1. (15 points) Under free trade, a large country produces 1 million leather bags

Question

1. (15 points) Under free trade, a large country produces 1 million leather bags per year and imports another 2 million bags per year at the world price of S60 per bag. Assume that the country imposes a specific tariff of S5 per bag. As a result, the per-unit price of leather bags decreases to S58 in the international market and the import of leather bags drops to 1.6 million. The domestic production, on the other hand, increases to 1.1 million Following the imposition of the tariff, what is the price for each bag that the domestic consumers pay? Fully explain a) b) Calculate the tariff revenue collected by the domestic government. c) As result of the imposition of the tariff, what is the impact on the national well-being? Fully explain.

Explanation / Answer

Solution:-

Market clearing price without tariff (P*) = $60

and Quantity (Q*) = 3millions (1m + 2m)

Assuming that every citizen obeys the law, after imposition of tax:

World Price (Pw) = $58

Specific tariff (t per unit) = $5

So Domestic price which buyers pay (Pb) =

a) Price of each bag that a domestic consumer will pay = $ (58 + 5) = $ 63.

Reason: Without tax market price were $ 60. So by imposing tariff domestic market price should be $ (60 + 5) = $ 65. But tariff effect has resulted in decreasing world price to $ 58. SO if buyers purchase from world market then they will have to pay $ (58 + 5) = $63. Since domestic price > world price so, all bags will be imported. So domestic supplier will not be able to raise price beyond $ 63 (to be in the market). By doing so domestic seller will be able to transfer $ 3 per bag on buyers and will bear $2 per bag.

b) Tariff revenue = (Difference in Buyers price and what seller gets) * Total quantity imported

= $ (63 - 58) * 1.6m = $ 5 * 1.6m = $ 8m

c) Impact on national well being:

Without tariff market clearing quantity was 3m and with tariff now total quantity is 2.7m (1.1m + 1.6m). SO there is decrease in the total quantity by 0.3m.

Total revenue;

Without tariff = $60 * 3m = $180m

With tariff = $63 * 2.7m = $170.1m

Change in revenue = $ (180 - 170.1)m = $9.9m

hence national well-being is decreased by $9.9m.

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