Question

Explain, using offer curves, how a tariff affects a large country in the context of general equilibrium. Can a tariff improve the welfare in the tariff-imposing country if both sets of offer curves are elastic in the relevant ranges? Explain.

Answer 1

Effect of tariff on Import in a large countr

OH is the offer curve in the home country and OF is the offer curve of the foreign country. IC is the indifference curve of the home country. Under free trade, the terms of trade between the two countries are given by the ray OT from the origin. They are in equilibrium at the point A where the offer curves intersect each other. Suppose home country imposes tariff on foreign country’s goods. As a result home country’s offer curve shifts to the left to OH₁. The new terms of trade line is OT₁ and B is the new equilibrium point. This tariff which has changed the home country’s offer curve from OH to OH₁ is the optimum tariff of the country. At point B home country’s trade indifference curve IC₁ is tangent to the foreign country offer curve. The tariff imposing country can gain from the tariff only if the offer curve of the other trading country is less than perfectly elastic. If the offer curve of the other country is perfectly elastic, levying the tariff will not increase the welfare of the tariff imposing country.

If the offer curve of the other foreign country is elastic it will shift from OH to OH1, Consequently demand for import decrease from OM to OM1. Thus the tariff importing country will suffer from international trade. If the offer curve of the foreign country is inelastic it will supply the same quantity OM at the new price and the tariff imposing country will gain from international trade.

Effects of tariff on Importing Country Consumers - Consumers of the product in the importing country suffer a reduction in well-being as a result of the tariff. The increase in the domestic price of both imported goods and the domestic substitutes reduces the amount of consumer surplus in the market.

Effects of tariff on Importing Country Producers - Producers in the importing country experience an increase in well-being as a result of the tariff. The increase in the price of their product on the domestic market increases producer surplus in the industry. The price increases also induces an increase in output of existing firms (and perhaps the addition of new firms), an increase in employment, and an increase in profit and/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of the change in producer surplus is represented.

Effects of tariff on Importing Country Government - The government receives tariff revenue as a result of the tariff. Who benefits from the revenue depends on how the government spends it. Typically the revenue is simply included as part of the general funds collected by the government from various sources. In this case it is impossible to identify precisely who benefits. However, these funds help support many government spending programs which presumably help either most people in the country, as is the case with public goods, or is targeted at certain worthy groups. Thus, someone within the country is the likely recipient of these benefits.

Importing Country - The aggregate welfare effect for the country is found by comparing the net gains and losses to consumers, producers and the government. The net national welfare effect can be either positive or negative. The interesting result, however, is that it can be positive if the benefit from government revenue and increase in production is greater than the effect of loss in consumer surplus. This means that a tariff implemented by a "large" importing country may raise national welfare.

But a notable point is that if the foreign country is retaliate in nature it will impose tariff on the other product of the home country which may considerably reduce the export earnings of the home country.