Question

Suppose that a country imports 2 billion barrels of crude oil per year and domestically produces another 4 billion barrels of crude oil per year. All the domestic production is consumed by domestic consumers (i.e. there are no exportations). The world price of crude oil is $80 per barrel. Assuming linear demand and supply schedules, economists estimate the price elasticity of domestic supply to be 0.3 and the price elasticity of domestic demand to be -0.15 at the current equilibrium.

A.) Consider the imposition of a $32 per barrel import fee on all crude oil imported into the country. Assume that the world price will not change as a result of this import fee, but that the domestic price will increase by $32 per barrel. Also assume that only producers, consumers, and taxpayers within the country have standing and that there will be an annual administrative cost of $270 million to impose and collect the new import fee. Using the information above regarding the current equilibrium price and quantity as well as the elasticity estimates, calculate the new total equilibrium quantity of crude oil demanded based on the import fee.

B.) Using the total equilibrium quantity from part a., find the amount of that total quantity that will be produced and supplied by domestic producers and the amount of the total quantity imported from foreign producers.

C.) Using your calculations from parts a. and b., estimate the annual social net benefits of the import fee by calculating the changes in consumer and producer surplus as well as changes in tax revenue. Does your estimate imply that the import fee should be implemented? Why?

Answer 1

Solution:

As per the given question, the quantity supplied domestically is 2 billion barrels, and imported is 2 billion barrel at the price of $80 per barrel. Therefore equilibrium qty is 3 billion and price is $72 billion per barrel

a)

Please refer to the below image for further explanation.

[image attached]

Line D represents the demand and S supply for the crude oil. At point 1 , at the price of $80 Qc1 Is the quantity demanded by domestically, however the domestic supply can only meet Qs out of it (point 2). Therefore the gap between Qs1 and Qc1 is met by the imports. At this point, the producer surplus is the are below Pw (shaded area)and r the consumer surplus is the area above Pw.

Now a import fee of $32 per barrel is applied on the imports, which rises the prices to $80+$32 = $112.Thus the price moves from Pw to Pt, which decreases the demand of the crude oil to Qc2 at point 3. Similarly the quantity produced by the domestic supplier will increase as the domestic price has increased by $32 as they wil have an incentive to sell more at this price. Thus the Qs1 moves to Qs2 and intersect the new price at point 4.

b)The quantity supplied by the domestic producer will increase to Qs2 and the quantity imported will decrease to Qc2

c) The consumer surplus before Tariff was the area = ½*6*80 = $240, which got reduced as the price moved up and the consumer will now have to pay more for the same unit of oil. After tariff, it reduced to area = ½*112* = $56

The producer surplus before tariff was the area = ½*3*80 = $120 which increased by A as the producer will be able to charge more than the previous price. So the benefit of the consumer will be passed on to the producer by the extent of Area a , where as the area covered by point C + E will be passed on to the Government as tax revenues, Area B and D are the social loss to for the tariff. The net loss to the society due to the tariff would be given by the total costs of the tariff minus its benefits to the society. Therefore, the net welfare loss due to the tariff is equal to:

Consumer Loss – Government revenue – Producer gain, which is B+D-E

These are beneficial only if teh area E is more than B+D, That is the Import fee should be implemented only if E>B+D

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