Friday, December 21, 2012

Tariffs on Sugar-based Ethanol expire and the amount imported increases dramatically. This calls for some graphing and welfare analysis. Who is with me?!?!

There has been a dramatic increase in the importation of Sugar-based ethanol from Brazil since a long-standing tariff on this type of ethanol expired in January 2012.
Imports from Brazil, which distills most of its ethanol from sugar cane, have risen nearly nine fold this year through October, compared with the same period in 2011, according to the U.S. Department of Agriculture. U.S. demand for foreign-made ethanol jumped after an import tariff that had been on the books for three decades expired in January. U.S. ethanol imports are expected to surge again next year, with the vast majority coming from Brazil. ---WSJ
The graphic below shows the percentage increase in the quantity of sugar-based ethanol imported in 2012 from Brazil relative to how much imported in 2011---a 750% increase!
Source: Wall Street Journal
In AP Microeconomics, analyzing the effects of tariffs on social welfare is an important concept.  Let's use this real life example and see what happened in the Market for Sugar Based Ethanol (SBE).

The first graph shows the Domestic Market Price and Quantity in equilibrium BEFORE trade.  We are assuming this economy is a "closed economy" and does not trade (a state of "Autarky").
This second graph shows the World Price of SBE and how it would effect the Domestic market IF it were to open up, or come out of the state of Autarky.  For this lesson, we are assuming the World Price is BELOW the domestic, closed market price but it COULD BE higher. We will save that for another day.
Because "P world" is lower than "P domestic" the quantity supplied by domestic producers decreases to "Qs domestic" (Point "B") BUT at the lower "P world" price the quantity demanded by domestic consumers increases to "Qd domestic" (Point "C").  This is an excellent example illustrating the respective Laws of Demand and Supply--When the price of the good changes (inc or dec) the quantity demanded and/or supplied increases and/or decreases. There is movement ALONG the demand and/or supply curves NOT a shift in either curve! We moved from "A" to "C" along the demand curve and from "A" to "B" on the supply curve.

As it stands right now, Quantity Demanded domestically ("Qd domestic") exceeds Quantity Supplied domestically ("Qs domestic").  If we were to open up to trade, the difference would be made up with imports as shown in this next graph.
Domestic producers would supply a quantity from "0 to Qs domestic" and imports would Qd domestic minus Qs domestic.

Happy people are consumers who get to enjoy more of this good at a lower price--Consumer welfare has increased.  Unhappy people are producers who produce LESS of the good at a lower price-- Producer welfare has decreased. 

Producers will not be pleased about this foreign competition. Producers have A LOT to lose! They will possibly/likely lobby for "something to be done" and that something will probably be the levying of a Tariff on this good through the political process.

As shown in the next graph, assume the amount of the tariff increases the price from "P world" to "P world + tariff" BUT not quite enough to go back to the original equilibrium point "A".
Now, at "P world + tariff"quantity supplied domestically is "Qs 1" and quantity demanded domestically is "Qd 2". 

Domestic producers increase their quantity supplied in response to the higher price (Law of Supply) and Domestic consumers decrease their quantity demanded in response to the higer price (Law of Demand).  Imports are now less than what they were before---Qd 2 minus Qs 1.

Who was helped in this scenario and who was hurt?

First to gain was the Federal treasury in terms of tariff revenue.  To calculate the tariff revenue you would multiply whatever the dollar amount of the tariff is times the quantity of imports--"Qd 2 minus Qs 1".  The RED box shows the area of tariff revenue.

A net loser #1 is the consumer.  They get to enjoy LESS of the good at a HIGHER price than they did before--as the price increases from "C" to "E" the quantity demanded decreased from Qd domestic to Qd 2. The graph below shows consumer welfare loss (Dead Weight Loss) equal to the area of the BLUE triangle.

Net loser #2 is Society as a whole. The "Dead Weight Loss to Society" is represented by GOLD box below.
 Why is this area considered DWL to society and not a gain for producer welfare?

It is because, as a result of the tariff, domestic societal resources are now employed to produce more of this good than otherwise would have been produced absent the tariff.  This is the opportunity cost of the tariff.  Resources are use to make a good that is already available to purchase, albeit produced by a "foreigner".  Economists ask: Could those resources have been used in a more efficient way?

Reason number 10,999 why people hate economists.

This story ends better.  The original focus of was the expiration of the tariff. The result?  Everything snaps back to the graph that shows the domestic economy coming out of Autarky.  Consumer welfare restored, tax revenue to the government gone and reduced producer welfare. 

 Hope this helps understanding the effects of a tariff---when assessed and when rescinded.
View My Stats