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Sample free response question (FRQ) on tariffs and trade

In this video, walk through the solution to a question on the effect of tariffs from the 2012 AP(R) Microeconomics exam.

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Video transcript

- [Instructor] We're told sugar is freely traded in the world market. Assume that a country, Loriland, is a price taker in the world market for sugar. Some of the sugar consumed in Loriland is produced domestically while the rest is imported. The world price of sugar is $2 per pound. The graph below shows Loriland's sugar market, and P sub W represents the world price. So we see our domestic demand, we see our domestic supply, and then we see the world price. All right, now let's try to answer the questions that they have given us. At the world price of $2 per pound, how much sugar is Loriland importing? So pause this video, and see if you can figure that out on your own. All right, now let's do it together. So at first, you look at your domestic demand and see, well, what would the domestic demand be at the world price? So that would be where these two lines intersect. So the domestic demand at the world price would be 14 million pounds. You might be tempted to put 14 million pounds here, but that would be the total domestic demand at that world price. But some of that is domestically produced, and some of it is imported. How much is domestically produced? Well, at a price of $2, the domestic producers are up for producing two million of those 14 million pounds. So this is domestic production. And so between these two points, that length, that represents how much is actually imported. So to go from two million pounds to 14 million pounds, 14 minus two is 12 million pounds. That is imported, 12 million pounds. Part b, suppose that Loriland imposes a per-unit tariff on sugar imports, and the new domestic price including the tariff is $4. Identify the new level of domestic production. So once again, pause the video, and try to figure that out. All right, so they say the new domestic price including the tariff is $4. So we are now in this situation. This is the new price. Now, they say what is the new level of domestic production? So the domestic supply, at that price, the domestic suppliers look like they are willing to supply six million pounds. So that is our new level of domestic production, six million pounds. All right, part ii, calculate the domestic consumer surplus for Loriland. You must show your work. Pause the video, and see if you can figure that out. Well, the domestic consumer surplus for Loriland in this scenario, where this is the price, well, then we are going to, let me scroll down a little bit so we can see the entire consumer surplus. That is going to be the area above this horizontal line at the price and below our domestic demand curve. So this right over here is the consumer surplus in that scenario. And so that is going to be this width, which is the quantity demanded, which is 10 million pounds, times the height, which is, you're going from four to $9, so it has a height of $5, and then times 1/2. If I just multiplied the quantity times the height, I'd be figuring out the area of this entire rectangle, so it's a little bit of a geometry review. To get half of that, we would multiply it by half. So this is going to be, it's going to be 10 million pounds. I'll do it right over here, so I have some space. 10 million pounds times, we have a difference of $5 per pound, $5 per pound. And then, of course, we want to multiply it times 1/2, so this one right over here. So let's see, the pounds cancel out. And so, if you multiply it out, this is going to be $50 million times 1/2. So it's going to be $25 million. All right, part iii, scroll down a little bit. Calculate the total tariff revenue collected by the government. This also says you must show your work. Once again, pause the video, and see if you can work through that. So the tariff revenue collected by the government, well, we went from a world price of $2 per pound to a domestic price of $4 per pound, so it was a $2 per pound tariff. And the government is collecting that $2 per pound on the imports. So in this situation, this is the domestic supply. We've already talked about that. And so this amount right over here, are the imports. So if you multiply this amount, which went from six million pounds to 10 million pounds, so this is going to be four million pounds, times the tariff, which is $2 per pound, per pound, you're going to get this area, which would be the government revenue. So this is going to be four million pounds times $2 per pound, times $2 per pound. Pound cancels out, and this is an area of a rectangle here. And so this is going to be equal to eight million, $8 million. All right, now let's do part c. Given the world price of $2, what per-unit tariff maximizes the sum of Loriland's domestic consumer surplus and producer surplus? Pause the video once more, and see if you can figure this out. All right, so you might be tempted to try out a bunch of tariffs and figure out if you can get a higher total surplus, but the important thing to realize is any tariff is going to reduce your total economic surplus. So you can immediately go and say that, hey, the ideal per-unit tariff is going to be $0 per unit. And if you want to see visually why that is, we talk about it in other videos. Remember, in the first situation, where we're just at the world price without any tariffs, the total economic surplus, this is the domestic producer surplus, which isn't that much, but you have a huge consumer surplus. You have all of this area as well. So those two triangles make the total economic surplus. Now, a tariff is going to raise this level. And as you raise this level, as you saw in the case of part b, well, you're going to shrink this upper triangle. You will grow this bottom triangle, but you're still going to be smaller than your two triangles that you had before. Because look at that second scenario, the scenario in part b. Your consumer surplus has now shrunk to this right over here. Your producer surplus has grown to that over there. But you haven't grown the total surplus. In fact, now for the consumers and the producers, you've lost this entire triangle. Some of it is captured by government revenue, but you also have deadweight loss. You also just have this section and this section as just deadweight loss. And so any tariff is going to reduce the, is going to reduce your possible economic surplus. So a $0 tariff, theoretically, would maximize your total economic surplus.