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Tariff, general equilibrium

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Presentation on theme: "Tariff, general equilibrium"— Presentation transcript:

1 Tariff, general equilibrium
We consider the situation for a country faced with the production possibility frontier as drawn in the figure below. small X Y pworld At the given world price pworld it would produce at point Q* and trade at world prices to consume at point C* ppf Q* U* C*

2 Tariff, general equilibrium
If the country imposes a tariff, t, on its import good (good X) this rotates the price line for domestic producers clockwise to pworld(1+t) X Y pworld pworld(1+t) Q* They will start to produce at point Q2 Q2 C* U*

3 Tariff, general equilibrium
Despite the tariff the country can still trade with ROW at the price pworld X Y pworld pworld(1+t) So the income available to the economy is represented by an income line parallel to the initial income line through the new production point Q* Q2 C* U*

4 Tariff, general equilibrium
Consumers, like producers, face the price pworld(1+t) X Y They equalize the marginal rate of substitution with the distorted price line along the new income line; a point like C2 pworld pworld(1+t) Q* The difference in production and consumption income (domestic prices) represents tariff revenue Q2 We assume that this is redistributed lump-sum to the consumers C* C2 U* U2

5 Tariff, general equilibrium
Tariffs result in a double distortion. First, producers change production and thus income. X Y pworld pworld(1+t) Welfare U1 at point C1 is still attainable. Second, consumers are also confronted with distorted prices, which lowers welfare to U2 Q* Q2 C* C2 C1 U* U1 U2

6 Tariff, general equilibrium
Here is an enlargement of the welfare loss arising from the tariff First, the production (income) loss Second, the consumption loss Check for yourself that the second loss does not arise if a production subsidy is given, rather than a tariff imposed. C2 C* C1 U* U2 U1

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