Question

Trade Policy (Total 62 points) 1. (16 points) Consider a small country applying a tariff t to imports of a good like that represented in the Figure below. a. Suppose that the country decides to reduce its tariff to t'. Redraw the graphs for the Home and import markets and illustrate this change. What happens to the quantity of goods produced at Home and their price? What happens to the quantity of imports? b. Are there gains or losses to domestic consumer surplus due to the reduction in tariff? Are there gains or losses to domestic producer surplus due to the reduction in tariff? Illustrate these on your graphs. c. What is the overall gain or loss in welfare due to policy change?
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Answer 1

Tariff cause deadweight loss due to production distortion and consumption distortion. With tariff the producers are producing at inflated prices. With limited capacity, while they increasing production, they can produce only at a higher marginal cost. This production distortion causes deadweight loss. The consumers are charged with higher price and its will distort their consumption patter. At higher price fewer consumers can access the commodity or the existing consumers are paying a high price and this distortion cause deadweight loss to the society A tariff badly affect the domestic consumers because a tariff reduce consumers surplus.. A tariff increase domestic production and reduces domestic consumption and increase government revenue. The domestic producers are gainers from tariff since a tariff increase producer's surplus. But a tariff reduce consumer surplus. A tariff cause domestic price to increase and reduce the quantity of import. In comparison with relative welfare before and after the tariff, the total welfare to the society decrease after a tariff regulation. But a reduction in tariff reduces the quantum of deadweight loss. It reduces the domestic production and government revenue, but increase domestic demand and the quantity of import. The domestic price decrease and the increase in demand at lower price increase consumer's welfare. A low price after the reduction in tariff reduces the domestic production and reduces the producer's surplus. The domestic consumers are the gainers from a reduction in tariff. By comparing the total welfare before and after the tariff reduction, one can conclude that the total welfare of nation increase after the reduction in tariff Price . pw+ .. PWIt -.. a X + X* It' . - b c PW SI S3 S2 D2 D3 D1 Quantity M2 M3 Mi Import a) The free trade price is Pw where the domestic demand is cqual to D1 and domestic supply is Sl. The total import is SI DI-MI.

The government imposes a tariff Pw+Pwt. Then the domestic price increase to Pw+t. The domestic production increase from Si to S2. The quantity of import decrease from S1 D1 to S2 D2 or it decrease from M1 to M2. The reduction in tariff to t' reduces the domestic price from Pwłt to Pwtt'. The domestic production decrease from S2 to S3. The quantity of import increase from S2 D2 to S3 D3 or it increases from M2 to M3. b) The government reduces the tariff from Pw+t to Pw+t'. Thus the domestic price decreases to Pw+t'. Then consumer's surplus increases. The increase in consumer's surplus is equal to ef bi d' The consumers gain by this area. There is a gain in consumer's surplus. The producer's surplus decrease due to the reduction in domestic price. Before reduction in tariff, the producer's surplus was equal to a e. But after the tariff reduction it decreases to the area 'a'. There is a loss in producer's surplus. c. There is an increase in welfare. The net increase in welfare is the reduction in deadweight loss which is represented by the areas b' and d' which goes to the consumers in the form of lower price and increased consumption.