How Do Tariffs Work? | CNBC Explains

This short video provides an overview of the recent tariffs being applied on the World Stage and what that means for consumers, businesses and governments.

What is Protectionism?

Protectionism is methods used by governments to distort free markets and movements of resources to protect domestic industries from foreign competition. In other words, it's the way Governments can use their power to distort the movement of goods to give an unfair advantage to domestic producers. The forms of protectionism include:

• Tariffs

• Subsidies

• Quotas

What are Tariffs?

Tariffs are one of the main forms of protectionism that involve creating a tax on imports to discourage the consumption of imports and decrease competition with domestic producers. Tariffs are the only form of protectionism that also provide a source of government revenue. 

For example, think about the Australian Government's tariffs on imported motor vehicles at 5%. This was aimed to make domestic producers such as Holden (before it went belly up), to be more competitive. If you had two car producers, say Toyota (Japanese) and Holden (Australian), selling a car for $30,000.

The Holden Car would remain unchanged at $30,000, however, the Toyota car would be priced at $31,500 ($30,000 * 1.05), making consumers want to buy the Holden Car as it is cheaper. 

Examples of Tariffs:

• Australian: 5% tariff on imported personal, light commercial and four-wheel drive vehicles

• China: 200% tariff on Australian imported wines

• China: 80.5% tariff on Australian Barley

• United States: 25% tariff on imported aluminium 

Tariffs are a short-term solution to prop up an industry. However, the losers always outweigh the winners. Think about the United States' 25% tariff on imported aluminium. The domestic US producers of aluminium will be better in the short-term, however, in the long-term, they have a lower incentive to reduce costs or innovate to be competitive and the cost of construction will increase as aluminium is a key input for construction.

What are Subsidies?

Government subsidies are grants given to domestic producers to lower their cost of production to better compete with lower priced imports. Subsidies are seen as favourable by the general public as it does not increase prices but do provide a hidden burden on tax revenues. Government revenue could be better used elsewhere, such as for infrastructure, health or education rather than funding inefficient domestic industries. 

Examples of Australian Government Subsidies:

• Automotive Transformation Scheme (ATS) - $2 billion grant given to Australian automotive producers

Think about the cost of the $2B Automotive Transformation Scheme. This money was used to help keep the car industry alive, however, with Holden's exit, the major car manufacturers have left Australia. Could this money better be spent on healthcare or education?

What are Quotas?

Quotas are a form of protection that restricts the quantity of imports that can be entered into a country. Quotas are most favourable amongst domestic producers as it provides certainty amongst the number of imports they will be competing against.

For example, pretend you are a beef producer. The Government limits the amount of imported beef to 100kgs per day. This provides certainty as you know there will be limited amount of imported beef, providing certainty for the price of beef.