Question

Acirema is a small country, unable to affect world prices. It imports sugar at a price of $10 per bag. The demand curve in Japan is D=1000 - 25P and the supply curve is S=100 + 5P. Using a graphical analysis please answer the following questions:

a) Calculate the quantity supplied, quantity demanded, and equilibrium imports when free trade prevails.

b) Suppose an import quota limits imports to 300 bags of sugar. Calculate the production distortion loss, the consumption distortion loss, and the quota rents. Can the application of quotas improve welfare in Japan relative to free trade? Could the application of a tariff improve welfare relative to free trade?

c) Consider again the problem described in item “b” but assume that production yields a marginal social benefit (externality) of $10 for each bag produced. Can the application of quotas improve welfare in Japan relative to free

trade? Explain what would be the optimal policy (tariffs, quotas, VERs, consumption tax, production subsidies, etc.) to maximize welfare. What would the value of the optimal tool be?

Answer 1

a) when free trade prevails, ---------

Quantity demanded = 750 sugar bags

Quantity supplied ( domestic producers) = 150 bags

Imports Equilibrium = 600 bags (750-150)

Calculations------

When Qd=QS------

1000-25p=100+5p

p=$30

Substituting value of p in any equation-----

We get , equlibrium quantity = 1000--25(30)=250

Or 100+5(30)=250

So equlibrium price =$30

Equilibrium Quantity =250 sugar bags

Making schedule ----

p($). Qd. Qs

0. 1000. 100

10. 750. 150

30. 250. 250.   

40. 0. 300

The graph shows initial Equilibrium Quantity, equlibrium price.

Also it shows, import price $10, which makes domestic production = 150 bags and imports = 600 bags .Thus total quantity demanded under free trade comes to 750 sugar bags@$10

b) Now import quota is 300 bags of sugar, so the Quantity demanded and domestic production changes----

See the graph below----

The graph depicts the clear picture when import quota is imposed(300 bags), corresponding to price $20.

* Now consumption distortion loss = shaded area C

*Production distortion loss is shaded area P

* The quota rent is loss of consumers surplus due to import quota.

Initial CS under free trade =area ASD

CS after Import quota=area ABL

Quota rent= area BSDL

*Govt revenue = R ( area between P&C

* The application of import quota reduces consumers surplus as now they could be able to buy less goods.Secondly, it encourages inefficient domestic production of sugar.It provides revenue to govt only.Thus application of tariff quota does not add to welfare.

* Effect of marginal sociai benefit------

The Demand curve shifts outward and makes new equilibrium point E'.

It adds to the consumers surplus only.

* The optimal policy to improve welfare is to provide subsidy to domestic producers so as to increase domestic demand which would eventually increase consumer surplus as well as producers surplus.