Question

Consider a commodity market in two economies of comparable sizes. Both economies have positive production and consumption of a commodity. Initially free trade exists between the economies. Explain how a non-prohibitive tariff imposed by the government of the importing country may affect the price levels in both economies. How will the tariff affect the welfare of the exporting country? Use diagram(s) to assist your answer.

Answer 1

Commodity market is a place where primary products like vegeatables, fruits, gold etc are bought and sold. Primary sector is a sector which produces agrixulture and allied products. It includes mining too. We take two countries - country X and country Y. Initially they are having free trade. Free trade means importing and exporting of goods and services can be carried out without any trade restrictions. So both the countries would produce the products that they are good at. Specialisation would have occured and importing without any restriction would have increased choice of the people.

Now country X imposes non prohibitive tariff on products of country Y. The prohibitive tariff is applied to restrict import totally. But non prohibitive tariff will increase the price of the product. But it wont restrict import totally. As country X impose tariff, import will be costlier. Import expenditure will get increased. So the people of country X will demand less of the county Y's products. So they will shift their demand to domestic products. But if the domestic companies are not efficient in making hese products, then cost of production will get increased. This reduces supply of the product and price will get increased in the country X. This is represented in the following diagram.

Country X's demand and supply of imported goods:

As tariff is being placed, supply curve of imported products will get shifted to left hand side. Thus it increases price of the products fro p to p1. As price is more, due to law of demand, demand curve is getting contratced. Equilibrium quantity decreases from q to q1.

As low import is being made by country X, country Y's export will get decreased. So more products will be available to the domestic people. When supply is more than demand, price will get decreased in the county Y.

County Y's demand and supply diagram in domestic market:

As export is getting decreased country Y's supply of products in domestic product will get increased and shift the curve to right hand side. As supply is more, price should get decreased to increase demand. So equilibrium price decreases from p to p1 and equilibrium quantity increases fron q to q1.

As country Y is exporting less to country X, it should decrease production of its own goods. Derived demand for labour will get decreased. More unemployment will occur. As people are unemployed, income will get decreased. As income is low, people cant satisfy their demand. The standard of living will get decreased. People wont be able to educate their children. So skilled workforce in the country will get decreased. People wont be able to spend on health care. So this will result in taking too much of sick leaves. This will reduce productoon and economic growth of the country. As people are earning less, they wont be paying income tax and as they are consuming less, indirect tax revenue also get decreased. So overall tax revenue will get decreased. The government may not be able to do important expenditure like defence.