Question

Q. 1. Suppose both supply and demand in a market are relatively inelastic. Will a tax placed on the product in market generate a relatively large or small deadweight loss? Why?

Q. 2. If the world price of a good exceeds the domestic price of the good, will the country export or import the good. In this scenario who gain from free trade: Domestic consumers or Domestic producers? Explain.

Answer 1

1. When the demand and supply of goods is inelastic, the quantity of the good demanded and supplied doesn't change much with change in price. The imposition of a tax creates deadweight loss when the supply or demand of the good declines due to the distortionary tax. This happens because those beneficial transfers of goods does not take place due to the tax. When the supply and demand of the good does not change with the change in the after tax prices, there is no market distortion. Thus the deadweight loss due to tax will be negligible in this case.

2) If the world price of the good is greater than the doemstic price, domestic goods will be attractive in the world market due to the competitive prices. This will increase the doemstic exports of the good and reduce imports. Since the domestic producers will be able to sell in the world market at a higher price, they will be benefitted while the domestic consumers will be harmed due to higher prices than without trade.