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How Tariffs Work and Why People Are Worried About Them

The following very, very rough and simplified example of how enforced tariffs work and how they may impact prices for consumers. I've used round numbers for easy math. If after reading this you are still not clear on how they work, I encourage you to contact your accountant to see if tariffs will affect you and your business. Or you can call a local news station and ask to speak to an economic reporter. With enough questions and interest, they may run a story.

Disclaimer 1 - if you don't like the numbers, run your own, but the theories and math are correct. If the incoming administration only institutes a 60% tariff (or doesn't do one at all), obviously the prices and results will be different. This is for example only.

Disclaimer 2 - I'm not claiming that enforced tariffs automatically cause inflation. I'm saying that they generally increase a product's cost. Inflation and in-depth economics are WAY too complicated to cover in a basic post like this. 

TARIFFS 101

ChinaCorp makes a widget and sells it to US-Megamart for $100. US-Megamart puts it on the shelf and sells it to US customers for $200, earning $100 profit per widget.

What happens if the US government puts a 100% tariff on Chinese-made widgets?

Tariffs are paid by the importing company, not by the exporting country. (This is what trips most people up. China pays NOTHING to the US government.)

The desired effect is that US-Megamart cancels their ChinaCorp contracts and buys widgets from elsewhere. Or even better, that US-Megamart finds a US supplier to keep all the money in the US economy. But the US government can't guarantee that US-Megamart will be able to source a widget for $100 outside of China. It's up to US-Megamart to find a new supplier.

Best Case Scenario

US-Megamart finds similar widgets available for $100 each from the India Widget Company and from Eagle Widgets in the US. No cost increase to the customer from either supplier. Business as usual.

Mildly Bad Scenario

US-Megamart finds a $110 widget from Widgets of Japan, and eats the extra $10, thus reducing their corporate profits to $90 per widget. No cost increase to the customer, but the corporation's bottom line is impacted, which affects their dividends and market values. (Big economics - we aren't going to get into that in this post.)

Moderately Bad Scenario

US-Megamart can't find a similar $100 widget anywhere. However, they do find an identical widget from South Korea, but SK-Widgets sell them for $150. Now US-Megamart is paying $150 per widget, so in order to make the same profit on it, they turn around and sell it to their US customers for $250. The customers pay that extra $50. That's a 25% price increase.

Worst Case Scenario

What if nobody else makes that kind of widget? Now ChinaCorp sells their $100 widget to US-Megamart for $100.  The government adds their 100% tariff, and US-Megamart must now pay $200 for it - $100 to ChinaCorp and $100 to the US government. In order to make the same profit on it, US-Megamart turn around and sell it to their US customers for $300. The customers pay the extra $100. The retail price has now increased by 50%.

US-Megamart is already going to take a huge hit to its profits when a good number of their customers don’t buy widgets because they can’t afford that extra $100. Do you really think their shareholders will approve of cutting their profits by 50% by selling the widget for $250 to encourage people to buy from them? Even if they did, it's still a 25% cost increase for the customer.

HOW TARIFFS AFFECT THE WHOLE MARKETPLACE

Unfortunately, tariff costs don’t always stop with the initially impacted company or manufacturers and may have another, less-desired outcome. This is also what people are afraid of (in addition to a general price increase on some products.)

Let’s say that US-Megamart competitor Ameri-Stuff buys their slightly inferior widgets from Narnia for $115 each. They sell them to their customers at $215 for a $100 profit. A Narni-Widget is more expensive and not as good, and therefore Ameri-Stuff sells fewer widgets than US-Megamart.

But - Ameri-Stuff won’t be affected by the tariff against China at all – hurray!

If US-Megamart can’t find an equivalent supplier at the same cost and decides to switch to SK-Widget, they will need to sell their quality widgets at $250 to keep their profits the same, and that means they are now much more expensive than Ameri-Stuff.

More importantly, Ameri-Stuff may see this and realize that they can increase their prices by $25 to sell their slightly inferior Narni-Widgets for $240, and still be cheaper than US-Megamart. Why wouldn’t Ameri-Stuff increase their profits by 25% if they can? People need widgets and our economic markets are based on capitalism. Companies take the most profit possible – as much as the consumer is willing or able to pay.

So, prices across the board may rise, even if all companies involved are not directly affected by the tariff. It's nice to imagine that corporations will lower their prices to help out Joe Buyer, but they are responsible to their shareholders, not their customers. That's how capitalism works.

And I reiterate - I'm not saying this WILL happen. I'm saying it's what a lot of people are worried about when they consider their finances and future purchases come January.