Question

In the absence of international trade, assume that the equilibrium price and quantity of motorcycles in Canada is $14,000 and 10 units respectively. Assuming that Canada is a small country that is unable to affect the world price of motorcycles, suppose its market is opened to international trade. As a result, the price of motorcycles falls to $12,000 and the total quantity demanded rises to 14 units; out of this total, 6 units are produced in Canada while 8 units are imported. Now assume that the Canadian government levies an import tariff of $1,000 on motorcycles. With the tariff, 8 units are produced in Canada and the quantity demanded is 12 units. Refer to the above information and answer the following: (i) What is the price of imported motorcycles as a result of the tariff. (ii) Calculate the tariff redistribution and revenue effect. ​(iii) What is the deadweight welfare loss for Canada?

Answer 1

o The below diagram, represents the market of motorcycles. The X-axis shows the quantity of motorcycles and Y-axis shows the price of the motorcycles. The domestic demand and supply intersect at the no-trade equilibrium point “C”, with equilibrium price level $14000 and equilibrium quantity demanded/supplied equal to 10 Units.

o As the economy of Canada, opens up to international trade the price of motorcycles fall to Pw = $12000. Here quantity demanded at Pw is 14 Units and quantity supplied in Canada is 6 units. Thus 14 – 6 = 8 units are imported.

- Consumer surplus under free trade is given by the area above the Priceline Pw and below the domestic demand curve, which is the area of triangle AGL = 1+2+3+4+5+6+7+8+9

- Producer surplus under free trade is given by the area below the Priceline Pw and above the domestic supply curve, which is the area of triangle GHM = 10

- Total surplus under free trade = 1 + 2 + 3 + 4 + 5 + 6 + 7+ 8 + 9 + 10

o If the Canadian government imposes an import tariff of $1000, then the price of imported motorcycles increases to Pw + Tariff = $12000 + $1000 = $13000. At this price, the quantity supplied by Canadian producers increases to 8 units, but the quantity demanded by domestic consumers decreases to 12 units. The amount of imports decreases to 12 – 8 = 4 units.

- Consumer Surplus under a Tariff falls. Here consumer surplus is the area above the new price line Pw + Tariff and below the demand curve , which is area of triangle ADF = 1+2+3+4

- Producer Surplus under a Tariff increases due to redistributive effect. Some part of the consumer surplus is transferred to the producers. Here producer surplus is the area below the new price line and above the supply curve, which is area of triangle

DEM = 10 + 5.

- The government revenue is given by the area of rectangle EFKI = 7 + 8

- Total surplus under a tariff = Consumer Surplus + Producer Surplus + Government Revenue = (1+2+3+4) + (10 + 5) + (7 + 8)

Welfare Loss Due to Tariff = Total Surplus under Tariff – Total surplus under free trade

= (1+2+3+4) + (10 + 5) + (7 + 8) – (1 + 2 + 3 + 4 + 5 + 6 + 7+ 8 + 9)

= 1 + 2 +3 +4 + 10 + 5 + 7 + 8 – 1-2-3-4-5-6-7-8-9 – 10

= - (6 + 9)

= Sum of areas of triangle EHI and FKL

(i) As explained above, the price of motor cycle after tariff imposition is Pw + Tariff = $12000 + $10000 = $13000

(ii)

o Redistribution Effect

From the above analysis and from the figure we can see, Area DGHE represented by number 5, has been transferred from consumer surplus to producer surplus. For this we need to calculate the area of rectangle DGEI (represented by 5+6) and area of triangle EHI (represented by number 6). By subtracting these two areas we can transfer area DGHE.

Area of Rectangle DGEI = Length x Breadth = GI x DG

= 8 x (13000 – 12000) = $1000 x 8 = $8000

Area of triangle EHI = 1/2x Base x Height

= ½ x HI x EI = ½ x (8-6) x (13000 – 12000) = ½ x 2 x $1000 = $1000

Area DGHE = Area of Rectangle DGEI - Area of triangle EHI = $8000 – $1000 = $7000

o Revenue Effect

The govern revenue is given by the area of rectangle EFKI represented by the number 7 + 8.

Area of EFKI = Length x Breadth = IK X EI

= Imported quantity under Tariff x Tariff Amount

= (12 – 8 ) x $1000 = 4 x $1000 = $4000

(iii) Deadweight Loss = Sum of areas of triangle EHI and FKL

We already know the area of triangle EHI = $1000

Area of triangle FKL = ½ x Base x Height

= ½ x KL x FK = ½ x (14-12) x $1000

= ½ x 2 x 1000 = $1000

Thus Deadweight loss = $1000 +$1000 = $2000