ECO HONS ASSIGNMENT – TARRIFFS UNDER

PARTIAL EQUILIBRIUM
DEEKSHA THAKUR (10747) & RIYA SHARMA (10610)
BCOM 3 SEM 6

PARTIAL EQUILIBRIUM - is a condition which takes into consideration only a part of the

market, to attain equilibrium.
Partial equilibrium analysis examines the effects of policy action in creating equilibrium only in
that particular sector or market which is directly affected, ignoring its effect in any other market
or industry assuming that they being small will have little impact if any. Hence this analysis is
considered to be useful in constricted markets.
TARRIFS - are duties on imports imposed by governments to raise revenue, protect domestic
industries, or exert political leverage over another country. Tariffs often result in unwanted side
effects, such as higher consumer prices.

When a small country imposes tariff on import of the product that competes with the product
of the small domestic industry, the tariff can neither affect the international prices (as the
country is small) nor can it affect the rest of the economy (as the industry is small). In such
conditions, the partial equilibrium analysis that concerns the market for a particular product
becomes the most appropriate.

ASSUMPTIONS:
The effects of tariffs under a partial equilibrium system can be analyzed on the basis of the
following set of assumptions:
(i) The demand and supply curves of the given commodity are concerned with home
country that imposes import tariff.
(ii) The given demand and supply curves remain constant.
(iii) There is no change in consumers’ tastes, prices of other commodities and money
income of the consumers.
(iv) There is an absence of technological improvements, externalities and other factors
that result in changes in cost conditions.
(v) No tariff is imposed by the home country on the import of materials that are
required for producing the given commodity.
 (vi) Imported product and home-produced product are perfect substitutes.
(vii) There is no change in the foreign price of the commodity.
(viii) There is an absence of transport costs.
(ix) The foreign supply curve of commodity is perfectly elastic.
(x) Domestic production of commodity takes place at increasing costs.

Kindelberger has mentioned eight effects of tariff in a partial equilibrium approach.

1. Protective or Production Effect: The imposition of tariff may be intended to protect the
home industry from the foreign competition. As tariffs restrict the flow of foreign products, the
home producers find an opportunity to increase the domestic production of import substitutes.
That is why Ellsworth termed the protective or production effect of tariff as the import-
substitution effect.

In Fig. 15.1 D and S are the domestic demand and supply curves of the given commodity
respectively. Originally PW is the world supply curve of the commodity and the pre-tariff price is
OP.
The gap QQ1 between demand and supply is met through import of the commodity from
abroad. If PP1 per unit tariff is imposed on import, the price rises to OP1 and world supply curve
shifts to P1W1. At this higher price, the demand is reduced from OQ1 to OQ2 whereas the
domestic supply expands from OQ to OQ3. In case the per unit tariff were PP2 causing the price
to rise to OP2, the domestic production would have expanded large enough to meet fully the
domestic demand. In such a situation, imports would have been reduced to zero.
This is the protective, production or import substitution effect.
2. Consumption Effect:
The imposition of import duty on a particular commodity has the effect of reducing
consumption and also the net satisfaction of the consumers.
According to Fig. 15.1 at the free trade price OP, the total consumption was OQ 1. It was
constituted by OQ as the consumption of home produced good and QQ1 as the consumption of
foreign produced good. After the imposition of tariff, when price rises to OP 1, the consumption
is reduced from OQ1 to OQ2.
Out of it, OQ3 is the consumption of home-produced good and Q2Q3 is the consumption of
foreign produced good.
Thus, there is a reduction in consumption by OQ1 – OQ2 = Q1Q2. There is net loss in consumer
satisfaction amounting to the area PHCP1. Kindelberger has called the combined protective and
consumption effects as the trade effect.

3. Revenue Effect:
The imposition of import duty provides revenues to the government. The revenue receipts due
to tariff signify a revenue effect. In Fig. 15.1 the original price OP does not include any tariff and
no revenue receipts become available to the government.
Subsequently when PP1 per unit tariff is imposed, the revenue receipts of the government can
be determined by multiplying per unit tariff PP1 (or BF) with the quantity imported Q3Q2 or (EF).
Thus, the revenue receipts due to tariff amount to PP1 × Q3Q2 = BF × EF = BCEF. This is revenue
effect of tariff.

4. Redistribution Effect:
The imposition of tariff, on the one hand, causes a reduction in consumer’s satisfaction and, on
the other hand, provides a larger producer’s surplus or economic rent to domestic producers
and revenues to the government. Thus tariff leads to redistributive effect in the tariff-imposing
country. The redistributive effect can be shown with the help of Fig. 15.1.
Loss in Consumer’s Surplus = RHP – RCP1 = PHCP1
Gain in Producer’s Surplus = TBP1 – TAP = PABP1
Gain in Revenues to the Government = BCEF
Net Loss = PHCP1 – (PABP1 + BCEF)
= ΔBAF + ACEH
Kindelberger calls this net loss as the “deadweight loss” due to tariff. It signifies the cost of
tariff. It is clear that tariff causes a redistribution of income or satisfaction in the given country.
Consumers suffer a loss while producers and government make a gain.
5. Terms of Trade Effect:
The modern theorists believe, the terms of trade, consequent upon the imposition of tariff,
depend upon the elasticities of demand and supply of products of the two trading countries. If
the foreign supply of a good is perfectly elastic or if the foreign suppliers are ready to supply the
product at a constant price, the imposition of tariff is not likely to improve the terms of trade
for the tariff-imposing country. In case the foreign supply of a good is not perfectly elastic, the
imposition of tariff can have varying effects upon the terms of trade of the tariff-imposing
country depending upon the elasticities of demand and supply in the two trading countries. It
has been explained through Fig. 15.2.

In Fig. 15.2, country A is an importing and country B is an exporting country.

In case, P1P2 is more than P1P0, the rise in price of the commodity in country A being larger than
the fall in export price of the commodity in country B, the terms of trade get worsened for
country A. It can happen when the elasticities of demand and supply for the commodity in
country B are relatively more than in country A.

6. Competitive Effect:
The imposition of tariff, can facilitate the growth of an infant industry which otherwise is not in
a position to face the foreign competition. As tariff makes the foreign product relatively more
costly, the domestic infant industry finds opportunity to grow behind the protective shield.
Thus, tariff increases the competitive power of the industries of tariff-imposing country. After
the infant industry becomes mature enough to face the foreign competition, tariff may be
removed. The increase in the competitive power of the domestic industries through tariff is
called as the competitive effect.
7. Income Effect:
The imposition of tariff reduces the demand for foreign products. The amount of money not
spent on imported goods may either be spent on the home-produced goods or saved. If there is
the existence of surplus productive capacity in the home country, switch of expenditure from
foreign to home-produced goods will lead to a rise in production, employment and income.

In Fig. 15.3, income is measured along the horizontal scale and saving (S), imports (M),
investment (I) and exports (X) are measured along the vertical scale. If investment and export
are assumed to be autonomous, the investment plus export function (I + X) can be drawn.
Assuming saving and import to be positively related with income, saving plus import function (S
+ M) can be drawn.

the original equilibrium is E0 and the original equilibrium income is Y0. If tariff causes a reduction
in imports by δM, the S+M function shifts down. At E1 the new equilibrium income at a higher
level Y1. The expansion in income Y0Y1 is much more than the change in imports

If the home country is in a state of full employment, the tariff causing a reduction in imports
and switch of expenditure to the home-produced goods, will not contribute in raising the
output. Consequently, the inflationary pressures alone will be felt. There may be an increase
only in money income and the real income, output or employment will remain unaffected.
8. Balance of Payments Effect:
When tariff is imposed by a country upon foreign products, the home-produced goods become
relatively cheaper than the imported goods. The price effect caused by tariff, on the one hand,
reduces imports from other countries and on the other hand, causes increased production and
purchase of home- produced goods. That leads to a reduction in the balance of payments
deficit of the home country. Needless to say that tariff can cause a reduction in the balance of
payments deficit of the tariff-imposing country.

In the regard, some doubts are raised that tariff may fail to improve the balance of payments
deficit. Firstly, if the demand for imports in the tariff- imposing country is inelastic, tariff may
not reduce the volume of imports despite the rise in the prices of imported goods consequent
upon the imposition of tariff.

Secondly, if the balance of payments disequilibrium is caused by the export surplus, the
imposition of tariff will further aggravate rather than adjust the balance of payments
disequilibrium. Thirdly, tariff can, at the maximum, bring about some adjustment in temporary
disequilibrium of international payments. There is no possibility of adjusting the fundamental
disequilibrium in the balance of payments through tariff restrictions.