An increase in tariffs will not lead to an increase in import expenditure if the demand for imports is price inelastic.

Introduction

Tariffs are taxes imposed on imports. Many students think that an increase in tariffs will lead to an increase in import expenditure if the demand for imports is price inelastic. This economic misconception will be explained in economics tuition in greater detail.

Exposition

A persistent balance of payments deficit may lead to problems such as high imported inflation, lower national output and hence national income, higher unemployment and rising public debt, depending on the exchange rate system. Therefore, in the face of a persistent balance of payments deficit, the government may increase tariffs to correct the deficit. If the government increases tariffs, the prices of imports will rise. When this happens, households and firms will switch from imports to domestic goods which will lead to a decrease in import expenditure resulting in an improvement in the current account and hence the balance of payments. Many students think that if the demand for imports is price inelastic, an increase in the price will lead to a smaller proportionate decrease in the quantity demanded. If this happens, import expenditure will rise which will worsen the current account and hence the balance of payments. However, although an increase in the price of imports will lead to a smaller proportionate decrease in the quantity demanded if the demand is price inelastic, import expenditure will not rise. Import expenditure is the expenditure made by domestic residents on foreign goods and services which is the product of the price and the quantity. An increase in tariffs will lead to a rise in the prices of imports as importers will increase prices to maintain profitability. However, the prices that importers will pay foreign exporters will remain the same. In other words, although an increase in tariffs will lead to a rise in the after-tariff prices of imports, it will not affect the before-tariff prices of imports. Therefore, the fall in the quantity demanded will lead to a decrease in import expenditure which will improve the current account and hence the balance of payments. It is correct to say that in the event that the demand for imports is price inelastic, the increase in tariffs is likely to lead to a small decrease in the quantity demanded resulting in a small decrease in import expenditure and hence a small improvement in the current account and hence the balance of payments. However, it is incorrect to say the increase in tariffs will lead to an increase in import expenditure which will worsen the current account and hence the balance of payments.

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