Question

Draw a domestic supply-and-demand diagram for a product in which the United States does not have a comparative advantage. What impact do foreign imports have on domestic price and quantity? On your diagram show a protective tariff that eliminates approximately one-half of the assumed imports. What are the price-quantity effects of this tariff on \((a)\) domestic consumers, \((b)\) domestic producers, and \((c)\) foreign exporters? How would the effects of a quota that creates the same amount of imports differ? LO38.4

Short answer

Foreign imports lower domestic prices and increase quantity. A tariff raises prices, benefiting producers but harming consumers and exporters. A similar quota limits imports directly.

Step-by-step solution

Understanding the Concept of Comparative Advantage

Comparative advantage occurs when a country can produce a good at a lower opportunity cost than another country. When the United States does not have a comparative advantage in a product, it means there are other countries that can produce it more efficiently. This typically results in foreign imports being cheaper than domestic production, which impacts domestic markets.

Drawing the Domestic Supply and Demand Diagram

Create a graph with price on the vertical axis and quantity on the horizontal axis. Draw two curves: a downward-sloping demand curve labeled 'D' and an upward-sloping domestic supply curve labeled 'S'. The intersection of these curves determines the domestic equilibrium price and quantity without foreign trade.

Showing the Effect of Foreign Imports

Introduce a horizontal line below the domestic equilibrium price to represent the world price at which the U.S. can import the product. The quantity where this line intersects the demand curve represents the quantity consumed, and the intersection with the supply curve represents the quantity supplied domestically. The difference is covered by imports.

Introducing a Protective Tariff

Display a new horizontal line above the world price representing the new price after the tariff is applied. The tariff is set to eliminate half of the imports. This raises the price, reduces consumer quantity demanded, and increases domestic quantity supplied.

Analyzing the Impact on Domestic Consumers, Producers, and Foreign Exporters

(a) Domestic consumers face higher prices and reduced availability, leading to decreased consumer surplus. (b) Domestic producers benefit from higher prices and sell more of their product, increasing producer surplus. (c) Foreign exporters experience reduced import quantities due to the tariff, decreasing their sales.

Comparing Tariff with a Quota

A quota that leads to the same reduced level of imports would create similar effects in terms of domestic price and quantity. However, instead of price changes due to tariffs, quotas limit the physical quantity directly, potentially leading to government revenue through import licenses.

Key concepts

Protective Tariff

A protective tariff is a tax imposed on imported goods. Its main purpose is to make imported items more expensive, thus encouraging consumers to buy domestic products instead.

Here's what happens when a protective tariff is applied:

• Imports become more expensive due to the added tax.
• Domestic producers can now compete more effectively, as the gap between import prices and domestic prices narrows.
• For domestic consumers, it might mean paying higher prices for both imported and domestically produced goods than they would without the tariff.

Though a protective tariff boosts the domestic market by enabling local producers to capture more of the market share, it can also result in price increases that affect consumer choices negatively. In the end, the effectiveness of a protective tariff largely depends on balancing these economic factors.

Foreign Imports

Foreign imports are products made in other countries but purchased and used locally. When a country imports goods it does not efficiently produce, it is generally because of higher efficiency or lower costs by foreign producers.

Some effects of foreign imports include:

• Lower local prices due to competition.
• Variety increases as consumers have access to international goods.
• Domestic producers may struggle unless they can compete with the efficiency or cost of foreign production.

In the presence of free trade, consumers benefit from more choices and often lower prices. However, domestic industries may not survive in the face of fierce competition without government aid or intervention.

Domestic Supply and Demand

Domestic supply and demand represent the total amount of goods and services available and desired within a country. It is showcased through supply and demand curves that depict how supply increases as prices rise, while demand decreases as prices increase.

In situations where a country lacks a comparative advantage in a product:

• Foreign imports can supplement domestic shortages by offering lower-cost alternatives.
• The presence of imports typically leads to lower equilibrium prices than domestic production would alone.
• Domestic producers must either lower costs or rely on government measures like tariffs to compete.

Supply and demand dynamics are significantly impacted by foreign competition, which influences pricing, quantity available, and market equilibrium within the domestic economy.

Quota

A quota is a fixed limit on the amount of a specific good that can be imported into a country. Unlike tariffs, which increase prices by adding taxes, quotas simply limit the numbers, potentially leading to supply shortages.

Key effects of quotas include:

• Stable prices for domestic goods due to restricted foreign competition.
• Limited imported supply, which may lead to higher prices for those goods as they become scarcer.
• Potential increases in government revenue if permits or licenses are sold for importing goods under the quota.

While both a quota and a tariff aim to protect domestic producers, quotas specifically restrict the amount of product, thereby creating a hard cap. This can encourage domestic production but may also mean consumers face limited choices and potentially higher prices.