Question

Consider a closed economy (an autarky). The equilibrium price of computers in this autarky is equal to $1,000. Suppose that the world price of computers is equal to $800.

2. Show the consumer surplus, producer surplus, equilibrium price and quantity traded for the closed economy in part-a in the market for computers.

3. Now suppose this closed economy opens up to international trade. Now show the consumer surplus, producer surplus, equilibrium price and quantity traded. Also make sure to show the exports / imports of the newly opened economy.

4. What happened to consumer surplus, producer surplus, equilibrium price and quantity traded after this economy opened up to international trade?

5. Suppose the policy makers in the newly opened economy are concerned about the welfare of computer producers. Hence, they decide to impose a 30% tariff (a tax on imports) on imported computers. Show the price of computers in the newly opened economy after the tariff is imposed. Show the consumer surplus, producer surplus, equilibrium price and quantity traded after the tariff is imposed. Also make sure to show the government’s tariff revenue.

Answer 1

(a)

In following graph, AB & CD are domestic demand & supply curves of the good. Domestic equilibrium is at point E with domestic price P1 and quantity Q1.

Consumer surplus (CS) = Area between demand curve and domestic price = Area AEP1

Producer surplus (PS) = Area between supply curve and domestic price = Area CEP1

(b)

With free trade, world price is P* (lower than domestic price P1), at which domestic demand is Q2 and domestic supplyis Q3, hence imports are (Q2 - Q3).

Consumer surplus (CS) = Area between demand curve and world price = Area AFP*

Producer surplus (PS) = Area between supply curve and world price = Area CGP*

(c)

After free trade, CS increased (by area P1EFP*) and PS decreased (by area P1EGP*). Price decreased and quantity (including imports) increased.

(d)

Imposition of tariff will increase the domestic price of the good, and domestic price increased to Pt, at which domestic demand is Q4 and domestic supply is Q5, hence imports area (Q4 - Q5). The tariff decreases imports.

After tariff,

New CS = Area AHPt

New PS = Area CJPt.

Government nTariff revenue = Area PtHLP*

Decraese in CS = Area PtHFP*, so consumers lose.

Increase in PS = Area PtJGP*, so producers gain.

Social efficiency loss = Area FHL + Area GJK