Any expanded domestic production must be sustained by permanently higher prices.
Michael Brendan Dougherty responded to my claim that raising domestic prices is the point of tariffs, since they aim to increase domestic production of tariffed goods by raising companies’ returns. Although he acknowledges “the price mechanism is the tool of tariffs,” and that tariffs must temporarily increase prices to be effective, Michael disputes that prices will be higher permanently in a responsive market economy such as ours.
He provides this theoretical example:
That is, if tariffs raise the price of an import (or goods made with imports) from $8 to $10, the American producer could set a price at $9.99 and win. But, the knowledge that a market clearing price exists below $9.99 is still a blaring incentive for other firms to enter the market at that price, usually by making some innovation or efficiency. . . .
Tariffs of this sort aim not at raising prices for their own sake, but on establishing incentives for investment in American industry which, once productive, has its own reasons to reduce prices. The note that this accords with experience is an important one, because we’ve seen that as the world trading order changes, investors adjust, and their new patterns of investment actually tend to bring about a period of business and productive innovation.
It’s true that if a tariff achieves its intended effect — boosting domestic production of a good — the price should eventually fall as supply rises. For Michael’s theoretical product, it might fall to $9 or $8.50, and it could hover around there permanently (assuming no general inflation). But tariffs cannot reduce the price of a good below its pre-tariff level. Prices may rise and fall, but they won’t fall lower than where they used to be.
There are two reasons for this maxim. First, any increased domestic supply that a tariff induces is only replacing the previous foreign supply that is now being turned away. At best, Americans gain access to only as much productive capacity as they lost from the trade barrier.
Second, domestic producers will never even reach that threshold of fully compensating for lost foreign supply, as to do so would reduce the price of their product to its pre-tariff level. This is what Michael implies should happen. But if a producer was unwilling to expand supply to meet an $8 price before the tariff, it will be unwilling to do so after the tariff as well. The relatively higher domestic production costs that made the tariff “necessary” in the first place remain constant.
For greater domestic production to be sustained, the good’s price must always stay higher than it was before the levy — even if it declines from the immediate post-tariff price. Michael is correct that, in the long run, tariffs may not raise prices as much as people think once the market reacts. But tariffs must permanently raise prices to some extent, even when they “work.”