Topic 5: Trade Policy and Welfare

Nikhil Damodaran

February 3, 2022

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Review: Consumer Surplus

I Reservation price: is the maximum price that a consumer is

willing to pay
– the consumers’ willingness to pay for the product equals the
height of the demand curve.

I Consumer surplus is the reservation price minus actual price

I Consumer surplus at P1 : the gain for consumers in total is the

area under the demand curve, above the price.

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Producer Surplus

I Supply curve: traces the mimimum price a producer is willing

to accept and the quantity supplied at that price
– the height of the curve represents the firm’s marginal cost
at each level of production

I Producer surplus is the actual price minus min price for supply

I Producer surplus at P1 : total is the area above the supply

curve, below the price.
– Return on fixed factor under PC: i.e.

RK = P1 S1 WL

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Producer Surplus

Figure: The supplier who supplies unit S0 has marginal costs of P0 but
sells it for P1 . The di↵erence is the producer surplus and represents the
return to fixed factors of production in the industry.

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Autarky in Partial Equilibrium

Figure: Autarky Equilibrium: with home demand of D and supply of S,

the no-trade equilibrium is at point A, at the price PA producing Q0

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Home Country under Trade

I Home: price taker in the world market

– faces the fixed world price of PW ,
– Its own level of demand and supply has no influence on the
world price.

I PW < PA implies the following adjustment after trade:

– D " Quantity demanded increases to D1
– S # Quantity supplied falls to S1 .

I Home is now an ‘Importer’ of the commodity in question

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Trade in Partial Equilibrium

I Net Surplus Gain

– Consumer surplus
increases by the area (b + d)
– Producer surplus falls by
area b.
– Total Gains from trade are
measured by area d

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Section 3: Tari↵ in Small Country under Perfect
Competition

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Tari↵ Under a Small Country

I What is a tari↵?
– It is a tax levied when a good is imported into the home
country.

I How does it alter trade incentives?

– Tari↵ acts like a transportation cost, making sellers
unwilling to ship goods unless the Home price exceeds the
Foreign price by the amount of the tari↵:

PT t PT⇤

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Tari↵ Analysis

I What are the types of Tari↵s?

– Specific tari↵ is levied as a fixed charge for each unit of

imported goods.
– For example, $3 per barrel of oil.

–Ad valorem tari↵ is levied as a fraction of the value of

imported goods.
– For example, 25% tari↵ on the value of imported trucks.

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Small Country

Figure: Tari↵: the export supply curve facing the Home country shifts up
by exactly that amount, reflecting the higher price that must be paid to
import the good.

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Import Tari↵s for a Small Country

I Homogeneity: We assume that the imported product is

identical to the domestic alternative that is available.
I Reduction in Home Demand under Law of One Price

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Welfare Analysis for Tari↵s in Small Country

I Consumers welfare reduces: as price increases for the product

– Defined by the area (a + b + c + d)

I Producers welfare increases as they sell at a higher price

– the net gain in revenues denoted by area +a

I Government’s revenue: increases due in tari↵s

– Indicated by the area +c, which is the product of tari↵
levied on imports times the quantity imported

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Welfare Analysis for Tari↵s in Small Country

I Consumer surplus falls by = a + b + c + d

I Producer surplus rises by area = a
I Government revenue increases by the area = c

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Deadweight Loss

I Deadweight Loss: the net loss in welfare to Home, is (b + d)

– measured by the two triangles b and d in panel (a) or the
single (combined) triangle b + d in panel (b).

I The triangle (b + d) is a deadweight loss, or a loss that is not

o↵set by a gain elsewhere in the economy.

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Section 4: Tari↵ in Large Country under Perfect
Competition (Assignment Question)

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