices — what economists call "the relative elasticities of supply and demand.”  

A thought experiment illustrates the concept. Imagine a product in which the United States is the sole producer and China is the sole consumer. If Chinese consumers are more responsive to changes in prices for this particular good than American producers – typically, because consumers can easily substitute toward another product – then U.S. producers pay most of the cost of the tariff. If the reverse is true – if Chinese consumers cannot easily substitute away from a particular product, making them less responsive to changes in prices than U.S. producers – then most of the cost of the tariff will be borne by Chinese consumers.  

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The same would be true about a good in which China is the sole producer and the U.S. is the sole consumer.

It follows that any claim that U.S. consumers are bearing the cost of a targeted tariff on a particular product must pass two empirical tests: China and the U.S. account for most of the world production and consumption of that product, and American consumers are less responsive to changes in prices than Chinese producers. 

It is unlikely that there are many Chinese exports to the United States that would meet both criteria. There may be a small number of agricultural exports from the United States to China (soybeans, for example) that would meet the criterion of accounting for most of world production and consumption. But any claim that U.S. producers are bearing the cost of the Chinese tariff also has to pass the empirical test that U.S. producers are less responsive to changes in prices than Chinese consumers.  

This is not to suggest that the effects of the trade war are negligible. U.S. manufacturing firms with supply chains that are tightly knit with Chinese contract manufacturers cannot reallocate production to other countries in the short run. Setting up a production facility in a third country, such as Vietnam, takes time. The Trump tariffs will either make their products less competitive in the U.S. market or reduce their profit margins. 

The same would be true for other multinational manufacturing companies with Chinese contract manufacturers and significant sales in the United States. The persistence of a trade war would force them to shift production away from China towards other countries.

The relocation of U.S. and other multinational firms out of China may, in fact, be the impetus behind the Trump tariffs. Indeed, anecdotal evidence is mounting that companies are reallocating plants to Southeast Asia. The goal of the tariffs may not be strictly economic, but geopolitical. In this light, the aim of the tariffs may be to debilitate the Chinese economy in response to China’s stated goal of becoming a global superpower.

If this hypothesis is correct, then two implications follow.  

First, President TrumpDonald John TrumpGOP divided over impeachment trial strategy Official testifies that Bolton had 'one-on-one meeting' with Trump over Ukraine aid Louisiana governor wins re-election MORE does not need to actually levy additional tariffs — he only has to credibly threaten to do so; the uncertainty about the potential disruption of global supply chains will induce foreign firms to relocate out of China. 

Second, readers should not expect a trade agreement between the United States and China anytime soon. 

Alexander Galetovic is an economics professor and senior fellow at the Universidad Adolfo Ibanez in Santiago, Chile, and a research fellow at the Hoover Institution at Stanford University. Stephen Haber is a professor of political science at Stanford University and a senior fellow at the Hoover Institution.