Who pays for Europe's tariffs on Indonesian biodiesel?

My ECONS102 class covered international trade last week, so it was interesting to see import tariffs in the news. As Reuters reported:

Asked about this situation, a European Commission spokesperson told reporters that the EU was confident its duties on Indonesia were in full compliance with WTO rules and that the EU was ready to discuss the matter with Indonesia.

Trade relations between the EU and Indonesia have been strained by the bloc's move to limit imports of commodities linked to deforestation, which is expected to curb EU imports of palm oil from top suppliers Indonesia and Malaysia.

As well as biodiesel, palm oil is used widely in food and cosmetics.

Welcoming the European Commission's investigation, the European Biodiesel Board said it estimated that imports circumventing duties may have cost the EU around 221 million euros ($240.34 million) last year.

The association was also working with EU authorities to address allegations of fraudulent biodiesel imports from China, it added in a statement.

Let's put aside the issue of avoiding the import tariffs (or duties) - we'll come back to those later in the post. Instead, let's focus on the effect of an import tariff on the market for biodiesel in Europe. This is shown in the diagram below. [*] With no international trade in biodiesel at all, the market would operate at equilibrium, with a price of P0, and Q0 biodiesel would be traded. However, the domestic price of biodiesel (P0) is higher than the world price (PW). This means that Europe has a comparative disadvantage in producing biodiesel. In other words, other countries can produce biodiesel at lower cost (specifically, lower opportunity cost) than Europe. One of those countries with a comparative advantage in producing biodiesel is Indonesia. If Europe allows international trade in biodiesel, European consumers will realise that they can buy biodiesel much cheaper from international sources. The price for biodiesel in the European market will drop to be equal to the world price PW. At this lower price, European consumers will buy more biodiesel (QD0). However, European biodiesel producers will only be willing to supply QS0 biodiesel at this lower price. The difference between QD0 and QS0 is satisfied by imports of biodiesel.

Now consider what happens if an import tariff (or import duty) is imposed. If consumers want to buy biodiesel from the international market, they must now pay the world price PW plus the tariff. The price for biodiesel in the European market will increase to PW+T (where T is the per-unit size of the import tariff). At this higher price, European consumers will buy less biodiesel than without the tariff (QD1), but European producers will be willing to supply more (QS1). The quantity of biodiesel imports decreases to the difference between QD1 and QS1. This was the purpose of the tariff, of course - to keep a lot of Indonesian biodiesel out of the European market.

However, who pays the cost of the tariff. We can work this out by thinking about the areas of economic welfare. Consumer surplus is the difference between the amount that consumers are willing to pay (shown by the demand curve), and the amount they actually pay (the price). In the diagram, at the equilibrium price and quantity (without trade), consumer surplus is the area AEP0. Producer surplus is the difference between the amount the sellers receive (the price), and their costs (shown by the supply curve). In the diagram, at the equilibrium price and quantity, consumer surplus is the area P0ED. Total welfare is the sum of the two areas (consumer surplus and producer surplus), and is equal to the area AED.

With international trade (but no import tariff), the consumer surplus increases to the area AFPW. Producer surplus decreases to the area PWGD. Total welfare is the combined area AFGD. Notice that European biodiesel consumers are better off with trade, but producers are worse off. As a whole, European society is better off, because total welfare is larger (by the area EFG - this is a measure of the gains from trade).

Now consider what happens when the import tariff is applied. Consumer surplus decreases to the area ABK. Producer surplus increases to the area KCD. The government gains tariff revenue equal to the area CBJH (this is the per-unit amount of the tariff, multiplied by the quantity of imports subject to the tariff). Total welfare is all three of these areas added together, which is the area ABCD+CBJH. In other words, the import tariff makes European biodiesel producers better off (higher producer surplus), and makes the government better off (due to the tariff revenue). However, the import tariff makes European biodiesel consumers worse off (lower consumer surplus), and European society as a whole worse off (lower total welfare). The loss of total welfare is equal to the areas BFJ+CHG - this is the deadweight loss of the import tariff.

So, the import tariff policy has a cost to society (equal to BFJ+CHG). Ideally, you would want there to be an offsetting benefit worth at least as much. The benefits of the tariff are (hopefully) less deforestation in Indonesia, and associated pollution (from burning forests), environmental and public health impacts.

Of course, the import tariff also makes Indonesian producers of biodiesel worse off, because they cannot sell as much into the European market (because their biodiesel is now more expensive due to the tariff. [**] That creates incentives for the Indonesian producers to try to avoid the tariffs. The European Union is alleging that this is what the Indonesian producers have done, by selling their biodiesel to entities in China and Britain (which apply low or no tariffs to imported biodiesel), and then re-exporting the biodiesel from those countries into the European Union (and the EU applies low or no tariffs to biodiesel imported from those countries). This sort of activity is extraordinarily difficult to police, because commodities like biodiesel can be difficult to trace. It will be interesting to see how this case plays out over the coming months.

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[*] I'll discuss this diagram as if it is the whole European market for biodiesel. However, you can easily interpret it instead as the European market for Indonesian biodiesel.

[**] The gains or losses to international producers and consumers are not shown in the market diagram above, which only demonstrates impacts within the European market.