Question

The demand curve for oil in the island of Liholiho is given by P = 40 - Q, where P is the price of oil and Q is its quantity. The long-run domestic supply curve for oil in Liholiho is given by P = 10 + Q.

(a) Calculate the market equilibrium price and quantity of oil produced (and consumed) in the island, assuming there are no imports. Also indicate these equilibrium values in a clearly labeled diagram that shows the demand and domestic supply curves. [6 points]

(b) Now assume that the island can import as much oil as it likes at a constant price of $15/barrel. Re-draw your diagram for part (a) but include the supply curve of foreign oil to indicate that trade is allowed. With the help of this diagram and the other information provided, determine the new market equilibrium values of price (P) and quantity of oil consumed (Q), the quantity of oil produced domestically (Q_D), and the quantity of oil imported (Q_I). Also indicate these four values in your diagram. [10 points]

(c) In your diagram for part (b), shade the area that represents the "social welfare" gain to Liholiho from permitting oil to be imported in an unrestricted manner. [2 points]

(d) The rulers of Liholiho recognize the advantages of importing oil but would nonetheless like to reduce their vulnerability to this strategic resource. They are considering two alternative policies to restrict oil imports: (1) A sales tax of $5/barrel on oil consumed domestically; and (2) A tariff of $5/barrel on imported oil.

Re-draw your diagram for part (b) in the case of each policy to help determine the impact of that policy on Liholiho’s (i) consumption, (ii) domestic production, and (iii) imports of oil. Also, based on your diagrammatic analysis, which policy is less effective in reducing the island's vulnerability to imports?

Answer 1

a) The demand curve given is P = 40 - Qd

The supply curve is P = 10 + Qs

To find the equilibrium price and quantity we need to find Qd and Qs

Now Qd = 40 - P and Qs = P - 10

Therefore at Equilibrium Qd = Qs

Therefore 40 - P = P - 10

Or P = 25 and Q = 15

b) The island can import from the world at a constant price of 15$ per barrel. As import price is less than the domestic price people will surely increase their consumption of foreign oil.

Putting 15 in supply and demand equations we get

that total 25 units of oil are being produced of which only 5 are produced domestically and 20 are imported from the world.

The diagram clearly shows the equilibrium price and equilibrium quantity at point B with 15 as price and 25 as quantity demanded.

Corresponding to point A we find that 5 units are domestically produced and corresponding to B on the x axis we find that total production is 25

Therefore imported is indicated by C = 2

c) The triangle EAB shows the social welfare which both includes loss to producers and gain to consumers.

d) The sales tax shifts the supply curve by $5 which will thus shift the equilibrium to a higher point denoted by F

Equilibrium quantity can be computed using P-5 = 10 + Qs and the demand equation.

We find that the equilibrium quantity demanded is 12.5 and the price is 27.5.

The CS indicates consumer surplus and PS indicates the producer Surplus and G is the part government receives as tax.

2)

A trade tariff of 5$ per barrel will rise the world price to 20 as a result of which it will shift upwards.

A B C D indicate the various regions which affect the different entities

Like a+ b + c + d is the consumer surplus

A is the producer Surplus C is the government earning from the tax and b + d is the deadweight loss.

The total demand falls from 25 to 20 of which domestic producers provide 10 units and the imported are 10 while in case which is still under the equilibrium of the demand and supply curve originally at (15,25).

In the sales tax effect no effect on import was seen as the world price was already 15 and the domestic price rose by 5 too which was already well above the world price.

The second policy is better at restricting the imports and reducing the vulnerability on imports as the imports did decrease as a result of the tariff from 20 to 10 while in the case of sales tax there was no effect on the imports as the basic price supply at 0 quantity was already 15 well in par with the world price.

And on increasing the quantity the price rose which would disbenefit the customers. For example the equilibrium price rose to 27.5 from 25 and the quantity equilibrium fell from 15 to 12.5 with no effect on import price .

So in conclusion it is better to use trade tariffs rather sales tax on domestic consumption to reduce the vulnerability of imports and well encouraging the domestic firms to compete with the foreign firms.