Question

Tariffs never make small countries better off, but there are cases where they can make a large country
better off. Draw side-by-side graphs for a good (call it “toothpicks”) where the small country can produce
the good at a lower price than the large country. In this problem:
SA : P =5 + 1.1Q
DA : P =14 − 1.1Q
SB : P =2 + 1.1Q
DB : P =10 − 1.1Q
Note that there is a worked example similar to this in the lesson. DO NOT just copy what was done
in the lesson. Think through the problem independently and be sure to explain your notation.
a) (5 points) Which country is the small country? How do you know?
b) (15 points) Show the domestic price and quantity in each market, free trade price (needs to be the
same in both countries), and the imports and exports in both countries. Be sure to label prices and
quantities on your graph.
c) (10 points) The large country imposes a tariff of T = $1.00 resulting in a domestic price that is below
its autarky price. What happens to the world price after this tariff? Why? Note: you do not need to
calculate actual numbers for this part.
d) (10 points) Show the tariff on the graph. How much is imported now? How much is exported?
e) (10 points) Show on the graph (and describe in words) how you would know if this tariff is welfare-
enhancing

Answer 1

The autarky price mean the equilibrium price and quantity which lead to self-sufficient economy. From your equations there are no sign of international trade, so the equilibrium will be reached when Qd=Qs.

The price and quantity mentioned in the pic is autarky condition (approximated).

Considering about the welfare associated with tarrif we can categorize this as effects on importing country and exporting country separately which is as follows:

Tariff effects on the importing country’s consumers. Consumers of the product in the importing country suffer a reduction in well-being as a result of the tariff. The increase in the domestic price of both imported goods and the domestic substitutes reduces the amount of consumer surplus in the market.

Tariff effects on the importing country’s producers. Producers in the importing country experience an increase in well-being as a result of the tariff. The increase in the price of their product on the domestic market increases producer surplus in the industry. The price increases also induce an increase in the output of existing firms (and perhaps the addition of new firms); an increase in employment; and an increase in profit, payments, or both to fixed costs.

Tariff effects on the importing country’s government. The government receives tariff revenue as a result of the tariff. Who benefits from the revenue depends on how the government spends it. Typically, the revenue is simply included as part of the general funds collected by the government from various sources. In this case, it is impossible to identify precisely who benefits. However, these funds help support many government spending programs, which presumably help either most people in the country, as is the case with public goods, or certain worthy groups. Thus someone within the country is the likely recipient of these benefits.

Tariff effects on the importing country. The aggregate welfare effect for the country is found by summing the gains and losses to consumers, producers, and the government. The net effect consists of three components: a positive terms of trade effect (G), a negative production distortion (B), and a negative consumption distortion (D).

Because there are both positive and negative elements, the net national welfare effect can be either positive or negative. The interesting result, however, is that it can be positive. This means that a tariff implemented by a large importing country mayraise national welfare.

Generally speaking, the following are true:

1. Whenever a large country implements a small tariff, it will raise national welfare.
2. If the tariff is set too high, national welfare will fall.
3. There will be a positive optimal tariff that will maximize national welfare.

However, it is also important to note that not everyone’s welfare rises when there is an increase in national welfare. Instead, there is a redistribution of income. Producers of the product and recipients of government spending will benefit, but consumers will lose. A national welfare increase, then, means that the sum of the gains exceeds the sum of the losses across all individuals in the economy. Economists generally argue that, in this case, compensation from winners to losers can potentially alleviate the redistribution problem.

Tariff effects on the exporting country’s consumers. Consumers of the product in the exporting country experience an increase in well-being as a result of the tariff. The decrease in their domestic price raises the amount of consumer surplus in the market.

Tariff effects on the exporting country’s producers. Producers in the exporting country experience a decrease in well-being as a result of the tariff. The decrease in the price of their product in their own market decreases producer surplus in the industry. The price decline also induces a decrease in output, a decrease in employment, and a decrease in profit, payments, or both to fixed costs.

Tariff effects on the exporting country’s government. There is no effect on the exporting country’s government revenue as a result of the importer’s tariff.

Tariff effects on world welfare. The effect on world welfare is found by summing the national welfare effects on the importing and exporting countries. By noting that the terms of trade gain to the importer is equal to the terms of trade loss to the exporter, the world welfare effect reduces to four components: the importer’s negative production distortion (B), the importer’s negative consumption distortion (D), the exporter’s negative consumption distortion (f), and the exporter’s negative production distortion (h). Since each of these is negative, the world welfare effect of the import tariff is negative. The sum of the losses in the world exceeds the sum of the gains. In other words, we can say that an import tariff results in a reduction in world production and consumption efficiency.