The Economics of Diversification Tariffs

Recent evidence shows that imports of critical products can be concentrated on a small number of supplier countries. Such supplies are therefore vulnerable to disruption, whether because unfriendly governments seek to weaponize dependency or for other reasons. In a laissez-faire equilibrium, importers are likely to buy from too few suppliers because the benefits of diversification are not fully internalized, while the costs of buying from more expensive sources remain with them. Heavy-handed policy action could end up exacerbating volatility and result in high costs for taxpayers. This article proposes diversification tariffs (DTs) as practical and market-friendly instruments to incentivize diversification. DTs apply on imports of a critical product from any country if its share of total domestic demand exceeds a certain threshold. Such a design would help to diversify the supplier base by encouraging imports from new sources. Compared to laissez-faire, DTs would push up the market price to be paid by users as the marginal seller would no longer be the least expensive one. However, if well implemented, in equilibrium, DTs are never really paid. Focusing on the economics of DTs, this paper introduces the concept, discusses implementation issues, and touches – inconclusively – on World Trade Organization (WTO) compatibility.