Lecture Notes: Tariffs and Free Trade Diagram

Key Concepts

• Free Trade Diagram
  • World suppliers have a comparative advantage over domestic producers.
  • Price is low at PW (world price).
  • Domestic supply is at Q1; domestic demand is at Q2.
  • Imports are the difference between Q1 and Q2.

Introduction of Tariffs

• Tariff Definition

  • A tax on imports that increases the price of imports.

• Impact of Tariffs on Prices

  • Increases the price from PW to PW + T (tariff-inclusive price).
  • New world supply curve is horizontal at this higher price (S W + T).

Effects of Tariff

1. Domestic Supply and Demand

   • Domestic Supply
     • Increases from Q1 to Q3 (expansion/extension of domestic supply).
     • Higher price attracts new or existing domestic firms to increase production.
   • Domestic Demand
     • Contracts from Q2 to Q4.

2. Import Reduction

   • Reduced from Q1 Q2 to Q3 Q4.

3. Domestic Producer Revenue

   • Before Tariff: Revenue = PW * Q1 (Area A).
   • After Tariff: Revenue = PW + T * Q3 (Area A + B + E + F + G).

4. Government Revenue

   • Tariff per unit is the vertical distance between supply curves.
   • Government revenue = Tariff per unit * Imports (Q3 to Q4), Area H.

5. Foreign Producer Revenue

   • Before Tariff: Revenue = B + C + D.
   • After Tariff: Revenue = C (Area H goes to government).*

Consumer Surplus

• Consumer Surplus Before Tariff

  • Area beneath demand curve and above price line.

• Consumer Surplus After Tariff

  • Reduced to a smaller triangle, resulting in a total loss of E + F + G + H + I.

• Dead Weight Loss of Consumer Surplus

  • Area I is unrecovered; represents inefficiency due to government intervention.

Producer Surplus and Allocative Inefficiency

• Producer Surplus Before Tariff

  • Small triangle area.

• Producer Surplus After Tariff

  • Expanded to a larger triangle (Area E + F).

• Allocative Inefficiency

  • Tariff increases world price artificially, leading to inefficient resource allocation.
  • Area G shows extra costs due to inefficient production by domestic firms without comparative advantage.

Conclusions

• Tariffs are a form of protectionism.
• While they benefit domestic producers and government revenue, they reduce consumer surplus and create allocative inefficiencies.
• Future video will discuss reasons for protectionism and evaluate protectionist policies.

Stay tuned for further insights on protectionism and its evaluation!