Question

Peronia is a large importer of motorbikes. Initially, Peronia does not have any tariffs on motorbike imports. The world price of motorbikes is $2,000. Consumers buy 4,000,000 units of autos each year while domestic annual production is 1,600,000. Motorbike producers in Peronia convince the trade minister that Peronia must take advantage of its size by imposing a tariff on motorbike imports. As a result, Peronia starts imposing a tariff of $1,000 on motorbike imports. The world price of motorbikes goes down to $1,800. Annual domestic motorbike consumption goes down to 3,000,000 units while annual domestic production goes up to 2,000,000 units.
i) Draw a graph illustrating the scenario above; make sure that you illustrate correctly your graph, including all meaningful areas.
ii) ii) Calculate the following: production distortion cost, consumption distortion cost, the terms of trade gain, net change in welfare. Show your work.

Answer 1

1. In the diagram below, the supply and demand curves for motorbike market in Peronia are shown. Demand curve is downward sloping, while, supply curve is upward sloping. When world price is $2000, Peronia produces 160,000 units of motorbike, and imports 240,000 units of motorbike. Now, due to imposition of tariff of $1000, price increases to $3000. At this level, Peronia produces 200,000 units and imports 100,000 units.

2. From the above diagram , due to imposition of tariff, production distortion cost denoted by area c = 1/2*base*height = 1/2*(200,000-160,000)*1000 = 1/2*40,000*1000 = $20,000,000.

Consumption distortion cost denoted by area f = 1/2*base*height = 1/2*(400,000-300,000)*1000 = $50,000,000.

There is terms of trade gain for the home country as it will reach to a higher level of indifference curve due to imposition of tariff whereas, the foreign country loses as it moves to lower level of indifference curves.

Initially, under free trade, total welfare = consumer surplus + producer surplus = (a+b+c+d+e+f) + g

With imposition of trade, total welfare = consumer surplus + producer surplus + government revenue = (a+e) +(b+g) + d

Thus, Net change in welfare = -(c+f)