Question

Consider a small country (perfect competition) applying a tariff, t, to imports of a good

a. Suppose that the country currently has a tariff on imports, but decides to reduce it from t to t’. Draw graphs for the Home and import markets and illustrate this change.

b. What happens to the quantity of goods produced at Home and their price? What happens to the quantity of imports?

c. Are there gains or losses to domestic consumer surplus due to the reduction in tariff? Are there gains or losses to domestic producer surplus due to the reduction in tariff? How is government revenue affected by the policy change? Illustrate these on your graphs.

d. What is the overall gain or loss in welfare due to the policy change?

Answer 1

(a) In following graph, DD and SS are domestic demand and suppl curves intersecting at point E with autarkic equilibrium price P0 and quantity Q0. With free trade, relevant price is world price (Pw < P0). With tariff of t, price is Pt. When tariff is lowered to t', price is lower at Pt'.

(b) With initial tariff and price Pt, domestic quantity demanded is Q1 and domestic quantity supplied is Q2. Imports equal (Q1 - Q2). With loer tariff and lower price Pt', domestic quantity demanded rises to Q3, domestic quantity supplied falls to Q4 and imports rise to (Q3 - Q4) > (Q1 - Q2).

(c)

Consumer surplus (CS) measures area between demand curve and market price. When tariff is t, CS equals area ACPt and when price falls to Pt', CS equals area AFPt'. There is a gain in CS equal to area PtCFPt'.

Producer surplus (PS) measures area between supply curve and market price. When tariff is t, PS equals area BDPt and when price falls to Pt', PS equals area BGPt'. There is a loss in PS equal to area PtDGPt'.

When tariff is t, government collects tariff revenue equal to area CDJH. When tariff is t', government collects tariff revenue equal to area CDLK. There is a gain in tariff revenue equal to area HJLK.

(d) There is a net welfare loss due to tariff. When tariff is t, net welfare loss is equal to sum of areas CNK and DML. When tariff is t', there is net welfare loss equal to sum of areas CFH and DJG. Therefore, lower tariff decreases net welfare loss by sum of areas HFNK and JGML.