Question

2. This problem asks you to work through the partial equilibrium analysis of some scenarios involving trade, consumer and producer welfare, and government tariff revenue. (a) Assume that the US does not participate in the international trade of kumquats (a small, citrus fruit) and therefore the kumquats market in the US clears domestically. Use a digram to show how the price (pa) and quantity (qa) traded are determined, and identify consumers’ surplus and producers’ surplus. (b) Assume that now the US opens to international trade to kumquats. The world price of kumquats is lower than the autarky price in the US, prior to trade (pW < pa). Will the US become an importer or an exporter of kumquats? Draw a diagram of the US market consistent with this assumption and discuss the welfare implications for each side of the market. Identify areas representing the welfare change. Is the US better or worse off, as a whole? (c) Redo (b), on a new diagram, but now under the assumption that the world price is higher than US’s autarky one (pW > pa). (d) Go back to the pW < pa case. The US government is considering a tariff on kumquats. Use a diagram for the equilibrium in world markets (hint: MD and XS*) to show the consequences of such a tariff for: i) the volume of international trade, ii) the price in the US market, iii) the price in the World market. Assume that the US is large relative to the rest of the world, when it comes to the demand for kumquats. (e) Redo (d), on a new diagram, under the assumption that the US is small relative to the rest of the world, when it comes to the demand for kumquats. (f) Go back to the large US case. Use a digram for the foreign/RoW market to show which side of the market is better-off and which is worse-off with the US tariff in place. Identify key areas representing welfare changes. (g) Use either a diagram for the US market or for world markets to show that the US can be, overall, better off with an unilateral tariff on kumquats, assuming that the governments in kumquat-exporting countries do not react to this policy. Be sure to identify the tariff revenue that gets collected by the US government. (h) The US is an importer of kumquats and the US government does impose the tariff we previously analyzed. On the other hand, the US is a big exporter of high-tech medical devices. How could foreigns governments react to the US tariff, in order to improve their terms of trade with respect to the US? How would US consumers and producers of medical devices feel about that reaction?

Answer 1

(a). Assuming that the US does not participate in the international trade of kumquats, the price (pa) and quantity (qa) traded are determined by demand and supply in domestic market. Optimal price and quantity is determined where demand and supply intersect each other. This is shown in the diagram below:

E is the equilibrium point with Pa as price and Qa as quantity in the diagram.

Consumer surplus (CS) is the area shaded in black and producer surplus (PS) is the area shaded in blue. We measure CS as area below the demand curve and above the equilibrium price. Similarly PS is measures as the area below the equilibrium price and above the supply curve.

(b). Assuming that now the US opens to international trade to kumquats and the world price of kumquats is lower than the autarky price in the US, prior to trade (pW < pa). The new market conditions are shown as follows:

In the new market conditions, the area under consumer surplus rises and the area under producer surplus falls. See from the diagram that the loss in PS = gain in CS. The CS increases by the area EMP_wP_a. This is the same area/amount by which there is a fall in PS. Since the gain and loss amount is same, the net value of surplus remains the same as it was in previous part so that the the country as a whole remains on same welfare level. Within the country however, consumers gain more surplus at the cost of producers.

There is on more change in terms of quantity. The domestic supplier supply S₁ quantity but the demand is of D₁ quantity. Therefore, there is imports upto the amount of D₁-S₁.

(c)  Assuming that the world price is higher than US’s autarky one (pW > pa), we will have following situation in the market:

When the price in international market is greater than domestic prices, the area under consumer surplus (black region in the diagram) falls and the area under producer surplus rises (blue region). So, the consumers loose while the producers gain. Also, note that the loss to consumer is exactly offset by gains to producer. This is given by the area EMP_wP_a. as we know that this part of CS is being transferred to PS. So overall surplus of the country remains same.

In terms of quantity, we see that the US now becomes the exporter of the fruit with exports equal to S₁ - D₁. This is because with higher prices, demand falls and supply increases.

(d)  As the US government is decides to levy tariff on kumquats, the world price in the international market increases because there are taxes to be paid to US government in addition to prices charged by the producers. So world prices rise to Pw+t. The following diagram shows the new world market:

From the diagram we see that the world trade volume falls from Qw to Qt.

ii) The price in the US market increases because of the tariff as the imports become expensive due to tariff, domestic suppliers also increase their prices within the extent of the tariff t. Let's see it with the help of a diagram of the domestic market.

As price rises to Pw+t, domestic suppliers supply S₂ (from earlier S₁) and consumers demand D₂ (from earlier D₁), so that imports fall to D₂-S_2..

iii) The price in the World market comes down because foreign supplier now have to pay to US government to sell their good in US market. So they get lesser than what they were getting under free trade. This is shown as the point 3 of the diagram in part  i) above