THE EFFECTS OF A TARIFF
The Isolandian economists next consider the effects of a tariff-a tax on imported goods. The economists quickly realize that a tariff on steel will have no effect if Isoland becomes a steel exporter If no one in Isoland is interested in importing steel, a tax on steel imports is irrelevant. The tariff matters only if Isoland becomes a steel importer. Concentrating their attention on this case, the economists compare welfare with and without the tariff Figure 4 shows Isolandian market for steel. Under free trade, the domestic price equals the world price. A tariff raises the price of imported steel above the world price by the amount of the tariff Domestic suppliers of steel, who compete with suppliers of imported steel, can now sell their steel for the world price plus the amount of the tariff. Thus, the price of steel-both imported domestic-rises by the amount of the tariff and is, therefore, closer to the price that would prevail without trade.
Figure 4 The Effects of a Tariff.
A tariff reduces the quantity of imports and moves a market closer to the equilibrium that would exist without trade. Total surplus falls by an amount equal to area D + F. These two triangles represent the deadweight loss from the tariff .
The change in price affects the behavior of domestic buyers and sellers. Because the tariff raises the price of steel, it reduces the domestic quantity demanded from of to and raises the domestic quantity supplied from of to Thus,’ the tariff reduces the quantity of imports and moves the domestic market closer to its equilibrium without trade Now consider the gains and losses from the tariff. Because the tariff raises the domestic price, domestic sellers are better off, and domestic buyers are worse off. In addition, the government raises revenue To measure these gains and losses, we look at the changes in consumer surplus, producer surplus, and government revenue. These changes are summarized in the table in Figure 4. Before the tariff, the domestic price equals the world price. Consumer surplus, the area between the demand curve and the world price, is area A + B + C + D + E + F. Producer surplus, the are between the supply curve and the world price, is area G. Government revenue equals zero. Total surplus.the sum of consumer surplus, producer surplus, and government revenue, is area A + B + C + D + E + F + G. Once the government imposes a tariff, the domestic price exceeds the world price by the amount of the tariff. Consumer surplus is now area A + B. Producer surplus is area C + G. Government revenue, which is the quantity of after-tariff imports times the size of the tariff, is the area E. Thus, total surplus with the tariff is area A + B + C + E + G.
To determine the total welfare effects of the tariff, we add the change in consumer surplus (which is negative), the change in producer surplus (positive), and the change in government revenue (positive). We find that total surplus in the market decreases by the area D + F. This fall in total surplus is called the deadweight loss of the tariff.
A tariff causes a deadweight loss simply because a tariff is a type of tax. Like most taxes, it distorts incentives and pushes the allocation of scarce resources away from the optimum. In this case, we can identify two effects. First, the tariff on steel raises the price of steel that domestic producers can charge above the world price and, as a result, encourages them to increase production of steel (from Of to @. Second, the tariff raises the price that domestic steel buyers have to pay and, therefore, encourages them to reduce consumption of steel (from Of to @. Area D represents the dead weight loss from the overproduction of steel, and area F represents the deadweight loss from the under consurnption. The total deadweight loss of the tariff is the sum of these two triangles.
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