Question

In our analysis of tariffs we assumed that the country in question faced a perfectly elastic supply curve for imports. Now assume this country faces a positively sloped supply curve for imported goods. a. Show graphically how the level of imports will be determined. b. Use your graph from part (a) to demonstrate the effects of a tariff in this market. c. Carefully identify the sources of the various changes in consumer and producer surplus that are brought about by the tariff in part (b). d. Show how the deadweight losses brought about by the tariff in this case will depend on the elasticity of demand and the elasticities of supply of domestic and imported goods.

Short answer

Answer: The size of deadweight losses caused by a tariff on imported goods with a positively sloped supply curve depends on the elasticities of demand and supply for both domestic and imported goods. The more inelastic the demand and supply curves, the larger the deadweight losses, as consumers and producers are less able to adjust to the price changes caused by the tariff.

Step-by-step solution

a. Determine the level of imports graphically

To determine the level of imports graphically, follow these steps: 1. Draw a coordinate system with quantity on the x-axis and price on the y-axis. 2. Draw a downward-sloping demand curve representing the demand for the good in the country. 3. Draw a positively-sloped supply curve representing the supply of domestic goods. 4. Draw another positively-sloped supply curve above the domestic supply curve representing the combined supply from domestic sources and imports. 5. The equilibrium is where the demand curve intersects the combined supply curve. 6. The quantity difference between the combined supply curve and the domestic supply curve at the equilibrium price indicates the level of imports.

b. Demonstrate the effects of a tariff

To demonstrate the effects of a tariff, follow these steps: 1. On the same graph, draw a horizontal line parallel to the x-axis at the level where the tariff price is. 2. The new combined supply curve will include the tariff, shifting up by the amount of the tariff. 3. Find the new equilibrium where the demand curve intersects the new combined supply curve. 4. The increase in price and decrease in the quantity demanded will demonstrate the effect of the tariff.

c. Identify changes in consumer and producer surplus

To identify the changes in consumer and producer surplus, follow these steps: 1. The loss in consumer surplus is represented by the area between the original demand curve and the new demand curve, up to the original equilibrium point. 2. The gain in producer surplus is represented by the area between the original domestic supply curve and the new domestic supply curve, up to the new equilibrium point. 3. The government revenue from the tariff is represented by the area of a rectangle with the width of the import level and height of the tariff.

d. Show how deadweight losses depend on elasticities

To show how deadweight losses depend on elasticities, consider the following: 1. The elasticity of demand determines how sensitive consumers are to price changes, which in turn affects how much the quantity demanded will decrease due to the tariff. 2. The elasticities of domestic and imported goods' supply determine the responsiveness of producers to price changes, affecting the magnitude of changes in producer surplus. 3. The more inelastic the demand and supply curves, the larger the deadweight losses, as consumers and producers are less able to adjust to the price changes caused by the tariff. In conclusion, the effects of a positively sloped supply curve for imported goods can be analyzed graphically to demonstrate the effects of a tariff on the market, changes in consumer and producer surplus, and the relation of deadweight losses to the elasticities of demand and supply.

Key concepts

Elasticity of Demand

The elasticity of demand is a measure that calculates the responsiveness of consumers to changes in price. When demand is elastic, a small change in price leads to a significant change in the quantity demanded. Conversely, when demand is inelastic, consumers are less responsive to price changes, and the quantity demanded changes only slightly.

In the context of tariffs, if the demand for imported goods is elastic, consumers will greatly reduce their purchases when a tariff raises prices. This leads to a larger decrease in consumer surplus as consumers either stop buying the good or switch to more expensive substitutes. An important point here is that not only does the quantity demanded drop, but the total spending by consumers does not increase by much, which could potentially reduce the intended government revenue gains from the tariff.

Therefore, understanding the elasticity of demand is crucial when analyzing the impacts of tariffs because it directly affects both the consumers' well-being and the country's revenue.

Consumer Surplus

Consumer surplus represents the difference between what consumers are willing to pay for a good and what they actually pay. It is visually illustrated by the area under the demand curve and above the market price. In the presence of a tariff, the consumer surplus typically decreases because the price of the imported goods increases. This results in a loss of welfare for the consumers as they are now paying more for the same goods, or not buying some goods at all because they have become too expensive.

The area that represents the loss in consumer surplus can be clearly seen on a graph where the original and new demand curves are present. After the imposition of a tariff, consumers bear the burden of the increased costs, which leads to a reduction in consumer surplus. This reduction reflects the lower utility they receive from paying higher prices or from consuming less quantity of the good because of the tariff.

Producer Surplus

Producer surplus, on the other hand, is the difference between the market price and the minimum price producers are willing to accept for their goods. It is the area above the supply curve and below the price consumers pay. When a tariff is imposed, domestic producer surplus usually increases. This happens because the tariff imposes an extra cost on imported goods, elevating their prices, and often allows domestic producers to raise their prices without losing consumers to cheaper foreign competitors.

However, this increase in producer surplus does not come without a cost. It reflects a transfer of welfare from consumers to domestic producers and does not represent a gain in economic efficiency. The higher prices can also lead to decreased consumer spending, which might negatively impact the volume of sales and, consequently, overall producer surplus.

The net change in producer surplus must be evaluated considering all these dynamic market responses, including potential long-term implications for competition and industry health.

Deadweight Loss

Deadweight loss constitutes the loss of economic efficiency when the equilibrium in a market is not achieved or is distorted, as in the case of a tariff imposition. Tariffs create a deadweight loss because they prevent the market from reaching its most efficient outcome where supply equals demand.

This loss is represented by the areas on a graph that indicate the reduction in both consumer and producer surplus that is not offset by government revenue. The size of the deadweight loss depends on the elasticity of demand and supply. When these elasticities are high, meaning both consumers and producers can easily adjust to price changes, the deadweight loss tends to be smaller. In contrast, when demand and supply are inelastic, the deadweight loss is larger because the tariff causes substantial inefficiencies in the market.

Ultimately, tariffs can lead to resources not being used in the most productive manner, consumers and producers making less optimal decisions, and the overall reduction in the welfare of a society.