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The domestic demand curve for the single good is shown by the line
DD,
and the domestic supply curve is shown by SS.
Because this is a closed system, the domestic market will be cleared when there is no excess demand nor supply. This leads to an equilibrium point E, with a supply and demand of MA units at a price of PA. |
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Now suppose we open up trade and the world price is PW,
which is less than the autarky equilibrium price PA.
By free trade, this economy becomes a price taker in the world market.
There is an infinite inflow of this good at price PW. Therefore domestic producers receive PW as their price and produce as much as M1, and domestic consumers consume at M2. As there is an excess demand for M at PW, the amount that this country imports will be (M2 - M1). Under these free trade conditions, the consumer's surplus is the area APWD and the producer's surplus is BPWC. |
CONSUMER'S SURPLUS
The height of a demand curve measures a monetised marginal utility of the good. Therefore, when the economy consumes M2 units of importing goods, the total utility will be the area AOM2D. As the price is PW, the total amount consumers pay is PW x M2 = PWOM2D. The difference between these two areas, APWD, is called consumer surplus, which represents the amount of extra utility consumers enjoy.
PRODUCER'S SURPLUS
The height of a supply curve measures a marginal cost of the good. Therefore, when the economy produces M1, the total cost of production is the summation of marginal costs to M1, that is, BOM1C. As the market price is PW, by selling M1 units, producers receive PW x M1 = PWOM1C. This revenue exceeds total cost by PWBC. This area is called producer surplus.
Now suppose that the government imposes a tariff (ad valorem tax)
of t on M, where t is a fraction from 0 to 1 (In other
words, this is a tax of 100 x t%).
This will cause the domestic price to increase to PW(1+t).
At this price, domestic producers will produce M3 (at F), but domestic consumers will want to consume as much as M4 (at G). Therefore, this country will now import (M4 - M3). In summary, compared to the free trade case: |
Imposing a tariff has two important effects: Efficiency loss and the
equity problem.
EFFICIENCY LOSS
Let's compare the country's welfare after applying the tariff with its welfare under free trade.
| Free Trade | Protection | |
|---|---|---|
| Consumer surplus | APWD | APW(1+t)G |
| Producer surplus | BPWC | BPW(1+t)F |
| Government tariff revenue | 0 | FHIG |
| TOTAL | ABCD | ABCD - (FCH + GID) |
As we can see, under protection, there is an "efficiency loss" of FCH and GID. What do these areas represent?
FCH (production distortion loss)
Because the tariff leads to a higher price, domestic producers produce more than they are supposed to do with the world price. Hence there is an inefficient allocation of resources in the domestic market.
Why? Consider which one is more efficient for this economy: To buy one unit of M from the world paying PW or to produce one unit of M spending marginal cost higher than PW.
GID (consumption distortion loss)
Because the tariff leads to a higher price, domestic consumers consume less than they do with the lower world price. Hence the consumer surplus decreases.
Imposing a tariff protects producers at the expense of consumers. How can we justify sacrificing consumer surplus to increase producer surplus?
By tariff, domestic import-competing firms will increase their production (and therefore employment). Doesn't it mean that other industries (mostly exporting sectors) will experience higher wages and reduce production?