Question

A small country’s demand curve is given by Q=10-(P/2) and its supply curve is given by Q=P-5. Assume that there is initially free trade and that the world price under free trade is $7. If an import quota of 1.5 is now introduced in this country, what will be the change in this country’s government revenue (everything else being equal) if foreign firms have to acquire an import licence at full value?

A	increases by 7

B	increases by 3

C

no change

D	increases by 5

Answer 1

It is given that the demand curve of the small country is Q=10-(P/2) and the supply curve is Q=P-5. At equilibrium, demand=supply which implies that 10-(P/2) =P-5

Or 15=3P/2

Or P = 10. This is the equilibrium price without trade.

It is given that with trade, the free-trade world price (Pw) = 7. At that price, Quantity Demanded (Qd) = 10-(Pw/2) = 6.5 units. Similarly, at that price, Quantity supplied (Qs) = Pw-5 = 2 units.

Therefore import under free-trade = 6.5-2 = 4.5 units.

When an import quota of 1.5 units is imposed, it means that the difference between Qd and Qs is 1.5 units. Using that information in the import equation, we get, 10-(P/2) - (P-5) =1.5.

No matter what happens, the demand and supply equations do not change in the economy for this particular example. Thus, -3P/2 = -13.5

Or P = 9. This Price is the new world price after imposition of quota and can be labelled Pq. Since under quota quantity of imports fall, the price in the world market rises from Pw to Pq.

Government revenue is therefore the difference between price under quota (Pq) and world price under free trade (Pw) times the quantity of imports. Here quantity of import is already restricted to 1.5. The difference between Pq and Pw = 9-7 = 2.

Therefore Government revenue = 2*1.5 = 3.

Since before the imposition of quota under free-trade, the government earned no revenue, and after imposition of quota, the government earns a revenue of 3, the government revenue of the country (everything else remaining the same) increases by 3.