Question

Assignment Question(s):                                                    (Marks:30)

Q. 1. Suppose both supply and demand in a market are relatively inelastic. Will a tax placed on the product in market generate a relatively large or small deadweight loss? Why? [15 Marks]

Q. 2. If the world price of a good exceeds the domestic price of the good, will the country export or import the good. In this scenario who gain from free trade: Domestic consumers or Domestic producers? Explain. [15 Marks]

Answer 1

1) deadweight loss depends upon the size of the tax and the reduction in the quantity from market equilibrium before tax. In this case when supply and demand are relatively inelastic, for a given tax rate, the decline in the quantity demanded and supplied is smaller relative to the one in which demand and supply are less inelastic. Due to this reason, the deadweight loss is smaller. In this way we can say that as the demand and supply curves become inelastic, the size of the dead weight loss decreases for a given tax rate

2) when the world price is greater than the domestic price, domestic producers are able to sell some portion of their output to foreigners because at the world price, quantity supplied is greater than quantity demanded and there is a surplus of good produced. This increases the producer surplus but decreases consumer surplus. also note that increase in producer surplus is greater than decrease in the consumer surplus which means domestic producers benefit more than the loss suffered by domestic consumers. Hence domestic producers gain from free trade.