When a small country imposes a tariff, the domestic price of the good increases. This causes a production effect and a consumption effect. Explain carefully these two effects, and discuss whether they increase or decrease the country's well-being.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: Small countries cannot influence the international prices of goods when they impose tariffs or other trade barriers. If a small country imposes a tariff, the domestic price of the product increases by the size of the tariff. This will have an effect on the decisions of domestic producers and consumers. 

Producers will start to produce more because they can now sell the product domestically at a higher price. From the viewpoint of the society as a whole, this increase of production is actually a loss. The increased production costs more resources to make at home than to import from abroad. This loss is called the "production effect." 

Consumers will start to consume less of the product due to its higher domestic price although they value the product more than its international price (without the tariff). This is the source of the "consumption effect," which again is a loss for the country.