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Taxes, Subsidies, and Tariffs: “Small” Country. Udayan Roy http://myweb.liu.edu/~uroy/eco41. The Effects of a Tariff. A tariff is a tax on imported goods Tariffs raise the price of imported goods above the world price by the amount of the tariff. This Reduces consumption, …

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taxes subsidies and tariffs small country

Taxes, Subsidies, and Tariffs: “Small” Country

Udayan Roy

http://myweb.liu.edu/~uroy/eco41

the effects of a tariff
The Effects of a Tariff
  • A tariff is a tax on imported goods
  • Tariffs raise the price of imported goods above the world price by the amount of the tariff.
  • This
    • Reduces consumption, …
    • Increases production, and thereby …
    • Reduces the amount imported
effects of a tariff on prices and quantities

Domestic

supply

Equilibrium

without trade

Price

after tariff

Price

World

before tariff

price

Imports

Domestic

with tariff

demand

S

S

D

D

Q

Q

Q

Q

Imports

under free trade

Effects of a Tariff on Prices and Quantities

Price

of Steel

Tariff

Quantity

0

of Steel

welfare under free trade

Consumer surplus

before tariff

Domestic

supply

Producer surplus

before tariff

Equilibrium

without trade

Price

World

before tariff

price

Domestic

demand

S

D

Q

Q

Imports

under free trade

Welfare under free trade

Price

of Steel

Quantity

0

of Steel

consumer surplus after tariff

Consumer surplus

after tariff

Domestic

supply

A

Equilibrium

without trade

B

Price

after tariff

Price

World

before tariff

price

Imports

Domestic

with tariff

demand

S

S

D

D

Q

Q

Q

Q

Imports

under free trade

Consumer Surplus after Tariff

Price

of Steel

Tariff

Quantity

0

of Steel

producer surplus after tariff

Domestic

supply

Producer surplus

after tariff

Equilibrium

without trade

Price

after tariff

C

Price

World

G

before tariff

price

Imports

Domestic

after tariff

demand

S

S

D

D

Q

Q

Q

Q

Imports

under free trade

Producer Surplus after Tariff

Price

of Steel

Tariff

Quantity

0

of Steel

government s revenue from tariff

Domestic

supply

Tariff Revenue

Price

after tariff

E

Price

before tariff

Imports

Domestic

after tariff

demand

S

S

D

D

Q

Q

Q

Q

Imports

under free trade

Government’s Revenue from Tariff

Price

of Steel

Tariff

World

price

Quantity

0

of Steel

effects of tariff on social welfare

Domestic

supply

A

Deadweight Loss

B

Price

with tariff

C

D

E

F

Price

G

without tariff

Imports

Domestic

after tariff

demand

S

S

D

D

Q

Q

Q

Q

Imports

without tariff

Effects of Tariff on Social Welfare

Price

of Steel

Tariff

World

price

Quantity

0

of Steel

welfare effects of a tariff
Welfare Effects of a Tariff
  • Consumers of the imported good are worse off (compared to free trade)
  • Producers of the imported good are better off
  • The government gains some revenue
  • Total surplus decreases, because the loss to consumers is larger than the gains to the producers and to the government
  • The decrease in total surplus is called the deadweightloss of the tariff.
tariffs are third best
Tariffs are “third best”
  • The tariff can be thought of as the combination of a production subsidy and a consumption tax
  • The only rationale for a tariff is that it helps producers
  • But even that goal can be better achieved by using only a production subsidy
  • That way, the bad effects of the consumption tax can be avoided
consumption tax12

Domestic

supply

S

= Q

Equilibrium

without trade

Purchase price after tax

World

price

Imports

Domestic

after tax

demand

S

D

D

Q

Q

Q

Imports

under free trade

Consumption Tax

Price

of Steel

Consumption Tax

Purchase price before tax

Quantity

0

of Steel

consumption tax13

Domestic

supply

S

= Q

Deadweight loss of the consumption tax

A

Equilibrium

without trade

B

Purchase price after tax

C

D

E

F

World

G

price

Imports

Domestic

after tax

demand

S

D

D

Q

Q

Q

Imports

under free trade

Consumption Tax

Price

of Steel

Consumption Tax

Purchase price before tax

Quantity

0

of Steel

consumption tax15
Consumption Tax
  • When a small country imposes a consumption tax on the imported good
    • Production is unchanged, and
    • Consumption decreases. Therefore,
    • The amount imported decreases.
    • Consumers lose
    • Producers are unaffected
    • The government gains some tax revenue
    • The country as a whole is worse off
production subsidy17

Domestic

supply

D

Q

World Price

Imports

Domestic

after subsidy

demand

=

S

S

D

Q

Q

Q

Imports

under free trade

Production Subsidy

Price

of Steel

Price sellers get after subsidy

Production Subsidy

Price sellers get before subsidy

price buyers pay, with or without the subsidy

Quantity

0

of Steel

production subsidy18

Deadweight Loss

Domestic

supply

D

Q

A

B

Price

For sellers

C

D

E

F

Price

G

For buyers

Imports

Domestic

with subsidy

demand

=

S

S

D

Q

Q

Q

Imports

under free trade

Production Subsidy

Price

of Steel

Production Subsidy

World

price

Quantity

0

of Steel

production subsidy20
Production Subsidy
  • When a small country gives a subsidy to domestic producers of an imported good
    • Consumers are unaffected
    • Producers gain (C), same as under the tariff
    • Taxpayers have to pay for the subsidy (CD)
    • Overall, the country is worse off (D).
    • Recall that under the tariff, the country suffered even more (DF)
    • Tariffs are “third best”
slide23

Domestic

supply

Equilibrium

without trade

Price

with tariff

Price

World

without tariff

price

Imports

Domestic

with tariff

demand

S

S

D

D

Q

Q

Q

Q

Imports

without tariff

Q: What if a tariff is replaced by a production subsidy and a consumption tax, both equal in size to the tariff?

A: The outcome would be identical to the outcome under the tariff.

Price

of Steel

Tariff

Quantity

0

of Steel

tariffs are third best24
Tariffs are “third best”
  • The tariff can be thought of as the combination of a production subsidy and a consumption tax
  • The only rationale for a tariff is that it helps producers
  • But even that goal can be better achieved by using only a production subsidy
  • That way, the bad effects of the consumption tax can be avoided
tariffs are third best25
Tariffs are “third best”
  • We can also establish the superiority of the production subsidy over the tariff by a head-to-head comparison
slide26

Q: What if the tariff shown earlier were replaced by a production subsidy equal in size to the tariff?

Domestic

supply

D

Q

A

B

Price

For sellers

C

D

E

F

Price

G

For buyers

Imports

Domestic

with subsidy

demand

=

S

S

D

Q

Q

Q

Imports

under free trade

Price

of Steel

A: Producers would not complain. Consumerswould be delighted. Taxpayers would complain. The country as a whole would be better off.

Production Subsidy

World

price

Quantity

0

of Steel

slide27

Domestic

supply

A

B

Price after intervention

C

D

E

F

Free Trade Price

G

Domestic

demand

S

S

D

D

Q

Q

Q

Q

Imports

under free trade

Price

of Steel

government intervention

World

price

Quantity

0

of Steel

the effects of an import quota
The Effects of an Import Quota
  • An import quota is a limit—imposed by the domestic government—on the quantity of a good that can be produced abroad and sold domestically.
the effects of an import quota30

Domestic

supply

Equilibrium

without trade

Domestic

supply

+

Import supply

Isolandian

price with

Equilibrium

quota

with quota

Price

World

World

without

=

price

price

Imports

quota

Domestic

with quota

demand

S

S

D

D

Q

Q

Q

Q

Imports

without quota

The Effects of an Import Quota

Price

of Steel

Quota

Quantity

0

of Steel

the effects of an import quota31
The Effects of an Import Quota
  • Because the quota raises the domestic price above the world price,
    • domestic buyers of the good are worse off, and
    • domestic sellers of the good are better off.
  • Import license holders are better off
    • they make a profit from buying at the world price and selling at the higher domestic price.
the effects of an import quota32

Domestic

supply

Equilibrium

without trade

Domestic

supply

A

+

Import supply

Isolandian

B

price with

Equilibrium

quota

with quota

E\'

C

D

F

Price

World

World

without

=

G

price

price

Imports

quota

Domestic

with quota

demand

S

S

D

D

Q

Q

Q

Q

Imports

without quota

The Effects of an Import Quota

Price

of Steel

Quota

E"

Quantity

0

of Steel

the effects of an import quota34
The Effects of an Import Quota
  • With a quota, total surplus in the market decreases by an amount referred to as a deadweight loss.
  • The quota can potentially cause an even larger deadweight loss, if a political mechanism such as lobbying is employed to allocate the import licenses.
tariffs v quotas
Tariffs v. Quotas
  • If government sells import licenses for full value,
    • the revenue would equal that from an equivalent tariff and
    • tariffs and quotas would have identical results.
  • Otherwise, quotas are worse than tariffs
the lessons for trade policy
The Lessons for Trade Policy
  • Both tariffs and import quotas . . .
    • raise domestic prices.
    • reduce the welfare of domestic consumers.
    • increase the welfare of domestic producers.
    • cause deadweight losses.
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