How does it work? Most goods in the world do not have perfect elastic supply (that is, quantity supply will vary with price changes). When a large country imposes a tariff, it reduces global demand for that particular good, and its price will fall (in its own domestic currency). The importing country pays less, although its domestic consumer may pay more (Trump is hoping that this will be offset by the corresponding rise in the US dollar and not cause a price inflation). Meanwhile, the government collects tariff revenue, while the foreign exporter receives less revenue. And this increases the national welfare of the US — as long as gains from improved terms of trade outweigh the losses to consumers (arising from higher prices in the US).
US President Donald Trump has just committed a big blunder, and it is not the tariffs he has imposed per se, but the size of them. Confused? Read on.
While not often articulated, it is in fact possible for a country with market power (able to influence world prices) to improve its own welfare by imposing a tariff on imports. The optimal tariff theory says that a country with market power can improve its terms of trade by imposing a small positive tariff on imports — by shifting the cost of the tariff onto foreign exporters. Effectively transferring income from the rest of the world to the tariff-imposing country (in this case, the US) by lowering the price the country pays for imports relative to exports. This is Trumpianomics and the Make America Great Again (MAGA) goal.
