Trade policy instruments - tariffs Flashcards
What is a demand curve?
Demand curve describes the functional relationship between the price of a product and the quantity consumers would buy of that product.
Assuming consumers’ rational, utility maximizing behavior, the demand curve can be interpreted as ‘marginal utility’ function.
What is marginal utility?
Marginal utility refers to how much utility (happiness) a consumer gets out of consuming one additional unit of the product.
A rational consumer therefore buys up to the point where the last one bought is just barely worth the price. The price reflects, thus, the marginal utility of consuming a little more.
What is a supply curve?
Supply curve describes the functional relationship between the price of a product and the quantity producers would supply of that product.
Assuming producers’ rational, profit maximizing behavior, the supply curve can be interpreted as ‘marginal cost’ function.
What is marginal cost?
Marginal cost referes to the cost added by producing one additional unit of a product or service.
A rational producer supplies up to the point where the marginal cost just equals the price.
When will producers/consumers stop produce/buy?
Consumers (producers) buy (produce) up to the point where the marginal utility (marginal cost) equals the price.
For all units bought (produced) up to this point, the marginal utility (marginal cost) is above (below) the price.
When will consumers/producers get a surplus? Please show this on a graph
For consumers, they get consumer surplus at any point where the price is below the marginal utility function.
For producers, they get producer surplus at any point where the price is above the marginal utility function.
For graph see p. 48
Will a change in price both affect consumer and producer welfare?
Yes, one goes up and the other goes down.
Please show and explain the direct effects of tariffs on the import demand curve
Without the possibility of imports, demand = supply at price p*
With the possibility of import, the amount of import will depend on the import price.
Two important assumptions:
- Imported and domestic goods are perfect substitutes.
- Import price fixes the domestic price.
As domestic consumers want to consume more than domestic producers are willing to produce at price p’’ or p’, the difference is met by imports.
graph p.41
Please show and explain the direct effects of tariffs on the import supply curve
Supply of imports to Home is supply of exports from Foreign.
Equilibrium price in Foreign at p*.
In case the export price is higher than p* producers in Foreign have an incentive to produce more and export.
Note: Export price sets the price in Foreign. Producers in foreign have no incentive to produce less because they can sell their product via export.
graph p.49
Explain and draw the workhorse diagram: MD – MS
Assuming imports and domestic production are perfect substitutes, the domestic price is fixed where demand and supply of import meet:
P_FT with FT = Free trade
- MD—MS diagram allows to determine the price and volume of imports.
- It does not allow to see impact on domestic consumers and producers.
graph p.42
Please explain and draw a tariff analysis for a small country case
Small country: Domestic consumption and production and import have only negligible effects on world market conditions, specifically the good’s price.
Assumption: Imported good perfect substitutes from domestic good
P^w= world price of good, since no consumer would buy at a higher price is there is free trade.
Ad valorem tariff rate of t > 0.
Import tax = tPw
Price of the imported good: Pw+tPw
Short term: Consumers turn to the cheaper domestic products
Over time: Post tariff increase in the domestic product’s price up until Pd = Pw + tPw, because the domestic producers will not produce at a quantity to satisfy all consumers, thus excess demand drives prices up again.
As prices increase, consumers will buy less, which is called the consumption effect of the tariff.
Meanwhile, domestic producers are willing to supply more as prices rises, called the protective effect.
Revenue effect of the tariff: Government collects revenues
Graph p. 24 and 50
What is ad valorem tariff?
ad valorem tariff = expressed as per cent of the imported good’s value / price
Please explain and draw a welfare analysis for a small country case
Tariffs cause price changes, which causes welfare effects.
Consumers are generally worse of after a tariff is imposed - must pay higher prices
Domestic producers are better off
o Higher prices for the product
o Higher levels of employment and production
o Resulting in higher profits
Government is better off with a tariff (as long as it is not a prohibitive tariffs, cutting of all imports)
o Tariff revenue on imports
Tariffs redistribute welfare. From consumers to producers and government (there are winners and losers)
- Reduction in consumer welfare: Areas a+b+c+d
- Increase in producer welfare: Area a
- Increase in government welfare: Area c
- Dead-weight loss due to the tariff: Areas b + d
Graph p. 27 and 50
Please explain and draw a tariff analysis for a large country case
Large country: Domestic consumption and production and import have a noticeable effect on world market conditions, specifically the good’s price.
Drop in imports after a tariff is imposed shifts the world demand curve and yields a reduction in world price.
Price of imported good falls from Pw to P1^w
Price of the domestic product only increases to P^d = P1^w + tP1^w
Consumer welfare loss: Areas a+b+c1+d
- Producer welfare gain: Area a
- Government welfare gain: Areas c1 + c2
Different from the small country case there may not be a net loss to society in terms of welfare. Because some of the welfare gain of the government is shouldered by the import partners – not by domestic consumers. If c2 > b + d, then the overall gain in domestic welfare is positive.
What is a preferential trade agreement (PTA)?
It is an international treaty with restrictive membership. A PTA can take different forms such as free trade agreement or customs union.
It is unilateral trade preferences, including generalized system of preferences schemes (under which developed countries grant preferential tariffs to imports from developing countries), as well as other non-reciprocal preferential schemes granted a waiver by the general council.
Preferential agreements can be interpreted as a negative externality that PTA members impose on non-members.
Mention some forms of PTA with deep integration
Fiscal union, monetary union and common market