[Academic Script]

[ Tariff: Types, Partial Equilibrium Analysis

Tariff and Effects of Tariff on Consumer and Producer Surplus]

Subject: Business Economics

Course: B.A., 5th Semester,

Undergraduate

Paper No. & Title: Paper – 541

International Economics

Unit No. & Title: Unit - 3

International Trade Policy

Lecture No. & Title: 1:

Tariff: Types, Partial Equilibrium
Analysis Tariff and Effects of Tariff
on Consumer and Producer
Surplus

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 Tariff:
Types, Partial Equilibrium Analysis of Tariff and Effects of a
Tariff on consumer and producer surplus.
Introduction:
International trade will take place if it gives benefits to all. If trade is free, benefit would
be maximized. It means that free flow of trade leads to more benefits. But nations
protect domestic industries through restrictions and regulations. The set of these
restrictions and regulations is known as trade policy. Governments may impose tariffs
to raise revenue or to protect domestic industries from foreign competition . Such policy
affects the flow of international trade.
[A] Tariff:
A tariff is a tax imposed on imported or exported goods and services. It is a tax levied
on a commodity when it crosses a national border. An import tariff is a tax imposed
on an imported commodity. An export tariff is a tax on the exported commodity. An
import tariff is a common tariff and an export tariff is a less common tariff.
[B] Types of Tariff:
(1) Ad Valorem Duty: This tax is legally specified as a fixed percentage of the
value of the commodity imported or exported. In other words, it is a fixed
percentage of the value of the traded commodity.
E.g. suppose that an ad valorem duty is 10% and the value of imports is $ 200.
Therefore, an importer of commodities must pay a $ 20
(10% of $ 200) import duty to the government. If import prices rise, ad
Valorem duties also rise and this aggravates the protective effect. If prices
fall the protective effect will be reduced.

(2) Specific Duty: This tax is legally specified as a fixed sum of money per unit
imported or exported. In other words, it is a fixed sum per physical unit of the
traded commodity.

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 E.g. An Indian importer of a Japanese car may be required to pay $ 2000
import duty to the government of India irrespective of the price of the car.
Specific duties are not affected directly due to increase or decrease in the
prices.

Ad valorem duty is more progressive in nature than specific duty. The

specific tax is regressive in the sense that it imposes higher burden on the
cheaper commodities. The specific duty is easy to apply whereas an ad
valorem duty can be calculated after the value of commodity is determined.

(3) Compound Duty: This is a combination of an ad valorem duty and specified

duty.
E.g. An Indian importer of a Japanese car may be required to pay $ 2000 plus
2% of the value of the car.

[C] Partial Equilibrium Analysis of a Tariff:

We assume that the nation which imposes an import tariff is a small nation. It
means that tariff cannot affect the international price of the commodity. The nation
is a price taker in world markets.

The effect of an import tariff can be explained as follows:

An imposition of a tariff on imports

ꜜ
Increase in domestic price of imports

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 The domestic output of import-competing industry expands and domestic
consumption of imports contract

ꜜ
Imports fall because the gap between domestic consumption and domestic
production reduces

It means that an imposition of tariff on imports reduces the domestic consumption. The
tariff revenue will be collected by the government, and income is redistributed from
consumers to producers. The partial equilibrium analysis is explained in Figure-1.

We measure quantity of commodity X on X-axis and price of commodity X on Y-axis.

(1) DX is a demand curve of commodity X which has a negative slope. It shows the
domestic demand for commodity X in a particular nation, say A.
(2) SX is a supply curve of commodity X which has a positive slope. It shows the
domestic supply of commodity X in nation A.

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Figure-1: The effects of an import tariff

Autarky situation:
(3) E is the autarky equilibrium point at which the price of commodity X is $ 25/unit.
(4) We assume that international price is $ 10/unit. This is shown by the PW line.
This is the perfectly elastic foreign supply curve of commodity X to nation A
under free trade conditions. It means that nation A cannot affect the
international price.
(5) At international price $ 10, the domestic consumption is 150X (AH). At this price
domestic production is 30X (AC). The remainder of 120X (CH) is imported.

Effect of an import tariff:

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 Suppose nation A imposes a tariff of $ 5, or 50 %, on the imports of commodity X.
As a result, domestic price of commodity X rises. This is depicted by the upward
shifted price line PW + T. Therefore, price increases from $ 10 to $ 15.

(6) At the price of $ 15, the domestic consumption is 125X (BG). Nation A
produces 45X (BD) domestically. The remainder 80X (DG) is imported.

The effects of increase in price can be explained as follows:

Consumption Effect:
An increase in the price of commodity X reduces consumption of domestic
consumers from 150X to 125X. The reduction of 25X is shown by IH. This is the
consumption effect.
Production Effect:
An increase in the price of commodity X increases the domestic production by 15X
i.e. from 30X to 45X. This is depicted by CF. This is the production effect.
Trade Effect:
An imposition of tariff causes imports to fall from 120X to 80X. It means that
imports have fallen by 40X (HI+CF) which are equal to increase in domestic
production by 15X (CF) and decrease in domestic consumption by 25X (HI). This is
known as trade effect.
Revenue effect:
After the imposition of the tariff, the government collects $5 x 80X = $400 as
depicted by area (DGIF). This is known as the revenue effect of the tariff.
[D] Consumer Surplus:
Consumer surplus is the difference between the willingness to pay and actual
payment of a consumer. Graphically, consumer surplus is measured by the area
under the demand curve above the market price.
E.g. If consumer is ready to pay $10 for one unit of commodity X and actual price
is $ 4 then, the consumer surplus $10 - $4= $6. An increase in price reduces
the consumer surplus.
The effect of tariff on consumer surplus is shown n Figure-2.

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Figure 2: Effects of Tariff on Consumer Surplus

We measure quantity of commodity X on X-axis and price of commodity X is on Y-

axis.
(1) Before the imposition of tariff consumer in nation A consume 150X at P W = $10.
(2) At point R, consumers in nation A would be willing to pay NR=$ 32 for the 45th
unit of commodity X. But under free trade conditions they pay only NT = $10. In
this situation C.S. = $ 32 - $ 10 = $ 22.
(3) Similarly, for the 125th unit of commodity X, consumers would be willing to pay
GK= $15. Since they only pay IK= $10. They receive a consumer surplus of
IG= $5.

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 (4) For the 150th unit of commodity X consumers would be willing to pay HL= $10.
This is equal to the price they actually pay. Therefore, the consumer surplus for
the 150th unit is zero.
(5) Before imposition of tariff, Consumer surplus is equal to AMH = ½ ($30 x 150X)
= $ 2250. This is the difference between what consumers would be willing to
pay OMHL and actual payment of OAHL i.e. AMH.
(6) When nation A imposes an import tariff, the price of commodity X rises from
$10 to $15. The domestic consumption decreases from 150X to 120X.
Therefore, consumer surplus falls from AMH to BMG. In this situation
(consumer surplus is equal to BMG = ½ ($25 x 125X) = $1562.5. Thus,
consumer surplus reduced from $ 2250 to $1562.5 i.e. by $ 687.5. It is shown
by the shaded area ABGH in Figure-2.)

[D] Producer Surplus:

Producer surplus is the difference between the amount a producer of a good
receives and the minimum amount the producer is willing to accept for the good.
The difference is the benefit the producer receives for selling the good in the
market. This difference is known as producer surplus. Graphically, producer
surplus is measured by the area above the supply curve and below the market
price.
E.g. A producer is willing to sell 50 units at $5 each and consumers are willing to
purchase these for $8 each. If the producer sells all of the units to consumers
for $8, it receives $ 400. Producer surplus is the difference between the
amount the producer received by the minimal amount it was willing to accept,
in this case $ 250. Therefore, the producer surplus = $400 - $250 = $150.
The effect of producer surplus is shown in Figure-3:

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Figure-3: Effect of Tariff on Producer Surplus

We measure quantity of commodity X on X-axis and price of commodity X on Y-

axis.
(1) At free trade, price of X is $ 10. Domestic producers produce 30X and receive
OACR = $10 x 30X = $ 300.
(2) An imposition of tariff increases the domestic price of X from $ 10 to $ 15. This
will increase the domestic production from 30X to 45X. They receive OBDS =
$15 x 45X = $ 675. An increase of revenue by $ 375 is decomposed in two
parts: RCDS and ABDC. RCDS shows the increase in their production cost
whereas ABDC is producer surplus.

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Summary:
Tariff is an instrument to protect domestic industries from foreign industries. There
are mainly three types of tariffs. Import tariff is most common among nations. Tariff
affects the nation’s domestic consumption and production. An imposition of tariff by
a small nation reduces the domestic consumption of importable commodity and
increases the production of domestic production. An import tariff also reduces the
imports of the nation. An imposition of a tariff decreases the consumer surplus and
raises producer surplus.

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