Question

Use a two country supply and demand diagram to illustrate how, starting from completely free trade, a tariff on wool blankets affects both the domestic and foreign markets for blankets. Label the important geometric areas in your diagram and explain how the tariff changes the consumer and producer surpluses in both countries as well as the well-being of other relevant groups.

Answer 1

The below diagram illustrates the increase or decrease in the welfare for two countries. I have marked all the regions for simplicity:

Pf is the free trade price

After tariff, price in the domestic country increase to P_T and reduces in foreign country to P_T

Following table shows the welfare comparisons of two countries:

	Domestic	Foreign
Consumer Surplus	- (A+B+C+D)	M
Producer Surplus	A	- (M+N+O+P)
Government Revenue	C+G	0
Country Welfare	G - B - D	- (N+O+P)

Relative groups welfare (world welfare) = - (B+D) - (N+P)

Domestic Consumers looses due to tariff

Domestic producers gain from the tariff

There is an increase in the revenue of government in the domestic country

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