Tariffs in a Large Open Economy
Caledonia is a large open economy that imports widgets.
1. Show, in a proper diagram, Consumer Surplus, Producer Surplus and Total Surplus for Caledonia in free trade. Denote the world price of widgets by PW.
Suppose now that the Caledonia government imposes a tariff on imported widgets. Because Caledonia will buy fewer widgets and it is a large country, this tariff will cause the world price to drop to P’W (with P’W + t > PW, where t is the tariff rate). Note that you are not asked to calculate the optimal tariff or the new world price, so you can choose any P’W and t consistent with P’W + t > PW .
2. Show, in the same diagram you used to answer question 1, Consumer Surplus, Producer Surplus, tariff revenue and Total Surplus for Caledonia after the tariff is introduced.
3. Is it possible for total surplus to increase as a result of the tariff?
