Tariff, partial equilibrium

1. Tariff, partial equilibrium Countries may restrict trade in several ways. For example, they may • Impose a 100 Euro tax per imported computer (tariff) • Impose a 12% tax per imported computer (ad valorem tariff) • Restrict the number of imported computers (quota) • Subsidize the production of domestically produced computers • Subsidize the export of domestically produced computers • Require a “minimum content” before a computer may be labeled “domestically produced” • Prohibit the sale of computers to certain countries for safety reasons • etc. All of this will affect trade flows in different ways. We will restrict attention mainly to tariffs.

2. p D S q Tariff, partial equilibrium We start with a basic partial equilibrium setup; quantity demanded increases and quantity supplied falls as the price falls. In autarky, the equilibrium price is p0, with quantity q0 The price in the world market, however, is equal to p1 p0 At that price the domestically supplied quantity equals q1, and the domestically demanded quantity equals q2. p1 The difference between these two quantities is imported from abroad. imports q1 q0 q2

3. p D S q Tariff, partial equilibrium Suppose the government wants to help the domestic suppliers who face a lower price with trade than in autarky. One way to do this is by imposing a tariff equal to T If this is a small country in the world markets this raises the domestic price to p1+T As a result the domestically produced quantity rises to q3, and the domestically demanded quantity falls to q4. p1+T p1 imports The quantity imported from abroad thus falls q1 q3 q4 q2

4. p D S Thus, the domestic producers support this policy; indeed their profits have increased by the area: q Tariff, partial equilibrium We note that the price level has risen from p1 to p1+T, which has increased the quantity of domestically produced goods from q1 to q3. The government turns out to be pleased as well; not only has domestic production and profitability increased, they earn a revenue as well equal to: p1+T p1 q1 q3 q4 q2

5. p D S q Tariff, partial equilibrium The only party not in support of this policy are the consumers. They see the price level rise from p1 to p1+T. This reduces the consumer surplus considerably, by the area equal to: Indeed, the loss in consumer surplus is so considerable that the total welfare change is negative, equal to the “deadweight loss” triangles: p1+T p1 q1 q3 q4 q2

6. p Remember that imposing D S a tariff reduces the quantity imported from abroad. If this fall in demand has a substantial impact on the rest of the world it will reduce the world price of this good, say from p1 to p2 (large country) q3 q4 q Tariff, partial equilibrium Is it possible in this analysis that the total welfare change is positive, rather than negative? Yes, it is. This does not mean that domestic prices will be lower than p1, since the tariff T has to be paid for imports (price wedge). p2+T T p1 p2 q1 q2

7. p D S q3 q4 q Tariff, partial equilibrium The producers gain the area: The government gains the area: The consumers lose the area: The total welfare change is equal to: - An omniscient government would set tariffs to maximize this welfare gain, the “optimal” tariff argument, see the sequel. p2+T p1 p2 q1 q2