Question

Suppose that the country of VIRUS is currently operating in FREE TRADE arrangement with its closest neighbour, VACCINIA. VIRUS, however, is currently going through a difficult economic period, and its largest domestic producer of goods and services is demanding that VIRUS’S Government implement a TARIFF on all goods being imported from VACCINIA to protect the VIRUS’S domestic economy.

(i)     The Prime Minister of VIRUS has hired you as she is uncertain what to do. She has asked you to (1) Explain Carefully to her exactly what a “Tariff” is and how a “Tariff” will alter the domestic market, AND (2) What will be the eventual impact on each of CONSUMER SURPLUS and PRODUCER SURPLUS compared to the current “Free Trade” position.

Answer 1

Answer to Part 1)

A tariff is a type of additional charge or tax which importing companies or people need to pay for acquiring goods or services that are not manufactured within the political boundaries of a country. These are usually undertaken to restrict imports into a country and to provide the required support to the domestic industry therefore.

What tariffs do for the domestic market is that it makes goods and services imported into the country expensive whereas those which are domestically produced face lesser competition.

However, as the advisor to the prime minister of the country, my suggestion would be to take a controlled approach. Tariffs are often subject to retrospective measures and if our products are equally taxed, then both exports as well as foreign currency would see a sharp decline for us.

Part 2)

If a tariff is imposed, the Consumers choices and therefore surplus declines sharply. This is because their available options first included imports as well which are discouraged and are high priced and some consumers may not be able to purchase the same.

Further, producers indeed gain from such tariffs and their surplus goes up as they are able to sell higher amounts at the same price which they were charging as demand for foreign goods shifts to domestic markets.

Please feel free to ask your doubts in the comments section.