"The higher the tariff, the more domestic production is increased. Thus, a prohibitive tariff is socially optimal." Explain whether or not this statement is valid.
What will be an ideal response?
POSSIBLE RESPONSE: The statement is based on the premise that more domestic production is better than less. The statement fails to account for the well-being of other groups in the economy who are not producers of the product. With a prohibitive tariff, consumers are worse off because the domestic price of the good is high, and the government collects no tariff revenue if imports fall to zero.
The economic inefficiencies of a prohibitive tariff show that the prohibitive tariff is not optimal. It's true that the higher the tariff the higher will be the quantity supplied by domestic producers. However, for the society as a whole this extra domestic production is too costly. It involves valuable resources that can be better used in other industries. The deadweight loss associated with such cost-inefficient production is the production effect.
A prohibitive tariff hurts domestic consumers because the higher domestic price leads consumers to buy less. The deadweight loss associated with the reduced consumption is the consumption effect.
Overall, a prohibitive tariff means that the country is giving up all the gains from trade in this product.
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