A major assertion by the Trump Administration is that tariffs are paid for by foreigners. And, indeed, under very specific circumstances, a tariff may be paid in part or in whole by a foreign producer:
- if the importing country is a monopsony (or has significant market power),
- if the exporting country has price power, and
- if there is no foreign retaliation,
then a sufficiently small tariff could induce the exporting country to lower prices in order to retain market share. That is, the exporter may absorb some or all of the tariff (an interesting and non-technical discussion on the theory and its history can be found here).
At least on paper, the US seems to fit the description. We are one of the largest countries in international trade. US imports account for about 13.8% of global imports and exports are about 8% of global exports (data from the World Bank). Furthermore, in some individual markets, we are the largest buyers/sellers by far.
So, at least in theory, there should be some part of a US tariff that is eaten by the foreign producer. At yet, that is not the case in reality.
Indeed, tariffs imposed by the US government are pretty much entirely paid by Americans. Why is this the case? One could be tempted to throw away trade models and make unscientific appeals to things like greed or politics (as the White House has done). But one shouldn’t throw out a perfectly good theory except when it cannot explain things. And, as it happens, properly understood trade theory explains this seeming contradiction.
Most trade models treat countries as individual economic actors: The United States trades with Mexico. This is done for pedagogical purposes to help our students see that there is little difference between domestic and international trade. And there are times when treating countries as individual economic actors is useful or appropriate. The theoretical ability to pass on a tariff depends on treating countries as individual actors.
But the reality is that trade, all trade, ultimately occurs between individuals, not countries. The United States is not trading with Mexico. A firm in Dallas is trading with a firm in Mexico City. Consequently, while countries in the aggregate may have some sort of market power, individuals mostly do not. The actual ability to pass on a tariff, or to force a foreign supplier to pay a tariff, is limited to non-existent.
But isn’t this the point of tariffs? To “collectively” negotiate for all? Can’t we apply the same logic here to the “firm” called The United States? Alas, no. A country is not a firm. Short of outright socialism, the president is not negotiating for inputs for American firms. The firms are still the ones making buying decisions. It is their ability to pass on prices, not some fiction called “The United States Company,” that matters.
The predictions and proclamations made by the Trump Administration and its economists fail to come true because they do not appreciate methodological individualism: that economic decisions are ultimately made by individuals, and that must be where our analysis begins. Those who claim American market power can make foreigners eat the cost of US tariffs zoom out too far to the aggregate and forget that the aggregate is not independent, but rather emergent, from individuals.
This fatal conceit, this fatal error, has been the burr under the saddle of many a politician, and the Trump Administration is no different. Reality is not optional, no matter how many fancy Greek letters you have to say otherwise.
