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Photo: Bloomberg
Photo: Bloomberg

How tariffs reshape global supply chains

The effect of tariffs, such as those imposed by the US on China, depends on the elasticity of demand for the final products, a study finds

The United States began imposing trade tariffs on China in 2018. In response, supply chains shifted the source of intermediate goods towards other Asian countries, such as Vietnam and Thailand. A new study examines the impact of such tariff changes on global supply chains.

Tariffs force changes in the relationship between producers and their overseas suppliers of intermediate inputs. Researchers Gene Grossman and Elhanan Helpman find in their paper that this effect depends on the elasticity of demand for the final product—that is, how sensitive the demand is to pricing changes.

If the demand is inelastic, then a tariff on input supply does not affect the terms of trade—the price of the final product relative to the cost of imported input—for the tariff-imposing country. Consumer prices rise, but since demand remains unaffected, producers do not lose revenue and so do not feel the pressure to renegotiate their contracts with the original suppliers.

However, if the demand is elastic, producers lose out and the terms of trade deteriorate. This pushes producers to find new overseas suppliers for their input.

Small tariffs are not enough to force a producer to exit a relationship with a supplier, because of the costs involved in finding the right trade partner afresh, the paper says. But large tariffs imposed by a country can force firms to look elsewhere for supply of input material.

This can lead to adverse implications for the terms of trade and welfare for the tariff-imposing country, the study says. Calculations by the authors suggest that a 25% tariff on intermediate goods imported from overseas can result in huge welfare losses in the home country. These losses “escalate rapidly" at even higher tariffs.

However, the welfare implications are less severe when the tariffs force producers to give up foreign sourcing altogether, the authors find.

Also read: When tariffs disturb global supply chains.

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