ChainWhat it assumes · how to break it
Start
The UK removes tariffs and quotas on trade with a partner through a free trade agreement, such as the UK–Australia agreement signed in 2021.
1
As a result, the price of imported goods in the domestic market falls towards the world price as the tariff is removed.
tariff · world price
tariff · world price
Best link to attack
Assumes: Importers and retailers pass the lower cost on to buyers.
Assumes: Importers and retailers pass the lower cost on to buyers.
But: Retailers with market power may keep part of the tariff cut as higher profit margins.
2
This means consumers pay less for imported goods in the CPI basket, such as food and clothing, so the price level falls directly.
CPI · import prices
CPI · import prices
Assumes: Goods from the partner make up a meaningful share of consumer spending.
But: If the partner supplies only a small share of the basket, the direct effect on the CPI is tiny.
3
In addition, firms buy imported raw materials and components more cheaply, lowering costs of production and shifting SRAS to the right.
costs of production · SRAS
costs of production · SRAS
Assumes: Firms use imported inputs from the partner.
But: Firms that source inputs mainly from countries outside the agreement see no fall in costs.
4
Consequently, greater competition from imports forces domestic firms to hold down their prices, so inflation falls for a time.
competition · market power
competition · market power
Assumes: Domestic firms previously had pricing power because of protection.
But: Where domestic firms already faced strong competition, there is little extra downward pressure on prices.
End
Cheaper imports, lower input costs and more competition reduce the price level, lowering inflation for a time.
Evaluation chain
- E1However, lower inflation depends on firms passing lower import costs on to consumers.
- E2When importers and retailers have market power, as in markets dominated by a few large supermarkets, they can keep prices close to their old level.
- E3As a result, part of the tariff cut becomes higher profit margins rather than lower prices.
- E4So the fall in the price level is smaller than the tariff cut implies, and it lowers the inflation rate only once.
Another way to attack it: The fall in the price level is one-off, so the inflation rate falls only for about a year. Lower prices also raise real incomes, and the extra spending adds some demand-pull pressure.
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Questions this answers
- Assess the likely impact of trade liberalisation on the rate of inflation.
- Discuss the benefits of free trade for consumers.
- Explain how removing tariffs can shift short-run aggregate supply.
Diagram
AD/AS diagram with SRAS shifting right and the price level falling; or the tariff diagram reversed, with the domestic price falling from Pw + tariff to Pw.
Reverse and related
Tariff imposed → import prices and input costs rise, causing cost-push inflation (see tar-inf).