Question

8. On the graph below, using Supply and Demand, show what happens if a "large" country implements a tariff in an import industry. Draw the necessary domestic demand and supply curves. Be sure to label the axes and any curves. Show where the domestic market clearing price is, the World Price, the consumer price, and the producer price are in the market after the tariffs are implemented. Indicate the areas of Deadweight Loss and the Terms-of-Trade Effect under the tariff. (6 points)

Answer 1

In the diagram below, we have shown effects of tariff on the import industry of a large country. We have plotted price on Y-axis and quantity on X-axis. Here, the demand curve for a good is downward sloping while supply curve for the same good is upward sloping. The demand and supply curves intersects at the market equilibrium price P and quantity Q. Now, when world price for that good is lower than the market equilibrium price (say p') , the country will import Q₁Q₂ units of that good. This is because at the lower price P', there is excess demand and shortage in supply in the domestic market.

Price Supply -World price+tariff F HI World price Demand Quantity 0 Q1 Q3 Q Q4 Q2

Now, suppose, tariff is imposed by the large country on quantity of imports. Then, the new price for the imported good is P'+tariff T per unit = P*(say). Due to tariff, domestic demand falls from OQ₂ to OQ₄ and domestic production increases from OQ₁ to OQ₃. Thus, level of imports falls from Q₁Q₂ to Q₃Q₄. In the above diagram, we have shown terms of trade effect due to tariff. Thus, price in tariff imposing (importing) country rises whereas, price for producers (exporters) falls with tariff This is known as terms of trade effect. Consumer surplus falls from area (A+B+C+D+E+F+G+H+I) to area (A+B+C+D) due to tariff while producer surplus rises from area (J) to area (J+E). Area (G+H) is the revenue collected by the domestic (tariff imposing) country. Areas F and area I are the dead weight loss due to tariff.