Quiz 9: The Instruments of Trade Policy

Business

Home import demand is the excess of demand of Home consumers over the supply of Home producers. So, Home import demand ( MD )equation is obtained by the subtraction of Home producers supply ( S )from home consumers demand ( D ). MD = D - S = (100 - 20 P )- (20+20 P )= 100 -20 P - 20 - 20 P = 80 -40 P...... (1)In the absence of trade, domestic demand and domestic supply equals each other such that import demand is zero. Thus, the price of wheat in the Home country in the absence of trade is M D = 80 - 40 P 0 = 80 - 40 40 P = 80 img img If the price of wheat increases, Home consumers demand less, but Home producers supply more, so, import demand declines. This inverse relationship between the price of the good and its demand for imports when depicted graphically gives rise to a downward sloping import demand curve which is show in the diagram below: img Import Demand Curve At price 2 the MD curve intercepts the price axis (import demand = 0 at price 2)

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a)In the absence of tariff, the price of wheat is 1.5 in both Home and Foreign. Given: • Home's demand curve for wheat is: o img • Home's supply curve for wheat is: o img • Foreign demand curve for wheat: o img • Foreign supply curve for wheat is: o img With the imposition of tariff of 0.5 by the Home country, shippers will be unwilling to move the wheat from Foreign to Home unless the Home price exceeds the foreign price by at least the tariff rate of 0.5. However, there will be an excess demand for wheat in Home and an excess supply in Foreign, if there is no shipping of wheat. Thus, the price in Home will rise and that in Foreign will fall until the price difference is 0.5. Therefore, a tariff drives a wedge between the prices in the two markets. The equation for new MD curve is img Where: • P is the price, equal to 1.5, and • t is the tariff rate, equal to 0.5. The equation for new XS curve is img The equation for the export supply curve by the foreign country is unchanged. Setting the import demand ( MD )equal to export supply ( XS )we solve the value of P as: img Therefore, the price of wheat in foreign country is 1.25. Now, adding the new price with the tariff rate gives us the domestic price as: img Therefore, the domestic price is 1.75. Thus, to summarize: • The world price is 1.25 • The price in home country is 1.75 • The price in foreign country is 1.25 Given: Home's demand curve for wheat is: img Home's supply curve for wheat is: img Now, substitute the above-calculated prices in the equations for demand and supply to get the demand and supply for Home and Foreign. Accordingly, img img Similarly, img img Now, calculate the volume of trade by the equation for MD or XS : img Therefore, the volume of trade is 10. The diagram below shows the effect of tariff on the trade market: img Effect of Tariff on Trade Market In the above diagram, the intersection of MD curve and XS curve determine the world price for wheat at 1.5. With the imposition of tariff, the MD curve shifts to MD 1. After tariff, the home price increases to1.75 while the foreign price falls to 1.25 so that the difference between the two is equal to the amount of tariff. In Home, imports will be fewer as producers supply more at a higher price, while consumers demand less. In Foreign, lower price leads to reduced supply and increased demand. Thus, export supply is smaller and the volume of wheat traded declines from 20 to 10. b)(1)Home import-competing producers are better off because they get higher prices for their goods and that induces them to increase the supply of wheat. Moreover, they have less competition from the foreign producers. (2)Home consumers are worse off because they have to pay a higher price for wheat. (3)The Home government benefits because now they have additional tariff revenue. c)The following diagram shows the terms of trade gain, the efficiency loss, and the total effect on welfare of the tariff: img Effect of Tariff on the Trade Gain, Efficiency Loss Welfare The cost and benefits of a tariff for the importing country is shown by the five area a , b , c , d and e. Let us first calculate the values for the following areas: img img img img img Note: In the calculation of area a , b , and c which are triangles, the formula is img . As a tariff lowers foreign export price, trade gains arise. Rectangle e in the above diagram represents the trade gain. img In the above diagram, triangles b + d represent the efficiency loss that arises because of tariff distorts. img The welfare effect of tariff on the three players of the economy is as follows: img img img