Question

Consider the Australian steel market. Australia is a small country and cannot influence the world price of steel which is $30 per ton. At this price, Australian demand for steel would be 120 tons. Nevertheless, Australia currently imposes a tariff of $10 per ton on steel imports. Demand for steel under this tariff is 100 tons.

Suppose now that Australia is considering entering a trade agreement with Korea that would reduce the tariff on Korean steel to zero while maintaining it on other steel producing countries. In particular, the tariff would remain on China, who is currently supplying all Australian imports of steel and the Chinese marginal cost is $30.

If the Korean marginal cost of steel is $35 (and Australia imports 110 tons at this price), what are the welfare implications of signing a trade agreement with Korea?

Answer 1

Solution

Given that Australia is small market and it's demand for Steel is 120 Tons initially.

When it imposes a tariff of $10 per ton,the demand falls to 100 tons.

Now it is given that Australia enters into a free trade agreement with Korea.But the marginal cost for Korea is $35 unlike China which has a marginal cost of $30 per ton.

So,initially when tariffs are imposed China steel will have costed $40 / ton (i.e., $30 / ton + $10 / ton as tariff)

But due to this deal with Korea,even though it's marginal cost is $ 5 / ton more than China (i.e., $35 / Ton) ,the steel is imported from Korea (i.e., 110 Ton of steel)

So, Korea is a beneficiary of this policy .China is presently (before this policy implementation) catering to all the demand (100 ton ) Korea lost out on this competition.

Korea gets the entire business from China

Revenue to Korea = $35 * 110 i.e., $3850

Revenue Loss to China in comparison to the 1st scenario (without tariff to all the countries) = $30 * 120 i.e., $3600

Revenue Loss to China in comparison to the 2 nd scenario (free trade agreement with Korea) = $30 * 100 i.e., $3000

Due to this free trade policy ,revenue loss to Australia = $10 * 100 tons i.e., $1000

The Australia govt. can utilize this revenue on welfare activities instead.

But due to this,the consumption demand has increased from 100 Tons (@ $40 / Ton) to $110 (@ 35 /Ton) due to which the Forex reserves with Australia will increase.(i.e., it's imports value will reduce from previous level and it will now need to make lesser conversion of Australian Dollar to foreign currency to pay the manufacturers)

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