Question

A small country both produces and imports bread, the world price of which is $1 per loaf. Production of the bread causes a pleasant smell, which the producers of bread are unable to charge for, and which the people in the country enjoy. In fact, it has been ascertained that the value of this smell to society is $0.50 per loaf.

1. Show and explain why, in the absence of any other policy, a tariff on bread in this country might be beneficial to the society as a whole.

2. Would a tariff of $0.50 per loaf necessarily be beneficial? Why or why not? Explain.

Answer 1

1. A tariff will stimulate production and thereby generating more of the good smell. If the benefit from this is larger than the dead weight loss due to the tariff, then it will be beneficial to the society as a whole. Refer to the following diagram.

In the above diagram, the value of the externality is shown as E=$0.50, and the gains and losses from this tariff are:

Area a : Suppliers gain = +a
Area a,b,c,d : Demanders lose = –(a+b+c+d)
Area c : Government gains = +c
Area e : Smellers gain = +e
Area e,b,d: net for the country = +e–b–d
As drawn, area 'e' is larger than b+d, so the country gains.

2. A tariff of $0.50 per loaf not necessarily be beneficial. It depends on the slopes of supply and demand curves, and if supply had been more nearly vertical, then both areas b and e would be small and could easily be outweighed by d, especially when demand were flatter. Refer to the following diagram.