Model Answer
0 min readIntroduction
International trade liberalization, while generally beneficial, often faces protectionist measures like tariffs. Tariffs, a tax on imported goods, are implemented by governments to protect domestic industries, generate revenue, or achieve other economic objectives. However, they also distort market signals and can lead to welfare losses. This question asks us to analyze the welfare effects of a specific tariff – Rs. 10 per unit – imposed by a small importing country on good X, starting from a free trade price. We will evaluate the changes in consumer surplus, producer surplus, and government revenue, and ultimately determine if the policy enhances national welfare.
Understanding the Initial Free Trade Equilibrium
Before the imposition of the tariff, the importing country is in a free trade equilibrium. This means the price of good X is determined by the world price (Pw). At this price, the quantity demanded (Qd) equals the quantity supplied domestically plus imports (Qs + Imports). Consumer surplus (CS) is the area below the demand curve and above the world price, while producer surplus (PS) is the area above the supply curve and below the world price.
Impact of the Tariff
The imposition of a Rs. 10 per unit tariff alters this equilibrium. The domestic price of good X rises to Pw + Tariff (Pt). This has the following effects:
- Consumer Surplus: The increase in price reduces the quantity demanded (Qd’ < Qd). Consumer surplus decreases. The loss in consumer surplus is represented by the area (A+B) on a standard supply and demand diagram, where A is the loss to consumers who no longer purchase the good, and B is the loss to those who continue to purchase but at a higher price.
- Producer Surplus: The higher domestic price encourages domestic producers to increase their output (Qs’ > Qs). This leads to an increase in producer surplus, represented by area C.
- Government Revenue: The government collects revenue from the tariff on each imported unit. This revenue is equal to the tariff amount (Rs. 10) multiplied by the quantity of imports after the tariff (Imports’). This is represented by area D.
Welfare Analysis and National Welfare
To determine if the tariff increases national welfare, we need to compare the loss in consumer surplus with the gains in producer surplus and government revenue. National welfare is maximized when the sum of consumer surplus, producer surplus, and government revenue is maximized.
The change in national welfare is given by: ΔWelfare = Change in CS + Change in PS + Government Revenue.
In this case: ΔWelfare = -(A+B) + C + D
Generally, for a small importing country, the loss in consumer surplus (A+B) is larger than the combined gains to producers (C) and the government (D). This is because the small country cannot influence the world price. Therefore, the tariff leads to a net welfare loss, represented by the area A. This area represents the deadweight loss due to the distortion of trade.
Graphical Representation (Conceptual)
While a diagram isn't explicitly requested, visualizing this with a supply and demand curve would greatly enhance understanding. The tariff creates a wedge between the world price and the domestic price, leading to reduced imports and the welfare effects described above.
Considerations for a Small Importing Country
The assumption that the importing country is 'small' is crucial. A small country's demand does not significantly affect the world price. If the country were large enough to influence the world price, the analysis would be more complex, potentially leading to terms of trade gains that could offset some of the welfare losses. However, given the stated assumption, a tariff is generally welfare-reducing.
Conclusion
In conclusion, the imposition of a Rs. 10 per unit tariff on good X by a small importing country leads to a decrease in consumer surplus, an increase in producer surplus, and government revenue. However, the loss in consumer surplus typically outweighs the gains to producers and the government, resulting in a net welfare loss for the nation. This policy, therefore, does not increase national welfare and represents a distortion of efficient resource allocation. The analysis highlights the potential drawbacks of protectionist measures, even when implemented with specific objectives like supporting domestic industries.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.