UNI Economics questions

[lalala]

Hey, i have my economic uni exam coming up in about a week and I'm really struggling with a few concepts. Just wondering if anyone would be able to help me with these questions??

1) True or false? If a government wanted to assist an import-competing industry, in a small country, it would be better to provide a tariff than a production subsidy because the tariff would increase government revenue.

2) Explain why assistance in the form of a tariff is equivalent to assistance in the form of a production subsidy combined with a consumption tax when both are levied at the same rate as the tariff.

3) State whether each of the following is True or False and explain why.
    (a) Many small countries have no comparative advantage in anything.
    (b) Foreign competition hurts other countries when it is based on low wages.
    (c) Free trade benefits all.

Anyone's help would be greatly appreciated as i am really struggling.

[TrueTears]

1) False on the basis of efficiency, however both interventions has pros and cons. A tariff has the effect of a consumption tax and a production subsidy combined. A production subsidy does not affect the consumers, it only affects the producers, by subsidising the producers of a specific good, it raises the domestic price of the good (because producers now have more money to produce goods), this increases the domestic output and reduces imports. However a deadweight loss is incurred due to the overproduction - an efficiency loss. However for an import tariff, it combines the effects of a consumption tax too. For a consumption tax, there are no effects on producers however a tax is imposed on every unit of the good consumed. This raises the buyer price (because buyers have to pay more) and reduces the quantity demanded, thus there is another deadweight loss which is the lost due to underconsumption. So the 'cost of protection' by implementing a tariff would include both the DWL caused by the production subsidy and the consumption tax. However an import tariff does reduce the amount of imports more than a production subsidy does because it reduces imports both from the consumer side and the producer side. A tariff is less transparent than a production subsidy (ie, on the budget you will only see 'net revenue') thus politicians will receive less public backlash, although tariffs may increase employment in the tariff-protected areas, it will also decrease employment in the export sector, this is because some imports are intermediate inputs to the export industry, thus rising the prices of imports will decrease the supply of exports which will decrease the amount exported thus reducing employment due to the reduced output.

So, if the aim is to create more employment in the import-competing industry with the least costs, then a production subsidy is the way to go, by subsidising the producers, it will increase production however incurring a DWL which is smaller than that of a tariff.

However if one does not worry about the efficiency costs, then a tariff is the best choice since it reduces the imports the most and thus reduces competition.

Hope that helped. I will attempt the other questions too.

[Voltaire]

Depends on what assumptions are being made...but if it's a basic full information neoclassical equilibrium affair
then I think the answers are:

(1) ..the question is pretty bad because it doesn't tell us what government revenue is depending upon, is it taxing export-based companies as well? (a tariff could thus lead to retaliatory tariffs and decrease revenues).

(2) Does this question follow from question one? Clarify.

(3) (a) false
     (b) It can hurt certain industries (i.e local, high wage manufacturing), but overall it will lead to greater welfare (assuming full neoclassical equilibrium affair, etc)
      (c) Not everyone benefits (like in part b), but overall 'free' trade benefits all (again this is assuming we are in the land of first year micro, if we drop certain assumptions we can get different results)

[TrueTears]

2) I kinda explained in the above post, however I shall endeavour to do a more detailed explanation.

A consumption tax is on every unit consumed, this raises the buyer price because buyers has to pay more in order to compensate the tax and still pay the same amount to producers. This reduces the quantity demanded and this creates a deadweight loss due to underconsumption, it also decreases imports (because the quantity demanded of the good has decreased). A production subsidy is on every unit produced, this raises the seller price which increases the quantity supplied domestically. This creates a deadweight loss due to overproduction. It also decreases imports because suppliers are now producing more domestically rather than importing the good.

Now a tariff combines both of these effects because a tariff is a tax on every unit imported. Producers will now think "the marginal cost of importing is now greater than the marginal cost of producing the good domestically, so why not produce the good domestically (up to a certain point when the marginal cost of producing domestically is greater than the import price+tax) rather than importing it." Thus the quantity produced domestically will increase and the seller price will go up. Consumers on the other hand will think "now that the prices of the goods has gone up we will demand less of the good" thus the quantity demanded of the good will decrease.

Thus the DWL loss mirrors that of the production subsidy and consumption tax combined.

[TrueTears]

3. a) False, a comparative advantage means that one can produce a good or service at a lower opportunity cost compared to someone else. It is false to assume small countries has no comparative advantage in anything.

b) Basically what Voltaire said.

c) Free trade benefits all in an aggregate sense, however there are still losers and winners individually, ie, cheap imports will benefit the consumers more than producers.

[Voltaire]

^Incorrect on the production subsidy. It causes a rightward shift in the supply curve (assuming that its upward sloping), the seller price is decrease at every level of output, this causes the new equilibrium point to be at a higher qty and at a lower price.

[TrueTears]

Hm but in my lecture notes it says it increases the seller price :S

I am confuse now

[Voltaire]

No, why would a subsidy increase the seller price..? if they where willing to supply 100 units at 1$ per unit, they are now going to be willing to supply 100 units at say 0.5$, because the goverment is paying them 50 cents or whatever for each unit they produce, so that would mean a rightward shift in the supply curve.

[Voltaire]

lalala can you expand on question 2? are we talking about the same import-competing industry?

[TrueTears]

no that is the price sellers receive from buyers, u didnt take into consideration the subsidy they are paid. the net effect is a increase in the seller price when compared to the original equilibrium.

[TrueTears]

Here's the lecture notes on it. It says seller price increase =S must be wrong then according to you D:

[IMG]http://img198.imageshack.us/img198/3261/productionsubsidy.jpg[/img]

[Voltaire]

^wait..? you realise that the suppliers are not buying things from importers, they are competing with importers..?

[TrueTears]

yes...

[Voltaire]

^^^ what is P0 and P1? Is there an accompanying diagram?

[Voltaire]

ALso what on earth is 'buyer price' and 'seller price'? Are you talking about a fixed international price scenario or something?