Question

Suppose the world price for a good is lower than the domestic price without trade. Explain the two sources of deadweight loss arising from a tariff.

IMPORTANT: I know that the two sources of deadweight loss arising from tariffs are inefficent production and lost transactions. However, I don't know why that is. Could you please explain to me why inefficent production and lost transactions are the two sources of deadweight loss arising from tariffs when the world price for a good is lower than the domestic price without trade? Thank you

Answer 1

Production distortion loss: This occurs and is considered as a loss in inefficiency because now with tariff those producers are also producing the good that had a high reservation price. This implies that they had high cost and previously with no tariff they were not producing since foreign (low cost) producers were supplying the market. But now with tariff, these (high cost) producers are allowed in the domestic economy to produce so there is too much domestic production at a higher cost.

Consumption distortion loss: This occurs and is considered as a loss in inefficiency because now many consumers with lower willingness to pay are out of the market because the price has increased. Previously with no tariff they were a part of market and were purchasing the good but now due to higher market price, only high valuation consumers are left. Thus, there is an efficiency loss as there is too little consumption after tariff.