Essential Microeconomic Tools (Based On BW, ch.4) : PEEU - 1st Module - Lesson 4

Demand, supply, welfare Import demand and supply Free trade equilibrium MFN tari¤ Welfare
Essential microeconomic tools

(based on BW, ch.4)
PEEU - 1st module - Lesson 4
D.Delli Gatti
D.Delli Gatti
PEEU - 1st module - Lesson 4 -Microeconomic tools
Demand
Let u = u (Y ) be the household’s utility function, i.e. the

utility u the household receives from consuming Y . The
marginal utility (mu) is mu = u 0 (Y ) .The function u (Y ) is
increasing and concave. Therefore u 0 (Y ) is decreasing with
Y.
The demand curve is derived from the household’s
optimization condition P = u 0 (Y ). Equivalently one can
write Y = D (P ) .
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Supply
Let c = c (Y ) be the …rm’s cost function, i.e. the cost c the

…rm incurs by producing Y . The marginal cost (mc) is
mc = c 0 (Y ) .The function c (Y ) is increasing. With
decreasing returns c 0 (Y ) is increasing with Y .
In the case of perfect competition, the supply curve is derived
from P = mc = c 0 (Y ). Equivalently one can write
Y = S (P )
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Welfare: de…nitions
The consumer surplus (CS) is measured by the area of the

triangle between the marginal utility curve (demand curve)
and the price paid by the consumer. It is a measure of total
utility net of consumer’s expenditure.
The producer surplus (PS) is measured by the area of the
triangle between the marginal cost curve (supply curve) and
the price received by the producer. It is a measure of pro…ts.
Total welfare (W) is the sum of the CS and PS.
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Welfare: graphical representation
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Closed economy (1)
In a closed economy, the price is determined at the

intersection of the demand and supply curves. It is the
equilibrium price.
Total Welfare is measured by the area of the triangle
comprised between the demand and he supply curves, with
height equal to equilibrium output.
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Closed economy (2)
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Open economy: Imports (1)
Suppose, for simplicity, that the world economy consists of

two identical countries, Home and Foreign.
Firms in both countries produce a homogeneous good (hence
imported, exported and domestic products are perfect
substitutes).
Suppose that the world price (PFT ) – to be determined later
– is smaller than the equilibrium price in the close economy
case for Home: PFT < PH .
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In this case, demand CH will be bigger than domestic

production HH at Home.
Imports (M ) …ll the gap between the two: M = CH HH .
It is easy to see that total welfare increases for Home by
opening up to foreign trade.
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Import demand curve (1)
The Home import demand curve represents the quantity

imported (M ) for any given domestic price (P ).
The equation of the Home import demand curve.is
MDH = DH (P ) SH (P ) = M (P )
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Import demand curve (2)
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Open economy: Exports (1)
Suppose that the world price (PFT ) is bigger than the

equilibrium price in the close economy case for Foreign:
PFT < PF .
In this case, demand CF will be bigger than domestic
production HF at Foreign.
Exports (X ) …ll the gap between the two: X = HF CF .
It is easy to see that total welfare increases for Foreign by
opening up to foreign trade.
D.Delli Gatti
Open economy: Exports (2)
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Import supply curve (1)
The Home import supply curve coincides with the Foreign

export supply curve. It represents the quantity exported by
Foreign (XF ) for any given domestic price P (which is the
price paid by the domestic consumer and received by the
foreign exporter).
Exports …ll the gap between foreign production and foreign
consumption.
The equation of the Foreign export supply curve is
XSF = SF (P ) DF (P ) = X (P ) where XSF = MSH .
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Import supply curve (2)
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Free trade equilibrium (1)
At the intersection of MDH and MSH we …nd the equilibrium

price and quantity of imported goods.In the absence of tari¤s,
this is the Free Trade equilibrium.
In equilibrium X (P ) = M (P ) . Solving this equation for P
gives the world price in the case of Free Trade PFT and
equilibrium quantity of imports MFT = M (PFT )
The world price will provide an anchor for the domestic price.
No consumer will pay more than PFT to buy goods produced
at Home and domestic producers will adjust to competition by
foreign producers.
Actual consumption and production at Home will be D (PFT )
and S (PFT ) such that MDH = D (PFT ) S (PFT ) = MFT .
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D.Delli Gatti
Suppose all the functions are linear. Let the demand and
supply of imports be:
MDH = c dP
XSF = MSH = a + bP
c 1
Inverse demand function: P = d d MDH ; inverse supply
function: P = ba + b1 MSF
c c
Assumption 1: P > d and d > ba .
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Equilibrium with Free Trade is the intersection point of the

MD and MS curves: c dP = a + bP.
The solution to this equation is the Free Trade equilibrium
price
c +a
PFT =
d +b
The quantity imported is
c +a cb da
MFT = M (PFT ) = c d = ;
d +b d +b
Thanks to assumtpion 1, MFT > 0.
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MFN Tari¤ (1)
What is the e¤ect of the introduction of a tari¤ of T euros

per unit imported?
No e¤ect on MDH . Hence MDH = M (P ) as before.
Exporters earn the border price, i.e. the di¤erence between
the domestic price and the tari¤.
The tari¤ shows up as a wedge between the domestic price
paid by the domestic consumer P and the border price
received by the foreign exporter P T .
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MFN Tari¤ (2)
The new equation of the import supply curve is therefore

MSH = X (P T ) .
The tari¤ shifts MSH curve up by T : exporters would need a
domestic price that is T higher to o¤er the same exports.
Alternatively one can interpret the shift as follows: for any
price, the exporters sell less at Home.
Example: XSF = a + b (P T ). Inverting the function one
gets: P = ba + b1 XSF + T
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MFN Tari¤ (3)
Equilibrium with a MFN tari¤: c dP = a + b (P T).

In equilibrium the price will be
c + a + bT b
P0 = = PFT + T
b+d b+d
and quantity imported
db db
M0 = M P0 = c dP 0 = c dPFT T = MFT T
b+d b+d
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MFN Tari¤ (4)
Notice that, due to the tari¤, the border price is

d
P0 T = PFT T
b+d
Hence
P 0 > PFT > P 0 T
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MFN Tari¤ (5)
P 0 is increasing with T while M 0 is decreasing with T .
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MFN Tari¤ (6)
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MFN Tari¤ (7)
The price paid by domestic consumers and received by

domestic …rms (selling on the domestic market) increases:
P 0 > PFT . Hence the Home consumer surplus goes down,
Home producer surplus goes up.
The border price, i.e. the price received by foreign exporters,
is P 0 T < PFT . P 0 T will be the price that Foreign …rms
and consumers will face in Foreign.
The Foreign consumer surplus goes up, Foreign producer
surplus goes down.
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MFN Tari¤ (8)
The import volume decreases: M (P 0 ) < M (PFT ) .

Home production increases: SH (P 0 ) > SH (PFT ) .
Home consumption decreases: DH (P 0 ) < DH (PFT )
Foreign production falls and foreign consumption increases.
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Welfare e¤ect of a tari¤ (1)
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Welfare e¤ect of a tari¤: Home
Change in Home consumer surplus: (A + B + C + D )

Change in Home producer surplus: +A
Home Government tax revenue: + (C + E )
Net Home welfare e¤ect:
(A + B + C + D ) + A + (C + E ) = E (B + D ).
A tari¤ is bene…cial for Home (it increases Home welfare) i¤
E > B +D
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Welfare e¤ect of a tari¤: Foreign
Change in Foreign consumer surplus: +F

Change in Foreign producer surplus: (F + G + H + I )
Net Foreign welfare e¤ect: (G + H + I ) < 0
A tari¤ is always detrimental for Foreign
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Change in Home private welfare: (J + K )

J measures the part of the tari¤ paid by the Home residents
through the increase in domestic price. Notice that J = C .
K is the "trade volume e¤ect": it measures the loss of Home
welfare due to the reduction of imports (e¢ ciency loss due to
the tari¤). Notice that K = B + D
Home Government tax revenue:+ (J + L) but J = C and
L = E . Hence J + L = C + E .
L is the "border price e¤ect": it measures the part of the tari¤
paid by Foreign. It can be thought of as a gain for Home by
taxing Foreign.
Net Home welfare e¤ect: L K = E (B + D ).
From previous analysis: Net Home welfare e¤ect: E B D
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Change in Foreign welfare: (L + M ) . Notice that L = H

and M = G + I . Hence (L + M ) = (H + G + I ) .
Change in Word welfare: L (L + M ) =
K (K + M ) < 0
A tari¤ is always detrimental for World.
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Summing up: winners and losers (1)
Winners:
Home producers
Home Government !The Government appropriates trade
rents.
Foreign consumers
Losers:
Home consumers
Foreign producers
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Summing up: winners and losers (2)
The imposition of a tari¤ will

make Home better o¤ only if E > B + D,
unambiguously make Foreign worse o¤,
unambiguously make World worse o¤.
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Trade rent
Trade rent: "pro…t" from selling at high domestic price and

buying at low border price.
A tari¤ creates wedge between domestic and border price.
This is appropriated domestically by the Home government.
Types of barriers to trade:
Domestically Captured Rents (DCR): import tari¤s, import
quotas.
Foreign Captured Rents (FCR): price undertakings.
Frictional barriers (no rents): Technical barriers to trade
involving real costs of importing and exporting due to
di¤erent regulations across countries.
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Looking ahead
So far tari¤ we have considered a lump sum tari¤ imposed on

any import from foreign countries, i.e., a non discriminatory
tari¤ (aka as MFN tari¤ where MFN stands for Most
Favoured Nation).
The removal of such a tari¤ amounts to a non-discriminatory
or non-preferential trade liberalization.
A non discriminatory trade liberalization will have e¤ects of an
opposite sign wrt the imposition of the tari¤.
D.Delli Gatti

Essential Microeconomic Tools (Based On BW, ch.4) : PEEU - 1st Module - Lesson 4

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Demand, supply, welfare Import demand and supply Free trade equilibrium MFN tari¤ Welfare

Essential microeconomic tools

Let u = u (Y ) be the household’s utility function, i.e. the

Let c = c (Y ) be the …rm’s cost function, i.e. the cost c the

The consumer surplus (CS) is measured by the area of the

Welfare: graphical representation

Closed economy (1)

In a closed economy, the price is determined at the

Closed economy (2)

Open economy: Imports (1)

Suppose, for simplicity, that the world economy consists of

Open economy: Imports (2)

In this case, demand CH will be bigger than domestic

Open economy: Imports (3)

Import demand curve (1)

The Home import demand curve represents the quantity

Import demand curve (2)

Open economy: Exports (1)

Suppose that the world price (PFT ) is bigger than the

Open economy: Exports (2)

Import supply curve (1)

The Home import supply curve coincides with the Foreign

Import supply curve (2)

Free trade equilibrium (1)

At the intersection of MDH and MSH we …nd the equilibrium

Free trade equilibrium (2)

Free trade equilibrium (3)

Free trade equilibrium (4)

Equilibrium with Free Trade is the intersection point of the

MFN Tari¤ (1)

What is the e¤ect of the introduction of a tari¤ of T euros

MFN Tari¤ (2)

The new equation of the import supply curve is therefore

MFN Tari¤ (3)

Equilibrium with a MFN tari¤: c dP = a + b (P T).

MFN Tari¤ (4)

Notice that, due to the tari¤, the border price is

MFN Tari¤ (5)

P 0 is increasing with T while M 0 is decreasing with T .

MFN Tari¤ (6)

MFN Tari¤ (7)

The price paid by domestic consumers and received by

MFN Tari¤ (8)

The import volume decreases: M (P 0 ) < M (PFT ) .

Welfare e¤ect of a tari¤ (1)

Welfare e¤ect of a tari¤: Home

Change in Home consumer surplus: (A + B + C + D )

Welfare e¤ect of a tari¤: Foreign

Change in Foreign consumer surplus: +F

Welfare e¤ect of a tari¤ (1)

Change in Home private welfare: (J + K )

Welfare e¤ect of a tari¤ (2)

Change in Foreign welfare: (L + M ) . Notice that L = H

Summing up: winners and losers (1)

Summing up: winners and losers (2)

The imposition of a tari¤ will

Trade rent: "pro…t" from selling at high domestic price and

So far tari¤ we have considered a lump sum tari¤ imposed on

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